The current economic downturn means that finance directors and in-house counsel are having to monitor very closely their loan agreements to ensure they are avoiding default situations.
Most loan agreements between commercial lenders and private sectors borrowers will contain a number of events of default. These will usually give the lender the contractual right to terminate the loan, cancel any funding commitment of the lender and to demand early repayment of all outstanding principal and interest on the loan. At a time when liquidity is tight, corporates will not want to have to shoulder the additional burden of immediate and unexpected repayment of loan facilities. This is especially the case if the default that occurs is as a result of a "technical default" rather than a default arising due to a more serious underlying cash flow or other problem in the business.
Finance directors and in-house counsel can ensure compliance by making certain that the terms and conditions of loan agreements are fully understood and that regular monitoring is undertaken. This is particularly key when companies have loans from different lenders with resultant differences in the contractual provisions of the loan agreements.
One of the main events of default is failure by the borrower to pay to the lender any amount payable under the loan agreement when it is due. There may be a very short grace period (for example two or three business days) but this will normally only apply in the case of administrative or technical error such as the wrong bank account details being provided. This event of default is vitally important to the lender for two reasons. One is, in theory at least, that the lender will have borrowed a matching deposit in the market to fund the loan. The second is that given the borrower's payment commitments are established in the loan agreement, these commitments should be accounted for in its projected cash flow requirements. A non-payment under the loan agreement may mean a missed budget and thus be a signal of serious cash flow or other issues with the business.
Another important event of default, linked to failure to pay, is the cross default provision. This clause will tend to apply in the context of a group of companies with borrowings from a lender. Essentially, it provides that it will be an event of default if any financial indebtedness of a member of the group of companies is not paid when it is due (or within any applicable grace period). This clause helps to ensure a lender enjoys equal rights with other creditors. A creditor who is entitled to accelerate (demand) the payment of their debt and/or enforce any security is potentially in a better position than the lender. What the clause does is allow the lender to also accelerate its debt in these circumstances.
Again, this is alarming for companies due to the potential domino effect of all of its debt effectively becoming due simultaneously. It is key for a borrower to ensure it understands exactly what is covered in the definition of financial indebtedness and also whether there is any minimum monetary threshold below which the clause does not take effect. Without such a threshold, a "minor" failure, such as missing a payment on a contract for the supply of office supplies, could be sufficient to trigger the cross default, with the consequent ill effects from the company's perspective.
If an event of default does occur, then this is the time when the relationship with the lender will come under close scrutiny. A close relationship, based on mutual trust and good communication, may well assist in working through a default scenario. However, if such a strong relationship does not exist, the lender may decide to terminate the loan and demand repayment.
As ever with finance contracts the devil is in the detail, so careful review is highly recommended.
Patrick Bell is a partner specialising in banking law at leading UK law firm Shepherd and Wedderburn LLP.