Summary
- A negative pledge is a legally enforceable promise in a loan agreement where your company undertakes not to grant security interests over its property to other lenders.
- If your company breaches a negative pledge, the lender may treat this as an event of default and demand immediate repayment of the outstanding loan.
- Carve-outs can exclude certain assets from the negative pledge, allowing your business to continue normal trading activities without breaching the agreement.
- This article explains the implications of negative pledges for business owners whose companies are negotiating or have obtained bank loans in the United Kingdom.
- LegalVision, a commercial law firm specialising in advising clients on corporate finance and lending matters, outlines what negative pledges are, how they work, what constitutes a breach, and the practical considerations for businesses.
Tips for Businesses
Review your loan agreement to understand prohibited security interests and identify carve-outs for normal trading. Before granting new security or entering quasi-security arrangements, check for potential breaches. If you discover a breach, notify your lender promptly to seek consent or a waiver.
If your business is negotiating a bank loan, one standard term you may find in the loan documents is a “negative pledge”. Put simply, a negative pledge is a form of undertaking where you promise not to do something. In legal terms, this is also called a ‘negative covenant’ or ‘restrictive covenant’ in financing documentation. If you breach such a pledge, this could have serious ramifications for your loan agreement. Hence, this article will explain the implications for you and your business if a negative pledge binds your company.
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Negative Pledges
For banks, lending is a risky endeavour. This is because there is always the chance that the borrower will not repay the loan. One way banks can provide themselves with some reassurance that you will repay the loan is by procuring a negative pledge.
A negative pledge is a kind of “undertaking”, which is a legally enforceable promise. It is an undertaking not to do something. If your company agrees to such a pledge in a loan agreement, it promises not to grant any other security interests in its property.
Alternatively, the negative pledge might state that if your company does grant another security interest, the additional security interest will be subordinate to the bank’s existing security interest.
In practice, when you obtain a loan, the bank will gain a security interest in your company’s property in the present and the future. Therefore, the negative pledge applies to all your company’s property unless there are “carve-outs”.
Carve-Outs
From a practical standpoint, a bank will seek to secure as much of your company’s property as possible. The language of the security agreement will therefore seek to secure all of your company’s assets. However, there are circumstances where your business will not be able to function if the bank takes security over certain assets.
For this reason, carve-outs seek to exclude specified assets from falling under the secured property. For instance, another lender may have already obtained security in some of your company’s property. To avoid a situation where the security interests conflict, the security interest of the second lender would exclude the property secured by the first.
Some examples of property that lenders commonly carve out of negative pledges include:
- company inventory;
- company cash you used to provide security for other services; and
- property that your company acquires with pre-existing security interests in it.
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What About Unsecured Lenders?
The vast majority of borrowing that small businesses obtain are bank loans. As a matter of convention, nearly all bank loans give the bank security in the company’s property. This is why bank loans are commonly called “secured loans”.
However, receiving loans that do not grant security over your company’s property is possible. These are called “unsecured loans”.
Therefore, if your company receives an unsecured loan, a negative pledge in the loan agreement prevents another bank from gaining a better claim on your company’s assets after you take out the initial loan.
What Counts as a Breach of a Negative Pledge?
Understanding what constitutes a breach of a negative pledge is important for borrowers. Your company breaches a negative pledge when it creates, or permits to subsist, a security interest that goes against the clause in its loan agreement. The consequences can be severe: lenders often classify a breach as an event of default, which may allow them to demand immediate repayment of the outstanding loan.
However, breaches are not always straightforward. Broadly drafted negative pledge clauses can capture some commercial arrangements, even if UK law does not traditionally treat them as security. For example, if you enter into a hire purchase agreement for equipment, you do not technically create a security interest because the financier retains title.
However, many negative pledges expressly restrict hire purchase, finance leases or similar quasi security arrangements. Likewise, certain retention of title provisions in supplier contracts, particularly extended or all monies clauses, can operate like security in practice and fall within the scope of a broadly drafted negative pledge.
If you discover that you may have breached a negative pledge, notify your lender promptly. Many UK loan agreements include waiver or consent mechanisms that allow lenders to approve transactions that would otherwise breach the clause. Lenders often take a pragmatic approach and may grant retrospective consent where the security or quasi security interest is minor or necessary for business operations.
Key Takeaways
One way banks mitigate their risk of not being repaid is to obtain a negative pledge from a borrower. A negative pledge promises that the company will not grant any other security interests over its property if it borrows from other lenders. This protects the bank from having to compete with multiple lenders if a company defaults on its payments and the bank seeks to enforce its security interest in the company’s property.
If you need help with your company’s loan agreement, LegalVision provides ongoing legal support for businesses through our fixed-fee legal membership. Our experienced corporate lawyers help businesses manage contracts, employment law, disputes, intellectual property, and more, with unlimited access to specialist lawyers for a fixed monthly fee. To learn more about LegalVision’s legal membership, call 0808 196 8584 or visit our membership page.
Frequently Asked Questions
A negative pledge is a term of a loan agreement that states the company will not grant any further security interests in the company’s property.
A negative pledge reassures the bank that if the company receives a subsequent loan from another lender, the bank can rely on its security interest to enforce against the company’s property. As a result, it will not have to compete with future lenders to recover its money and will rank ahead of the other lenders.
Generally, no. Well-drafted negative pledges include carve-outs for ordinary course business activities. This means your company can continue to grant security interests that arise naturally in the course of trading, such as retention of title clauses with suppliers or hire purchase agreements for equipment, provided these fall within specified limits. However, you should always review the specific terms of your negative pledge to understand what restrictions apply to your business.
A negative pledge is a contractual promise not to grant security interests to other lenders, but it doesn’t give the lender actual security over your assets—it simply prevents you from granting security to others. A fixed charge, by contrast, gives the lender an actual security interest in specific identified assets, meaning they have a proprietary right to seize and sell those assets if you default. Many loan agreements contain both: a fixed charge over certain assets and a negative pledge preventing you from granting further security.
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