Event of Default: What It Lets a Lender Do

A term loan or committed revolving facility binds the lender for its term. Broadly, if a business makes every payment and keeps every promise, the lender has to keep lending and wait until maturity. Default clauses are how the lender gets out early. They are a matter of contract, so what counts is what the document lists. Facilities repayable on demand, such as many overdrafts, work differently: the lender can call them with no default to point to.

The lender's interest in the list is timing. A loan is repaid from the cash a business generates, and events on the list are the signs that this may stop. The clause lets a lender act, or credibly threaten to, while there is still value in the business.

Lists differ, but each usually covers non-payment, often with a few days' grace for administrative error; breach of a financial covenant, commonly with no grace unless an equity cure applies; breach of other undertakings, with a cure period if the breach can be put right; a false representation; cross-default; insolvency events; and frequently change of control and a material adverse change.

Two defined terms do different work. A Default, in many agreements, is something that would become an event of default once a grace period ends or notice is given. An Event of Default is the finished article. The first often stops new drawings; the second usually opens the rest. Many agreements then allow the lender to act only while the event is "continuing". Depending on the drafting, that means not yet remedied or waived, or simply not waived, which is a much harder test for a borrower.

The menu that opens is typically to refuse drawings, cancel undrawn commitments, charge default interest, require repayment and enforce security, the last with its own procedures. The law trims it in places. In Australia, section 451E of the Corporations Act can stay a right triggered by a company's entry into voluntary administration, subject to listed exclusions, some of them protecting lenders. The UK's similar restriction, section 233B of the Insolvency Act 1986, does not reach lending contracts. And an Australian bank that subscribes to the Banking Code of Practice limits itself with small business customers: at least 30 days' notice of a missed payment before demanding repayment or enforcing, subject to exceptions. On standard-form loans, defaults other than missed payments must be on the Code's list and be material, usually with 30 days' notice to remedy; ratio covenants are confined to loan types such as property development and specialised lending; and unspecified material adverse change is excluded.

A harbour tug operator, constructed for this page like every figure in it, has a term loan and revolving facility with its bank, and separately finances one tug with an asset financier. The bank's cross-default clause counts debt elsewhere that is unpaid or accelerated, and applies only above US$250,000 in total. That threshold is the example's and not a market norm. In March the operator disputes a refit charge with the asset financier and withholds an instalment. Three weeks later the financier accelerates.

Nothing has happened at the bank. Every instalment has been paid and every covenant passed. Even so, on the day the financier accelerates, the bank has the right to refuse the remaining US$0.6m and require repayment of US$7.4m. It does neither. It writes to reserve its rights, asks for a cash forecast and tells the operator to resolve the dispute.

The operator pays the instalment under protest, and the financier rescinds its acceleration. Whether that ends the matter depends on the word "continuing". If the agreement treats a remedied event as over, the bank's rights have gone. If only a waiver ends it, the event stays open until the bank signs one, and the operator needs that letter before it can draw.

A review event sits on a separate, gentler list in many bank letters. Its first consequence is a meeting and a chance to agree new terms, which is why borrowers ask for matters outside their control, such as the loss of a licence or a change in the shareholder base, to be placed there. A borrower reading its letter should check which list each item is on.

Default in the regulatory sense is a different thing again. A bank classifies a borrower as defaulted for capital purposes on tests such as ninety days past due or unlikeliness to pay. A borrower can be in contractual default without being in regulatory default, as the operator above may have been, and the reverse can also occur. The same word sits in two different files.

DEFINED IN ONE PARAGRAPH → · CROSS-DEFAULT → · REVIEW EVENT →

Before signing, the list is one of the most negotiable parts of a facility: thresholds on cross-default, a trigger that needs actual acceleration elsewhere, cure periods, carve-outs for disputed amounts. A carve-out for amounts disputed in good faith might have changed the operator's April.

Once an event has occurred, the lender has a decision to make and a reason to make it carefully. It can waive, reset, reserve its rights, agree a standstill or demand. Most first breaches lead to the earlier options. The practical value of the clause is that it brings the borrower to the table on the lender's terms, and a lender that has not kept its rights intact finds that seat harder to hold.

LOAN COVENANTS, EXPLAINED → · WHEN YOUR LOAN GOES TO WORKOUT → · READING YOUR FACILITY LETTER →