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Limitation on Liens

Category — Covenants
By Nikita Bundzen Head of North America Fixed Income Department
Updated January 15, 2025

What is a Limitation on Liens

A limitation on liens is a covenant that restricts a property owner’s ability to subordinate their assets through lien subordination. This means that liens such as a judgment lien, tax lien, mortgage lien, or mechanic's lien cannot be placed on real property, personal property, or other valuables securing indebtedness unless these liens are equally and ratably secured. This covenant ensures that other liens, such as judgment liens and federal tax liens, do not take precedence over the primary lien, except for certain exceptions known as "Permitted Liens." This helps protect the interests of lien holders, creditors, and real estate investors by maintaining the priority of their legal claims on the property.

/></p> <h2>Limitations on Liens Explained</h2> <p>A limitation on liens is a detailed covenant that is often included in the terms of debt securities to protect the interests of bondholders, creditors, and real estate investors. This covenant primarily restricts the ability of the issuer of certain types of debt securities from creating or incurring any lien, encumbrance, or security interest on real property, personal property, or other valuables, except for certain categories of permitted liens.</p> <p>In practical terms, this means that if a creditor files a lien against a property, the issuer must ensure that the lien is either a permitted lien or that the debt securities are equally and ratably secured. For instance, if a mortgage lien is filed, it must not take priority over existing liens unless specified in the permitted liens category.</p> <p>Furthermore, when dealing with judgment liens, tax liens, or mechanic's liens, the issuer must navigate the legal framework to ensure compliance with the limitation on liens covenant. This often involves coordination with the county recorder's office to record liens accurately and a title company to conduct a thorough title search and ensure that all legal claims are accounted for.</p> <h2>Key Aspects of Limitation on Liens</h2> <ol> <li> <p><strong>Restriction on Liens</strong>. The issuer is restricted from creating or incurring any new liens, such as a judgment lien, tax lien, mortgage lien, or mechanic's lien, unless these are categorized as permitted liens. This helps protect the property owner from excessive encumbrances on their property, whether it be real estate or personal property.</p> </li> <li> <p><strong>Permitted Liens</strong>. Certain specified liens are allowed under this covenant. These permitted liens might include essential liens like property taxes or federal tax liens, which are necessary for legal and financial compliance.</p> </li> <li> <p><strong>Negative Pledge</strong>. The covenant permits additional liens on the condition that the debt securities subject to the covenant are equally and ratably secured. This is often referred to as a negative pledge, ensuring that all creditors and lien holders have an equal claim on the property, preventing subordination of their liens.</p> </li> <li> <p><strong>Application to Subsidiaries</strong>. In some cases, the limitation on liens covenant also applies to the issuer's subsidiaries, including material, designated, or otherwise restricted subsidiaries. This ensures that the subsidiaries' assets are also protected from excessive liens and encumbrances.</p> </li> <li> <p><strong>Priority of Security Interests</strong>. If a lien secures subordinated indebtedness, the negative pledge will apply to provide the holders of the debt securities with a security interest that is senior in priority to the lien securing such subordinated indebtedness. This prioritizes the claims of the primary lien holders over other liens or debts.</p> </li> </ol> <h2>What is a Lien</h2> <p>A lien is a legal claim that a creditor has on a property or asset of a debtor. This legal claim may be against a property or asset that is used as collateral to ensure the payment or recovery of a debt owed. The creditor, or lien claimant, has the right to hold or sell the property or asset as collateral for an outstanding debt or obligation that is owed to them by the debtor. Common types of liens are:</p> <ol> <li> <p><strong>Mortgage Lien</strong>. A mortgage lien is placed on a house by a mortgage lender as collateral for a home loan. If the property owner fails to pay the loan, the lender has the right to foreclose on the property and sell it to recover the debt owed.</p> </li> <li> <p><strong>Mechanic’s Lien</strong>. A mechanic’s lien is placed on a property by a contractor or subcontractor who has not been paid for work done on the property. This lien remains attached to the property until the debt owed is paid.</p> </li> <li> <p><strong>Judgment Lien</strong>. A judgment lien is placed on a property as a result of a court judgment against the property owner. Judgment liens work to ensure that the creditor can claim the property or its sale value to satisfy the court judgment.</p> </li> </ol> <h2><strong>Example of Limitation on Liens</strong></h2> <p>A company issues a bond with the following limitation on liens clause:

Scenario:

  • The company owns $1 billion in total assets.

  • It secures a $150 million loan with a lien on its tangible assets valued at $200 million.

  • This action violates the covenant because the lien exceeds 10% of total assets and does not equally secure the bondholders. 

FAQ

  • Why is Limitation on Liens important for bondholders?

    This covenant protects bondholders by ensuring the issuer does not prioritize other creditors over them by pledging significant assets as collateral. It helps maintain the bond’s credit quality and repayment priority.

  • What role does the lien statute play in limiting liens?

    The lien statute defines the conditions and time frame within which a lien must be filed and enforced. Liens expire if not enforced within years from the date of filing, protecting the current owner from outdated claims.

  • How does a lien stay work in bankruptcy?

    When a homeowner declares bankruptcy, a lien stay can temporarily halt foreclosure actions and other legal actions on the property. This allows the homeowner time to reorganize their finances and address unpaid debts.

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