When a person wishes to make a loan or borrow a certain amount of money, he or she is usually required to enter into a contract with the lender. The contract exists to ensure that the person abides by the conditions set by the lender. Such conditions may include terms of payment, the amount of money to be borrowed, and other pertinent information. The contract may also include a clause or provision that prevents the person from making any additional loans without the consent of the original lender. This provision or clause is referred to as a negative pledge. It is also known as a covenant of equal coverage clause.
The purpose of a negative pledge is to prevent the event of dilution of security from occurring. This event refers to the inability of the lender to recover the debt if the borrower defaults on the payments. This provision exists in most contracts between borrowers and lenders. As such, it is absolutely necessary that one review the contract before signing and entering into the agreement.
A negative pledge does not exist in all loan contracts. However, it usually exists in contracts that involve unsecure loans. For example, if no negative pledge exists in the contract, the borrower may borrow from another lender. This lender may seize the assets set up as collateral for the loan, leaving the original lender with no means of recovering the debt in the event of a default. The point of creating a negative pledge is to ensure that the original or first lender is able to recover the debt, rather than other subsequent or later lenders.