Negotiating Loan Documents for Borrowers – Part V

Access to capital is critical to every business. Entering into loan arrangements with a lender is a complex process, the results of which can be vital to the success or failure of a company. This is the fifth in a series of articles intended to explain various aspects of the loan process. In our prior articles, we discussed the importance of the term sheet stage of a loan transaction, factors for the prospective borrower to consider in choosing a loan and the types of loans that are available, steps the borrower can take to help expedite the loan process to reduce transaction expenses and the representations and warranties section of a loan agreement. In this article, we continue looking at the loan agreement itself by reviewing the affirmative, negative and financial covenants sections of the document.

What are Covenants?

A covenant is a promise or agreement to do or not do a particular thing. In the context of a loan agreement, the covenants are basically the things the borrower is either required to do or restricted from doing during the term of the loan.

Covenants are often only loosely referenced in a term sheet, resulting in the covenant section and related definitions being among the most heavily negotiated portion of the loan agreement. Lenders typically want covenants to be as restrictive as possible whereas borrowers will seek flexibility in order to operate its business without undue interference. The ability of the borrower to negotiate less stringent covenants will depend on many factors, including the business purpose of the request, the creditworthiness of the borrower and general market conditions.

Affirmative, negative and financial covenants are each typically found in their own section of a loan agreement, although some loan agreement will combine all covenants into one section. Borrowers are also cautioned to review ancillary documents carefully as covenants may also be found in other agreements such as security agreements and pledge agreements.

Impact of Covenants on the Borrower

In a loan agreement, a borrower’s breach of a covenant will generally constitute an event of default, the consequences of which include that the lender can declare the loan immediately due and payable and enforce any security interests.

Covenants that restrict the ability of the borrower from engaging in its desired business operations will either result in a default under the loan agreement or require the borrower to seek an amendment or waiver from the lender. Even if the lender is willing to grant such an amendment or a waiver, it typically comes at a financial cost to the borrower or requires some concessions from the borrower.

As the consequences of a breach of a covenant are severe, the borrower should read each covenant carefully and ensure that it will be able to comply with such terms, particularly as it relates to the borrower’s plans for its business during the term of the loan.

Affirmative Covenants

Affirmative covenants in a loan agreement are things the borrower promises to do during the term of the loan. These remain obligations until the loan is repaid. From the borrower’s perspective, the affirmative covenants should not require the borrower to do anything that it is not already doing. From the lender’s perspective, affirmative covenants are designed to (i) ensure the lender receives sufficient information to monitor the borrower’s continuing compliance with all of its obligations under the loan agreement, (ii) confirm that the borrower continues to operate its business consistent with industry standards and its own past practices, and (iii) make certain that the borrower is able to repay the loan. Examples of affirmative covenants include promises to deliver financial statements to the lender, pay taxes, maintain insurance and take the necessary steps to preserve the borrower’s legal existence.

Negative Covenants

Negative covenants in a loan agreement are things the borrower promises to refrain from doing during the term of the loan. These remain obligations until the loan is repaid. From the borrower’s perspective, the negative covenants should not prohibit the borrower from doing the things that it currently does and what it wants to do in the future. From the lender’s perspective, negative covenants are designed to (i) establish guidelines for the borrower in operating its business, (ii) ensure the borrower’s ability to repay its loans, and (iii) protect the lender’s priority with respect to its security interest in its collateral and that the borrower does not take any actions that may impair the lender’s security interest in any collateral. When reviewing negative covenants, special attention should be given to the interplay between different negative covenants as an action that is permitted by one covenant may be prohibited by another covenant. Examples of negative covenants include restrictions on the incurrence of additional indebtedness or liens, prohibitions on pledging the borrower’s assets, limitations on the borrower’s ability to sell assets or make acquisitions and constraints on the borrower’s ability to declare dividends or make distributions to its equity holders.

Financial Covenants

Financial covenants measure the financial health of a borrower by reference to a range of metrics. The most common financial covenants are designed to measure a borrower’s cash flow, leverage, liquidity and net worth. There are two types of financial covenants: incurrence covenants and maintenance covenants. Incurrence covenants prohibit a borrower from taking certain actions, such as making acquisitions or paying dividends, unless the financial covenant is satisfied. These covenants are measured at the time of the desired action. Incurrence covenants are usually measured on a pro forma basis taking into account the effect of the proposed action. Failure to satisfy an incurrence covenant will preclude the borrower from taking the desired action, but will not, by itself, result in a default. Maintenance covenants are tested periodically, usually on a quarterly or annual basis. Maintenance covenants serve as an early warning sign for the lender about impending trouble with the borrower’s financial health and provide the lender with an opportunity to potentially restructure the loan before the borrower finds itself in a bankruptcy situation. A breach of a maintenance covenant on the date it is tested will result in an event of default, unless it is able to be cured. To protect the borrower against cyclical changes, maintenance covenants are typically measured on a trailing twelve month or trailing four quarter basis. In circumstances where the borrower’s projections include reducing its leverage ratio over the term of the loan, either through amortization or excess cash flow sweeps, the borrower may be able to negotiate appropriate periodic step ups or step downs in the financial covenants.

Drafting Suggestions

Covenants are frequently drafted by lender’s counsel as unqualified statements. One way to limit the scope of a covenant is to request a materiality qualifier to protect the borrower from an immaterial breach.

Careful attention should be paid to the definitions section of the loan agreement and the impact that such definitions have on the covenants section. The borrower may seek to modify certain definitions in order to provide more flexibility with respect to its compliance with the applicable covenants.

It is critical for the borrower to understand who will be subject to the covenants. Often, the covenants will apply not just to the borrower, but also to its direct and indirect subsidiaries. While this is intended to protect the lender’s ability to be repaid, the borrower should ensure that transactions between it and its subsidiaries are not unduly restricted, particularly where such transactions do not impact upon the lender’s security interest in the collateral. Lenders will sometimes permit certain subsidiaries to be deemed unrestricted subsidiaries. Such subsidiaries will be exempt from complying with the covenants in the loan agreement. However, such unrestricted subsidiaries will also usually be precluded from receiving any of the loan proceeds and their financial performance will be excluded from the calculation of the financial covenants.

For negative covenants, it is common to build in exceptions to the general restrictions such as certain permitted liens or certain permitted debt that are incurred in the ordinary course of business. When reviewing the covenants section, the borrower needs to consider its current as well as projected operations and build in the necessary exceptions to the covenants that will allow it to operate its business without running afoul of the covenants.

Finally, borrowers should seek to include cure periods in the event of a breach of a covenant so that it has an opportunity to cure its breach before it triggers an event of default. Depending on the covenant, cure periods of 10 to 30 days are customary, other than for payment defaults for which up to 5 days is customary. For financial covenants, the borrower may wish to seek a right to cure breaches of such covenants by the injection of equity. The lender may be amenable to permitting this equity cure but will typically want to control the amount and frequency of any such cash injections.


Debt financing can be vital to the ongoing operations of a business and a powerful expansion tool, but a borrower must remain wary of pitfalls within the loan documents that can interfere with its business. Careful attention during the drafting stage of the loan agreement can prevent unexpected consequences in the future. Borrowers and prospective borrowers are encouraged to work with their legal and financial advisors throughout the negotiation and drafting stages of the loan process as their involvement can help to ensure smooth and efficient operations of the borrower’s business during the term of the loan.

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