Covenant Agreement Contract: Everything You Need to Know
A covenant agreement contract is a written promise in an indenture or formal debt agreement between individuals who promised to do or not do certain activities.12 min read
What Is a Covenant Agreement Contract?
A covenant agreement contract is a written promise in an indenture or other formal debt agreement. It's between individuals who have promised to do or not do certain activities.
In finance, covenant agreements relate to financial contracts. These include loan documents that outline borrower limits. These limits protect lenders from defaulted borrowers and make up the covenant agreement contract.
Covenant agreements are also known as restrictive covenants or restrictive agreements. They're often used in real estate and commercial land use situations. For example, to avoid competition, someone buying a commercial property might be restricted from soliciting employees from the previous business.
Covenant agreements can cover everything from maintaining employees to the smallest dividend payments. They're most often represented as financial ratios that need maintenance. One example of this is debt-to-asset ratios. Even employment contracts come with restrictive agreements.
Aside from "covenant agreements," there are also affirmative covenants and negative covenants.
Affirmative (or positive) covenants are contract clauses that require the borrower to complete certain actions, such as getting insurance. Complying with the law, providing financial audits to the lender, and maintaining a good credit rating are other examples. When a borrower violates an affirmative covenant, he or she defaults and the lender can demand payment in full. In certain situations, borrowers have a grace period to fix any violations.
Negative covenants require borrowers to avoid certain activities that might lower their credit standing and ability to repay debts. Financial ratios are a good example of negative covenants. Most lenders look at a borrower's total debt against his or her earnings. If the debt-to-income ratio is too high, the lender will refuse the loan.
Another example of a negative covenant is the interest coverage ratio. According to this, earnings before taxes and interest must be higher than interest payments by so much. As such, this ratio keeps a borrower in check to make sure he or she has enough earnings to pay the loan's interest.
Why Is a Covenant Agreement Contract Important?
In practice, a covenant agreement contract is a form of "action ex contractu." This is a legal action resulting from a breach of contract. Covenants work to protect all parties involved in the contract, ensuring that each will hold up their end of the bargain. If they fail to do so, the other party will receive compensation or recover damages.
Legal dictionaries spell out the importance of "performance" and "non-performance." In other words, covenants almost always boil down to a party performing or avoiding certain actions in the best interest of the other party.
Covenants are also either dependent and concurrent or mutual and independent. Dependent agreements rely on a prior performance condition. Until the first party meets that condition, the second party isn't liable to keep up his end of the covenant.
According to legal history, there's also a difference between a "covenant real" and a "personal covenant." A covenant real is a formal agreement by which an individual might bind himself to a real thing, such as real estate. A personal covenant, however, binds an individual to personal representatives in respect to his assets and may also be something an individual must perform in person.
Personal covenants can also be transitive or intransitive. Transitive covenants are when the duty to perform the covenants passes to the party's representatives. Intransitive is when the party has limited these actions to himself, such as teaching an apprentice.
All parties perform mutual covenants at the same time. If one party has fulfilled his end of the bargain but the other hasn't, the one who is ready has the right to take action against the other party's default. No matter the type of covenant, these agreements protect individuals and companies entering contracts so they can recover damages following a breach.
Reasons to Consider Not Using a Covenant Agreement Contract
Enforcement is the main problem with covenant agreements. While you may stipulate the other party can't compete against yours, this doesn't always prevent someone from stealing a trade secret and using it to their advantage. If this happens, you could end up going through a costly legal process to recover damages, and those trade secrets are still out for good.
Certain states, including California, have struck down non-compete agreements that have aimed to restrict competition. By contrast, Georgia has recently implemented new statutes that give employers more leeway to make broader non-compete agreements. Be sure to consult with a lawyer familiar with your state laws before including certain restrictive covenants.
Non-compete agreements are used in two conditions:
- Employment situations where an employer wants to restrict an employee from quitting and starting a competitor business next door. Non-competes typically restrict employees from working in similar businesses within a set timeframe, such as one or two years. The non-compete agreement might also stipulate a defined radius from the original business in which an employee may not work after leaving. Non-compete agreements, however, are hard to enforce and can even restrain trade. Some states do enforce them if a business has sustained a loss of income.
- Business sales agreements where the old owner agrees not to compete with the new owner for a set time, area, and type of business. In this case, the seller receives compensation for the non-compete agreement.
Reasons to Consider Using a Covenant Agreement Contract
Fundamentals for using a covenant agreement help solidify a contract and protect everyone involved. These include:
- Proper parties.
- Words of agreement.
- A legal purpose.
- A proper form.
In a covenant agreement contract, the parties must legally be able to enter it. If they aren't mentally capable of doing so, not of legal age, or are under duress, they can't bind themselves in a contract.
As for words of agreement, parties must give mutual consent on what is being signed. Otherwise, the contract would be unfair and incomplete. When agreement isn't given, the contract is void.
Any covenants that go against the law or public policy are also void. For example, a business person entering a covenant stating that he will not follow his occupation would be null and void because it goes against public policy. However, a covenant can state that he can't conduct business in a certain place, such as one that might interfere with the other party's business.
Covenants must be formed by deed or under seal. No particular words are necessary, but the covenant must detail the parties' intentions in respect to the contract's subject matter.
When an action initiates damage recovery following a breach of contract, it's known as a "remedy." Remedies must consider the subject with reference to:
- The type of obligation or claim maintaining the action.
- The declaration form.
- The plea.
- The judgment.
To support a remedy, there must be a breach of contract. Breaking a promise to do something or avoiding an activity as laid out in a covenant is sufficient proof, but the declaration must show the contract was under seal. Judgments following a contract breach will help parties reclaim damages. It's always best to spell out your agreements under contract to protect yourself from a breach.
Covenant Agreement Contracts Versus Representations Versus Warranties
Words like "covenants," "warranties," and "representations" are so common in legal contracts that most people overlook them. Each word may sound similar, but they have distinct meanings that help fix violations, false representation, and contract breaches. Before signing any contract, familiarize yourself with this vocabulary to boost your understanding.
In the traditional sense, representations come before a contract. They're statements that one party makes to the other party before signing the contract. For instance, a business person selling a product might represent the fact that they haven't received a patent infringement.
Including representations in a contract means they function as conditions or warranties. For example, a lawyer hired under a contract agreement must have a license to practice. If this condition is false, the employer has the right to void the contract.
Warranties, on the other hand, are promises that appear in the contract that require strict compliance. These may include agreements, promises, or representations, but a warranty is essentially a guarantee from the contracting party. In some cases, a warranty may state that a product is as promised or that one party will compensate the other if they aren't satisfied.
Warranties come in two forms: affirmative and promissory. Affirmative warranties are assurances that certain statements are true and specific activities have taken place before the contract. Promissory warranties are future agreements. As such, warranties protect the parties from damages or a breach of contract. Today, warranties typically protect consumer products and are subject to federal law and the Uniform Commercial Code.
Extended warranties further protect the buyer after the initial purchase agreement. They're another form of insurance depending on the warranty coverage and state laws.
It's important to remember that the state of mind of the party with the warranty doesn't matter in the grand scheme of things. A party can enforce a warranty even if the one holding it thinks it might face a breach.
Further, warranties differ from representations in the following ways:
- A warranty is part of a contract, while a representation is a separate matter discussed before the contract.
- Warranties are material, and a party claiming misrepresentation must establish materiality.
- A warranty is explicitly stated on the face of a contract.
- Representations are often oral or written before a contract.
- Warranties must be followed and contracts remain binding even if a warranty undergoes a breach.
- Damages are recoverable from a warranty breach.
When you understand the terms "representation" and "warranty," it's easier to know where a covenant comes into play. A covenant agreement is traditionally a promise in writing. The party agreeing to the covenant pledges that he or she has done or will do something if the stated facts are true. Historically, witnesses must establish covenant terms.
Covenants also tend to be secondary to the main purpose of the contract. For instance, there may be a covenant agreement preventing a party from suing the other while a loan remains unpaid.
Covenant contract agreements, warranties, and representations have become the norm for contracts. While some choose to use the terms "agree," "obligate," or "represent" in place of the more formal legal terms, the concepts remain the same.
Covenants for Title
When someone obtains a title to real estate property, he or she is afforded six covenants. These include:
- Covenant for seisin.
- Covenant of the right to convey.
- Covenant against encumbrances.
- Covenant for quiet enjoyment.
- Covenant of general warranty.
- Covenant for further assurances.
Deeds that provide for usual covenants include the first five of the above. If a deed includes full covenants, it extends to all six of these covenants.
Covenants for seisin and covenants of the right to convey are typically considered the same thing. They guarantee the person granting the deed is the owner of the property that he or she is selling or transferring.
Covenants against encumbrances guarantee that properties being conveyed are not subject to any outstanding interests or rights, including liens, mortgages, profits, easements, and restrictions that would lessen the property's value. Zoning restrictions are not considered a covenant breach, although a violation of a building or zoning restriction is considered a breach.
The first three covenants typically do not "run with the land," while the final three do.
Covenants of quiet enjoyment and general warranty both protect the person receiving the deed against unlawful claims of other people who might try to convict the grantee.
Finally, the covenant for further assurances is rarely used in the United States. In this covenant, the deed granter promises to perform any necessary acts within his or her ability to perfect the title.
When a breach of a covenant occurs, the covenantee experiences financial loss since these covenants are contracts of indemnity. In most cases, the maximum amount of damages one can pursue for the breach is the land's purchase price plus interest.
Covenants in Land Use Planning
Covenants often affect land use planning and help create particular types of communities as part of neighborhood plans. For example, a developer might buy vacant land to divide it into buildable housing lots. The developer pays a low price for the undeveloped land and then sells the divided lots with a number of restrictive covenants.
The developer might specify in the sales contract that the owner cannot further divide the lot and must construct a house of a certain size and specification to ensure the community has a cohesive look. In this case, courts can enforce these types of covenants as long as they benefit and burden all property owners in the development equally.
Even so, covenants can't be enforced if they're used for illegal purposes. In 1948, the Supreme Court ruled in Shelley v. Kraemer, 334 U.S. 1, 68 S. Ct. 836, 92 L. Ed. 1161 that "no court or state officials have the power under law to take any action toward the enforcement of a racial covenant." In this Supreme Court case, a group of neighbors sued to keep a property owner from selling his home to African-Americans. The neighbors used the argument that the owner was subject to the restrictive covenants, but the covenant was found to be unenforceable based on equal housing laws and the fact that it was a Civil Rights violation.
If you provide false representation in a covenant agreement contract, the defrauded party might choose to void the entire agreement. When this happens, they're entitled to financial recovery, which you'll need to provide.
Always be willing to accept responsibility when entering a contract.
If you're drawing up a contract, don't forget to include necessary covenant agreements. Consult legal counsel if you need help determining which covenants apply to your situation.
Frequently Asked Questions
- What is a contract?
A contract is a written or oral promise enforceable by law. It's a voluntary agreement between two or more parties that includes a promise to do something. Contracts are common in business, real estate, apartment leases, banking, and other transactions. For a contract to be valid, there must be an acceptance offer, an intention to create legal relations between parties, and a valuable consideration, such as a payment.
- What does "running with the land" mean?
Covenants can "run with the land" if they face annexation to an estate and can't separate from the land. In this case, the original owner and any successive owners are subject to the covenant's burden or benefit. For instance, a buyer might own property restricted for church purposes only. If she sells the land, the other buyer must continue to use the property for these purposes. This type of covenant is also called a "covenant appurtenant."
On the other hand, if a covenant is "in gross," it only binds with the original owner and not the land itself, so any future owners aren't bound by the promise.
- What are title covenants?
Individuals who obtain titles, such as for real estate property, have the right to convey against encumbrances and with further assurances. Mortgage deeds that provide full covenants give the owner the highest protection.
- What is the difference between a contract and a covenant?
A contract represents a broad legal area. It's an agreement with legal obligations and is enforceable by law. A covenant refers to a type of agreement. It constitutes a pledge and is included in contracts.
- What is the difference between principal and auxiliary covenant agreements?
Principal covenants directly relate to the principal matter stated in the contract. Auxiliary covenants are agreements that don't directly relate to the main matter between parties and instead relate to something connected with the contract. This may include collateral such as land or real estate.
- How is land use planning affected by covenants?
As an example, a covenant might demand a particular type of neighborhood plan. This can pertain to housing developers who divide building lots, separating the land with restricted covenants. These restrictions might include the type of house built on the lot or the types of houses not allowed, such as mobile homes.
- Is a condition a covenant?
There is a distinction between conditions and covenants that stem from a 2010 decision from the 9th Circuit Court of Appeals.
The decision emphasized the importance of a distinction, which is broken down as follows: A condition is a fact that must or must not exist before a contract can take place. If these conditions are not met, the contract is void. A covenant is a promise to do or not do something. If it's broken, the one breaching the promise is liable for monetary damages.
- Are covenant agreement contracts the same as express assumpsits?
No. An express assumpsit must be outlined with a deed with sufficient consideration. With a covenant, no consideration is necessary to make it valid, and the covenant can be either verbal or in writing.
- What are the differences between express and implied covenants?
An express covenant is clearly agreed upon between all parties and has been included in the deed. There is no particular form required to create an express covenant, but phrases like "I agree," "I bind myself," and "I oblige" are all considered covenant agreement language.
An implied covenant is one that is intended but not expressed in words. For instance, if someone leases land for a given amount of time, the implied covenant is that he or she can enjoy the land quietly without impediments during the lease term.
- What is the difference between an executed and executory covenant agreement?
Executed covenants relate to an activity already performed, while executory covenants must be performed in the future.
- Are all covenants obligatory?
While most are, some are declaratory, which limit and direct certain uses rather than place a strict binding on a party.
- Are any covenants considered illegal?
Legal covenants are always binding on all parties involved, but there are such things as illegal covenants, too. These types of agreements may violate the law, be of an immoral nature, or illicit activities that go against public policy. They're always considered void.
- What is a mutual covenant?
A covenant is considered mutual when both parties agree to perform an action at the same time. It may also be considered an independent or dependent covenant.
- What elements must a covenant contain in order to be enforceable by law?
A covenant must include an offer and an acceptance in order to be enforceable by law. There must be an intention to create legal relations between all parties and the agreement must be made for payment or other valuable consideration. All parties must have the capacity to contract and the subject of the contract must be legal.
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