What is a default?
A default is typically used to describe a breach of a contract or agreement which occurs when one party fails to uphold their contractual duties. When a lender provides a loan to a borrower, both parties agree to specific terms as set out in a loan agreement (often referred to as a facility agreement). Unless the loan is repayable on demand (such as an overdraft facility), a loan agreement will often include specific events of default, e.g. conditions or circumstances which, if they occur, typically give the lender the right to refuse to make any further advances, demand immediate repayment of a loan, make a loan repayable on demand and/or enforce any security granted by the borrower or any guarantors in favour of the lender.
What are typical "events of default"?
Events of default commonly included in loan agreements include the following:
- Non-payment: when the borrower does not pay any amount when it becomes due under the facility agreement this will constitute an event of default, taking into account any commercially agreed grace periods under the facility agreement (e.g payment within 3 business days).
- Breach of a financial covenant: a financial covenant is an obligation of the borrower to meet and maintain an agreed financial position throughout the life of the loan. For example, in real estate finance transactions there is typically a loan to value covenant (LTV) which provides that the loan amount cannot exceed a certain proportion of the value of the property and a breach of such covenant would trigger an event of default.
- Cross default: when the borrower defaults under any other agreement with a third party.
- Misrepresentation: a representation or statement made by the borrower under the facility agreement (or any other related finance documents) which proves to be incorrect or misleading. Representations are given on the date of the facility agreement and in most cases are deemed to be repeated on specific key dates (for example any future utilisation dates or interest payment dates).
- Breach of other obligations: this captures all other obligations of the borrower under the facility agreement (other than non-payment and breach of any financial covenant as referred to above), for example breaches of any information or any other undertakings. From a borrower’s perspective, this event of default should ideally include a grace period during which period the breach can be remedied to avoid triggering an event of default.
- Insolvency: the borrower becomes insolvent or enters into a relevant insolvency process.
What are the consequences of an "event of default"?
The occurrence of an event of default will typically provide a lender with a menu of different rights or options which it may choose to exercise. These will usually include the following rights:
- The lender can cancel any outstanding commitments so the borrower cannot request any further advances.
- The lender can accelerate the loan by demanding that the borrower immediately repays all amounts of principal and any other amounts outstanding under the loan agreement including any accrued interest and any other outstanding fees, costs or expenses.
- The lender can enforce any security granted by the borrower or any guarantors in favour of the lender (subject to any relevant intercreditor arrangements).
Some loan agreements distinguish between defaults (or potential events of default) and events of default. Defaults (or potential events of default) typically refer to events which, with the expiry of a grace period or trigger of some other qualification or threshold, could become an event of default. Events of default by contrast refer to those defaults which have already crystallised (because a relevant grace period for example has already expired without the borrower having remedied the situation or having obtained a waiver from the lender). A loan agreement might restrict new advances where a default or potential event of default arises, whereas the lender’s acceleration and enforcement rights should only become exercisable following the occurrence of an event of default.
In practice, lenders are often reluctant to exercise their acceleration and enforcement rights upon the occurrence of an event of default because of the additional time, costs and potential adverse publicity which may be incurred by doing so. Instead, lenders will usually look to work with the borrower to negotiate a mutually acceptable solution. Invoking events of default and choosing to accelerate a loan is very much the nuclear option, which lenders will typically regard as an option of last resort. Before going down that path, and depending upon the nature of the default in question, lenders will often negotiate a suitable waiver of any default which has or is expected to occur with a view to giving a borrower time to redress a particular situation before escalating matters further.