Key Takeaways:

  • An event of default allows a lender to demand immediate repayment or take remedial action based on specific contract violations.
  • Common default events include missed payments, insolvency, and covenant breaches.
  • Borrowers and lenders may renegotiate terms to avoid foreclosure or legal action.
  • Remedies can include acceleration of debt, foreclosure, or termination of the agreement.
  • Borrowers should carefully review and negotiate cross-default and material adverse change clauses.
  • Courts typically require objective evidence of default, especially for vague or discretionary provisions.

An event of default is established in advance and lets the lender request full payment of money owed before it's due.

Usually, agreements include a contract provision where, in an event of default, it's protected in case the borrower will not or won't be able to repay the loan in the future.

What Is an Event of Default?

It's an event in a commercial contract that allows the nondefaulting party the right to end the contract. It also allows the lender to seize collateral that the borrower has pledged to sell and recoup what's owed. An event of default is a term for lease and loan contracts.

The following would define an event of default for a credit agreement clause:

  • nonpayment for any amount due, which includes interest
  • cross-default
  • insolvency
  • loan covenant or warranty breach

Even though a creditor can demand repayment in a default event, in real life it rarely does. The creditor works with the borrower to rewrite the loan agreement terms. If both parties agree, this can mean tighter terms and a higher interest rate.

Example of an event of default is when Sears Holdings Corporation entered into a $100 million loan agreement with several lenders on Jan. 10, 2018. The contract's Section 7.01 has 11 various default events, where ambivalent terms are normal in a well-written credit contract. The Sears contract, though, is very detailed and limited because the lenders are taking an extra precaution to protect their assets.

Common Triggers for an Event of Default

While loan agreements vary, some common triggers that constitute an event of default include:

  • Failure to pay principal or interest when due.
  • Breach of covenants or representations made in the loan agreement.
  • Insolvency or commencement of bankruptcy proceedings.
  • Cross-defaults—defaults under other agreements that are tied to the current one.
  • Judgments or government actions that materially affect the borrower’s ability to repay.
  • Change of control in the borrowing entity without lender approval.

Sophisticated lenders may also include material adverse change (MAC) clauses, which allow them to declare a default if the borrower’s financial condition deteriorates significantly—even if no specific breach occurs.

Legal Implications of an Event of Default

When an event of default occurs, the lender’s rights under the contract become enforceable. This often includes the right to:

  • Accelerate the loan, meaning the lender can demand immediate repayment of the full outstanding balance.
  • Enforce any security interest by seizing and liquidating collateral.
  • Terminate the lending agreement and refuse to extend additional credit.
  • Pursue legal remedies such as filing a lawsuit or initiating foreclosure proceedings.

Courts typically require clear and objective evidence that the event of default occurred. Vague contract language can lead to disputes over whether default has actually been triggered. As a result, many agreements attempt to specify defaults clearly to avoid litigation.

Default or Event of Default

An event of default is any of the possible things a bank wouldn't want to happen to its borrowers.

A default is an event that in time or notice, or both, would mean an event of default.

Considering the definitions of both, you would think they mean the same thing. Some contracts use different terms instead to avoid confusion, Potential Event of Default and Event of Default, which reflects the definitions better.

Events of a Default In a Loan Agreement

An event of default clause is typically found in a loan agreement, except for loan facility, where the amount owed can be requested on demand. The clause sets out the events that will allow the lender to request payment beforehand. These are circumstances with power that should only be active while the default is continuing, and ended once the default has ended.

The cross-default provision gives the lender the power to call a default in the agreement when there are a third party and borrower default to any other agreement. The lender can be in a complex situation if the borrower defaults in other agreements, therefore, the lender has to know this type of situation which will be specified in the contract.

The borrower would want this provision to be limited because if there's a breach in one agreement, it could affect other agreements he might have at the same time. The borrower should make sure that the provision in minimized, an amount that depends on the borrower and the loan.

The cross-default should also be limited to other debt contracts, but should exclude trading agreements where late payments can happen. There's also no default if the debt is in good faith and paid in various periods.

A borrower's point of view of an uncertain material adverse change provision can be a problem since it gives the lender the right to freeze assets, and at least give the lender leverage to hike interest rates or a tougher deal.

A borrower should try to have a material adverse change be something:

  • Not triggered by individual companies, but by the companies as a whole.
  • That is limited to a situation which directly affects the borrower's ability to pay under the agreement terms.

The material adverse change provision is usually broad for the lender to be protected from unforeseen changes. Specific default events can be specified by the lender to cover concerning areas the lender foresees. The broadness of the provision makes it difficult for the lender to call a default since it's not clear whether there's been a breach or not.

Lenders prefer to declare a default when there's no payment, as it's clear whether there has been payment or not.

Example Scenarios and Case Insights

Consider the following scenarios that commonly lead to an event of default:

  • A company fails to meet a quarterly financial covenant, triggering default despite making all payments.
  • A borrower receives a court judgment that affects its financial health, allowing the lender to invoke a MAC clause.
  • A startup secures additional debt without lender consent, breaching a negative covenant.
  • A borrower’s CEO resigns unexpectedly, causing the lender to call default based on a “change of control” clause.

These examples highlight the importance of understanding how broad or narrow your event of default provisions are, and how they may be interpreted by courts or lenders in practice.

Borrower's Strategies to Mitigate Default Risk

To protect themselves, borrowers should consider the following actions during negotiation and throughout the life of the loan:

  • Limit broad default definitions—negotiate clear, objective triggers for default.
  • Negotiate cure periods, which give the borrower time to fix a default before consequences apply.
  • Avoid cross-default provisions that make minor breaches in other agreements a default here.
  • Clarify material adverse change clauses to avoid subjective enforcement by the lender.
  • Monitor compliance regularly to detect and address covenant breaches early.

Staying proactive and maintaining open communication with lenders can help borrowers avoid default and preserve financing terms.

Remedies Available to the Lender

Upon an event of default, lenders typically have the right to pursue one or more of the following remedies:

  • Acceleration: Demanding full repayment of the outstanding balance immediately.
  • Foreclosure or repossession: Enforcing a security interest to seize and sell collateral.
  • Increased interest rates or fees: Often stipulated in the agreement as penalty terms.
  • Legal action: Including lawsuits for breach of contract or enforcement of personal guarantees.
  • Appointment of a receiver: In some cases, especially with commercial properties or business loans, the lender may request court appointment of a receiver to manage the asset.

Remedies are usually subject to a “notice and cure” period, giving borrowers a brief window to rectify the default before enforcement begins.

Frequently Asked Questions

1. What happens when an event of default is triggered? The lender can demand immediate repayment, seize collateral, terminate the agreement, or pursue legal remedies.

2. Can a borrower negotiate an event of default clause? Yes, borrowers often negotiate for narrower definitions, cure periods, and exceptions to reduce the risk of inadvertent default.

3. Is nonpayment the only event of default? No. Other events include covenant breaches, cross-defaults, insolvency, and adverse legal judgments.

4. What is a material adverse change clause? This clause allows lenders to declare default if there is a significant negative shift in the borrower’s financial condition—even if no technical breach occurred.

5. How can I avoid triggering an event of default? Stay compliant with loan terms, communicate proactively with lenders, and monitor financial covenants regularly.

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