What is a negative pledge clause?

A promise, not a property right

A lender can protect itself against a borrower's other creditors in two ways. It can take a security interest: a property right in the borrower's assets, created by a security agreement and made public by a UCC-1 financing statement, which lets it take and sell the collateral and be paid before unsecured creditors. Or it can take a negative pledge: the borrower's promise not to give a security interest to anyone else. The first is a claim on the assets. The second is a claim on the borrower's behavior.

The last row is the one borrowers most often misunderstand. If a business breaches a negative pledge and grants a lien to a new lender, the new lender generally still has a valid lien, because the pledge binds the borrower, not the new lender. A new lender that knew of the pledge may face a claim for interfering with the contract, but the lien usually stands, and the lender holding the pledge cannot undo it. What it can do is declare an event of default and demand repayment, which, for the business, is usually worse.

Where negative pledges show up

Unsecured loans. A lender making an unsecured term loan or line of credit to a strong borrower is relying on the business's assets being available to all its unsecured creditors equally if things go wrong. A negative pledge protects that. Without one, the borrower could later grant a lien on everything to a new lender, and the unsecured lender would find itself behind a secured creditor it never agreed to. This is why an unsecured lender's negative pledge sometimes comes with a promise that if the borrower ever grants liens, it will secure this lender equally and ratably.

Secured loans. In a secured loan the negative pledge appears as the liens covenant, one of the negative covenants. The lender already has a blanket lien, so the purpose is different: to stop anyone else taking a lien that would compete with its own, even a junior one. A second lender behind the bank means a second creditor with rights in the same assets, and the bank does not want that without an intercreditor agreement it has negotiated.

Specific assets. Lenders sometimes take a negative pledge over an asset instead of a lien on it. A bank that does not want the cost of a mortgage on the owner's real estate may accept a negative pledge agreement: the owner promises not to mortgage the property to anyone else while the loan is outstanding. It is a lighter-touch protection, and some borrowers prefer it to a recorded lien.

Permitted liens: the exceptions that matter

No business can operate with no liens at all. Equipment is financed, vehicles carry titles, landlords and tax authorities have statutory rights. So every negative pledge comes with a list of permitted liens, and that list is the part to negotiate. The usual entries:

• Liens securing the lender's own loan. In a secured facility, obviously.
• Existing liens listed on a schedule at closing. Anything not on the schedule is not permitted, so the schedule must match a current lien search.
• Purchase money liens and finance leases, up to a stated total amount. This is the basket that lets the business finance new equipment without asking permission each time. See purchase money security interests.
• Liens arising by law: taxes not yet due, landlords', mechanics' and carriers' liens in the ordinary course, deposits for utilities and workers' compensation.
• A general basket for other liens securing small amounts.

The permitted liens schedule is agreed once, at closing, and governs every financing decision until the loan is repaid. It is worth an hour of the owner's time.

A business that expects to buy equipment on finance during the life of the loan should size the purchase money basket to its capital expenditure plan, not to whatever figure the lender's form proposes. An undersized basket means asking for consent every time a truck or machine is financed, and consent can come with conditions.

When an equipment financer or unsecured lender is already there

The negative pledge matters most at the point a business brings in a second source of capital. Three situations come up repeatedly:

• Adding equipment financing beside a bank loan. The equipment lender will want a first lien on the specific equipment it finances. If the bank's purchase money basket has room, this is routine. If it does not, the borrower needs the bank's consent, or the equipment lender needs to take a subordinate position. See equipment financing alongside a senior facility.
• Adding a secured lender beside an unsecured one. A business with an unsecured line from a relationship bank that wants to add an asset-based line or a secured term loan must deal with the existing negative pledge first. Usually that means refinancing the unsecured lender, getting its waiver, or granting it an equal lien, which the new secured lender will rarely accept.
• Taking a merchant cash advance. An advance funder files a UCC-1 against the receivables and often the whole business. That filing is a lien the existing loan agreement almost certainly does not permit, and it is frequently how the bank discovers the advance. See how cash advance history affects a bank loan.

The order of operations matters. Asking the existing lender for consent before the new financing is signed is a request. Telling it afterward is a disclosure of a default.

What a new lender checks

A lender considering a new loan reads the borrower's existing loan agreements for negative pledges and liens covenants, and runs a UCC search to see which liens are actually on file. The two should match: every filed lien should be permitted under every existing agreement, and nothing in the agreements should forbid the lien the new lender wants. When they do not match, the new loan waits until they do. The line of credit checklist Transparent works from includes a debt schedule with the UCC position, existing liens, for exactly this reason; the lender package sets out every existing lender, what it holds and what its documents permit, so a new lender knows at the outset what consents or payoffs its loan will need. See what goes in the package.