An event of default (EOD) is a breach of the terms of a debt facility or loan agreement by the borrower. EOD clauses outline specific events or actions that allow the lender to demand full and immediate repayment of the debt obligation.
If an EOD occurs, the lender has the right to take certain actions like demanding immediate repayment, enforcing security interests, or restricting further access to credit facilities.
Common Types of Events of Default
Debt agreements often categorize EODs into financial and non-financial events covering areas like:
Failure to Pay
One of the most common EODs is the failure of the borrower to make any payment when due, including:
- Principal loan repayment
- Interest payments
- Fees outlined in the loan agreement
Most agreements include a grace period, usually 30 days, before non-payment constitutes an EOD. This allows for short administrative delays (e.g. 5 days after month end to reconcile and transfer).
Breach of Covenants
Debt agreements contain affirmative and negative covenants that dictate certain actions the borrower must comply with over the term of the loan such as:
- Maintaining insurance on collateralized assets
- Restrictions on asset sales, mergers, or changes of ownership
- Adherence to certain debt ratios and liquidity minimums
- Delivery of audited financial statements
Breaching any established covenants typically constitutes an EOD and is a common trigger.
Insolvency
If the borrower enters bankruptcy, receivership, or becomes insolvent, this immediately triggers default in nearly all debt agreements. This may include:
- Filing for bankruptcy protection
- Unsuccessful attempts to restructure existing debts
- Entry of adverse judgements that threaten insolvency
Lenders need immediate repayment priority if a borrower can no longer pay debts.
Misrepresentations
Another common EOD trigger is factual misrepresentations by the borrower either when obtaining the loan, or over the term of the borrowing. For example:
- Inaccurate or misleading financial statements
- Incorrect ownership information
- Falsely reporting compliance with covenants
- Lack of notification around material events
Integrity and transparency are paramount in the lender-borrower relationship.
Other Types of Default Triggers
In addition to the major categories above, debt agreements may also specify other unique triggers such as:
- Change in ownership – if key principals or majority shareholders exit
- Key tenant loss – for loans secured by real estate assets
- Regulatory non-compliance – failure to maintain licenses, approvals, etc.
- Tax default – failure to pay major business taxes
- Key customer loss – credit risk increase if major contracts cancelled
These allow lenders to call a default if events substantially compromise the borrower’s credit quality over the term of the debt obligation.
Material Adverse Changes
Many agreements contain material adverse change (MAC) clauses that trigger default if the borrower’s financial position substantially deteriorates – even if covenants are technically met.
MAC clauses act as a fallback measure to protect against cases where sudden declines in financial performance don’t breach a narrowly-defined covenant but still threaten the borrower’s ability to repay.
As MACs are loosely defined, lenders tend to invoke these cautiously to avoid legal disputes. But they provide another possible default trigger in the lender’s toolkit.
Consequences of Default: Lender Remedies
Upon default, debt agreements grant lenders a variety of legal remedies to protect the repayment of their loan. While specific clauses vary, common lender remedies include:
Demand Full Repayment
The most typical lender response is to issue written default notice to the borrower, then demand immediate and full repayment of the entire outstanding debt obligation.
This allows the lender to exit the lending relationship, withdraw future funding obligations, and seek returns of loaned funds.
If the borrower cannot pay in full, it permits the lender to pursue additional default remedies such as seizing collateral or forcing bankruptcy.
Enforce Security Interests
If repayment is not forthcoming, secured lenders can seize and liquidate pledged collateral to satisfy debts. This includes:
- Repossessing physical assets like real estate, inventory, equipment
- Freezing cash collateral accounts associated with the loan
- Selling shares or equity pledged by shareholders
- Enforcing guarantees made by corporate affiliates, sponsors, or the borrower’s parent company
After seizing and selling assets, proceeds pay down the defaulted debt.
Initiate Bankruptcy Proceedings
Since most borrowers cannot immediately repay full debts during distress, default often leads lenders to initiate involuntary bankruptcy against the deficient entity.
Insolvency proceedings either:
- Force an orderly liquidation to pay creditors such as a Chapter 7 bankruptcy
- Result in a judicially-enforced reorganization plan to restructure debts under Chapter 11
Launching bankruptcy benefits lenders by freezing obligations owed to the borrower that creditors cannot immediately recover such as:
- Staying litigation against the borrower
- Suspending senior liens so lenders don’t lose repayment priority
- Discontinuing construction projects financed by the borrower
- Prohibiting additional borrowing or asset transfers
Bankruptcy also establishes a clear repayment plan overseen by the courts to maximize creditor recoveries.
Request Receivership
Some debt agreements allow lenders to petition courts to appoint third-party receivers upon default. These officers then take over management of the borrower’s firm or its accounts receivables to ring-fence cash flows so they repay creditors.
Receivers make operational decisions to generate repayment capital, although in practice full existing management teams often stay in place to assist the process.
Limit Further Access to Credit
Following default, borrowers lose access to additional credit facilities or revolving loans tied to the debt facility in default. This includes withdrawal of:
- Unused revolver commitments
- Any incremental or accordion term loans
- Ability to request letters of credit
- Other ancillary facilities like hedges
Terminating access to financing puts significant pressure on borrowers to remedy defaults quickly or source alternative lending sources. However, cutting off a borrower’s only liquidity could force unplanned asset sales or heighten bankruptcy risk which could ultimately lower recoveries.
Standstill or Forbearance Agreements
Upon material default, borrowers can negotiate temporary standstill agreements where lenders refrain from demanding repayment or seizing assets for a defined period, usually 60-90 days.
This delay gives distressed borrowers time to cure events of default:
- Seeking emergency financing from current stakeholders
- Liquidating non-core assets to quickly raise capital
- Securing prospective third-party buyers to acquire a majority stake
If successful, borrowers might cure defaults or present lenders with credible repayment plans that persuade them to waive defaults.
However, lenders only grant standstills if borrowers use the time productively towards legitimate financing solutions. Lenders can terminate agreements if no credible progress materializes leading again to demands for full repayment.
EOD Provisions
Well-constructed EOD terms clearly outline actions by the borrower that constitute default and specific rights the lender has. Key considerations when formulating EODs in debt agreements cover:
Defining Material Adverse Changes
MAC clauses that declare defaults if the borrower’s financial position substantially weakens should contain clear quantitative thresholds in areas like:
- Minimum revenue, EBITDA, or tangible net worth declines
- Maximum permissible asset value deterioration
- Minimum required debt service or interest coverage ratios
Quantifiable metrics reduce lender discretion invoking MAC clauses at the first sign of borrower distress. They also clearly outline scenarios that threaten repayment capabilities versus temporary dips unlikely to generate losses.
Carve-Outs for Excusable Defaults
Most loan agreements exempt certain default triggers if causes arise outside the borrower’s control like:
- Declines from broad economic downturns
- Changes in laws and regulations
- Major disruptive events (natural disasters, wars) that severely impact operations
Carve-out clauses restrict lenders from exaggerating the material impacts of temporary external factors the borrower could not influence. They also incentivize lenders to act reasonably given extenuating circumstances.
Notice & Cure Periods
While lenders want to default borrowers at early signs of repayment risk, borrowers conversely want opportunities to remedy issues before triggering enforcement actions.
Appropriately structuring notice and cure periods allows this balance. For example, debt agreements may state:
- Minor Defaults: 15-day notice and 30-day cure periods from the first default date
- Material Defaults: 5-day notice and 15-day cure periods
Minor issues get more remedy time versus material events threatening solvency. Clearly outlined windows let borrowers understand critical deadlines before losing control to lenders.
Conclusion
Events of default are critical provisions in debt agreements that outline specific borrower actions that constitute a default and permit lenders to take enforcement actions. Core default triggers cover failure to pay interest or principal, insolvency, covenant breaches, and material misrepresentations.
Default clauses establish standards of conduct to facilitate lending relationships while protecting lenders against credit deterioration.