NARRATOR: Most dictionaries define the word covenant as a formal agreement, sometimes with a caveat that there's an expectation that some action shall be performed. Loan covenants are no exception. However, they're actually small formal agreements within a much larger formal agreement, which is the loan contract itself, sometimes called a promissory note. Loan covenants expressly outline actions or behaviors that a borrower is expected to or expected not to engage in. A covenant breach occurs when the borrower does not adhere to one or more of these actions or behaviors.

Loan covenants can usually be categorized in a few different ways. These are standard or non-standard, positive or negative, and financial or non-financial. Standard covenants are pretty boilerplate and tend to be standard for all borrowers, like no changes of ownership without consent from the financial institution. Nonstandard covenants are customized based on characteristics or risks that are unique to a specific client or credit request. A positive covenant is usually worded as "the borrower shall" or "the borrower must."

Negative covenants are structured using restrictive language like "the borrower shall not," or "the borrower must not." Financial covenants are usually unique to each deal and they may be worded as positive or negative. They generally relate to specific financial metrics such as a minimum DSC requirement. Non-financial covenants are other expected behaviors that are not financial in nature, like a required reporting period for operating results or company projections. Covenants are a really important component of loan structure. They're set in place to help align incentives between lenders and borrowers in order to maintain better financial health and to mitigate against loan loss.

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