Limitation on restricted payments: Overview, definition, and example
What is limitation on restricted payments?
Limitation on restricted payments refers to a provision in financial or loan agreements that restricts a borrower from making specific types of payments, such as dividends, distributions, stock repurchases, or certain investments, without prior approval from the lender. This clause ensures that the borrower prioritizes their financial obligations under the agreement, such as repaying the loan, before making payments that could weaken their financial position.
Why is limitation on restricted payments important?
This clause is important because it protects lenders by ensuring that borrowers maintain sufficient financial resources to meet their debt obligations. It prevents borrowers from engaging in activities that might deplete their cash reserves or compromise their ability to repay loans.
For businesses, understanding and complying with this provision is crucial to maintaining good relationships with lenders and avoiding penalties or default under the loan agreement.
Understanding limitation on restricted payments through an example
Imagine a company borrows $10 million from a bank to finance its expansion. The loan agreement includes a limitation on restricted payments clause, prohibiting the company from paying dividends to shareholders until certain financial ratios, like a minimum debt-to-equity ratio, are met. This ensures that the company uses its cash flow to repay the loan and sustain operations before distributing profits.
In another example, a startup raises funds through a convertible debt agreement. The agreement restricts the company from repurchasing its shares or making significant investments in unrelated projects until the loan is fully repaid or converted into equity. This protects the lender’s interests by preventing the startup from diverting funds away from repayment.
An example of a limitation on restricted payments clause
Here’s how a limitation on restricted payments clause might appear in a loan agreement:
“The Borrower shall not, directly or indirectly, declare or make any Restricted Payments, including but not limited to dividends, stock repurchases, or distributions to equity holders, unless the Borrower maintains compliance with the financial covenants outlined in this Agreement and receives prior written consent from the Lender.”
Conclusion
Limitation on restricted payments clauses safeguard lenders by ensuring that borrowers prioritize debt repayment and maintain financial stability. For borrowers, understanding and adhering to these restrictions is essential to avoid default and preserve access to future financing. Including clear terms for restricted payments in financial agreements promotes transparency and aligns the interests of both parties, protecting the overall financial health of the borrower.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.