NEGATIVE PLEDGES: DO THEY DELIVER WHAT YOU THINK THEY WILL?
Lenders will sometimes require a negative pledge from a borrower or related party as a condition of a loan. Despite the title, a “negative pledge” is not a pledge of collateral and does not grant any kind of a security interest in assets. A negative pledge is a promise by a borrower not to allow any liens to be placed upon some or all of the borrower’s or grantor’s assets. A negative pledge agreement is sometimes signed as a stand-alone document, and, if real estate is involved, a negative pledge agreement will often be recorded in the county where the real estate is located. In the alternative, negative pledge language can be contained in a bank loan agreement as one of many covenants made by the borrower or a grantor.
While most lenders understand what a negative pledge does, some lenders don’t understand how a negative pledge would be enforced by the lender if it is violated by the borrower. It is important to note that a negative pledge does not prevent a third party from obtaining an involuntary lien on a borrower’s assets, such as liens that arise through a judgment or tax liens. However, a borrower will typically be in violation of a negative pledge if any lien is placed on the property, regardless of whether the lien arises as a result of a grant of the lien by the borrower in violation of the negative pledge or whether the borrower allows a lien to be placed involuntarily. While the borrower would be in breach of the negative pledge, a lender would typically have no cause of action against a third party who places liens on assets that are covered under a negative pledge. A lender might have a cause of action against a third party who has actual notice of a negative pledge, such as a third party who finds a negative pledge agreement that has been recorded against real estate in the county where the real estate is located.
Negative pledges are a useful tool for a lender who wishes to enforce these types of covenants against a borrower. However, a lender should be aware that a negative pledge will not prevent liens from arising on the property that is the subject of a negative pledge.