Restricted payments: Overview, definition and example
What are restricted payments?
Restricted payments refer to specific payments or financial actions that are limited or prohibited by the terms of a contract, often within the context of financing or corporate governance. These payments are typically restricted to ensure that the company or entity does not overextend itself financially, thereby protecting creditors or investors. Restricted payments may include dividends, distributions, loans, or other financial transfers to shareholders, affiliates, or related parties that could impact the financial stability of the business.
For example, a company may be prohibited from making certain types of payments to its shareholders if it does not meet specific financial thresholds or if it is in breach of its financial covenants.
Why are restricted payments important?
Restricted payments are important because they help ensure that a company maintains its financial health, meets its obligations to creditors, and does not divert resources in ways that could jeopardize its ability to continue operations or repay debts. By placing restrictions on certain payments, businesses are incentivized to prioritize their financial stability and avoid actions that could harm creditors or other stakeholders.
In contracts, particularly in loan agreements, bond indentures, or other financing agreements, restricted payment clauses are used to protect lenders and investors by limiting the company's ability to make financial transfers that could reduce available cash or assets for repayment.
Understanding restricted payments through an example
A company enters into a loan agreement that includes a restricted payments clause. The clause states that the company can only pay dividends to shareholders if its net income exceeds a certain amount or if its debt-to-equity ratio remains below a specified threshold. This ensures that the company maintains adequate financial resources to meet its obligations before making payments to shareholders.
An example of a restricted payments clause
Here’s how a restricted payments clause might appear in a contract:
“The Borrower shall not make any restricted payments, including, but not limited to, dividends, stock repurchases, or payments to affiliates, unless: (1) the Borrower’s Net Income for the preceding fiscal quarter exceeds $1,000,000; (2) the Borrower maintains a debt-to-equity ratio of no more than 2:1; and (3) all required debt service payments have been made. Any violation of this provision shall constitute a default under this Agreement.”
Conclusion
Restricted payments clauses are essential tools in corporate governance and financing agreements to ensure that a company does not deplete its financial resources in ways that could jeopardize its ability to meet obligations to creditors or investors. By limiting or prohibiting certain financial transfers, businesses are encouraged to maintain adequate liquidity and solvency. A well-drafted restricted payments clause provides clarity on the circumstances under which such payments can be made and protects stakeholders from potential financial risks.
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.