A restricted payments covenant is a contractual provision in a loan agreement or bond indenture that limits how much cash or value a company can send to its shareholders, equity holders, and junior creditors. It exists to keep assets inside the business, where they remain available to service senior debt. Every leveraged credit agreement and high-yield indenture contains one, and the specific terms are heavily negotiated. Get the mechanics wrong and the company can trigger a default that accelerates the entire debt stack.
What Counts as a Restricted Payment
Lenders draft the definition broadly so that any transaction moving value toward equity holders or junior stakeholders is captured. Four categories do most of the work.
- Dividends and distributions. Cash dividends to common or preferred shareholders are the clearest case. They move liquid assets directly beyond the reach of creditors.
- Stock repurchases and redemptions. Buybacks spend corporate cash to retire equity. From the lender’s view, the company is prioritizing shareholder exits over debt service liquidity.
- Payments on junior debt. Voluntary prepayments or early redemptions of subordinated notes, mezzanine debt, or anything ranking below senior obligations. Senior lenders expect their claims paid first, and unscheduled junior payments undermine that priority.
- Restricted investments. Loans, advances, or capital contributions to entities outside the restricted group under the credit agreement. If the recipient sits outside the collateral package, the money is functionally gone.
The investment prong is the one borrowers most often miss. An intercompany loan to a non-guarantor foreign subsidiary, or a capital contribution to a joint venture, consumes capacity just as fast as writing a dividend check. Agreements reach transfers made in any form, whether cash, assets, or newly issued securities.
The Builder Basket
The builder basket is the main mechanism that determines how much a company can distribute over the life of a deal. It starts with a fixed “starter” amount agreed at closing and then grows or shrinks with financial performance.
In most high-yield indentures, the basket grows by 50% of the company’s cumulative Consolidated Net Income earned since the closing date.1U.S. Securities and Exchange Commission (SEC). Senior Notes Indenture Shareholders get a share of profits; the other half stays in the business. In credit agreements for term loan B facilities, borrowers sometimes negotiate a build based on retained excess cash flow rather than net income, which changes how the basket interacts with mandatory prepayment calculations.p>
The basket also grows when the company raises fresh equity. Cash proceeds from new stock issuances and capital contributions are typically credited at 100% of value, reflecting the balance-sheet cushion new equity provides. Debt-to-equity conversions can add to the basket as well, since leverage improves when debt drops off the balance sheet.
Losses cut the other way. Periods of negative net income reduce the accumulated total. Most agreements floor the basket at zero, so a company that burns through its capacity during a downturn starts rebuilding from zero rather than from a deficit. The result is that the builder basket tracks cumulative success, rewarding profitable operations with distribution flexibility and tightening when performance slips.
The Ratio-Based Basket
Separate from the builder, many agreements include a ratio-based exception that permits unlimited restricted payments as long as the company meets a leverage test. The premise: a healthy enough balance sheet should support broad flexibility to return capital.
The threshold is deal-specific. The leverage multiple required for unlimited restricted payments is typically tighter than the one required for incurring new debt, because lenders view distributions as less accretive than reinvestment. A company with closing leverage of 5.0x might need Total Debt to EBITDA inside 3.5x or 4.0x to reach the ratio basket, while the ratio debt basket may open at a more permissive level.
This basket matters most for companies that delever quickly after a leveraged buyout or recapitalization. Once leverage drops below the threshold, distributions no longer eat builder basket capacity. Institutional term loan covenants have moved closer to indenture-style flexibility over recent years, and lenders have generally grown more comfortable with this structure.
Permitted Payments and Carve-Outs
Beyond the two baskets, borrowers negotiate specific carve-outs that allow distributions regardless of basket balance or leverage ratio. These exceptions address routine corporate needs that don’t meaningfully threaten the lender’s position.
- General or de minimis baskets. Fixed dollar amounts, often ranging from $10 million to $50 million depending on deal size, available for any restricted payment without a performance test.
- Parent company overhead. Payments to a holding company parent for administrative expenses, insurance, and tax obligations are typically permitted as operating costs rather than leakage.
- IPO-related distributions. An initial public offering often unlocks additional rights, including a one-time dividend to pre-IPO investors funded from IPO proceeds.
- Permitted refinancing. Repaying junior debt with new financing is generally allowed on specific conditions: the replacement debt cannot exceed the original principal (plus accrued interest, premiums, and fees), must mature no earlier than the debt being replaced, and must retain at least the same subordination to senior obligations.2U.S. Securities and Exchange Commission (SEC). Credit Agreement Exhibit 4.3
Some carve-outs are “life of loan” baskets that don’t refresh once used. Others reset periodically. Basket interaction matters too: in many indentures, using certain fixed-dollar carve-outs also draws down the builder basket, while in credit agreements the baskets often run independently. Treasury teams track each separately, and most agreements require quarterly compliance certificates reporting usage to the administrative agent.
Conditions That Gate Every Distribution
Available capacity in a basket doesn’t automatically mean the company can write the check. Most agreements layer conditions on top of the math.
The most important is the “no default” condition. If the company is in default, or an event of default has been triggered, distribution rights are suspended immediately. This applies not only to payment defaults but to any covenant default, including financial maintenance tests, reporting failures, or material adverse change provisions.
Many agreements also impose a pro forma leverage ratio test. The company must show that after the proposed payment, Total Debt to EBITDA would remain below a specified threshold. If the dividend would push leverage over the line, the payment is blocked regardless of basket capacity. The test acts as a real-time check, blocking distributions that pencil out on paper but leave the balance sheet stretched.
Pro forma calculations are where EBITDA adjustments become consequential. Aggressive add-backs for cost savings, synergies, or one-time items inflate EBITDA, lower the apparent leverage ratio, and open up more capacity. Many recent agreements cap total add-backs at a percentage of EBITDA to limit manipulation.
Restricted and Unrestricted Subsidiaries
One of the most consequential features of modern covenant packages is the ability to designate certain subsidiaries as “unrestricted.” That designation places those entities outside the restricted group, so the indenture’s covenants no longer apply to them. An unrestricted subsidiary can incur debt, grant liens, and transact freely without triggering a covenant test at the parent level.
The trade-off is that the designation itself is treated as a restricted payment. The amount “invested” in the unrestricted subsidiary at the time of designation consumes builder basket or other permitted capacity. Once that initial cost is absorbed, though, the subsidiary sits in a blind spot from the lender’s perspective. Its debt doesn’t count against the parent’s leverage ratio, and its assets sit outside the collateral package.
This mechanism has been at the center of several high-profile creditor disputes. In the J.Crew transaction, the company moved a majority interest in its trademarks to a restricted subsidiary, which then transferred them to an unrestricted subsidiary, pulling the company’s most valuable intellectual property beyond bondholder reach. The transfer was technically permitted by the covenant language. Several other distressed companies followed similar playbooks. Lenders have since tightened designation conditions in newer deals, restricting the types of assets that can be transferred and capping the aggregate value that can move to unrestricted entities. Borrowers still push for broad designation rights, and evaluating these provisions is one of the most important parts of any credit analysis.
What Happens When the Covenant Is Breached
An unauthorized restricted payment triggers a covenant default, and the consequences move quickly. The company is typically required to notify the administrative agent or indenture trustee once the breach is identified. Cure periods exist in some agreements, but they’re often short, and bank loan cure windows are meaningfully shorter than bond indenture windows. Restricted payment breaches are particularly hard to cure in any real sense because the cash has already left the company.
If the breach ripens into a full event of default, the lender’s most aggressive remedies open up:
- Acceleration. Lenders can demand immediate repayment of the entire outstanding balance, including principal and accrued interest. For a heavily leveraged company, that demand is often fatal.
- Collateral enforcement. In secured facilities, lenders can foreclose on pledged assets, including equipment, real estate, and intellectual property.
- Default interest. The contract rate typically increases by 1% to 2% for as long as the default persists.
- Cross-default. A default under one agreement almost always trips cross-default provisions in the company’s other debt. A restricted payment violation under a bond indenture can simultaneously put the revolving credit facility, term loan, and other obligations into default.
The cross-default chain is what makes these breaches so dangerous. A single misstep can put the entire capital structure into default at once, stripping the borrower of any negotiating leverage.
Fraudulent Transfer and Clawback Risk
Covenant compliance doesn’t close the legal analysis. Even a distribution that passes every basket and condition can be unwound if the company later files for bankruptcy.
Under federal bankruptcy law, a trustee can avoid any transfer made within two years before a bankruptcy filing if it was made with intent to defraud creditors, or if the company received less than reasonably equivalent value and was insolvent at the time or became insolvent as a result.3Office of the Law Revision Counsel. 11 USC 548 – Fraudulent Transfers and Obligations A dividend is a textbook example of a transfer for less than reasonably equivalent value, since the company gets nothing back.
The practical consequence: a company can make a distribution that satisfies every contractual test, file for bankruptcy 18 months later, and see the trustee sue shareholders to claw back the dividend. Recipients have a defense if they took the payment in good faith and gave value in exchange, but passive dividend recipients almost never qualify. State fraudulent transfer statutes typically extend the lookback further, with many states allowing challenges for up to four years.
This risk is most acute for private equity sponsors taking large dividend recapitalizations from portfolio companies. If the company was borderline solvent when the dividend was paid and later fails, the sponsor may have to return the money, wiping out returns already booked.
Director Liability for Unlawful Distributions
State corporate law imposes its own limits on when a company can distribute cash, independent of the credit agreement. Most states require dividends to be paid only out of surplus or current net profits, and prohibit distributions that would leave the company unable to pay its debts as they come due. Directors who authorize a distribution violating these solvency rules face personal liability for the full unlawful amount, plus interest. Liability is joint and several, so creditors can pursue any participating director for the entire sum.
The statute of limitations on these claims is typically six years, and directors escape liability only by proving they were absent or formally dissented at the time. A director who voted yes or stayed silent is exposed. Directors held liable do have contribution rights against fellow board members and subrogation rights against shareholders who received the payment knowing it was unlawful.
Restricted payments therefore face two independent layers of scrutiny: the contractual covenant negotiated with lenders, and the corporate law solvency test imposed by the state of incorporation. Satisfying one does not excuse a violation of the other. Board approval of any significant distribution should involve both a covenant compliance analysis and a solvency opinion.