Event of Default: Everything You Need to Know
An event of default is established in advance and lets the lender request full payment of money owed before it's due.3 min read
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
- 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.
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.
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