A negative pledge is a term in a borrowing agreement which prohibits the borrower from taking on additional debt without consent from the original lender. This is designed to protect the lender from “dilution of security,” in which it would be unable to recover its debt in the event of a default. These types of clauses are used in a variety of agreements related to borrowing and lending money and they are one reason why people should review the terms with care before borrowing funds.
One classic reason to use a negative pledge is a large unsecured loan. Lenders who make unsecured loans are aware that if the borrower takes out another loan and pledges assets as security, the new lender can seize those assets in the event of a default, leaving the unsecured lender with less chance of recovering the funds it is owed. Likewise, lenders want to prevent situations in which people pledge the same assets twice.
This type of clause is also known as a covenant of equal coverage clause. When a negative pledge clause is included in the terms of a loan, the borrower may not create situations in which later lenders get priority in the event of a default. If the borrower does want to take out another loan, it can be negotiated with the lender and the lender can decide whether or not the borrower represents a security risk.
Lenders which have a priority claim on assets owned by the borrower can include a negative pledge to make it clear that the borrower cannot repledge those assets or pledge assets in such a way that the security of the original loan would be compromised. For example, when someone takes out a mortgage, the bank has a priority claim on the house in the event of a default. Pledging the house against another loan would dilute the security of the original mortgage and for this reason the bank would likely include a negative pledge agreement in the mortgage paperwork.
The documentation which accompanies a loan can be lengthy, and many borrowers are often tempted to skim over it. However, it is strongly advisable to read the material over with care and to ask a lawyer for assistance if there are clauses which are unclear. When a negative pledge is included in a loan, an attorney can discuss the implications of the clause with the borrower and the borrower can make a decision about whether or not to take on the debt on the basis of how the clause might affect his or her activities.
