Security Interests in a Loan Transaction and the Negative Pledge Clause

It is often the case that the existence of a contract is determined by an agreement to that effect between the parties to the said contract. Provided that the terms being agreed on are not contrary to public policy, illegal or incapable of being performed, the law gives contractual effect to the terms agreed by the parties. In traditional loan transactions, there are many terms which form part of the negotiations and eventual contract between the lender and the borrower. Such terms range from those governing the principal amount, repayment terms, interest charges, conditions for drawdown of the loan, various undertakings, representations, and warranties given by both parties.

Loan transactions by their very nature involve quite a number of risks. One of those risks is the default risk occasioned by the borrower’s (in this case, a company) inability or unwillingness to repay the debt. To hedge against this risk, lenders typically seek to create some form of security over the borrower’s assets so as to reduce the risk of loss and incentivize the borrower to repay the loan. Generally, a security may be in the form of a charge, mortgage, pledge, lien, or an assignment of interest in an asset. For a lot of loan transactions, parties tend to create a security in the form of a charge over assets belonging to the borrower. Such a charge may be in the form of a fixed charge or a floating charge. A fixed charge attaches to specific assets of the borrower that can be easily identified. A floating charge, on the other hand, creates a security interest over a group of non-constant assets. According to Nigeria’s Companies and Allied Matters Act (CAMA) 2020, a floating charge covers the whole or specified part of the chargor’s undertakings and assets, which may include cash and uncalled capital of the company, both in the present and the future. Another key distinction between a fixed charge and a floating charge is that a floating charge “floats” or “hovers” over the assets thus permitting the borrower to continue dealing with the assets until the security crystallizes or becomes enforceable (may typically be triggered by the occurrence of an event of default as specified under the terms of the contract).

The floating charge is one of the primary ways of securing interest over an asset. As mentioned earlier, the creation of a floating charge allows the company to continue dealing with the assets in the ordinary course of business. While this is a favourable position for the borrower, it may endanger the lender’s security interest where the company somehow disposes or depletes the assets covered by a floating charge. Notably, the term “ordinary course of business” has been given rather wide interpretation under case law, thus making it imperative for lenders to restrict the borrower’s authority over the charged assets. It is also important to state that the mere existence of a loan contract between a lender and a borrower does not automatically preclude the borrower from approaching other lenders to take out additional loan commitments. Similarly, the creation of a security interest in favour of a lender does not inhibit the borrower from creating further securities (even over the same asset) in favour of other lenders. Thus, the junior (subsequent) lenders may deal with the assets in a manner that is inconsistent with the senior lender’s claims. This can be precarious to the position of the senior lender as the creation of additional security could possibly affect its priority position/ right to the asset in the event of potential default. The essence of a security interest is that it acts as a sort of recourse for the lender and helps secure its position; an advantage which would be severely threatened if there is a depletion of the assets over which security has been created.

To mitigate the occurrence of such events, loan contracts often include a covenant requiring the borrower to provide an undertaking that it will not create new security interests, in order to safeguard the lender’s position during the tenure of the loan. Such a negative covenant is called a Negative Pledge Clause. The Negative Pledge Clause is a clause that prohibits the borrower from creating security interests over specified assets. This ensures that the borrower’s assets remain unencumbered and available to satisfy any claims that may arise in the event of default. In secured loan transactions, the Negative Pledge Clause serves to preserve the priority of the lender, while in unsecured lending transactions, the clause helps to preserve the assets and ensure their availability to set off a potential default.

In international financing transactions, the Negative Pledge Clause also plays a key role given the prevalence of unsecured lending in such driven by the complications with administering security across borders. It is also key to note that the clause serves to reduce excessive borrowing by the borrower. One of the most common examples of the use of the Negative Pledge Clause in international lending transactions is the World Bank’s negative pledge clause contained in section 6.0 of the Loan General Conditions, which prevents countries who have accessed credit from the bank or received guarantees for a loan from creating a lien on public assets as security for external debt. Under the clause, any lien created on public assets as security that results in priority for a third-party creditor will secure all amounts payable by the borrower, allowing the World Bank share in the amount to be paid to the third-party creditor.

It is important to note that the clause does not of itself give rise to the creation of a security interest, a breach of the clause however is typically treated as a breach of the loan contract, thus allowing the lender to seek remedies for the breach. The Negative Pledge Clause remains a standard clause in many lending transactions as lenders continue to seek ways to reduce the risk in loan financing transactions.