# Understanding Negative Pledge Clauses: Definition, Benefits, and Drawbacks

## What Is a Negative Pledge Clause?

A negative pledge clause acts as a safeguard in loan agreements, preventing borrowers from pledging assets to other lenders, which could jeopardize the security of existing lenders. This clause is crucial in protecting lender interests, typically appearing in bond indentures or traditional loans, where it ensures priority should the borrower default.

### Key Takeaways

*   A negative pledge clause prevents a borrower from pledging their assets to additional lenders if it would reduce the security of existing lenders.
*   Including a negative pledge clause may enable borrowers to secure loans at lower interest rates by reducing risk for lenders.
*   Breaking a negative pledge clause can lead to a technical default, giving lenders recourse to accelerate loan repayment or take legal action.
*   Although intended to protect lenders, negative pledge clauses can limit borrowers' ability to leverage their assets in the future.
*   Unsecured loans often include negative pledge clauses to ensure borrowers do not use their assets to secure other financial commitments.

## How a Negative Pledge Clause Functions

Negative pledge clauses help lenders or bondholders protect their investments. A negative pledge clause in a bond stops the issuer from taking on new debt that might affect its ability to pay current [bondholders](https://www.investopedia.com/terms/b/bondholder.asp).

It also reduces the chance of an asset being pledged to multiple lenders, preventing disputes if the borrower defaults.

> **Important**
>
> Mortgages sometimes include negative pledge clauses that prevent the borrower from encumbering their home.

## Evaluating the Pros and Cons of Negative Pledge Clauses

Because a negative pledge clause reduces the risk of a loan or bond issue, it often allows the borrower to get a slightly lower interest rate. This creates a win-win situation that benefits both the lender and borrower.

It reduces risk for bondholders by limiting the issuer's actions, often stopping them from using the same assets for other debts.

Violating a negative pledge clause can cause a technical default. Usually, lenders allow a set time, like 30 days, for the borrower to fix it before proceeding with default actions.

Pros

*   Lowers risk for the lender
    
*   Lower interest rates for the borrower
    
*   Ensures that lenders will have recourse if the borrower declares bankruptcy
    

Cons

*   Limits the borrower's ability to sell or borrow against their assets in the future.
    
*   May cause borrower to default if they inadvertently break the covenant.
    
*   They are difficult to enforce for lenders.
    

## Key Considerations for Negative Pledge Clauses

Financial institutions may add a negative pledge clause to protect themselves when giving [unsecured loans](https://www.investopedia.com/terms/u/unsecuredloan.asp).

In this case, the clause prevents the borrower from using its own assets to secure other sources of financing. If the borrower obtains additional loans, the first loan becomes less secure, as new debts take priority.

Many home mortgage agreements prohibit borrowers from using their mortgaged property as collateral for new loans, unless it is for refinancing.

## What Is a Negative Covenant?

A negative covenant is a contractual agreement that binds prevents one party from taking a certain action. In other words, it is an agreement not to do something. Negative covenants might prohibit a person or company from selling certain assets or taking on more than a certain amount of debt, for example.

## What Is a Double Negative Pledge?

A double negative pledge is a promise not to enter into negative covenants with any third party. In other words, it is a negative covenant that prohibits other negative covenants. This type of agreement is frequently used by banks or other lenders to ensure that they have a priority claim to a borrower's assets if they declare bankruptcy.

## What Happens If a Borrower Breaks a Negative Pledge Clause?

The loan agreement will specify the type of recourse that is available to a lender if the borrower sells or otherwise encumbers property protected by a negative pledge clause. This will usually allow the lender to sue the borrower, or [accelerate](https://www.investopedia.com/terms/a/acceleration-clause.asp) the loan's repayment schedule. However, the lender cannot pursue action against any third party, only the borrower.

## The Bottom Line

A negative pledge clause is a crucial component in loan contracts that protects lenders by restricting borrowers from pledging their assets to other lenders, ensuring the lender's recourse in case of borrower default. It offers benefits like reduced interest rates for the borrower, yet also limits their future financial maneuvers.

Violating this clause can lead to technical default, highlighting the necessity for borrowers to carefully navigate their agreements. For financial stakeholders, understanding the implications of negative pledge clauses is essential for safeguarding loan priorities and ensuring financial resilience.

> **Article Sources**
>
> 1.  Martindale. "[The Negative Pledge](https://www.martindale.com/legal-news/article_certilman-balin-adler-hyman-llp_1197080.htm)."
>     
> 2.  UpCounsel. "[Negative Pledge Clause: Everything You Need to Know](https://www.upcounsel.com/negative-pledge)."