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A negative lien clause in a loan agreement prohibits the borrower from taking on further debt without the lender’s consent to protect the lender from security dilution. It is used in unsecured loans and to prevent pledging the same assets twice. Borrowers should review the terms carefully and seek legal assistance.
A negative lien is a term in a loan agreement that prohibits the borrower from assuming further debt without the consent of the original lender. This is designed to protect the lender from “security dilution”, where they would be unable to recover their debt in the event of default. These types of clauses are used in a variety of lending and moneylending agreements and are one of the reasons people should review the terms carefully before borrowing funds.
A classic reason to use a negative lien is a large unsecured loan. Lenders making unsecured loans are aware that if the borrower takes out another loan and pledges assets as collateral, the new lender may seize those assets in the event of default, leaving the unsecured lender less likely to recover the funds it is owed. . Likewise, lenders want to prevent situations where people pledge the same assets twice.
This type of clause is also known as an equal coverage covenant clause. When a negative pledge clause is included in the terms of a loan, the borrower cannot create situations where subsequent lenders have priority in the event of default. If the borrower wishes to take out another loan, it can be negotiated with the lender, and the lender can decide whether or not the borrower poses a security risk.
Lenders who have a lien on assets owned by the borrower may include a negative lien to clarify that the borrower cannot pledge such assets or pledge assets in a manner that compromises the security of the original loan. For example, when someone takes out a mortgage, the bank has a priority right on the house in case of default. Pledging the home against another loan would dilute the security of the original mortgage and for this reason the bank would likely include a negative lien agreement in the mortgage paperwork.
The paperwork accompanying a loan can be lengthy and many borrowers are often tempted to skim through it. However, it is strongly advised that you re-read the material carefully and seek legal assistance if any clauses are unclear. When a negative lien is included in a loan, an attorney can discuss the implications of the clause with the borrower, and the borrower can make a decision about whether or not to assume the debt based on how the clause might affect his business.
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