Negative covenants of the borrower: Overview, definition, and example
What is negative covenants of the borrower?
Negative covenants of the borrower are contract terms that restrict the borrower from taking certain actions without the lender’s prior consent. These covenants are commonly found in loan agreements and are designed to protect the lender’s interests by limiting the borrower’s ability to engage in activities that could increase risk, reduce creditworthiness, or affect repayment.
Why is negative covenants of the borrower important?
Negative covenants are important because they give lenders a level of control over how the borrower operates during the life of the loan. By limiting high-risk activities—such as taking on additional debt, selling key assets, or paying large dividends—the lender can better safeguard its chances of being repaid. These covenants also create clear boundaries that, if crossed, may trigger defaults or renegotiation.
Understanding negative covenants of the borrower through an example
A borrower agrees to a $5 million loan and, as part of the loan agreement, agrees not to incur any additional debt over $250,000 without lender approval. If the borrower later enters into a new $1 million loan without notifying the original lender, it may be in breach of the negative covenant, giving the lender the right to accelerate repayment or declare a default.
Example of how a negative covenants of the borrower clause may appear in a contract
Here’s how a negative covenants of the borrower clause may appear in a loan agreement:
"The Borrower shall not, without the prior written consent of the Lender: (a) incur additional indebtedness exceeding $250,000; (b) create or permit any lien on its assets; (c) make any distribution or dividend; or (d) sell, lease, or otherwise dispose of any material assets."
Conclusion
Negative covenants of the borrower are key protective terms in loan agreements that limit risk to the lender by restricting the borrower’s actions. They ensure financial discipline and provide early warning signals if the borrower's behavior could endanger the loan. Borrowers should understand these restrictions clearly, as violating them can lead to serious consequences, including default.
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.