Law Dictionary

restrictive covenant

Updated on: 26 Jul 2017

Legal Definition of restrictive covenant

  1. 1 :  a covenant acknowledged in a deed or lease that restricts the free use or occupancy of property (as by forbidding commercial use or types of structures) one who purchases for value and without notice takes the land free from the restrictive covenantAmerican Jurisprudence 2d Editor's note: For a restrictive covenant to run with the land it must be intended to do so by the original parties to it, it must directly concern the land itself and be enforceable, and there must be privity between the original parties and between the original and subsequent grantee.

  2. 2 :  covenant not to compete restrictive covenants unenforceable upon physicians — Annotated Laws of Massachusetts

Additional Notes on restrictive covenant

A restrictive covenant in a work contract must be reasonable to be enforceable, which means that it must be reasonably necessary to protect the legitimate interests of the employer or partnership, must not impose undue hardship on the individual concerned, and must not harm the public interest (as by causing undue restraint of trade).

Financial Definition of RESTRICTIVE COVENANT

restrictive covenant

What It Is

A restrictive covenant is a promise a company makes to not exceed certain financial ratios or not conduct certain activities, usually in return for a loan or bond issue.

How It Works

Let’s assume Company XYZ wants to borrow $10 million from Bank ABC. The loan agreement contains restrictive covenants that limit Company XYZ to $0.10 per share in dividends per year and prevent it from issuing additional debt without Bank ABC’s consent.

Restrictive covenants can exist in employment agreements and even merger or acquisition agreements, but they are most common in lending agreements and bond indentures. Covenants, in general, can be financial or operational in nature.

The lending agreement or indenture in which the covenant appears will also provide detailed formulas to be used to calculate the ratios and limits on restrictive covenants. It is important to note that in many cases these formulas do not conform to generally accepted accounting principals (GAAP). For example, the restrictive covenant may include leases in a debt-limit calculation, or it may consider capital leases as an expense. As a result, it is very important that borrowers scrutinize covenants before borrowing.

Why It Matters

Lenders attach restrictive covenants to bond issues and loans as a way to force the borrower to operate in a financially prudent manner that most ensures it will repay the debt. Issuers, on the other hand, usually negotiate the most flexible covenants they can so they have the freedom to make decisions and take risks that might ultimately benefit the lenders and the shareholders. Thus, the more restrictive covenants a bond issue has, the lower the interest rate on those bonds tends to be.

Violating a restrictive covenant can trigger a technical default. This means that although the issuer is making interest and principal payments on time, it is not operating within the agreed-upon guidelines and is thus increasing the risk of nonpayment in the eyes of the lender or bondholders. Often borrowers have a certain amount of time to remedy (or "cure") the technical default (for example, the borrower must lower its debt-to-equity ratio within 30 days), but technical defaults often lower the borrower’s credit rating and stock price.

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