Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Negative Pledge Clause

What it is:

A negative pledge clause is lending agreement language designed to prevent borrowers from pledging the same collateral to multiple lenders or otherwise taking actions that might jeopardize the security of existing lenders.

How it works (Example):

For example, let's assume that Company XYZ borrows $10 million from Bank A. Bank A requires Company XYZ to pledge all $7 million of its factory assets and some of its securities as collateral for the loan. The lending agreement includes a negative pledge clause.

Later, Company XYZ wants to borrow $2 million from Bank B. Bank B wants Company XYZ to pledge $1 million of factory assets as collateral for the loan. Because Company XYZ has a negative pledge clause in its loan agreement with Bank A, Company XYZ cannot pledge the $1 million of collateral, because doing so would reduce Bank A's security. Company XYZ might choose to pledge other assets to Bank B, ask Bank B for an unsecured loan if it has no other collateral to offer, or try to renegotiate its collateral agreement with Bank A.

Why it Matters:

Negative pledge clauses are generally intended to ensure that a bank does not suffer from the subsequent actions of the borrower. Without such clauses, borrowers might have the option to pledge the same collateral to multiple lenders. In the event of default, these lenders would scramble to recover the same collateral.