1. Why Lenders Put It?

Cash preservation. Dividend is cash leaving the company. Lender wants cash retained for debt service. So covenants often limit amount and frequency of dividends.

Typical formulations in India:

• Absolute Block: No dividend if any Event of Default continuing, or DSCR <1.2, or account is SMA.
• Conditional: Dividend only out of current year profit, after meeting debt service, and only if no overdues.
• Cap: Dividend not to exceed 30% of PAT, or not to exceed 50% of average of last 3 years.
• Debenture Trustee Version: As per Vardhman Trustee standard - Company shall initiate action in case of breach of covenants viz. accelerated payment, borrowing restriction, not to declare dividend before payment, declaration of event of default etc.

A lawful company-law dividend can still breach financing covenant if treasury checks distributable reserves under Companies Act 2013 Sec 123 but not the loan agreement.

2. What Constitutes Breach?

Breach of a negative covenant occurs if party engages in prohibited activity. For dividend:

• Declaring dividend without lender NOC when NOC is required
• Paying dividend when interest coverage ratio < 3.70 or net income < threshold
• Paying dividend from reserves when loan agreement says only from current year profit
• Paying dividend while overdues exist - even 1 day delay
• Upstreaming dividend via subsidiary to bypass - treated as deemed dividend under tax law and as breach

Breach is a Technical Default - even without missed EMI, it is Event of Default and empowers lender with remedies.

3. Consequences

As per standard facility documents:

1. Acceleration: Lender can demand full immediate repayment
2. Loss of Flexibility: Lender imposes tighter controls - limiting capital expenditure or prohibiting dividend payouts
3. Cross-Default: If one loan declares breach, it triggers violation on other loans via cross-default provision
4. Enforcement: Debenture trustee can enforce security, invoke pledge, take control of assets
5. Penal Interest / Default Interest: 2-3% extra

4. Case Laws - India & Global

A. Covenant Breach - General Principle - Indian Contract Law

• Shanti Conductors Principle: Negative covenants can be enforced only during pendency of contract and not beyond. So dividend restriction cannot continue after loan is fully repaid, unless expressly made survival clause. If loan agreement expired, you can declare dividend freely.

B. Tarulata Shyam vs CIT (1977) 3 SCR 697 - Supreme Court of India - Deemed Dividend
The sole object of provision is to curb evil of distributing profits under guise of loans. If loan repaid in same accounting year, still deemed dividend. Court held repayment does not exempt - initial disbursement triggers fiction.

Use in loan disputes: Borrowers argue "we gave loan to promoter, not dividend, and repaid same year". Lenders use this judgment to argue substance over form - any upstreaming is breach of dividend restriction, even if routed as loan.

C. Pradip Kumar Malhotra (2011) 338 ITR 538 Calcutta HC + Bagmane Constructions Karnataka HC
If loan or advance is given to shareholder as consequence of further consideration beneficial to company received from shareholder, such advance cannot be said to be deemed dividend.

Use: Borrower defence - dividend restriction breach does not apply when payment is in return for advantage conferred, e.g., shareholder gave personal guarantee for company's loan, or kept property as mortgage for company to get Vijaya Bank loan. Then advance is not gratuitous distribution, not breach.

D. CIT vs Madhur Housing (2018) 93 taxmann.com 502 SC
Where loans and advances are given in normal course of business and transaction benefits both payer and payee companies, provisions of section 2(22)(e) cannot be invoked. Defence for inter-corporate group fund transfers against allegation of dividend restriction breach.

E. Gopal & Sons HUF vs CIT 391 ITR 001 SC
Even if HUF is not registered shareholder, but Karta who is shareholder has substantial interest in HUF, payment to HUF is deemed dividend. Lenders cite this to catch circular dividend payments via HUFs / LLPs to evade restriction.[2017]

F. English Court - Shareholder Default Provisions as Penalty - Morgan Lewis Case 2023
Agreement contained restrictive covenants and provisions stating if seller becomes defaulting shareholder including by breaching covenants, seller would forfeit earnout and put option. Court found such forfeiture may be unenforceable as penalty. Indian DRTs apply same - if loan agreement says breach of dividend covenant leads to forfeiture of entire shareholding or 100% acceleration for small dividend, court may strike as penal under Section 74 Contract Act.

5. How Banks Actually Enforce in India

In DRT / Debenture Trustee action, steps:

1. Issue Breach Notice - 5 business days cure period typical - Failure to perform negative covenant in Section 6 and failure remains unremedied for 5 business days after officer becomes aware
2. Declare Event of Default
3. Stop further disbursement
4. Call for NOC reversal - Company must reverse dividend entry, bring back cash.
5. If not cured, accelerate.

If you are borrower, immediate remedies:

• Get retrospective NOC - Show DSCR post-dividend still >1.1, no overdues
• Show payment was not dividend but trade advance in ordinary course - cite Madhur Housing
• Show further consideration - personal guarantee / collateral - cite Pradip Kumar Malhotra
• Challenge acceleration as penalty if disproportionate