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The contract is the fundamental building block of the business world. It has been around since the days of the ancient Sumerians, and has remained an important part of the world market throughout the centuries. In all contracts there is some form of a covenant, whether it be in a purchase contract, in a trade agreement, or in a business loan.

What is a covenant? Quite simply, a covenant is an agreement by two or more parties working together to either do or not do something. Covenants outline the limits of that which each party can act and keeps them working honestly. Covenants take different forms across business lines, so the type of covenant that you see in a trade agreement will often be different from that which you see in a business loan. What is a covenant in the latter case? Basically, the covenant outlines what the borrower must do in order to repay the loan, and defines the limits on what the lender can impose.

So for example, a business loan may outline payment due dates, penalties, conditions for default, and a number of other conditions that act as the covenant on the borrower’s behalf. They come in two principal forms; negative covenants and positive covenants. Negative covenants impose limits on what the borrower cannot do, such as restrict payments or take out new debts, while positive covenants denote requirements for what the borrower has to do, such as the maintenance of a certain level of working capital, or a requirement to issue reports of financial status to creditors. These are, of course, all agreed to before the contract is signed, and it is a good idea to have an understanding of this system so that you don’t have to ask “in a business loan, what is a covenant” when you go to borrow!

This Business article was written by Mark Karavan on 2/20/2010