What is a Negative Pledge?

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. 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. 

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. 

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, the purpose of a negative pledge in the loan agreement will be to prevent another bank from gaining a better claim on your company’s assets after the initial loan has been made. 

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, our experienced commercial lawyers can assist as part of our LegalVision membership. You will have unlimited access to lawyers to answer your questions and draft and review your documents for a low monthly fee. So call us on 0808 196 8584 or visit our membership page.

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