How Negative Pledge Sets Off the Weakness of Floating Charge

Negative pledge clauses have been in use for many years in financing transactions. The
negative pledge clause usually seeks to protect the unsecured creditor by providing
contractually that the debtor shall no, so long as any part of the indebtedness remains
outstanding, create any security in favour of another creditor. It is also used to protect floating
charges by restricting the freedom which the charger has to deal with the assets comprised in
the floating charge. Since the very essence of floating charge is that the company has continuing
authority to dispose of its assets in the ordinary course of business, the debenture holders are
potentially endangered since the company might sell or encumber the assets covered by the
floating charge. This can be clearly seen in the case of Tan See King v Anata Knitting Industry,1
where in that case, the Court of Appeal recognised that the properties forming the subject matter
of floating charge could be sold in the ordinary course of business.

Thus, in order to unsecured interest over a charge, the creditor under a floating charge
will insists that the clauses be inserted into the debenture prohibiting certain specified
transactions that are capable of affecting the priority of the floating charge while generally
allows the company to continue to trade. The most important of the prohibited transactions was
to restrict the ability of the company to create security which might rank pari passu or in
priority over the floating charge. For instance, company A assign its assets as security in
floating charge to Bank X. This means that company A can still use its assets in the ordinary
course of business. Later company A assign its same assets to bank Y over security for second
loan, which eventually will caused bank Y to have priority over the assets against bank X.
Therefore, under such circumstances, negative pledge clause under the agreement between
company A and bank X will come into play in which it will prohibit company A from making
another security to bank Y. Bank Y then will have security interest over the property.

In the event that subsequent charge is still made to a subsequent charge, the subsequent
charge of the security with notice of restriction would not gain priority over the floating charge.
this means that if the subsequent charge has notice of negative pledge clause at the time he
takes his security, his charge will be postponed to the prior floating charge. the knowledge of
the negative pledge clause by the subsequent charge must be in full knowledge and not mere

1
[2013] 2 MLJ 284.
information. This point is illustrated by the case of The English and Scottish Mercantile
Investment Company Ltd v Brunton,2 in which in that case, the company issued debentures
secured by a floating charge over its property whereby the debentures contained negative
pledge clause. Subsequently, the company assigned its interest to the plaintiff as security for a
loan. Plaintiff’s solicitor knew the existence of the debenture but not the negative pledge clause.
The Court of Appeal in that case held that merely being aware of the existence of debentures
did not fix the plaintiff with knowledge of its terms and there is no duty to be imposed on a
subsequent lender to seek out the precise terms of the debentures. However, in the absence of
actual notice of such clause by subsequent charge, the charger will continue to have apparent
authority to deal with its assets in the ordinary course of business. As such, in the event of the
chargor’s liquidation, a prior floating charge may find his security postponed to a subsequent
charge, provided that the subsequent charge has no actual notice of such clause.

Although negative pledge does not give rise to a charge, there is no doubt that it
constitutes a personal covenant. As such, infringement of negative pledge clause that will give
rise to a cause of action may be a consolation to the holder of floating charge who finds his
security postponed to a subsequent chargee. In order to strengthen the protection afforded by a
negative pledge, upon a breach of such clause, the creditor is entitled to enforce the floating
charge which will have crystallised upon the intervention of the creditor.

In conclusion, indeed, a negative pledge clause can be used to improve the position of
floating charge against subsequent charge and as such, it is agreed that negative pledge clause
is regarded as an instrument that is able to set off the weakness of floating charge.

2
[1892] 2 QB 700.