A negative pledge is a contract provision prohibiting the debtor in a contract from creating security interests over specified property assets. The contractual provision aims to protect unsecured creditors by ensuring that debtors can only use unencumbered assets as collateral.
Over time, the negative pledge’s become a boilerplate in financing transactions. It does not give rise to a security interest because it does not grant the creditor any proprietary interest in the debtor’s property.
A negative pledge clause prohibits the debtor in the contract from creating a security interest on an encumbered asset. It is extremely common in financing transactions.
The clause is utilized to protect the interests of unsecured lenders that can be negatively impacted by a company’s borrowing.
Secured and unsecured assets are the two primary types of security interests.
What is the Purpose of a Negative Pledge?
The negative pledge clause ensures that the borrower’s assets remain unencumbered and available to satisfy the claims from unsecured creditors in the event of insolvency.
Often, the negative pledge clause is complemented with covenants that restrict the borrower’s ability to take on more unsecured debt. The negative pledge is important because it protects the interests of unsecured lenders that may be negatively impacted by a company’s borrowing.
How Did the Negative Pledge Come to Be?
Before the negative pledge, the primary security interest used was the floating charge. Floating charges were applied to property in a shifting manner and allowed the borrowers to use and dispose of the asset in the ordinary course of business.
Floating charges became incredibly popular among secured creditors because the security covers all assets of the debtor. Borrowers also were partial to the floating charge because it allowed them to realize the maximum credit benefit from lenders, and they did not need to disclose disposing of secured assets.
The floating charge exerted a negative impact on the protection afforded to the creditor in the agreement. Specifically, the creditor can lose priority right to the debtor’s assets in the event of insolvency.
Types of Debt
1. Secured debt
The borrower promises its assets as collateral in a financing transaction. It results in a secured debt owed to the creditor.
2. Unsecured debt
The borrower can receive financing without pledging assets as collateral. It results in an unsecured debt owed to the creditor.
Characteristics and Use of the Negative Pledge
The negative pledge is a clause in a loan agreement that states that the debtor does not encumber specific debtor assets, which can be called the “collateral,” until the loan is repaid.
In the case of a secured loan, it will allow the creditor to control the debtor’s subsequent borrowings. Therefore, it provides the creditor assurance of repayment. The restriction on the issuer’s activities mitigates the risk the bondholders take on.
In the case of an unsecured loan, the creditor will only be able to collect on the debt if the debtor still owns certain unencumbered assets.
Common Usage of the Negative Pledge
Commonly, the negative pledge permits the borrower to take on future secured debt as long as either the transaction is a permitted exception or the beneficiary of the existing negative pledge is equally secured at the time the new secured debt is incurred.
If the borrower violates the negative pledge clause, they can be found liable for breach of contract. The appropriate remedy for breach of contract can be either injunction, specific performance, or damages.
Example of a Negative Pledge
Consider a scenario where a company borrows one million dollars from a bank, and the bank requires all $500,000 of the company’s fixed assets to be used as collateral for the loan. The bank wishes to protect their interest; therefore, it will include a negative pledge clause.
Soon after, the company requires additional funding for expansion, approaches a venture capitalist, and requests to borrow another one million dollars. The venture capitalist asks the company to pledge $500,000 of its fixed assets as collateral.
Unfortunately, the company will be unable to pledge the assets as collateral because they’ve already been used as collateral in the financing transaction with the bank.