If you’re borrowing money and are presented with a negative pledge clause, you want to thoroughly understand the actions a lender can take against you if you fail to meet your obligations or violate the agreement.
Definition and Example of a Negative Pledge Clause
In a negative pledge clause, you agree not to add a lien or security interest, or offer up the same asset as collateral. A negative pledge clause is typically used for a loan or bond agreement.
Alternate names: Covenant of equal coverage, negative pledge agreement
In particular, this type of covenant is often included if you’re applying for an unsecured loan. Lenders will often include a negative pledge clause designed to inform you that they don’t want you to use the asset for any other purpose than as collateral for the loan they are providing. If you grant a lien or security interest to another creditor, it could minimize the amount available to the lender. The clause legally establishes your acknowledgment of their terms and is designed to give them cause to file a lawsuit for damages or breach of contract.
How a Negative Pledge Clause Works
A negative pledge agreement has multiple sections and generally covers any circumstances regarding the asset(s). A clause may include:
An initial statement: A statement of who the lender and borrower areTerms: The agreement’s terms, such as the effective and termination dates of the agreement, fees, expenses, or charges.Representations and warranties: Includes definitions of who the borrower is as a legal entity, and states that the lender has authorized the borrower to use collateral; states that the lender has reviewed all financial evidence and decided the collateral is of sufficient valueNegative pledge/covenant: Defines the pledgeRights of setoff: Defines the lender’s ability to deduct from the borrower’s accounts or other claims with the lenderMiscellaneous provisions: Includes other agreements such as litigation methods, waivers, notices, and debt successionDefinitions: Defines any terms that may need to be explained, such as “grantor,” “guarantor,” “collateral,” or “security interest”
The legal language used in a negative pledge clause doesn’t create a security interest or lien on the collateral—instead, it gives the lender a cause to take legal action. For example, say a company takes out a $2 million loan from a bank. As collateral for the loan, the company pledges inventory that equals the loan value. The loan agreement includes a negative pledge clause stating the company can’t use that inventory as collateral to obtain another loan. If that company violates the negative pledge clause, the lender has cause to file for a breach of contract. However, if the company files for bankruptcy, the lender has no priority over other creditors until the court establishes priorities.
Pros and Cons of a Negative Pledge Clause
Pros Explained
Flexible covenant: A negative pledge clause is flexible and easy to include in a financial agreement. There are no requirements to comply with local laws.Protects the lender: A negative pledge clause gives the lender a certain amount of control over the borrower and warns them against creating security interest on assets listed in the agreement. This is especially important with unsecured debt, where the lender doesn’t have collateral to fall back on.Establishes cause: A negative pledge clause gives the lender a reason to file for breach of contract if you default, file for bankruptcy, or violate the agreement.
Cons Explained
Not a security interest: A negative pledge clause is not a security interest, and including one in a contract doesn’t always guarantee the lender will have priority over third parties.Hard to enforce: Negative pledge clauses can be difficult to implement, and a court may not be willing to enforce the covenant.May not stand up in court: If a third-party lender wasn’t aware of the negative pledge clause, the lender might not have an advantage over them in court.
