Show Restrictions put on debt agreements by the lender to limit the borrower's actions Debt covenants are restrictions that lenders (creditors, debt holders, investors) put on lending agreements to limit the actions of the borrower (debtor). In other words, debt covenants are agreements between a company and its lenders that the company will operate within certain rules set by the lenders. They are also called banking covenants or financial covenants. The Purpose of Debt CovenantsDebt covenants are not used to place a burden on the borrower. Rather, they are used to align the interests of the principal and agent, as well as solve agency problems between the management (borrower) and debt holders (lenders). Debt covenant implications for the lender and the borrower include the following: LenderDebt restrictions protect the lender by prohibiting certain actions by the borrowers. Debt covenants restrict borrowers from taking actions that can result in a significant adverse impact or increased risk for the lender. BorrowerDebt restrictions benefit the borrower by reducing the cost of borrowing. For example, if lenders are able to impose restrictions, lenders will be willing to impose a lower interest rate for the debt to compensate for abiding by the restrictions. Reasons Why Debt Covenants are UsedNote that in the scenarios below, it is in the best interest of both parties to set debt covenants. Without such agreements, lenders may be reluctant to lend money to a company. Scenario 1Lender A lends $1 million to a company. Based on the risk profile of the company, the lender lends at an annual interest rate of 7%. If there are no covenants, the company can immediately borrow $10 million from another lender (Lender B). In this scenario, Lender A would set a debt restriction. They’ve calculated an interest rate of 7% based on the risk profile of the company. If the company turns around and borrows more money from additional lenders, the loan will be a riskier proposition. Therefore, there will be a higher possibility of the company defaulting on its loan repayment to Lender A. Scenario 2Lender A lends $10 million to a company. In the following days, the company declares a liquidating dividend to all shareholders. In this scenario, Lender A will set a dividend restriction. Without the restriction, the company can pay out all of its earnings or liquidate its assets and pay a liquidating dividend to all shareholders. Therefore, the lender would be out of his or her money if the company were to liquidate the company and pay out a liquidating dividend. List of Debt CovenantsBelow is a list of the top 10 most common metrics lenders use as debt covenants for borrowers: Positive vs Negative CovenantsDebt covenants are defined as positive covenants or negative covenants. Positive debt covenants are covenants that state what the borrower must do. For example:
Negative debt covenants are covenants that state what the borrower cannot do. For example:
ExampleLet us consider a simple example. A lender enters into a debt agreement with a company. The debt agreement could specify the following debt covenants:
Violation of Debt CovenantsWhen a debt covenant is violated, depending on the severity, the lender can do several things:
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Unconscionable conduct is generally understood to mean conduct which is so harsh that it goes against good conscience. Under the Australian Consumer Law, businesses must not engage in unconscionable conduct, when dealing with other businesses or their customers Unconscionable conduct does not have a precise legal definition as it is a concept that has been developed on a case-by-case basis by courts over time. Conduct may be unconscionable if it is particularly harsh or oppressive. To be considered unconscionable, conduct it must be more than simply unfair—it must be against conscience as judged against the norms of society. Business behaviour may be deemed unconscionable if it is particularly harsh or oppressive, and is beyond hard commercial bargaining. For example, Australian courts have found transactions or dealings to be 'unconscionable' when they are deliberate, involve serious misconduct or involve conduct which is clearly unfair and unreasonable. There are a number of factors a court will consider when assessing whether conduct in relation to the selling or supplying of goods and services to a customer, or to the supplying or acquiring of goods or services to or from a business, is unconscionable. These include: This is not an exhaustive list and it should be noted that the court may also consider any other factor it thinks relevant. The following practical tips may assist businesses to avoid becoming a victim of unconscionable conduct: The following practical tips may assist businesses to avoid engaging in unconscionable conduct: If the court determines that unconscionable conduct has occurred, a variety of remedies may be ordered including: Business snapshot – Unconscionable conduct Make a consumer complaint Make a complaint as a business |