Negative Pledge Clause

What Is a Negative Pledge Clause?

A negative pledge clause is a type of negative covenant that prevents a borrower from pledging any assets if doing so would jeopardize the lender’s security. This type of clause may be part of bond indentures and traditional loan structures.

Key Takeaways

  • A negative pledge clause is a part of a loan contract that prevents the borrower from pledging their assets to another lender.
  • Negative pledge clauses are also referred to as "covenants of equal coverage."
  • Negative pledge clauses may stipulate that if the bond issuer grants liens against any assets in the future, an equal lien must also be granted to the issuer’s investors.
  • A negative pledge clause ensures that the original lender will maintain priority if the borrower defaults and their assets are seized.
  • Negative pledge clauses are sometimes included in mortgages to prevent the borrower from using their home as collateral for other lenders.

How a Negative Pledge Clause Works

Negative pledge clauses help lenders or bondholders protect their investments. When a bond indenture includes a negative pledge clause, it prevents the bond issuer from taking on future debt that could compromise its ability to meet obligations to existing bondholders.

A negative pledge clause also limits the likelihood that a particular asset will be pledged more than once, preventing conflict over which lending institution has the right to the asset if the borrower defaults.

Mortgages sometimes include negative pledge clauses that prevent the borrower from encumbering their home.

Advantages and Disadvantages of a Negative Pledge Clause

Because a negative pledge clause reduces the risk of a loan or bond issue, it often allows the borrower to get a slightly lower interest rate. This creates a win-win situation that benefits both the lender and borrower.

The negative pledge clause mitigates risks to bondholders by restricting the activities in which the issuer can participate. Most often, this means preventing the issuer from using the same assets to secure another debt obligation.

On the downside, violating a negative pledge clause can trigger a default on the loan, albeit a technical default. Lenders generally give an allotted amount of time, such as 30 days, to remedy a covenant break before moving ahead with default procedures.

Pros and Cons of a Negative Pledge Clause

Pros
  • Lowers risk for the lender

  • Lower interest rates for the borrower

  • Ensures that lenders will have recourse if the borrower declares bankruptcy

Cons
  • Limits the borrower's ability to sell or borrow against their assets in the future.

  • May cause borrower to default if they inadvertently break the covenant.

  • They are difficult to enforce for lenders.

Special Considerations

When a financial institution provides an unsecured loan to an individual or entity, it may include a negative pledge clause in the contract in order to protect itself.

In this case, the clause prevents the borrower from using its own assets to secure other sources of financing. If the borrower secures other loans, the original loan by the first institution becomes less secure, because the borrower now has a greater amount of debt obligations, and the original institution may not have priority status for repayment.

In the case of home mortgages, many loan agreements include terminology that restricts the borrower from using the mortgaged property as collateral against any new loan, except in the case of refinancing.

What Is a Negative Covenant?

A negative covenant is a contractual agreement that binds prevents one party from taking a certain action. In other words, it is an agreement not to do something. Negative covenants might prohibit a person or company from selling certain assets or taking on more than a certain amount of debt, for example.

What Is a Double Negative Pledge?

A double negative pledge is a promise not to enter into negative covenants with any third party. In other words, it is a negative covenant that prohibits other negative covenants. This type of agreement is frequently used by banks or other lenders to ensure that they have a priority claim to a borrower's assets if they declare bankruptcy.

What Happens If a Borrower Breaks a Negative Pledge Clause?

The loan agreement will specify the type of recourse that is available to a lender if the borrower sells or otherwise encumbers property protected by a negative pledge clause. This will usually allow the lender to sue the borrower, or accelerate the loan's repayment schedule. However, the lender cannot pursue action against any third party, only the borrower.

Article Sources
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  1. Martindale. "The Negative Pledge."

  2. UpCounsel. "Negative Pledge Clause: Everything You Need to Know."

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