Negative Pledge: What the Clause Stops You Signing

Broadly, if a company fails, creditors holding security are paid from the assets they hold before unsecured creditors see anything. A lender with no security therefore wants assurance that nobody else will be allowed to jump ahead of it, and that is the original purpose of the clause. A secured lender wants it too, for a different reason. Its security may rank first today, but a new charge can compete for the same assets, and in New Zealand and Australia some financiers of specific goods can rank ahead of an earlier general security interest if they register in time.

The clause is a contract between borrower and lender. It creates no mortgage or charge and does not by itself stop the borrower from granting security to someone else. Security granted in breach is usually still security; what the lender has is an event of default against its own borrower. Any claim against the other creditor depends on what it knew and on local law. A UK lender that also holds a charge can give some notice of the clause: the Companies House form for registering a charge has a box for terms that prohibit further security ranking equally with or ahead of it.

Four parts decide what a particular clause does. The first is whose assets are covered: the borrower alone, or every guarantor and group company. The second is what counts as security. The third is the list of exceptions, usually defined as permitted security. The fourth, more common in bonds and unsecured corporate debt, is an equal-and-rateable provision, under which new security is allowed if the lender is secured alongside it.

The second part is where the three markets differ. New Zealand and Australia have personal property securities statutes that look at substance, so a supplier's retention of title is treated as a security interest. A lease of goods from a business that regularly leases goods falls under the same regime if its term is more than one year in New Zealand or more than two years in Australia. An agreement that uses the statute's meaning catches those arrangements without naming them. The UK has no equivalent statute, and retention of title and hire purchase are not security in the strict sense. A UK clause reaches them only if its words do, which is why many extend to quasi-security: sale and leaseback, recourse factoring and similar arrangements.

Permitted security commonly covers liens arising by law in the ordinary course, security already listed at signing, the normal retention of title on supplier terms, and asset finance up to a fixed sum.

A maker of fibreglass water tanks in New Zealand, constructed for this page like every figure in it, owes its bank US$6.5m under a term loan and overdraft secured by a general security agreement. The negative pledge allows supplier retention of title on normal terms and asset finance of up to US$500,000 in total. That sum is the example's and is not offered as a market norm. The business has US$130,000 outstanding on forklift leases. It now wants a filament-winding machine on a five-year lease of US$420,000.

The production manager sees a lease, not a loan, and the lessor's documents arrive with a registration on the Personal Property Securities Register already prepared. Signed as it stands, the lease breaches the clause by US$50,000, and the breach is an event of default once any cure period has run, however well the business is trading. The lessor, if it registers in time, can also rank ahead of the bank over that machine.

The bank is likely to find out either way, because it searches the register at review. If the finance director asks first, the conversation is short: the machine is new, it earns its keep, and the bank's general security over everything else is untouched. The bank agrees in writing to raise the basket to US$600,000, or offers to fund the machine itself. Asked afterwards, the same request reaches credit as a covenant breach and a question about who reads the facility letter.

Security gives its holder a right over an asset and a place in the queue. A negative pledge gives neither. If a company with a negative pledge and no security fails, the lender stands with the other unsecured creditors, and the clause has done its work only if it kept the assets unencumbered until then. That is the reasoning behind unsecured lending to strong corporates, and it is why a lender relying on the clause reads the registers rather than the promise.

It also differs from a limit on borrowing. A negative pledge restricts security; a separate restriction on financial indebtedness restricts debt. A business may be able to take on unsecured debt without touching the first clause and breach the second. Where a lender does consent to new security, a deed of priority usually settles the ranking, and a lessor or supplier financing specific goods may have the purchase money priority the example describes.

DEFINED IN ONE PARAGRAPH → · WHAT YOUR BANK HOLDS AS SECURITY → · EQUIPMENT LOAN VS LEASE →

The time to deal with the clause is before signing. A borrower with a fleet on lease, a growth plan that needs machinery or a supplier with retention of title should list them against the permitted-security definition and ask for what is missing. Later, a lender tracks each exception used against the basket and the register.

Acquisitions are the other common trap. A target's existing leases and charges come with it, and if the target joins the group, they may breach the pledge on completion unless the agreement allows them for a period. When a lender is asked for consent in either case, it weighs the same thing: what the new claim takes out of its recovery and what the money does for the business.

READING YOUR FACILITY LETTER → · EVENT OF DEFAULT →