Negative Pledges In Commercial Real Estate Financings ' Why Do We Need Them?

• Published date: 02 July 2021
• Subject Matter: Corporate/Commercial Law, Real Estate and Construction, Real Estate, Securities
• Law Firm: Cadwalader, Wickersham & Taft LLP
• Author: Mr William Lo

Negative pledges are contractual constructs widely used in many financings − from simple mortgage loans to complex, large-scale real estate financing transactions − and, as a result, are often taken as a market standard inclusion in finance documents. That said, why do lenders insist we have them? Why are they necessary even in secured financings where the lender has the benefit of first ranking security? Why do lenders insist that they feature in the security documents even though the loan agreement has them? This article seeks to provide a wider understanding of negative pledges' existence and purpose.

What is a negative pledge?

A negative pledge is an undertaking granted by the borrower and, if applicable, obligors not to create, or permit to subsist, any security over any of its assets. The generally accepted European market standard construct of a negative pledge clause can be found in clause 22 (General Undertakings) of the Loan Market Association ("LMA") form of the real estate finance loan agreement, which goes further to covenant that the obligors "shall not:

• (i) sell, transfer or otherwise dispose of any of its assets on terms whereby they are or may be leased to or re-acquired by an obligor;
• (ii) sell, transfer or otherwise dispose of any of its receivables on recourse term;
• (iii) enter into any arrangement under which money or the benefit of a bank or other account may be applied, set-off or made subject to a combination of accounts; or
• (iv) enter into any other preferential arrangement having a similar effect,

in circumstances where the arrangement or transaction is entered into primarily as a method of raising financial indebtedness or of financing the acquisition of an asset."

Why are negative pledges needed?

Negative pledge clauses are important in lending transactions. As with other negative covenants in a loan agreement, they aim to give the lender control over the activities of the borrower by preventing it from, at the expense of the lender, creating security over its assets in favour and support of any indebtedness owed to other creditors.

A negative pledge covenant therefore becomes even more crucial for an unsecured lender because, in the absence of security, such lender would be vulnerable to the risk of security being created by the borrower in favour of another creditor, positioning it ahead of the unsecured creditor on the borrower's insolvency, which could have the effect of reducing the pool of assets available for the...