Negative Pledge

What is a Negative Pledge?

A negative pledge is a contractual agreement between the lender and the borrower, which acts as a protection for the lender by restricting certain actions of the borrower that cause a negative financial effect on the lender.

“But why do that to a borrower? What right does the lender have over the borrower that allows the lender to restrict the borrower’s freedom of choice?”

Many economic entities, particularly financial institutions, actively participate in credit, a key component of their business model focused on lending financial resources.

Such organizations need to ensure protection from malicious debtors who borrow resources for fraudulent reasons. In case of default, such as bankruptcy, it is sure to pose existential threats on different scales depending upon the lent amount in question.

Therefore, such financial institutions implement legal safety brackets such as collateral, which will force the debtor to pay on time to avoid losing the asset in collateral.

The collateral will typically be of the borrowed value, which guarantees that the debtor would pay on time or, if defaulted, the financial institution can take collateral as compensation.

But as with any man-made policy, they are bound to have loopholes attached. To combat such loopholes, there are some legal strategies placed to protect the lender, one of which is the Negative Pledge.

Understanding A Negative Pledge? 

A negative pledge is a contractual provision or clause that protects creditors from debtors who possess assets not free from liabilities or place the same asset twice or more as collateral by restricting the debtor from lending further financial services.

Any financial institution, for instance, a bank, can lend a loan with a negative pledge clause. The clause ensures that the borrower won’t have the ability to obtain more debts in the future to avoid any compromises with the existing creditor, i.e., the bank.

This is because the more debt the borrower indulges in, the more time it takes for the bank to receive its full due settlement, along with a higher chance of the borrower going bankrupt.

The negative pledge is not only seen in loans (Collateral) but also in other forms of borrowing, such as Mortgages (Real Estate) and Bond Indentures (Bondholders).

In case of a technical default resulting from a breach, the specific terms and agreements outlined in the negative pledge address the situation, distinct from a default due to a breach of the covenant itself.

What Is The Purpose Of A Negative Pledge?

As mentioned above, the negative pledge is a provision in which the debtor is restricted from providing the liability-held assets (mortgaged house) or assets provided twice or above as collateral for financial services. 

In general, there are two types of debt services a lender would provide based on the circumstances and relationship with the borrower:

1. Secured Debts: Secured debts are those involved in a contractual agreement of collateral that would protect the lender if the borrower defaults. Here, the lender controls the creditor’s borrowings to ensure the lender’s proper repayment. A typical financial provider would indulge in this type of financial services.
2. Unsecured Debt: Unsecured debts are those debts that do not involve a contractual agreement that favors the lender but instead indulge the services with trust in the borrower. Here, the lender collects the debt when the debtor has no other obligations or priorities. 

In an age where fraudulent activities prevail more than ever before, especially with the advancement of technology and convenience, it has caused great concern for financial institutions to provide financial services to capable prospectus. 

Financial creditors have implemented assurance strategies to ensure protection from falling prey to fraud, such as credit score checks to assess potential borrowers’ behavior, as well as setting collateral to ensure the borrower fulfills the due obligations towards the creditor.

But even with such assurance strategies, fraudulent activities never cease to exist. For every advancement, there will be an advancement in fraud. To ensure the protection of creditors, the lenders of financial services have implemented negative pledge covenants in their contracts.

A double negative pledge is a covenant that prevents the borrower from using assets with liabilities as collateral for multiple borrowings, thereby restricting access to additional debt from any financing sources.

Compliance with the contractual agreement by the borrower is legally mandatory. If the borrower were to breach the terms and agreement of the covenant, it would lead to technical default. Then, the bank has the right to cease the property held as collateral as a repayment.

Technical default due to a breach of covenant not only causes the borrower to lose the collateral assets to the lender but also causes the borrower to face legal actions and dampen the credit score, rendering them unworthy of future credits. 

Advantages Of Negative Pledge 

Like every policy, it has advantages and disadvantages that affect everyone involved. This also applies to negative pledges. Let us explore the advantages of a negative pledge: 

1. Enhanced lender security: The pledge enhances the security for lenders by ensuring that there is a recourse to repayment in the form of collateral per borrowing if the borrower falls to technical defaults or indulges in fraudulent activities.
2. Reduction in lending risk: The pledge enhances repayment security for lenders through appropriate collateral, promoting borrower compliance and ultimately reducing lending risks.
3. Enhanced confidence: The pledge can increase confidence in the repayment by the borrower due to a safety net binding the contract, which increases not only lenders currently providing credit services but also potential lenders.
4. Setting priorities: The pledge enforces a negative covenant upon the recipient via the contract, which limits the borrower from borrowing further loans using the same collateral or using assets that have liability upon them. The more the debt borrower takes, the more time it will take the borrower to pay the due amount. Therefore, it limits the borrower from borrowing further, and the lender gets priority when the borrower pays the due amount. 
5. Collateral clarity: The pledge provides clarity in the circumstances and the ownership of the assets given as collateral by the borrower, reducing the chances of potential disputes due to misunderstanding.
6. Improved credit score: The pledge benefits not only the lenders but also the borrowers. The pledge ensures security for the lenders, which forces borrowers to stay compliant with the contract. Borrowers' compliance leads to increased credit scores that build trust with the lender and, therefore, help the borrower avail of any future additional loans and financial services from the financial provider.
7. Reduction in borrowing interest rates: The pledge also benefits the borrower in the way of reduced interest rates while borrowing. As the pledge provides security to the lender on the loan, this reduces the lending risk and, therefore, reduces the interest rate. The higher the risk, the higher the interest rate. 

Disadvantages Of Negative Pledge

Now, there is not a single man-made policy that comes with just perks. There’s shade in broad daylight. Every policy, even the negative pledge, has drawbacks that are bound to backfire if it does not proceed with enough consideration and caution. The cons for negative pledges are:

1. Complex legal structure: Creating the negative pledge clause is a time- and resource-consuming deal, especially the negotiation and implementation, which should be agreed upon between both parties of the contract agreement.
2. Increased borrowing costs: The provision made for negative clauses can make borrowing costs expensive for the borrower, especially when the borrower is borrowing for the first time.
3. Questioning enforceability: The pledge, when it comes to legal enforcement, may or may not possess the right to enforcement depending upon the jurisdiction of the local laws. Therefore, hinders the effectiveness of the pledge.
4. Limited flexibility: The negative covenant restricts the borrower’s ability to acquire more borrowings by pledging collateral, which is an advantage to the lender as the lender can redirect the priority of the borrower towards itself, but it poses a disadvantage for the borrower.  
5. Potential disputes: The pledge has a high potential to stir some conflicts between the two parties due to misunderstanding, lack of clarity, and utilization of ambiguous terms. This is why the negotiation between the two parties is a time-consuming effort to ensure the same level of understanding between both parties to avoid any unwanted potential disputes.

Practical Example Of A Negative Pledge

Now we have gone through what a negative pledge is, who, and when it is used, theoretically. Let us see a practical use case of financial providers' negative pledges using a simple realistic scenario.

Imagine you are starting a small-sized B2B business specializing in providing cybersecurity solutions to client businesses. You have $100,000 in savings, which is enough to set up the business but not enough to hire manpower and run the business.

So you have approached the bank asking for a loan of $300,000 with 2% interest. Now, since you are seeking a loan of such a high amount for the first time, the bank is not confident in your ability to repay.

Therefore, the bank requests collateral, to which you have agreed and provided your house valued at $320,000. The bank agrees as it covers its risk of lending and issues a secured loan for ten years along with a negative pledge clause in it.

Now,, four years have passed, and your business is thriving. You have clients all over, your business is expanding, and you have increased your manpower to meet the demand. But there’s a limit to everything, and soon you realize you can’t expand the way you do anymore.

To meet the increasing demand, you have to expand on a large scale. A different branch, maybe. Therefore, you approach the bank and ask for a loan of $100,000. Consequently, the bank reviews your credit score and acknowledges your consistent and timely payments.

But the catch is the previous bank has restricted your further borrowing, as it has provided a secured loan. On top of that, the negative pledge clause from the previous loan agreement, which you are still tied to, has restricted you from placing your house again for collateral.  

This is how a negative pledge works in real life. The contract remains with you till the end of the contractual period, and you have fulfilled the contractual obligations and are compliant with its terms and conditions.

Pretty clever, huh? It is a simple way of making money work (passive income) when you have enough legal backing and financial instruments to reduce the risks involved. Banks and financial institutions understand the strategy of making money work and thus implement it effectively.  

Researched and authored by Muhammed Ishfaque Ishaque | LinkedIn

Reviewed and edited by Mohammad Sharjeel Khan | Linkedin

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Negative Covenant
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• Public Information Book (PIB)
• Reverse Termination Fee
• Smart Contract