Negative pledge: Overview, definition, and example
What is a negative pledge?
A negative pledge is a contractual clause that prevents a borrower from pledging, granting, or creating a security interest in certain assets to secure additional debt without the consent of the lender or another specified party. Essentially, it is a promise by the borrower not to encumber or use specific assets as collateral for future borrowing. The purpose of a negative pledge is to protect the interests of the existing lender by ensuring that the borrower does not over-leverage themselves or dilute the value of the assets that have already been pledged as security for the current loan.
In most cases, a negative pledge applies to tangible assets, such as real estate or equipment, but can also include intangible assets like intellectual property or financial assets.
Why is a negative pledge important?
A negative pledge is important because it ensures that the existing lender has priority over the borrower’s assets in case of a default. By preventing the borrower from using the same assets to secure additional debt, the lender can maintain a level of security and reduce the risk of the borrower becoming over-encumbered.
For businesses, a negative pledge is a way to prevent dilution of the value of their assets by guaranteeing that those assets will not be pledged to other creditors. It helps the lender retain their position and ensures that the borrower’s assets are protected.
Understanding negative pledge through an example
Imagine a company takes out a loan from a bank, securing the loan with its real estate property. The bank requires the company to sign a negative pledge that prohibits the company from using the same property to secure any additional loans in the future without the bank’s approval. If the company later attempts to borrow additional funds using the real estate as collateral for another loan, the negative pledge clause would prevent it from doing so unless the bank agrees.
In another example, a business enters into a loan agreement with a lender, and the contract includes a negative pledge clause that prevents the business from pledging its intellectual property (such as patents or trademarks) to any other creditor. This ensures that the intellectual property remains solely available to secure the loan with the current lender, safeguarding the lender's interest.
An example of a negative pledge clause
Here’s how a negative pledge clause might look in a contract:
“The Borrower agrees not to pledge, mortgage, assign, or create any lien on any of its assets, including but not limited to [list of assets], to secure any future borrowing or debt obligations, without the prior written consent of the Lender. Any breach of this provision will constitute an event of default under this Agreement.”
Conclusion
A negative pledge is a key provision used to protect the interests of a lender by preventing the borrower from using the same assets to secure additional debt without the lender’s approval. This helps ensure that the lender’s existing security interest remains intact and reduces the risk of the borrower over-leveraging their assets. For businesses, agreeing to a negative pledge can provide peace of mind by securing access to capital while protecting key assets from future claims.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.