Banking | The Negative Pledge

No doubt Banks will first secure themselves before providing any sort of loan or other facility to any prospective customer/borrower.  In an event of default by the borrower, that being the borrower’s failure to honour its’ commitments under any banking facility agreement, banks will in no time be secured due to a charge or mortgage that the borrower has agreed to while signing the agreement.  This however is not always the case, especially in the case of a wealthy borrower.

Wealthy borrowers or, in other words, AAA rated borrowers, are always welcome to banks and banks are ready to provide their services in a much more welcoming way, even by not being fully secured or not being secured at all.  This is not a rare case since it is not always practical to lend money on a fully secured basis.  This is where “negative pledge” joins in the picture.

In some Loan Agreements, banks will include a clause providing something like: “Negative Pledge – The Obligor (ie the borrower) shall not create or permit to subsist any Security over any of its assets”.  In other words, the borrower agrees not to create or allow subsisting encumbrances over the assets.

The clause provided above is a typical negative pledge in its most simple version though; such clauses can form a single paragraph, as above, or a number of pages, depending to the size of the proposed facility or Loan.  Some other versions of a negative pledge may go further prohibiting the borrower from being a guarantor or giving indemnity to any other third party.  It may also go even further prohibiting the disposal of any of the borrower’s fixed assets; strictly speaking though it is submitted that these prohibitions are not part of the negative pledge.

When will banks use a negative pledge?  It can be used in the following cases; in cases where they really want the customer; in cases where a very wealthy prospective borrower needs a loan or other banking facility; in cases where every bank looks out and search for such customers.  In such cases, banks will prefer not to ask the customers and simply to ensure that the borrower will honour his commitment; in other words, to be somehow secured.

The negative pledge has to following functions:

  1. It provides a assurance that the borrower’s assets will not become unavailable by reason of a charge or security in favour of a second creditor;
  2. It is an ensuring that the unsecured bank maintains an indirect control to the borrower’s asset and retains priority;
  3. The bank will indirectly control the borrower’s financial agreements (ie his borrowings);
  4. It provides a measure of equal treatment among different creditors, by attempting to prevent a second creditor from gaining an advantage by obtaining security.

It is generally accepted that the negative pledge does not create any proprietary rights and therefore it is not registrable under sections 90-101 of the Cyprus Companies Law Cap:113; the same situation also exists under English Law leaving the negative pledge non registrable under section 396 of the Companies Act 1985.  It is common practice though the Banks to set out full details of the negative pledge filed with the registrar of Companies.  Although it does not amount to a constructive notice to the world, the intention is that it will come to the notice of a prospective third party creditor by undergoing a reasonable company search.  If however no such search is made by the third party creditor, he will not be bound by the negative pledge clause since he would have no knowledge of it.

There are two types of negative pledge; the “purely” and the “affirmative”.

The purely negative pledge is the most commonly used one.  It restricts the borrower from creating any security unless such that it is necessary for the borrower to run his business and to trade (the so called “Permitted Encumbrances”) or, that which is allowed by application of the law.  The remedies for breaching a purely negative pledge are only contractual and does not give any proprietary rights to the banks; in other words it does not create any security whatsoever over the barrower’s assets.  It will only rank ahead of a second creditor if that creditor had knowledge of the clause but still induced the borrower.

The affirmative negative pledge is of less frequent use.  Here, the borrower agrees that if he creates a security interest in favour of a second creditor, the obligation of the first creditor will be automatically and immediately secures on the same assets equally with the liabilities owed to the second creditor.  This however gives rise to a number of difficulties for which many professors and commentators disagree.  Some say that the provision of automatic attachment does not have the effect of granting security interests because it lacks consideration whereas some others are of the opposite opinion saying that in cases of negative pledge the creditor and borrower have a mutual intention that the lender will have a present right to have a property made available to him for the repayment of the dept.  This appears to be grey area of the law surrounding the negative pledge provision where no clear cut answer can be provided.  A different approach is used by USA Courts where a breach of a negative pledge will automatically give security over the borrower’s assets; the agreement itself gives rise to a present equitable interest by way of an equitable lien.

Breach of a negative pledge is an event of default by the borrower entitling the creditor to call the loan in, ie to ask for immediate repayment.  However the creditor may not be aware of the borrower’s breach even until the borrower is insolvent.  Again, of crucial seek to control anti-competitive arrangements and practices within the E.U.  The effect of negative pledge may prevent the borrower from entering into a secured loan agreement with a creditor in another Member Sate and therefore may affect trade between Member States.  This is a question that needs elaboration and shall therefore not to be further considered here.

To conclude, as appears from the above brief guide on negative pledge, remedies for a breach of a negative pledge clause are limited and hardly confer on the creditor any rights over the borrower’s property.  Any security granted by the borrower in breach of a negative pledge may “as a general rule” still be valid but, since all rules have their exceptions, it may as well be void.  So, is a borrower liable for taking security over an asset subject to a negative pledge?  There cannot be a clear answer to the question; a proper answer would simply be that it depends on the facts of each separate case.  One opinion would be that lending on negative pledge is not an alternative to a secure loan but still, banking practice appears to favour negative pledges since banks favour having a wealthy customer! A.G.Paphitis & Co. LLC ©