The negative pledge clause is a standard covenant in international loan agreements where the borrower agrees not to grant security to other lenders that would have priority over the initial lender. There are two main types: a basic negative pledge and an affirmative/quasi-security negative pledge. While the basic pledge is generally ineffective if breached, the affirmative pledge aims to automatically grant equal security to the initial lender if a prohibited security is given to another. However, the affirmative pledge faces issues regarding consideration, registration requirements, and priority that challenge its enforceability. Nonetheless, the negative pledge still provides some protection for lenders through triggering other clauses if breached.

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Negative pledge
The negative pledge clause is a standard covenant in international term loan
agreements. It consists of an undertaking by the borrower that it will not
encumber its property, including present and future property, to secure the
loan of another creditor so that the later creditor obtains priority over the
lender. The development of the negative pledge over the years gave rise to
two fundamental types of clause, namely the “normal” or “basic” negative
pledge and the “affirmative” or “quasi-security” negative pledge (the
nomenclature varies). This essay will look at those two varieties of the
negative pledge clause, highlighting the potential legal issues that could arise
from the breach of the clause by the borrower.
The basic negative pledge corresponds to the definition of negative
pledge given above, that is, the borrower promises that it will not grant
security to any other party which would take priority over the lender’s
entitlement to be repaid while the relevant agreement is in force. The breach
of the clause brings about a discussion as to the remedies that then would be
available to the lender and their effectiveness. As any other breach of
covenant, breaching the negative pledge clause will trigger the events of
default clause, so that the lender will be entitled to accelerate the facility.
However, this will not improve the lender’s position, as the relevant assets
will have been distorted by way of security to a third party. Damagescan be
regarded as a generally available remedy in cases of breach of contract.
Nonetheless, damages would not improve the lender’s situation in the case
of breach of a negative pledge clause, since the lender would end up with the
same right as it already had before the breach, pursuant to the contract itself,
namely the right to be paid the sum advanced to the borrower, since the aim
will be to compensate the lender as if the contract had been performed. The
relevant assets, however, would have been anyway disposed by way of
security to an extraneous. If this is the case, another option would be

2. lookingat remedies in equity, such as an injunction or an order for specific
performance. An injunction would compel the borrower to refrain from
doing any act towards giving the prohibited security to a third party, while
an specific performance would have a similar effect by forcing the borrower
to observe the agreement, which in this case could provide for the granting
of a “similar security” or security over “assets of the same value” for the
event of breach of the negative pledge. Those two types of equity remedies
depend on the courts’ discretion and, in the event of a breach of a negative
pledge clause, it seems unlikely that the judges would grant an injunction or
an order for specific performance. Firstly, the court could take the view that
damages are an available remedy, therefore excluding the possibility of one
of those alternative equitable remedies being granted. Besides that, a court
order for an injunction or specific performance would only be meaningful
where the lender is aware of the security being given by the borrower to a
third party in breach of the negative pledge; otherwise, once the security has
already been given without the lender becoming timely aware, the order
would be useless, since the third party would be already vested on the
security and the original lender would be already in a worse off position.
Furthermore, specific performance for the giving of security over equal and
rateable assets would also depends on the existence of unencumbered assets
(since the “same assets” would have been charged first upon the breach of
the negative pledge). Remedies in tort would end up in damages when
successfully considered by the courts, bringing about the same problem of it
not being appropriate to compensate the loss due to the security being given
to the third party anyway, and the lender ranking below. Claims in tort
against third parties would require the numerous requisites provided by
OBG v Allan to be fulfilled, such as knowledge and inducement through
positive action by the third party to harm the lender (Mainstream v Young).
Therefore, pragmatically speaking, it seems that the basic negative pledge is
likely to be ineffective, with the lender losing the paripassu treatment and
entering into a subordinate position. If the negative pledge were registrable
in itself, it could take priority in a similar fashion of what was decided in
Pritchard v Briggs, but this possibility was once considered and rejected by
the government (Modern Company Law for a Competitive Economy report),
as it could create, it was assumed, practical problems if the pledge were to
be registered on a voluntary basis and not on a mandatory and therefore
wider basis, which, nevertheless, were not subjected to consideration at that
opportunity.

3. The above backwashes may have precipitated the development of the
affirmative negative pledge. The affirmative negative pledge provides that,
where the clause is breached and security is granted to a third party, then
equal security is also immediately vested in the negative pledge lender. For
the analysis that follows, it is important to bear in mind that the “problem”
addressed by the negative pledge clause is not specifically the risk of the
borrowerdefaulting in his obligation, but actually the paripassu treatment as
between the lender and other creditors of the borrower. It is generally
acknowledged that a bank (lender) might admit losing money in the course
of its business but would not easily accept being placed behind other
creditors or, in other words, it would not admit losing money “alone” while
other banks are able to recover the amount theyhave lent to the same
borrower. Nevertheless, the negative pledge clause differs from the
paripassu clause because the latter restricts the creation by the borrower of
unsecured debts that would by law rank ahead of its debt to the first lender,
while the negative pledge is aimed at preventing the diminution of the asset
pool by way of it being someway disposed to a different lender as security.
There are a number of legal issues arising from this type of negative pledge,
which, as will be seen in the following discussion, challenge the
enforceability of the affirmative negative pledge clause.
As it is the case of the basic form of the clause, the quasi-security
form of negative pledgecreates only a personal right as between the parties
to the loan agreement, and not a proprietary interest. This fact led some
commentators to the conclusion that, as the agreement providing for an
affirmative negative pledge is to provide only a contractual right to security
when the clause comes to be breached, then such a contractual interest is
incapable of turning into a proprietary right at that moment, for there will be
a lack of consideration for that effect (assuming a fully drawn down facility),
since past consideration cannot be regarded as good consideration. As a
result, the affirmative variation of the clause would be rendered ineffective
as regards to its objective of granting automatic security (Arkins, Goode). It
would be necessary to show that the lender has given value. It seems that
this would be present if the lender has decided not to call an event of default
in exchange for the grant of security, but this requires forbearance
(refraining from enforcement) and, therefore, knowledge of the breach,
which would not be present if the lender were unaware of the breach.

4. Peter Gabriel offers a different account. In his opinion, the negative
pledge lender obtains an equitable interest when and only when the specified
event occurs, that is, the giving of a prohibited security. He says that, by
lending money to the borrower, the lender provides full consideration for the
borrower’s entire obligation under the loan agreement, including the
negative pledge and the provision for automatic security if a prohibited one
is created. Stone has a similar view. Goode claims that the granting of equal
and rateable security to the lender, either as a condition to the borrower’s
license to encumber its property in favour of another (“not to give security
without giving equal and rateable security to the lender”), or as a
consequence to the borrower having encumbered its assets in favour of a
third party (“equal and rateable security will be given to the lender if the
borrower gives security to another”) would lack consideration. In either
case, Goode argues, the clause gives the lender a mere contractual right and
an agreement for security takes effect only if value is furnished at or after
and in consideration for the security.
Others take the view that the affirmative negative pledge is actually a
floating charge over all the borrower’s property, which would crystallise
upon the breach of the negative pledge. This is the opinion of Gregory Hill.
For Hill, the negative pledge, although contingent on a specified event (the
creation of a prohibited security in favour of a second lender) is itself a
proprietary right, capable of being binding on the subsequent lender if
appropriately registered according to the Companies Act 2006, s. 860. He
also addresses the concern of crystallization of the floating charge into a
fixed charge in order for the original lender to have priority over the
subsequent lender. He suggests that the clause is drafted so that the
crystallization occurs (and hence priority arises) when the borrower “decides
to create” a prohibited security, which obviously happens before the creation
of the security itself. Although the latter reasoning is of an ingenious taste,
regarding the negative pledge as a floating charge registrable upon
conclusion of the loan agreement appears to contrast the fact that the parties
do not intend to create security at the time the contract is made, otherwise
they could create a proper floating charge or other type of security. Indeed,
the parties’ intention is of fundamental importance in the context of security
interests (two-stage test in the Agnew case, confirmed by the House of Lords

5. in Spectrum Plus).
The possible lack of consideration is not the sole concern as to the
affirmative form of negative pledge. It should be kept in mind that, if
securityautomatically arises upon the breach of the clause, it would be
necessary to register the security interest (CA 2006, s. 860). The problem is
that it must be done within 21 days from creation and it is very likely that
the lender will not become timely aware of the borrower having breached
the clause. If this is the case and the lender fails to arrange for the relevant
registration, the security then created upon breach will be void (CA 2006, s.
874).
Under specific circumstances, other legal issues around the
enforceability of the negative pledge could be pointed out. Where the
borrower is insolvent, there is the risk of the liquidator attacking the security
on the grounds that it involved a giving of preference to the lender (IA 1986,
s. 239) or a transaction at an undervalue (IA 1986, s. 238), especially if the
automatic security clause was triggered during the so-called “hardening
period” for insolvency purposes (IA 1986, s. 240). Other issue is related to
the difficulties that can arise where the relevant asset is in a jurisdiction that
requires certain formalities to be observed in order to constitute security.
Even if these specific circumstances (insolvent borrower or assets abroad)
do not take place, there still will be concerns as regards the registration of
the charge within 21 days (again) and the priority it will give the creditor.
These last two concerns will be now examined in turn, starting with the
latter one.
As provided by the Companies Act 2006, s. 860, priority is given
upon creation of the security interest. If a security interest arises for the
lender upon the breach of the negative pledge, it means that the creation of
the security which have triggered the breach of the negative pledge has
occurred first in time, the negative pledge lender’s security being in a
subordinate position as to the other security. One could say that, to avoid
that problem, the clause should be drafted in a way to provide that the breach

6. of the clause by the borrower will take effect not with the giving of a
prohibited security to a third party, but with the “decision” taken in order to
give the security to the new lender. In the case of companies, that “decision”
is normally materialized through a company’s resolution in board meeting.
Notwithstanding the fact that this position, similar to the solution suggested
by Gregory Hill in the case for the crystallisation of a “floating charge”,
offers an interesting exit to the problem of priority, it remains a question
aboutthe registration of the security. Even if the problem of priority can be
overcome by the “strategic wording” of the clause so as to provide for
creation of the security at the time when a resolution is passed by the
borrowing company, there is still a very serious problem that can render the
security void. As previously said in this essay, the Companies Act 2006
requiresregistration of a security with the relevant body within 21 days from
creation (s. 870). The problem is that the original lender will probably not be
aware of the breach committed by the borrower. Therefore, the security
automatically created at that event will probably become void for not have
been registered within the time allowed to that effect (s. 874).
In essence, it seems that the negative pledge, once breached, carries
serious concerns about enforcement and the appropriate remedies. There
appears to be no effective remedy to compensate the lender harmed by the
breach of a basic negative pledge, while the affirmative negative pledge is
likely to be rendered void for lack of consideration or lack of registration
upon creation. However, apart from the issues regarding its enforceability in
case of breach, there seems to be other factors that can discourage the breach
of a negative pledge by the borrower. For example, a breach of the negative
pledge, being an event of default in the relevant loan agreement, could
trigger a cross-default clause inserted in a different contract, which could
bring trouble to the borrower in its relations with other lenders or
commercial partners. Therefore, regardless the issues that potentially
undermine its enforceability, it appears that the negative pledge clause in
term loan agreements can be a worthwhile device that, to a certain extent,
could serve the interests of the lender.