Bankers when offering banking facilities would prefer that the company provide certain security/collaterized  assets

However, in the event of an UNSECURED commercial loan, we will often then see a Negative Pledge Covenant letter being issued. So what is this negative pledge clause letter and what are its purposes?

Firstly, a negative pledge is a provision in a contract which prohibits a party to the contract from creating any security interests over certain property specified in the provision.

As for the purpose, it is to ensure that a borrower, having taken out an unsecured loan, cannot subsequently take out another loan with a different lender, securing the subsequent loan on the specified assets. If the borrower could do this, the original lender would be disadvantaged because the subsequent lender would have first call on the assets in an event of default. As it is an attempt to ensure no unequal/unfair treatments to bankers, it is also referred to as a “covenant of equal coverage”.

Take for example in the case of a bond, a negative pledge clause is just another way for bondholders to protect their investment. By including a negative pledge clause in a bond indenture, the bondholders of the current bond issue prevent the company from issuing any debt in the future which would jeopardize their current priority claim on the company’s assets. Including a negative pledge clause in a bond indenture increases the safety of the bond issue from the investors’ perspective, and therefore often allows the bond issuer to borrow funds at a slightly lower interest rate.

Appended below is a typical Letter Of Negative Pledge:

To: ABC Bank
Date:
Dear Sirs
Re: Banking Facilities

In consideration of your agreeing to grant, continue and/or further extend credit facilities and other financial accommodation to us or at our request upon and subject to such terms and conditions as you shall from time to time think fit, we hereby irrevocably and unconditionally covenant and undertake with you as follows:

(1.0) Without prejudice to any other undertakings on our part, we shall not, and shall procure that none of our subsidiaries shall, without your prior written consent:
(a) create or attempt to create or permit to subsist any mortgage, debenture, charge, pledge, lien or other incumbrance upon, or permit any lien or other encumbrance( save a lien arising by operation of law in the ordinary course of trading) to arise on or affect, the whole or any part of our or their respective undertaking, property, assets and rights other than pledges created over goods and/or services acquired pursuant to documentary credits opened in the ordinary course of trading for the purpose of financing the acquisition or provision of goods and services; or
(b) part with, transfer, sell, or dispose of or attempt or agree to part with, transfer, sell or dispose of the whole or any part of our or their respective undertaking, property, assets and rights except by way of sale at full value in the usual and ordinary course of trading as now conducted and for the purpose of carrying on the relevant business;

(c) grant, issue or extend any guarantee or indemnity or enter into any other form of contractual undertaking or arrangement of similar effect in respect of any indebtedness or obligations, actual or contingent, of any other person whatsoever except in the usual and ordinary course of trading as now conducted by us and our subsidiaries and for the purpose of the carrying on by us or the relevant subsidiary of our or its business.

(2.0) The undertakings set out above shall not be deemed breached by reason only of the existence of any mortgage, debenture, charge, pledge, lien or other encumbrances or guarantee or indemnity which has been created or which subsists or has arisen prior to the date hereof, provided that any further or additional encumbrance over or affecting the relevant asset, or increase in the amount secured by or other variation of the relevant encumbrance or guarantee or indemnity of similar effect, shall constitute such breach.

(3.0) We further authorize you, in your absolute discretion at any time and from time to time to notify any other creditors of our company and/or any of its subsidiaries of the terms of the undertakings set out above in the event that you receive notice of proposals which if implemented would or might be in breach of such undertakings.

Yours faithfully,
Company ZUY

…………………
(Directors)

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