1. Why Include a Negative Pledge Clause in a Loan Contract?
2. Limitations of the Negative Pledge Clause
3. Scenarios Where the Negative Pledge Clause Is Used
4. What Happens When a Negative Pledge Is Breached?

A negative pledge or "covenant of equal coverage" is a clause used in some loan contracts that prohibits a borrower from using the same collateral with multiple lenders. The clause is normally used for unsecured loans and is intended to minimize the chances of a lender losing out when a borrower fails to pay an unsecured loan.

Why Include a Negative Pledge Clause in a Loan Contract?

It is a standard practice for lenders to include a negative pledge clause in a contract for an unsecured loan. The negative pledge is basically a promise the borrower makes that states that he will not use the attached collateral for another loan from a different lender.

For example, when a company obtains a $5 million loan from a bank and pledges its entire $5 million worth of assets as collateral for the loan, the bank can include a negative pledge clause in the contract. This means that should the same company seek another $2 million loan from another bank, if the second bank insists that the company pledges $2 million worth of its assets as collateral, the negative pledge the company made with the first bank prohibits it from entering the second loan agreement.

The negative pledge can prevent the two lenders from scrambling for the same assets if the company fails to pay the loan.

Limitations of the Negative Pledge Clause

A negative pledge clause has a number of shortcomings:

  • Third parties are not subject to the clause. A negative pledge clause can only be enforced by courts against the borrower. Should the borrower and a third party breach the clause, courts cannot generally act against the third party. For example, suppose a company obtains a loan from bank Z, and the bank protects the collateral with a negative pledge. If the same company breaches the negative pledge and obtains another loan from bank Y using the same collateral, courts can generally act against the borrower but not against bank Y.
  • They are hard to enforce. Negative pledge clauses are mostly used for contracts of unsecured loans. Unlike secured loans where a lender has control over the security, the lender has limited control over collateral of an unsecured loan. The lender may not be in a position to enforce the negative pledge. For example, a borrower can easily breach the negative pledge clause by selling off the collateral without the lender's knowledge. Although the lender can subsequently sue the borrower, the lender might not legally be in a position to recover the sold assets from a third party.

Scenarios Where the Negative Pledge Clause Is Used

  • Bond Indentures. Bondholders can include a negative pledge in a contract with a company to prevent the company from issuing debt if it would negatively affect the bondholder's claim on the company's assets. The negative pledge may help the bond issuer, in this case, to borrow at lower interest rates, as such a loan is considered safer.
  • Banks and Corporations. The emergence of the negative pledge clause has enabled financial institutions to issue big loans to corporations without requiring corporations to present security. In this case, the corporation pledges its assets as collateral, and the bank uses a negative clause to prevent the corporation from using the same assets as collateral for other loans.
  • Mortgages. Many property mortgage loan agreements include clauses that limit the ability of the borrower to use the property as collateral for another loan.

What Happens When a Negative Pledge Is Breached?

Sometimes, the borrower may breach the negative pledge. A number of options are available to the lender in such a scenario:

  • Get a court injunction. If the lender is aware ahead of time that the borrower plans to break the negative pledge, the lender can obtain a court injunction to prevent the borrower from breaching the contract. This scenario is rare because borrowers do not normally publicize their plans to breach the negative pledge.
  • Accelerate the loan. The lender may decide to accelerate the loan. A threat of acceleration may also be used by the lender to bring the borrower to the negotiating table or to change the terms of the loan contract.
  • Enforce the security. If the loan has a security, the lender may enforce the security. However, most loans with the negative pledge clause are not secured, limiting the options of the lender in this regard.
  • Litigate against the borrower. The aggrieved lender can sue the borrower and seek damages for breach of contract.

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