Negotiating defaults under a loan agreement – what should a borrower pay attention to?
Events of default occur most commonly in the context of credit agreements and are similar to termination rights found in commercial contracts, albeit with potentially different consequences. An event of default is an event or circumstance relating to a borrower or its activities that gives a lender the right to refuse further advances, require immediate repayment of a loan, make a term loan repayable on demand and/or enforce its security.
Below is a brief guide for borrowers to navigate through the default events that typically occur in real estate financing Documentation and some tips on common negotiation points.
Events of Default
Common default events in a real estate financing transaction:
If a borrower fails to pay an amount when it is due under the loan agreement, this constitutes a default. Lenders are very unlikely to negotiate this. It may be possible for a borrower to require the inclusion of a reasonable grace period within which to pay the overdue amount before the breach becomes an event of default. Normally, such a grace period does not last longer than a few working days.
Breach of financial covenant
A financial covenant is a promise by the borrower to meet and maintain an agreed financial position for the life of the loan. In the case of real estate financing transactions, financial covenants are usually linked to the market value of the underlying property and/or the amount of income generated from the property. For example, a loan to value (or “LTV”) covenant requires that the loan amount not exceed a certain percentage of the property’s market value (based on the bank’s most recent appraisal). Such covenants are most often tested on each interest payment date (or “IPD”) and any breach would trigger a default event. Quite often, a covenant breach is an early warning sign to a lender that a borrower may have difficulty making interest payments and/or repaying the loan. Negotiations will likely focus on agreeing the threshold at which the borrower’s financial condition becomes a breach and triggers a default event. Very often, healing rights are agreed to allow a borrower to “heal” a covenant breach in order to avoid triggering a default event.
breach of other obligations
In addition to the breach of the payment term and financial covenant, a more general event of default is often included to cover a breach of all of the borrower’s other obligations under the loan agreement, such as B. breaches of contract to record. The Borrower may wish to attempt to limit the Event of Default to “material” breaches and/or negotiate a grace period within which the breach can be remedied before the Event of Default occurs. It is therefore important that the borrower carefully consider all of their obligations under the loan agreement, including any limitations on their ability to deal with the property (e.g. in relation to leasing, sale and development) and any further monies from third parties borrow party lenders. The various representations, warranties and covenants may therefore need to be modified to ensure that they do not hinder the borrower’s smooth running of his business or hinder his intentions for the property.
This event of default is triggered when a representation or statement made (or deemed to have been made) by the borrower under the loan agreement (or sometimes other related financial documents) is found to be false or misleading. The pledges can be made only on the date of the agreement or can be seen as repeating every day throughout the life of the loan (or on specific dates such as draw dates, IPDs or dates of a repayment or prepayment). The borrower could attempt to limit the event of default by including materiality language so that the event of default occurs only when the misstatement has only a material impact on the borrower’s ability to meet its obligations under the loan agreement. The borrower will also want to ensure that the representations are limited only to written statements in the loan agreement and not to verbal discussions or other correspondence between the parties.
A cross-default event of default is triggered when the borrower defaults under another agreement with either the lender or a separate third party. The borrower should therefore carefully check what other agreements he has made and what the probability of default is. If necessary, the Borrower could attempt to insert exception language that exempts certain agreements from this provision. For example, it is quite common for a de minimis amount to be included in relation to a default under another arrangement. Borrowers should also take care to ensure that the language of this event of default does not preclude or otherwise impede the efficient conduct of their business.
This event of default will almost always appear in some form in a loan agreement. Depending on the structure, an event of default is triggered if the borrower is in an insolvency situation (however defined in the loan agreement). Sometimes the threat of bankruptcy proceedings against the borrower is enough to trigger this event of default. As such, this provision can be fairly heavily negotiated as the borrower will want to limit the meaning of an insolvency event as much as possible, while the lender will likely want the ability to trigger an event of default and demand immediate repayment of the loan at the first sign of it that the borrower is in financial difficulties.
Borrower’s Reporting Obligation
When a borrower becomes aware that an event of default has occurred or is likely to occur, they are generally required to notify the lender promptly and provide the relevant details, including steps that have been taken, if any, to remedy any breach.
consequences of the delay
After an event of default, the lender has a number of options, which are set out in the “acceleration clause” of the loan agreement. This usually includes the ability to:
- immediately cancel all undrawn elements of a loan;
- declare all outstanding loans immediately due and payable;
- declare all outstanding loans due on demand; and or
- declare all or part of its collateral enforceable (this may include, for example, legal fees, personal guarantees or stock fees received in favor of the lender).
After an Event of Default, the Lender has no specific obligation to exercise its rights under the Acceleration Provisions and could agree to waive the Event of Default altogether.
The lender may choose to issue a “Letter of Record” (often referred to as “Default”) to the Borrower after an Event of Default (or sometimes after a breach of the Loan Agreement but before the Event of Default is triggered). Pursuant to the Reservation of Rights Letter, the Lender will attempt to reserve for itself any right or remedy it may have under the Loan Agreement in relation to any Event of Default (or Breach), even if it has not taken any immediate or prompt action in relation to the same. This should avoid a situation where the borrower can argue that the lender waived the event of default (or breach) and therefore protects the lender’s ability to take action later.