Key Takeaways:

  • A negative pledge is a contractual promise that prevents a borrower from pledging the same assets to another lender, protecting the first lender’s claim.
  • Common in unsecured loans, bond indentures, corporate financing, and some mortgage agreements to reduce risk for lenders.
  • Benefits include preserving asset availability for repayment and potentially lowering borrowing costs, but enforcement can be challenging.
  • Limitations arise because third parties are generally not bound by the pledge, and lenders have limited control over unsecured collateral.
  • Breach remedies include injunctions, loan acceleration, litigation, or enforcing security if available.
  • Effective clauses clearly define restricted assets, exceptions, and reporting requirements to strengthen enforceability.

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.

How a Negative Pledge Works in Practice

A negative pledge functions as a preventive safeguard for lenders by ensuring that the borrower’s assets remain unencumbered for the duration of the loan. The clause typically specifies the categories of assets covered, such as real estate, equipment, or receivables, and may also outline permissible exceptions, like existing liens or leases.In practice, lenders monitor compliance through financial reporting requirements built into the agreement, such as periodic asset lists or certificates of compliance. Some agreements extend the clause to cover “future assets” acquired after the loan is issued, ensuring the borrower cannot circumvent the restriction by pledging newly obtained property.A well-drafted negative pledge will also address indirect encumbrances, such as creating subsidiaries to hold pledged assets, and will require lender consent before any such transactions occur.

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.

Drafting Considerations to Improve Enforceability

To strengthen a negative pledge’s effectiveness, lenders often:

  • Define collateral broadly to include tangible and intangible assets, subsidiaries, and after-acquired property.
  • Include “pari passu” provisions requiring that all unsecured debt ranks equally in repayment priority.
  • Require notice and consent before a borrower can incur new debt or grant liens.
  • Incorporate financial covenants (e.g., debt-to-equity ratios) to trigger early warnings if the borrower’s risk profile changes.
  • Specify remedies for breach beyond litigation, such as interest rate increases or immediate repayment triggers.
    While these measures cannot bind third parties, they deter breaches and give lenders greater leverage if a violation occurs.

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.

Additional Common Uses Across Industries

Beyond corporate loans, negative pledge clauses are frequently applied in:

  • Project finance agreements, where lenders rely on anticipated project revenues and want assurance that project assets will not be pledged elsewhere.
  • Real estate financing, especially in commercial deals where property owners are prohibited from using the same property as security for multiple lenders.
  • Syndicated loans, ensuring all participating lenders share equal claims without a borrower granting priority to a new creditor.
  • International financing transactions, where cross-border borrowers might otherwise pledge foreign assets to different lenders, complicating enforcement.

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.

Potential Consequences for Borrowers

Borrowers who breach a negative pledge may face more than legal action. Possible consequences include:

  • Credit rating downgrades, as agencies may view the breach as a sign of financial instability.
  • Loss of future borrowing capacity, since lenders may be unwilling to extend credit to borrowers with a history of covenant violations.
  • Cross-default triggers, where a breach in one agreement causes defaults in other loan agreements.
  • Increased borrowing costs on future loans, as lenders may demand higher interest rates or collateral to offset perceived risk.
    These consequences can significantly impact a borrower’s financial flexibility, making compliance with a negative pledge an important priority.

Frequently Asked Questions

1. Is a negative pledge the same as a lien? No. A lien is a legal claim over an asset, while a negative pledge is a contractual promise not to create such a claim in favor of another creditor.

2. Can a negative pledge apply to future assets? Yes. Many agreements include after-acquired property clauses to prevent borrowers from pledging future assets without consent.

3. Are negative pledge clauses enforceable against third parties? Generally no; they bind only the borrower, not third-party lenders who may receive the pledged assets.

4. Why would a borrower agree to a negative pledge? Borrowers may accept one to secure better loan terms, such as lower interest rates, without having to provide collateral.

5. What happens if a borrower accidentally breaches a negative pledge? Even an unintentional breach can trigger remedies like acceleration of debt or legal action, so borrowers should have monitoring systems in place.

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