What is a 'Negative Pledge Clause'
A negative pledge clause is a negative covenant in an indenture stating a corporation will not pledge any of its assets if doing so gives the lenders less security. It is also referred to as a "covenant of equal coverage." A negative pledge clause is just another way for bondholders to protect their investment.
BREAKING DOWN 'Negative Pledge Clause'By including a negative pledge clause in a bond indenture, the bondholders of the current bond issue prevent the company from issuing any debt in the future that would jeopardize their current priority claim on the company's assets. Including a negative pledge clause in a bond indenture increases the safety of the bond issue from the investors' perspective, and therefore often allows the bond issuer to borrow funds at a slightly lower interest rate.
The negative pledge clause is designed to prevent a bond issuer from participating in activities that may benefit holders of other bonds. Additionally, if the issuer grants any liens against assets in the future, a lien in an equal amount must be granted to the investors.
Negative Pledge Clause and Risk Mitigation
The negative pledge clause is designed to mitigate risks to bondholders by restricting certain activities in which the borrower can participate. Generally, this involves preventing the issuing organization from using assets to support another debt obligation if the transaction would have a negative impact on current bondholders.
Negative Pledges in Traditional Loan Structures
Negative pledge clauses may also exist in other financial transactions. If a financial institution grants a large unsecured loan to a particular individual or entity, a negative pledge clause may be required to complete the transaction.
In these cases, the clause prevents borrowers from using assets to secure other financing, as this makes the unsecured loan issued by the first financial institution less secure than when it originated. The borrower is limited to financial transactions in which the original lender maintained priority if assets are seized as part of a default. It also limits the likelihood a particular asset is pledged more than once, creating an issue of which institution has rights to the asset in the event of borrower default.
Example of a Negative Pledge Clause Scenario
Often, when a person takes on a mortgage loan for the purpose of purchasing a particular property, the mortgage loan agreement includes terminology restricting the borrower from using the property covered by the mortgage as collateral against a new loan, barring circumstances where the intent is to refinance the original loan. However, the borrower may not be restricted from using any available equity in the property to secure additional funding, as the first lender’s interest is still protected based on the amount the borrower still owes.