When negotiating a loan agreement in Indonesia, borrowers often focus primarily on the interest rate and repayment schedule, while treating the remaining provisions as standard contractual boilerplate. However, one of the most important sections of any financing document is the negative covenant clause. Although frequently overlooked during negotiations, negative covenants can impose significant restrictions on a borrower’s business operations and strategic decisions throughout the term of the loan. Understanding how these provisions operate under Indonesian law is therefore essential for companies seeking external financing.
Negative covenants are contractual provisions that prohibit a borrower from undertaking certain actions without first obtaining the lender’s prior written consent. Unlike affirmative covenants, which require a borrower to perform specific actions, such as maintaining insurance coverage or providing periodic financial reports, negative covenants are restrictive in nature. They are designed to limit activities that may adversely affect the borrower’s financial condition or the lender’s ability to recover the outstanding debt.
Under Indonesian law, negative covenants are generally enforceable based on the principle of freedom of contract as stipulated in Article 1338 of the Indonesian Civil Code. Pursuant to this principle, agreements lawfully entered into by the parties shall bind them as law. Accordingly, provided that the covenant does not violate mandatory legal provisions, public order, or morality, Indonesian courts will generally recognize and enforce such contractual restrictions.
In practice, Indonesian loan agreements commonly contain several categories of negative covenants. These may include restrictions on the borrower’s ability to incur additional indebtedness beyond an agreed threshold, create or permit security interests over its assets in favor of third parties (commonly referred to as a negative pledge), dispose of, transfer, or otherwise encumber material assets, undertake mergers, consolidations, corporate restructurings, or changes of control, and declare or distribute dividends above a specified amount while the loan remains outstanding. The scope and complexity of these restrictions typically depend on the size of the financing transaction and the lender’s risk assessment.
From the lender’s perspective, negative covenants serve an important risk-management function. Their primary objective is to preserve the borrower’s financial position and asset base throughout the loan term. Without such protections, a borrower could materially alter its financial condition by taking on substantial additional debt, transferring valuable assets, or restructuring ownership in a manner that weakens the lender’s position, even while remaining current on its payment obligations. Negative covenants therefore provide lenders with a degree of ongoing oversight and protection against actions that could compromise repayment prospects.
Borrowers should also recognize the serious consequences that may arise from breaching a negative covenant. In most financing agreements, a breach constitutes an Event of Default regardless of whether the borrower has missed any payment obligations. Once an Event of Default occurs, the lender may have the right to accelerate repayment of the outstanding loan, enforce security interests granted in its favor, or exercise other contractual remedies. Furthermore, a covenant breach may trigger cross-default provisions contained in the borrower’s other financing arrangements, potentially resulting in wider financial and operational consequences.
Given these risks, borrowers should carefully review and negotiate negative covenant provisions before executing any loan agreement. Rather than accepting broad and unrestricted prohibitions, borrowers should seek appropriate carve-outs, exceptions, and materiality thresholds. For example, a borrower may negotiate the ability to incur indebtedness below a specified amount, dispose of assets in the ordinary course of business, or undertake certain corporate actions that do not materially affect its financial condition. Properly tailored covenants can strike a balance between protecting the lender’s interests and preserving the borrower’s operational flexibility.
As Indonesia’s financial and corporate sectors continue to evolve, negative covenants remain a critical component of commercial lending transactions. A thorough understanding of these provisions enables borrowers to assess potential restrictions in advance, avoid inadvertent defaults, and maintain greater flexibility in managing their business operations throughout the financing period.
If you have any questions regarding negative covenants, loan agreements, or other corporate financing matters in Indonesia, Schinder Law Firm has extensive experience advising domestic and foreign clients on a wide range of banking, financing, and corporate transactions. Our team of experienced corporate and commercial lawyers is ready to assist you with practical and legally sound solutions. For further information or consultation, please contact us at info@schinderlawfirm.com.
Author:
Dewi Susanti