Clauses on Default

Events of Default

Under general law, parties are free to designate which clauses are so fundamental that their breach entitles the other party to terminate its commitment and to return of monies and compensation.  In the context of a loan agreement, an event of default will be a designated circumstance of fundamental breach. As under contract law generally, the “innocent” party has the option to terminate the contract or waive the breach.  A bank may wish to reserve its rights, even if it does not enforce.

Generally, a loan will not become immediately payable until demanded. This is significant, as otherwise, the Statute of Limitations may commence on the date of the first technical default.  An event of default is a circumstance that entitles the bank to terminate the loan and demand repayment of the entire loan monies.  Typically, an event of default will also constitute circumstances in which a mortgage or charge can be enforced.  Certain events of default may provide for a grace period in which the borrower can remedy the default.

On default, the bank will usually have a number of rights.  It may cancel undrawn parts of the facility. It may demand the entire loan monies and may enforce the security. The bank may not necessarily wish to take all or any of these actions. The appropriate course may be to negotiate with the borrower to remediate the position. The renegotiation may involve increased margin, tighter covenants, reduced loan to value, more security, etc.

A bank can be liable to a borrower for breach of contract if it demands repayment or enforces security, where it is not entitled to do so. Therefore, the default should be clearly defined so that no question may arise of the bank wrongly calling a default.  If a bank calls an event of default erroneously, then it may be liable for breach of contract to the borrower.


Financial Default

Non-payment of interest or capital will invariably be events of default.  Default interest may also arise. Late payment will also constitute a default. There may be provisions for a grace period to cover an inadvertent failure to pay on time.  This may cover some unexpected failure in the payment system.  A grace period is less likely in respect of non-payment of the principal.

Non-payment is the most fundamental event of default. The other events play a supporting role, in that they try to protect against prospective non-payment, by allowing for early action.  Even if a grace period is allowed for payment of interest, default interest will normally apply from the due date. The bank may require to be indemnified against losses sustained or incurred as a result of the late payment. General principles of contract law relating to penalties apply to default interest.  Provided that the default interest is a reasonable pre-estimate of likely loss, it will be valid.


Breach of Warranties and Covenants

The breach of a warranty, representation or covenant will usually be an event of default.  The breach may occur at a point in time when the warranties and representations are deemed to be repeated.  If a breach can be remedied, the bank will generally allow a period of grace.  A grace period may be provided in the loan agreement itself.   This is best provided for in the covenant or representation itself rather than in the event of default clause.

A borrower may seek to limit breaches of representations, warranties, and covenants which constitute events of default, to material breaches.   He may argue that the bank should not be entitled to terminate its commitment and demand repayment, by reason of a relatively trivial breach.

If materiality is agreed as a limiting factor, there should be a defined threshold. For example, a breach may continue for a number of days, at which point the breach it may be deemed material.  If materiality cannot be measured in this way, it is preferable for the lender that materiality should be determined by the lender’s opinion. In the absence of an objective touchstone, the bank risks being liable for breach of contract, if it wrongfully calls an event of default.


Cross Default

A cross-default clause deems an event of default to have occurred where the borrower defaults on another loan.  The cross-default clause will generally be limited to loans or equivalent indebtedness.  In the absence of such a clause, a bank would be powerless in a situation where another lender had called a default. Another lender may, for example, require extra security, thereby eroding the lender’s position. The cross-default provision enables the bank to protect its position by accelerating or threatening to accelerate the loan.

A cross-default clause may have a domino effect and lead to multiple defaults and ultimately insolvency. A borrower may, therefore, seek to restrict a cross-default clause.  He might argue that it should be limited to a cross-default having a significant effect on its business.  He might argue that it should not apply on the basis of breach of another loan agreement unless that other loan agreement has actually been demanded.  This is a cross acceleration clause and is less favourable to the lender.

The borrower may wish to provide an exception (carve out) for defaults in respect of debts which are being disputed in good faith.  The bank may not wish to concede a subjective basis for contesting the nature of the debt.

If the borrower is part of a group, the bank may require that the cross-default clauses apply to all companies in the group.  The borrower will usually seek to limit this cross default to the material or principal subsidiaries.


Material Changes I

A change in the nature of the business, without the bank’s consent, may be an event of default.  The bank may have lent on the basis of a particular assessment of the ability to repay.  The cessation of a material part of a business or the disposal of business assets may be detrimental and accordingly be deemed an event of default.

A change in control of the borrower entity may constitute an event of default.  The relationship between parent and subsidiary may be a part of the original credit assessment. The identity of the company’s controllers may be a key part of the credit assessment.

An event of default by reason of a “material adverse change” is sometimes provided as a “sweep up” provision.  The clause may be controversial.  The borrower may seek to exclude it and argue that it is overly subjective. The bank will wish to phrase it in subjective terms.  The borrower will wish to limit it to an objective basis.


Material Change II

In practice, the clause may be used to limit the bank’s obligation to make further advances, rather than as a basis for demanding repayment of all loan monies. The bank would need to be sure of its grounds to rely on the clause as the consequences of wrongly calling the clause may be severe.

If it becomes illegal by reason of a change of law or other circumstance, for the bank to continue to maintain its obligations, it will wish to cancel its obligations and seek immediate repayment (whether technically an event of default or not). The bank may agree that it shall instead take other alternative reasonable steps in order to mitigate the effect of the illegality.


Solvency

The borrower’s insolvency or events which commence an insolvency process will invariably be events of default. The inability to pay debts as they fall due, cessation or threatening to cease business, enforcement of other security and steps taken by way of winding up or receivership may also constitute events of default. The bank will wish to take action at the first sign of formal insolvency.  It will want the option to optimise its position in relation to other creditors and preserve the borrower’s assets, by enforcement or otherwise.

There may be a “carve out” for a bona fide dispute with a creditor to prevent the risk of a creditor issuing a tactical “Section 214” notice. There may be a limit on the level of debt which may trigger the default.


References and Sources

Irish Texts

Breslin Banking law + Supplement     3rd Ed  2013

Mortgages Law & Practice     Maddox 2nd Ed            2017

NAMA Act 2009: A Reference Guide Raghallaigh, Kennedy, Whelan

Money Laundering & Anti-Terrorist Financing Act 2010

Financial & Emergency Provision Legislation Annotated      2011

Shelley & McGrath     National Asset Management Agency Act Annotated 2011

Dodd & Carroll            Law Relating to NAMA 2012  0

Ashe & Reid    Anti-Money Laundering: Risks, Governance & Compliance             2013

Johnston & Ors           Arthur Cox Banking Law Handbook               2007

Dr Mary Donnelly  The Law of Credit and Security, 2nd Ed, 2015

UK Texts

A Hudson The Law of Finance 2nd Ed (Sweet and Maxwell 2013)

Veil (Ed) European capital markets law (Hart Publishing 2013)

IG MacNeil An Introduction to the Law on Financial Investment 2nd Ed ( Hart Publishing 2012)

E Ferran Principles of Corporate Finance 2nd Ed ( OUP 2014)

Gullifer (ed) Goode and Gullifer on legal problems of credit and security (6th edn Sweet and Maxwell London 2017).

MA Clarke et al (eds) Commercial Law: Text, Cases and Materials (5th edn OUP Oxford 2017)

McKendrick (ed) Goode on commercial law (5th edn Penguin London 2017)

G McCormack Secured credit under English and American law (CUP Cambridge 2004)

L Gullifer and J Payne Corporate Finance (2nd edn Hart Oxford 2015)

D Sheehan The Principles of Personal Property Law (2nd edn Hart Oxford 2017)

Ross Cranston, Emilios Avgouleas, Kristin van Zwieten, Christopher Hare, and Theodor van Sante Principles of Banking Law 3rd Ed 2018

E.P. Ellinger, E. Lomnicka, and C. Hare Ellinger’s Modern Banking Law 5th Ed 2011

Andrew Haynes The Law Relating to International Banking  Bloomsbury Professional 2009

Charles Proctor Mann on the Legal Aspect of Money 7th Ed 2012

Charles Proctor The Law and Practice of International Banking 2nd Ed  2015

Sheelagh McCracken The Banker’s Remedy of Set-Off   2010 Bloomsbury Professional

Louise Gullifer, Jennifer Payne Banking & Financial Law 2018

Hubert Picarda QC The Law Relating to Receivers, Managers and Administrators 4th Ed  2006 5th Ed 2019

Lightman & Moss on the Law of Administrators and Receivers of Companies 6th Ed  Sweet & Maxwell 2017

Timothy N Parsons  Lingard’s Bank Security Documents 6th Ed 2015