What Is a Negative Pledge Clause?
A negative pledge clause is a contractual promise in a loan agreement, bond indenture, or mortgage under which a borrower agrees not to grant security interests (liens) over specified assets in favor of other creditors. It protects an unsecured lender’s or bondholder’s economic position by preventing the borrower from subordinating their claim on assets through later-secured debt. Negative pledge clauses therefore help preserve asset value available to existing creditors if the borrower defaults or becomes insolvent.
Key Takeaways
– Purpose: Prevents the borrower from pledging specified assets to other creditors so existing lenders/bondholders do not become unnecessarily junior.
– Common use: Unsecured loans, bond issues, and some mortgages or corporate debt facilities.
– Benefit to borrower: Can reduce interest cost compared with fully unsecured debt without any negative pledge because it limits lender risk.
– Risk for borrower: Restricts future borrowing flexibility and asset financing options.
– Enforcement: Violation generally creates a technical default and gives lenders remedies (acceleration, injunction, damages, waiver negotiation), but enforcement versus third parties is limited.
How a Negative Pledge Clause Functions
– Scope: The clause will define which assets are covered (all assets, specific classes, real property, intellectual property, etc.) and whether future-acquired assets are included.
– Prohibition: The borrower agrees not to create, incur, assume or permit any lien or charge on the covered assets in favor of other creditors.
– Exceptions (Permitted Liens): Typical carve-outs allow certain liens (e.g., statutory liens, liens in favor of the lender, purchase-money security interests under a de minimis threshold, liens for taxes not yet delinquent). These are negotiated.
– Remedies: The agreement specifies what the lender may do if the clause is breached—notice, cure period, acceleration of debt, injunction or damages. Most agreements allow a limited cure period before the lender takes harsher action.
– Practical aim: Keep the borrower “unencumbered” relative to the creditor who negotiated the clause so that, in insolvency, the creditor’s recovery prospects do not worsen because of subsequent secured creditors.
Important Concepts
– Negative covenant: A broader category of contractual promises not to take certain actions. A negative pledge is one type of negative covenant (one that restricts granting security over assets).
– Double negative pledge: A rarer provision that promises not to enter into other negative covenants with third parties (i.e., a pledge not to agree to further restrictions). It’s intended to preserve the lender’s relative priority and flexibility.
– Technical default: A breach of a covenant such as a negative pledge typically constitutes a technical default. It doesn’t always mean the lender will immediately accelerate; most agreements include notice and cure procedures.
– Priority in bankruptcy: Negative pledges do not create a security interest by themselves. In bankruptcy, secured creditors with valid liens typically have priority; a negative pledge is primarily contractual protection, not a substitute for a registered security interest.
Pros and Cons of Negative Pledge Clauses
Pros (for lenders and issuers)
– Lowers lender risk in unsecured financings because the borrower is restricted from creating later, higher-priority secured debt.
– Can enable borrowers to access unsecured credit or bonds with lower interest rates than fully unrestricted unsecured debt.
– Gives lenders contractual remedies if borrower encumbers assets later.
Cons (for borrowers)
– Limits flexibility to use assets as collateral for future financing, which may be needed for growth, refinancing, or asset-based lending.
– Accidentally violating the clause (e.g., creating a permitted-looking security interest without proper carve-outs) can trigger a technical default.
– Enforcement can be difficult—lenders still must monitor, detect, and litigate breaches; third-party secured creditors may be unaffected if they are bona fide purchasers for value.
Key Considerations When Drafting or Negotiating Negative Pledge Clauses
– Define covered assets precisely: “all assets” vs. “material assets” vs. specific categories.
– Permitted liens: carve out ordinary commercial liens, purchase-money liens, tax liens, liens securing specific permitted financings, and small-dollar security interests.
– Basket thresholds: Allow secured financings up to an aggregate cap (e.g., up to X% of assets or $Y million) to preserve financing flexibility.
– Exceptions for refinancing: Allow the borrower to refinance existing secured indebtedness on similar or more favorable terms.
– After-acquired property: Decide whether the clause applies to assets acquired after the date of the agreement and define the treatment.
– Reporting and notice obligations: Require notice if the borrower grants a lien and give lenders rights to consent, waive, or cure.
– Remedies and cure periods: Clear procedures for notice, cure, waiver payments, and acceleration.
– Intercreditor arrangements: When secured debt exists or may be taken, an intercreditor agreement can set priority rules and protect unsecured creditors’ interests.
What Happens If a Borrower Breaks a Negative Pledge Clause?
Practical steps and typical consequences:
1. Detection: Lender discovers encumbrance (via covenant reporting, UCC filings search, public records or borrower disclosure).
2. Notice: Lender gives formal notice of breach to borrower as required under the loan docs.
3. Cure period: The borrower typically has a contractually specified time to cure the breach (e.g., 30 days) by removing the lien, obtaining a release, refinancing, or negotiating a waiver.
4. Remedies if not cured:
– Acceleration of debt (declare the loan due).
– Injunctive relief to prevent enforcement of the later lien against the borrower (limited vs third-party rights).
– Damages or indemnities per contract.
– Renegotiation of terms (waiver for a fee or new covenant package).
Remember: The lender cannot usually sue a third-party secured lender claiming direct remedy under the loan agreement; remedies are against the borrower for breach.
Practical Steps — Checklist for Borrowers (Before Signing and After)
Before signing:
– Review the scope and definitions carefully (covered assets, after-acquired property).
– Negotiate reasonable permitted liens and baskets for small or routine secured financings.
– Obtain carve-outs for specific business needs (equipment financing, leasing, trade credit).
– Ask for a mutuality or limitation on the lender’s remedies (reasonable cure period, waiver conditions).
– Consider whether a security interest in a narrow set of critical assets is preferable (accept secured financing in exchange for different pricing/terms).
After signing:
– Maintain covenant compliance monitoring routines (UCC searches, internal approvals).
– Avoid inadvertent liens—coordinate with treasury, legal, and accounting.
– If new secured financing is needed, approach existing lenders to negotiate waivers or amendments early.
– Keep documentation to show any liens are permitted liens under the agreement.
– If a breach happens, act quickly to cure within the contractually allowed period or seek a negotiated waiver.
Practical Steps — Checklist for Lenders (Before and After Loan)
Before lending:
– Insist on clear definitions and appropriate carve-outs. If borrower assets are critical collateral elsewhere, require an intercreditor agreement or an actual security interest.
– Include covenant reporting requirements and filing rights (UCC filings, searches).
– Determine what remedies you want and ensure they are legally enforceable in relevant jurisdictions.
After loan closing:
– Monitor public filings, borrower disclosures and financial statements for encumbrances.
– Send periodic reminders about negative pledge covenants to borrowers.
– If a breach is discovered, serve prompt notice, preserve priority attached to your loan (seek interim relief if needed), and negotiate cure or waiver terms.
Negotiation Tips and Common Compromises
– Lender accepts a negative pledge but allows a “permitted liens” schedule covering typical operating liens and small finance transactions.
– Include a de minimis basket (e.g., secured indebtedness up to $X or Y% of total assets).
– Permit refinancing of existing secured debt provided new secured debt is not senior or materially more burdensome.
– Agree on a reasonable cure period and pre-agreed fee or premium for waivers rather than immediate acceleration.
– Use intercreditor agreements where secured lenders exist or are likely to appear.
Sample (Simplified) Negative Pledge Clause Language
“The Borrower shall not, and shall not permit any of its Subsidiaries to, create, incur, assume or permit to exist any Mortgage, Lien or encumbrance on any of its present or future property or assets, whether real or personal, tangible or intangible, except for (i) Liens in existence on the Closing Date set forth on Schedule X; (ii) Permitted Liens (as defined herein), and (iii) Liens securing indebtedness not to exceed $[de minimis amount] in the aggregate. Any encumbrance not permitted hereunder shall constitute an Event of Default, subject to a [30]-day cure period following receipt of written notice from the Lender.”
(Always have counsel tailor clause to the transaction and applicable law.)
Double Negative Pledge
A double negative pledge is an undertaking not to agree to other negative covenants with third parties—i.e., a promise not to restrict the borrower’s actions by way of further negative covenants. Its use is uncommon and may be controversial; it is intended to preserve a lender’s relative contractual status by preventing the borrower from later contracting more restrictive covenants in favor of other creditors.
Enforcement Challenges
– A negative pledge is contractual, not a security interest—so it doesn’t automatically create a lien that is effective against third parties.
– Secured creditors who obtain perfected liens may still have priority unless the lender has a prior perfected security interest or the borrower does not have the right to create such liens.
– Lenders must proactively monitor for lien filings and act promptly when breaches occur; otherwise, they may lose practical priority.
The Bottom Line
A negative pledge clause is a key protective tool for unsecured lenders and bondholders: it preserves asset availability and reduces the risk that later-secured creditors will erode existing creditors’ recovery prospects. For borrowers, it can help secure lower pricing on unsecured finance but restricts flexibility to use assets for future secured financing. Carefully drafted exceptions, baskets, and negotiation over remedies and cure periods are central to balancing lender protection and borrower flexibility.
Sources and Further Reading
– Investopedia, “Negative Pledge Clause.” https://www.investopedia.com/terms/n/negativepledgeclause.asp
– Martindale, “The Negative Pledge.”
– UpCounsel, “Negative Pledge Clause: Everything You Need to Know.”
If you’d like, I can:
– Draft a tailored negative pledge clause with specific permitted liens and baskets for your deal,
– Create a one-page checklist you can use during negotiations, or
– Review a clause you’ve been asked to sign and suggest negotiation points. Which would be most helpful?