Breach of Covenant

What is a Breach of Covenant?

A breach of a covenant occurs when one or more parties do not carry out their obligations under the present agreement. The person who has violated the covenant and is in default may be held accountable for the resulting damages.

A written pledge that cannot be broken is what is meant by a covenant. Many financial contracts have covenants.

Types of Breach of Covenant

There are two types of breach of the covenant: 

1. Breach of Affirmative covenant

It is also called the positive covenant. In this, the agreement holds several conditions and terms to which the borrower must adhere to. When the borrower violates these terms and conditions or fails to perform as per the obligations, it is considered a breach of the positive covenant. 

2. Breach of Restrictive covenant

It is also called a breach of a negative covenant. Under the restrictive covenant, the agreement states some restrictions to the party involved. The breach of such a covenant occurs when the party involved takes actions they are restricted to performing as per the covenant. Also, this may attract huge penalties. 

Covenants are intended to protect creditors against management activities that can harm their situation and the company's creditworthiness, increasing the uncertainty around the timely and complete payment of interest and principal.

Bank Covenants

In many cases, bank covenants—as outlined in bank loan agreements—may be even more restrictive than bond covenants. 

Often, a bank may demand that a debtor keep leverage ratios like debt/equity, debt/EBITDA, or debt/EBIT below a specific limit. Maintenance covenants are the name given to this category of covenants.

Examples of positive and negative covenants that seek to shield a creditor's position from company acts that can deteriorate it include the following:

1. Limitations on payments
2. Restrictions on the growth of debt
3. Modifications of the control put
4. Obligation to timely file annual reports and other pertinent paperwork

Breach of covenants Importance

The covenants have great importance in the corporate world. The significance of these covenants can be explained in the following points: 

1. Preserve the confidentiality of the harmed party's private information
2. It guarantees defense against harm done to the wronged person
3. It guarantees timely compensation if the injured party is harmed
4. The court also upholds and secures the contract's legal fulfillment
5. The positive and negative covenants of a loan attempt to assure the borrower's financial stability and prompt payment to the creditor

A covenant violation may result in a technical default. The precise repercussions of a covenant violation should be examined case-by-case and will depend on whether the creditor chooses to waive the breaches.

Consequences of Breach of Covenant

A covenant breach typically has the following consequences:

1. A fine or fee imposed by the creditor on the debtor
2. An increase in the bond or loan's interest rate
3. An increase in the security
4. The debt agreement's termination
5. A waiver of the offense without significant repercussions

Waiver of a Breach of Covenant

The resolution to whether defaulters have any recourse for breach of covenant is a waiver.

Though breaches can range in severity and call for different kinds of responses, not all are handled identically. A waiver will typically be granted following negotiations between the debtor and the creditor for less severe breaches.

It's crucial to realize that unconditional waivers differ significantly from conditional waivers in several ways. First, in conditional waivers, the party being wronged consents to forego the right to court in exchange for the defaulter fulfilling specific requirements.

An unconditional waiver may be agreed upon by both the debtor and the creditor. For example, it might occur because the violation is especially slight or because it might result from circumstances beyond the debtor's control.

A waiver with additional restrictions, such as other maintenance covenants or different ratios applied to existing covenants, may be agreed upon by the debtor and the creditor. 

The requirements could stipulate that the penalty be paid or the contract's collateral be compensated.

A debtor's liquidity and solvency may be affected by a covenant breach. This is because the debt involved becomes a current liability for the debtor and may impact their financial situation if the covenant permits the lender to demand immediate repayment of the loan.

Example of Breach of Covenant

Some examples of negative covenants are indebtedness limitations, investment limitations, sale of asset limitations, equity payment limitations, and material agreement change limitations. 

Examples of positive covenants involve those which require money for expenses, maintenance works, construction of structures or boundary walls, and payment of additional funds contingent upon receiving a planning permit. 

It is crucial to understand that this provision saves the day when someone violates the conditions of a contract. Therefore, it is always included in an agreement to safeguard the rights and interests of both parties against any severe harm caused by a breach.

For example, company XYZ Ltd. has a covenant or an agreement with its supplier, ABD Ltd, which states that by industry norms and practices, the supplier must deliver the services promptly, diligently, and professionally.

If  ABC Ltd. violated this clause in the covenant, it is said to be a breach of the covenant. This may lead to several penalties and immediate action against the supplier. Hence, this is considered one of the positive covenants. 

When you violate a restrictive covenant, the opposing party may take legal action against you if they decide. And this same goes on with the example mentioned about ABC Ltd. 

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Billing Cycle
• Business Plan
• NINJA Loan
• Sales Risk
• Signature Loan