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Negotiating Loan Documents for Borrowers – Part VI

Understanding Events of Default

Access to capital is critical to every business. Entering into loan arrangements with a lender is a complex process, the results of which can be vital to the success or failure of a company. This is the sixth in a series of articles intended to explain various aspects of the loan process. In our prior articles, we discussed the importance of the term sheet stage of a loan transaction, factors for the prospective borrower to consider in choosing a loan and the types of loans that are available, steps the borrower can take to help expedite the loan process to reduce transaction expenses and the representations and warranties and covenants sections of a loan agreement. In this article, we continue looking at the loan agreement itself by reviewing the events of default section of the document.

Events of Default

Events of default are circumstances set forth in a loan agreement, the occurrence of which entitle the lender to pursue remedies against the borrower. Events of default are intended to alert the lender to any deteriorating situation and give the lender the ability to take timely remedial action. Generally, the condition giving rise to the event of default must be continuing when the lender declares an event of default in order to exercise any of its rights set forth in the loan agreement.

While events of default will vary from one agreement to another, there are certain standard events of default that are generally included in all agreements, including payment defaults, breaches of representations, warranties or covenants, judgments, invalidity of liens, unenforceability of loan documents, change of control and insolvency or bankruptcy.

It should be noted that there is a distinction between a default and an event of default. An event of default is an event, condition, or circumstance giving a lender immediate rights under the loan agreement. A default is an event, condition or circumstance that with the passage of time would result in an event of default.

Events of default are often only generally referenced in a term sheet, resulting in the events of default section being negotiated as part of the loan agreement. Lenders typically want events of default to be defined as broadly as possible whereas borrowers will seek to define the list of events as narrowly as possible in order to continue to operate its business without undue interference and limit the circumstances that could give rise to an event of default. The ability of the borrower to negotiate less stringent events of default will depend on many factors, including the business purpose behind such request, the creditworthiness of the borrower and general market conditions.

Consequences of an Event of Default

If an event of default occurs, the lender will be permitted to exercise remedies against the borrower. Typical remedies include accelerating and demanding repayment of the loan and all other amounts owing to the lender, terminating the commitment to advance any additional funds, charging default interest and foreclosing on collateral. The exercise of such remedies can be catastrophic to a borrower as it may not have funds available to repay the loan, could result in a cross-default under other debt obligations or agreements and may result in the insolvency or bankruptcy of the borrower. Accordingly, it is imperative for the borrower to have a strong culture of compliance in its organization to avoid inadvertently triggering an event of default.

It does not matter which event of default is breached. Whether it is a missed payment, the failure to deliver a required financial report or a significant judgment decided against the borrower, any event of default will trigger the lender’s enforcement remedies. In practice, however, lenders make a distinction because lenders generally do not want to be viewed by the borrower or the courts as being unreasonable or as acting in bad faith. Rather, absent other extenuating circumstances, a lender is more likely to use a minor default as an opportunity to bring the borrower back to the negotiating table rather than exercise more extreme remedies.

If a borrower believes that an event of default is likely to occur, the borrower should discuss the situation with the lender in advance in order to seek an amendment or a waiver. A lender is likely to be more receptive to assist in working towards a resolution prior to the occurrence of an event of default as most lenders would prefer to have a performing loan rather than being involved in a restructuring transaction or foreclosing on collateral as such extreme outcomes are expensive and time consuming and can remove control from the lender making the outcome uncertain. Borrowers should note that, if the lender is willing to grant such an amendment or a waiver, it typically comes at a financial cost to the borrower or requires some concessions from the borrower.

As the consequences of an event of default can be severe, the borrower should review the events of default section carefully and ensure that it will be able to comply with such terms, particularly as it relates to the borrower’s plans for its business during the term of the loan.

Drafting Suggestions

Careful attention should be paid to the definitions section of the loan agreement and the impact that such definitions have on the events of default section. The borrower may seek to modify certain definitions in order to provide more flexibility with respect to its compliance with the applicable covenants or conditions in order to avoid actions that result in an event of default.

It is critical for the borrower to understand who will be subject to the items described in the events of default section. Often, these items will apply not just to the borrower, but also to its direct and indirect subsidiaries.

The borrower should request materiality qualifiers and reasonable thresholds or other de minimis exceptions before certain circumstances rise to the level of an event of default to avoid immaterial events resulting in unintended consequences. In addition, in some cases it may be more appropriate for a particular event of default to only apply where it will have or is reasonably likely to have a material adverse effect, rather than refer to materiality or a monetary threshold.

The borrower should try to avoid including any items in the events of default section that are beyond its control. For example, the borrower should try to omit from the events of default section the termination of service of a particular employee or the loss of a particular customer.

The borrower should seek to include cure periods should a default occur so that it has an opportunity to cure its breach before it triggers an event of default. Depending on the default, cure periods of 10 to 30 days are customary, other than for payment defaults for which up to 5 days is customary. Often, lenders are willing to provide cure periods for interest payments, but not for principal payments. Ideally, any cure period would not apply until the borrower has been notified by the lender of the default. However, lenders have become increasingly reluctant to provide such a notice provision reasoning that it is the borrower’s responsibility to be aware of any default. In addition, lenders will not provide cure periods for certain defaults that are the result of an action affirmatively taken by the borrower such as a voluntary bankruptcy filing.

Finally, for defaults not capable of being cured within a specified cure period, borrowers should request a “continuing cure” right such that so long as the borrower is actively attempting to cure such default, the borrower shall not be deemed in default for such breach. Such “continuing cure” rights are typically subject to an outside cutoff date of 60 to 90 days.

Conclusion

Debt financing can be vital to the ongoing operations of a business and a powerful expansion tool, but a borrower must remain wary of pitfalls within the loan documents that can interfere with its business. Careful attention during the drafting stage of the loan agreement can prevent unexpected consequences in the future. Borrowers and prospective borrowers are encouraged to work with their legal and financial advisors throughout the negotiation and drafting stages of the loan process as their involvement can help to ensure smooth and efficient operations of the borrower’s business and avoid catastrophic consequences during the term of the loan.

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