Solange M. Martin
Counsel – IFC
ABA International Law Section Spring Meeting 2009 in Washington DC entitled
"Nuts and Bolts of International Finance" April 15, 2009
The purpose of this note is three-fold: (1) to describe the role of negative pledge
provisions in international financing transactions; (2) to highlight the circumstances in
which they are used; and, (3) to briefly discuss how the current international financial
crises may impact the use of this clause.
This note further explores the effect of having negative pledge provisions and the
recourse a lender may have for breach of such provisions. As for the latter, the note
intends to describe potential courses of action available to a lender based in law and in
equity by reference to cases decided within the last ten years by the Supreme Court, the
Second Circuit, and New York state courts -- all of which are principal fora for resolution
of disputes involving international financing transactions. The note will not make
reference to potential actions that require an element of fraud to prosper (e.g., potential
actions for disgorgement aimed at having a party surrender profits obtained by unjust
enrichment).
A reference is made to the limits and challenges posed in connection with the exercise of
rights arising from a negative pledge in the context of financings with collective creditors
and a final reference is made to multilateral financing for the private sector and a
description of the structure and rationale for collective creditors financings of IFC, as a
multilateral financial institution.
I.
Negative pledge – role in international financing
Negative pledge is a common contractual provision in international finance agreements,
by which a borrower agrees not to create or permit to exist any security on its, or its
subsidiaries’ assets. A typical negative pledge clause reads as follows:
The borrower will not create or permit to exist any security on its
property, revenues or other assets, present or future, or those of its
subsidiaries.
A variation to this basic structure often contains a carve-out to capture a situation in
which:
… the obligations of the borrower under the loan are equally and
ratably secured with the obligations of the borrower with respect to other
secured indebtedness.
While some variation of a standard negative pledge provision is often used in financing
documents of different types of financing structures (including project financing, trade
financing, secured transactions and corporate loans), this provision becomes especially
relevant in corporate loans (i.e. unsecured loans in which the lenders rely on corporate
Solange M. Martin
Counsel – IFC
management’s ability to generate cash flows sufficient to repay the loan rather than in
security over specific assets).
The rationale for the provision is to preserve the pari passu payment assumption made at
the time of assessment of the financing and avoid future subordination in payments
arising from the borrower raising future secured financing. A lender making an unsecured
loan is particularly interested in the borrower not having any other secured loans that may
entitle secured creditors to collect payment before an unsecured lender receives
repayment funds. The coverage of the borrowers’ undertaking is particularly important in
respect of two elements of the restriction: (i) types of security or quasi-security
arrangements covered by the restriction; and (ii) the entities covered by the contractual
restriction.
The type of security that a standard negative pledge provision would cover includes the
following: mortgage, pledge, charge, assignment, hypothecation, security interest, title
retention, preferential right, trust arrangement, counterclaim or banker's lien or any
preference of one creditor over another arising by operation of law. In addition the parties
may extend coverage of the restriction to other types of arrangement having the effect of
a security interest (such as right of set-off and any privilege or priority of any kind having
the effect of security). These however are the subject of careful negotiation with the
borrower to avoid restricting arrangements that are necessary for a borrower to conduct
its business or trade.
As for the second element of the provision, the extent of a borrower’s entities covered by
the negative pledge, a lender would typically seek to bind a borrower’s subsidiaries to the
parent’s negative pledge obligations in order to avoid becoming structurally subordinated
to the subsidiaries’ secured lenders. Structural subordination in any such case would
result from a borrower’s subsidiaries entering into secured financing with secured
creditors that would have a direct claim against any such subsidiary’s assets that are the
subject of the security. This issue becomes even more relevant for lenders providing
corporate loans to holding companies (with no assets other than their interest in operating
subsidiaries) that rely on cash flows from its subsidiaries to meet repayment obligations
under its financing documents.
Nevertheless, the negative pledge provisions are typically subject to exclusions of various
arrangements such as liens arising by operation of law (e.g., tax liens or other
governmental charges), security required to fund customary trade activities (e.g., over
receivables relating to pre-export financing, but usually subject to a dollar limit) or
security on assets to finance asset acquisition (limited to those assets the borrower would
acquire to conduct its business and limited to certain dollar restrictions). Other exclusions
may include security on assets of after-acquired subsidiaries (to the extent that the
security was not incurred to finance the acquisition).
The effect of the negative pledge in a financing document is not that of security or quasisecurity, but that of a borrower undertaking not to secure any other creditor’s financing.
In fact a negative pledge provision does not restrict a borrower from raising additional
unsecured financing. As such the negative pledge is a contractual commitment of the
borrower and in the event a borrower should default in such obligation, then a lender
Solange M. Martin
Counsel – IFC
would typically rely on the financing document’s provisions triggering various
contractual remedies.
In the event that the negative pledge provides that in case the borrower obtains secured
financing then the lender’s existing financing must be equally and ratably secured with
the obligations of the borrower in respect of the borrower’s other indebtedness (as
described in the example above) then the lender may, among other things, seek to obtain
such security. Such a contractual provision would rarely (if at all) provide a lender with
some sort of automatic security over the borrower’s assets. Instead the lender must rely
on the borrower creating and perfecting the security to secure the lender’s existing debt at
the time of the borrower’s breach of the negative pledge. In addition, even if the borrower
were to agree to secure the existing lender’s loan at the time of breach of the negative
pledge, the security could be tainted by the possibility of voidance if granted during a
borrower’s preference period under applicable insolvency laws.
Further, a lender may rely on the financing document’s provisions that entitle a lender to
declare an event of default (following a lender’s knowledge of a breach or potential
breach of the negative pledge) under the agreement and trigger early termination rights
accelerating all payments under the financing document, which would then become due
in full as of the date of the exercise of the lender’s acceleration rights.
In the event a borrower fails to make payment as demanded by a lender upon acceleration
of the loan, the lender would have a contract claim for money damages against the
borrower. However, absent an element of fraud, a lender would most likely be unable to
prevent a borrower or its subsidiaries from granting security over their assets in breach of
a negative pledge before obtaining a judgment vindicating its claim. Several prominent
cases have established this principle, albeit for different reasons.
In Grupo Mexicano de Desarrollo, S.A., v. Alliance Bond Fund, Inc., 527 U.S. 308
(1999) (A preliminary injunction requested by investors regarding notes of a Mexican
construction company in order to restrain it from transferring assets and effecting
assignments of rights in violation of the negative pledge provisions of the notes’
documentation was denied.) In Grupo Mexicano, Alliance Bond Fund had initiated an
action for breach of contract and while the action was still pending requested a
preliminary injunction to restrain the issuer from transferring assets and effecting
assignments of rights to receive certain government-issued notes. The Supreme Court
reversed a judgment of the Second Circuit (that had previously granted the preliminary
injunction) and held that “the District Court had no authority to issue a preliminary
injunction preventing petitioners from disposing of their assets pending adjudication of
respondents’ contract claim for money damages”. The Supreme Court in Grupo
Mexicano based its decision on the principle “that courts of equity will not, as a general
matter, interfere with the debtor’s disposition of his property at the instance of a
nonjudgment creditor”. The Supreme Court emphasized as a historical principle “that
before judgment (or equivalent) an unsecured creditor has no right at law or in equity in
the property of his debtor”.
In AIG Insurance Company v. The Robert Plan Corporation, 851 N.Y.S.2d 56 (N.Y. Sup.
Ct. 2007, plaintiff’s request for a preliminary injunction pending a claim for monetary
Solange M. Martin
Counsel – IFC
damages based on the violation of negative covenants (including a negative pledge) was
denied. The injunction was denied based on the court’s conclusion that the main purpose
for requesting the relief was to restrain the debtor’s asset transfers that allegedly would
defeat satisfaction of any anticipated judgment (rather than for the purposes of enjoining
defandant’s apparent breach of contract).
In sum, lenders concerned with violations of negative pledge provisions will likely find it
difficult to obtain equitable, pre-judgment relief in order to enforce the negative pledge
before obtaining a judgment on the claim.
Absent fraud, another action a lender may consider in the event of a breach of negative
pledge is to file a claim for tortious interference with contractual relations against the
third party that obtained security over a borrower’s assets in breach of the borrower’s
negative pledge. However, successful assertion of such a claim would require a lender to
establish, among other things, the third party’s knowledge of the negative pledge and the
third party’s intention to induce the breach of the negative pledge or otherwise render its
performance impossible. Proof of the element of knowledge may be particularly
challenging in financing structures that do not require prospectus registration or
otherwise public disclosure of the terms and conditions of a financing. The possibility of
a third party knowing of the existence of a negative pledge in non-public international
transactions will greatly depend on information obtained from the borrower of the
borrower’s existing financing. Moreover, in case of local secured financing being sought
by a subsidiary with local financiers in a subsidiary’s jurisdiction, knowledge by a local
financier of the terms of the subsidiary’s parent company’s international financing
documentation will likely be difficult to establish by an international lender.
Finally, a particular lender’s contractual enforcement of a negative pledge against a
borrower may become especially challenging in case of financing structures with
collective creditors unless certain requisite majorities are obtained. In the case of
syndicated loans, participated loans or bond issues involving several financiers or
investors, then a single financier or investor or a group of financiers or investors may not
be able to trigger contractual provisions or initiate contractual actions unless a certain
majority of financiers or investors agree to any such action. Documentation for collective
creditors financing (e.g., syndicated loans, indentures or participation agreements) may
require majority consent to instruct an agent or trustee to undertake action under the
agreement (e.g., to exercise early termination rights under the financing documents) or in
other cases provide for simpler consultation process (without requiring majority
consents).
Such documentation would typically require unanimous consent of financiers or investors
for limited matters under the financing document, such as a change in the financial terms
of the loan or bond (e.g., tenor, interest rate, currency). In a fairly recent case, the U.S.
District Court for the Southern District of New York denied an investor’s claim for
declaratory judgment and injunctive relief, based on the court’s finding that the
elimination of the negative pledge (as well as other covenants) from the indenture in the
process of an exchange offer of bonds was not an amendment that required unanimous
consent under the applicable indenture provisions. Greylock Global Opportunity Master
Solange M. Martin
Counsel – IFC
Fund v. Province of Mendoza, 2005 U.S. Dist., aff’d, 2006 U.S. App. (2d Cir., Jan. 18,
2006). As a result of this decision, a minority of holders of bonds issued by the Argentine
Province of Mendoza were unable to prevent the exchange offer approved by the
majority of the holders that resulted in an amendment to the indenture that included the
elimination of the negative pledge along with other covenants.
In the context of the current global financial crisis, as a result of deteriorating financial
conditions in most jurisdictions, it is not unusual for lenders to provide secured financing
rather than corporate unsecured financing. In this context, issues may be expected to arise
in respect of negative pledges included in borrowers’ existing corporate financing
documents. In addition, in cases where financiers are prepared to provide corporate loans,
drafting of negative pledge provisions in new financing documents is being tightened to
permit very few exceptions (mainly statutory exceptions and trade or other operational
liens) and by shortening or, even in some cases, eliminating grace periods associated with
defaults of negative pledges.
II.
Collective creditors’ structures in multilateral financing
Multilateral financial institutions, that is institutions created by multilateral international
treaties among countries (e.g., the IFC has 181 member countries), typically engage in
financing that may be referred to as developmental financing, which refers to funding
projects or entities in emerging countries that seek to create improvements in their
respective economies or sectors within their economies. While developmental financing
in international finance transactions is largely conducted by multilateral financial
institutions pursuant to treaties that govern the relevant institutions’ activities,
developmental financing is not necessarily unique to such institutions and is presently
being conducted by various other types of governmental and non-governmental
institutions.
In addition while foundational documents of multilateral institutions often contain certain
incentives (tax or others) for the supply of developmental financing into host countries,
some sort of comparable incentives or specific aspects of such incentives to
developmental financing may also be found in the domestic legislation of host countries.
IFC is a multilateral institution, member of the World Bank Group, whose mission is to
Promote sustainable private sector investment in developing countries,
thereby helping to reduce poverty and improve people’s lives.
In order to advance its mission, IFC makes investments in private sector entities with
activities in emerging markets in diverse types of industries and sectors (including
manufacturing, infrastructure, tourism, agribusiness, health and education and financial
services). IFC’s investment products range from various types of debt financing
Solange M. Martin
Counsel – IFC
(including project, corporate and trade among others) to equity and quasi equity financing
and risk management products. IFC conducts its investment activities based on
international market conditions and practices. As a consequence IFC charges market
interest rates on its loan investments and acquires equity in enterprises at market values.
In line with market practices IFC reviews the profitability of projects to the investors. In
addition IFC requires that its investment projects generate benefits to the host country’s
economy (such as job creation and expansion of taxable incomes). Finally, IFC’s
investment must comply with IFC’s environmental and social standards.
IFC funds its investment activities mainly by (i) placing long-term debt securities in
international financial markets, and (ii) making investments in private entities located in
its members’ countries.
In addition to IFC’s own investment in different projects, IFC mobilizes resources from
international lenders into specific projects that IFC is financing through its syndicated
loan-type of program. This program, many times referred to as “B lenders program”,
provides IFC the ability to fund larger projects by committing its own funds along with
those of other lenders (typically commercial international banks) to IFC’s investments.
The B lenders provide financing without receiving an assignment under a loan agreement
between IFC and the borrower. Under the basic structure of a B loan, IFC is and remains,
through the term of the loan, the single lender of record for the entire portion of the loan
and is in charge of the administration of the loan. For all legal purposes with respect to
the borrower, IFC is the lender and B lenders have recourse and certain rights with
respect to IFC only (and not the borrower) under a participation agreement entered into
between IFC and the B lenders. Such agreement would contain the terms and conditions
of the participants’ funding undertakings and the rights governing the collective creditors
features of the B loan (e.g., consultation rights in case of waiver or defaults by the
borrower under the loan agreement as well majorities required to make any changes to
the financial terms of the B loan).
The rationale for the B lenders investments in IFC funded projects include IFC’s
knowledge and experience in investing in emerging markets (IFC has been doing so since
1956) and IFC’s reputation as a Aaa-rated (by Moody’s) international financial entity. As
for the lenders’ risks on this regard, claims on IFC are eligible for 0% risk weight for the
purposes of calculating minimum capital requirements under the rules of International
Convergence of Capital Measurement and Capital Standards B
Solange M. Martin
Counsel – IFC
Solange M. Martin
Counsel – IFC
asle Committee for Banking Supervision (June 2006, Chapter II (Credit Risk: Standard
Method) of Section II (Minimum Capital Requirements).
Additional rationale for B lenders include investing under IFC’s “umbrella”, which
includes certain privileges and immunities granted to IFC by countries that adhered to
IFC’s Articles of Agreement (these include tax immunity granted to IFC based on
developmental policies) as well as transferability benefits recognized by consistent
practice of IFC member countries referred to as preferred creditor status. IFC’s umbrella
of benefits is often instrumental to attract investments of international lenders into
countries in which such lenders may not otherwise invest due to unstable conditions.
Such conditions often involve economic or political challenges arising from matters such
as interventionist executives, high tax rates, pervasive financial regulations, among
others. The B lenders program provides in this sense a catalyst to balance risks that
commercial lenders may not otherwise assume.