The world has long been practicing a credit system, which is constantly being improved. According to statistics, a huge number of people and various organizations use loans quite successfully, since it is convenient and promising. However, in order to provide certain guarantees, covenants have recently been used in drawing up loan agreements. This means that the borrower agrees to fulfill certain conditions during the repayment of the loan. Let us consider in more detail what covenants are, what are their types and what are they used for.
What are covenants?
From a legal point of view, covenants are an obligation to perform a specific action or to refuse to perform an action that is of significance and legal force for a committed party. Covenants are used in a variety of areas, including the conclusion of transactions, fixing the cost of sales, etc.
Covenants relate to that part of financial agreements or transactions that are binding. If there are no covenants, then in this case the banks either institutional investors may not give a loan. Sometimes, in the process of organizing enterprises or their mergers, a contract is also concluded, a covenant in which implies a taboo on conducting some kind of activity.
Types of Covenants
Financial experts identify several types of covenants:
- Active - this is an obligation to commit an action. An example is the provision of important information, notification of events, etc.
- Passive. Here we are talking about the need not to commit the agreed actions.
- Financial covenants are obligations to maintain a certain level of economic performance indicators. So, they establish the specific value of the coefficient of sufficiency of equity capital, the size of receivables, the share of assets that are in the hands of a third party, etc.
- Non-financial covenants.
- Restrictive. They are used when mergers acquisitions, the creation of joint ventures, as well as the sale of firms. In particular, they can put a ban on luring good employees, regular customers, and potential customers.
- The right of veto, which allows you not to give your consent to the commission of any action.
Definition and purpose of financial covenants
Nowadays, banking institutions are doing their best to protect themselves from various kinds of troubles, defaults, force majeure, in order to avoid collapse and ultimately ruin. Financial ones help them, or they are also called bank covenants.
This concept came to us from English jurisprudence and perfectly stuck in modern banking system. This term means an obligation that the borrower takes "on his own shoulders" if he wants to get a loan in his name. From the point of view of protecting the interests of the structure that gives credit, covenants act as a kind of safety cushion, with which you can avoid financial problems.
Covenants are prescribed in writing. If the applicant does not follow the rules prescribed in them, the financial structure is allowed to demand the return of all funds given in debt, taking into account interest.
Covenant Game Rules
When drawing up financial covenants, various possibilities of the borrower are prescribed. So, asset values, debt level, equity, customer solvency, etc. can be clearly defined.
It is believed that obligations are “awarded” in the preparation of agreements for the most part by legal entities. However, individuals are also involved in the execution of covenants. The only difference is that the conditions for fulfilling the contract are specified in one document, which shows the details of repayment for a loan or a loan, that is, payment of debt. In this case, debt covenants are meant.
What is their task? First of all, using covenants, you can reduce the total amount of borrowed funds. This is easy to do if you provide employees of a financial institution with certain guarantees. The point is that the repayment of the debt will not stop, even if the solvency of the client decreases. As practice shows, sometimes loans are given to organizations where financial confusion takes place. It all depends on the specific numbers and arrangement.
The consequences of violation of covenants
If for banks and other financial organizations covenants are guarantees of repayment of funds, then for the borrower they are an assistant in obtaining the necessary loan. However, violation of covenants may lead to an early termination of the agreement and large losses for the same borrower.
Often, the banks of a particular country themselves can be borrowers and fulfill certain obligations to other more stable lenders. In this case, the solvency of large financial institutions is affected not only by internal processes, but also by external macroeconomic events, world crisis in the economy, etc. Violation of debt covenants by banks leads to loss of credibility, weakening liquidity, in the worst case, the whole thing can end in complete fiasco.
Important Debt Covenants
According to financiers, twenty percent of market funding agreements indicate a credit covenant that relates to capital adequacy and compliance with a certain level.
On the one hand, violation of this particular obligation negatively affects the liquidity of the bank, and on the other hand, it provides sufficient room for maneuvers. If at least sometimes there are capital injections, then it is possible to maintain the desired level of capital, despite the losses. In addition, covenants of this type are often set at the same level as the requirements of regulatory and supervisory authorities. Therefore, it is also worth observing them for this reason.
Covenant Selection
Currently, most financial institutions establish certain covenants when concluding loan agreements. Which covenants are chosen depends on the type of activity of the borrower and its financial capabilities. In other words, this aspect is always individual for each individual organization. It should be borne in mind that the conditions of covenants should not in any way affect the production turnover of the company. The composition of obligations depends on the characteristics of business processes.
According to experts, this mechanism does not always provide a full guarantee, because in case of violations the risks only increase. If we analyze the judicial practice, then most often the borrower is justified if it bears all responsibility for paying the debt. Therefore, financial covenants do not always reduce risks, and this should be taken into account when concluding various transactions and consider other guarantee methods.
Differences of Covenants from Warranties and Representations
In jurisprudence, covenants are not simple guarantees and assurances; there is a significant difference between them. You should also distinguish these obligations from the preliminary conditions of agreements and contracts. So, thanks to guarantees and assurances, you can confirm the factual circumstances that are valid at the time of conclusion of the contract. All information about them is provided to both parties before the conclusion of the transaction.
With covenants, everything is different: they are aimed at the future and establish those actions that the borrower undertakes to commit or refuse to commit. These actions will be carried out after the conclusion of the agreement, regardless of other promises.
