Negative Pledge Explained
A negative pledge clause inhibits a borrower from undertaking any additional security, if doing so would risk the lender’s ability to enforce its security. This type of clause may be part of bond indentures and traditional loan structures.
In some situations, where a lender would like to have security for its loan but the borrower cannot, or will not, consent to a mortgage or security interest in or over its property, the lender may settle for a negative pledge where the borrower covenants not to sell or burden certain assets without the consent of the lender.
For example a negative pledge clause may read as follows: 'The borrower will not enter into a single transaction or a series of transactions (whether related or not) and whether voluntary or involuntary to sell, lease, transfer or otherwise dispose of any asset.' Where there is more than one borrower, each one must separately agree to this statement by confirming that they understand their liabilities and the consequences of not abiding to this agreement. Clearly, there need to be exceptions to such a clause or else the company could not trade.
A borrower may, perhaps, amend the clause so that it applies only to a substantial part of its assets (an unreported case Commercial Union Assurance Co Ltd v Tickler, 4 March 1959, indicated that cumulative disposals of 10% to 15% might be substantial). This often would not provide adequate security to the lender, especially in the context of a secured facility because of the possible impact of such a permission on the fixed or floating characterisation of the security. Moreover, a breach of such provisions would normally amount to an event of default entitling the lender to accelerate the loan and, if it has security, to enforce its security.
If the lender becomes aware that its borrower intends to breach the negative pledge or disposals restriction it could seek an injunction against the borrower and, conceivably, against any other party involved, such as the party to whom security may be granted or to whom assets are to be disposed. This may prove rather difficult to enforce in practice as the other party could proceed without the lender knowing of this breach until it has occurred.
However, there are options available to the lender to exercise its contractual remedies under the loan documents (mortgage terms), seek a court-ordered resolution or proceed under Article 9 of the Uniform Commercial Code (UCC) The process is rather lengthy. Whilst the lender prepares to take the matter to court, a third party could take security with knowledge that the security or disposal is in breach of the borrower's loan covenants. The negative pledge is an undertaking between the borrower and the lender only and is not binding upon any other third party. However, if the third party has carried out the act with the knowledge of breach of the borrower’s contractual terms under the loan agreement then the court could find the third party liable in damages for inducing a breach of contract. However, proving loss may be difficult unless one can ascertain a specific shortfall in security causing loss to the lender which is caused by the alternative security or disposal. The Rule in De Mattos v Gibson states that the bank may obtain an injunction based on the principle stated by Knight Bruce LJ in De Mattos v Gibson:
Reason and justice seem to prescribe that at least as a general rule, where a man, by gift or purchase, acquires property from another, with knowledge of a previous contract, lawfully and for valuable consideration made by him with a third person, to use and employ the property for a particular purpose in a specified manner, the acquirer shall not, to the material damage of the third person, in opposition to the contract and inconsistently with it, use and employ the property in a manner not allowable to the giver or seller.
Finally, common pitfalls for solicitors who act for a lender is that they may omit to read the mortgage offer thoroughly and are unable to identify a negative pledge clause within the document. Now, this could lead to a potential professional negligence claim if the solicitor has not registered the correct security for the lender with the Companies House. It is best practice to confirm the agreed terms with the Lender. The security must be registered with the Companies House within 21 days, or temporarily within 31 days of its creation, or it will be void against other creditors, administrators, and liquidators of the company. Simply, you should complete Form MR07 and file this with the Companies House together with a certified copy of the mortgage deed. The Companies House will then issue a certificate for registration of the charge which would then be sent to the Land Registry and the lender. The consequences of not meeting the deadline are enormous, as the lender would need to go through the courts to enforce the registration of the security on the title.
The time taken to register a charge with the Companies House is incomparable to having to take the matter to court by reason of failure to do so. The matter could remain unresolved for many months not to mention the likelihood of a professional negligence claim being brought against the solicitors’ firm and the damage to its reputation.
Solicitors must exercise exceptional attention to detail and act in a timely and compliant manner to avoid breaching their duties to lender and the wide-reaching implications as a result of the same.