Events of Default are most often found in the context of loan agreements and are similar to termination rights that may be found in commercial agreements, albeit with potentially different consequences. An Event of Default is an event or circumstance relating to a borrower or its activities which will give rise to a right for a lender to refuse to make any further advances, demand immediate repayment of a loan, make a term loan repayable on demand and/or enforce its security.
Below is a short borrower’s guide to navigating those Events of Default which are typically found in real estate finance documentation, and some tips on usual points of negotiation.
Events of Default
Common Events of Default in a real estate finance transaction:
If a borrower does not pay an amount when it becomes due under the loan agreement, this will constitute an Event of Default. Lenders are very unlikely to negotiate this. It may be possible for a borrower to seek to request the inclusion of a reasonable grace period within which the overdue amount must be paid, before the breach becomes an Event of Default. Ordinarily, such grace period would be no longer than a couple of business days.
Breach of Financial Covenant
A financial covenant is a promise by the borrower to meet and maintain an agreed financial position, during the term of the loan. In real estate finance transactions, financial covenants are usually linked to the market value of the underlying property and/or the level of income received from the property. For example, a ‘loan to value’ (or ‘LTV’) covenant will require the loan amount not to exceed a certain proportion of the market value of the property (based on the bank’s most recent valuation). Such covenants are most often tested on each interest payment date (or ‘IPD’) and any breach would trigger an Event of Default. Quite often a covenant breach is an early warning sign to a lender that a borrower may struggle to service the interest and/or repay the loan. The negotiation is likely to be around agreeing the threshold at which the borrower’s financial position becomes a breach and triggers an Event of Default. Quite often, cure rights are agreed to allow a borrower to ‘cure’ a covenant breach to avoid triggering an Event of Default.
Breach of Other Obligations
In addition to breach of the payment clause and breach of financial covenant, a more general Event of Default will often be included to capture a breach of all other obligations of the borrower under the loan agreement such as breaches of undertakings. The borrower may wish to seek 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 arises. It is therefore important for the borrower to carefully consider all its obligations under the loan agreement, including in relation to any restrictions on its ability to deal with the property (such as in respect of leasing, disposal and development) and borrowing further monies from third party lenders. The various representations, warranties and undertakings may therefore need to be amended to ensure they do not hinder the smooth running of the borrower’s business, or obstruct its intentions for the property.
This Event of Default will be triggered if any representation or statement made (or deemed to have been made) by the borrower pursuant to the loan agreement (or sometimes also other, related finance documents), is shown to have been incorrect or misleading. The representations may be given on the date of the agreement only, or may also be deemed to be repeated on each day throughout the term of the loan (or certain dates such as drawdown dates, IPDs or the dates of any repayment or prepayment). The borrower could seek to limit the Event of Default by inserting some materiality wording so that the Event of Default only occurs when the misrepresentation only has a material effect on the borrower’s ability to fulfil its obligations under the loan agreement. The borrower will also want to ensure that the representations are limited to written statements in the loan agreement only, and not verbal discussions or other correspondence between the parties.
A cross-default Event of Default will be triggered if the borrower defaults under any another agreement, either with the lender or a separate third party. The borrower should therefore carefully consider what other agreements it has in place, and what the likelihood is of a default under the same. If necessary, the borrower could seek to insert some carve out language, exempting certain agreements from being captured by this provision. For example, it is quite common to see a de-minimus value included in respect of a default under another agreement. Borrowers should also be careful to ensure that the wording of this Event of Default does not preclude or otherwise hinder the efficient conduct of its business.
This Event of Default will almost always appear in a loan agreement in some form. Depending on the way it has been drafted, an Event of Default will be triggered when an insolvency situation (however it is defined in the loan agreement) has arisen in respect of the borrower. Sometimes simply the threat of an insolvency process being initiated against the borrower can be enough to trigger this Event of Default. As such, this provision can become quite heavily negotiated because the borrower will want to limit the meaning of an insolvency event as much as possible, whereas the lender is likely to want to have the ability to trigger an Event of Default and demand immediate repayment of the loan, at the first indication of the borrower being in any financial difficulty.
Borrower’s Obligation to Notify
If a borrower becomes aware that an Event of Default has occurred or is likely to occur, it will usually be under an obligation to promptly notify the lender of the same and provide the relevant details including what steps, if any, have been taken to remedy any breach.
Consequences of Default
Following an Event of Default, the lender will have a number of options available to it, which will be set out in the ‘Acceleration’ clause of the loan agreement. These will typically include the ability to:
- immediately cancel any undrawn element of a loan;
- declare all outstanding loans immediately due and payable;
- declare all outstanding loans to be payable on demand; and/or
- declare all or any of its security to be enforceable (this may include for example, any legal charge, personal guarantee or share charge entered into, in favour of the lender).
Following an Event of Default, the lender will not be under any particular obligation to exercise its rights under the Acceleration provisions, and it could agree to waive the Event of Default altogether.
The lender may choose to issue a ‘reservation of rights letter’ to the borrower following an Event of Default (or sometimes following breach of the loan agreement, but before the Event of Default has been triggered, (often known as a ‘Default’)). Under the reservation of rights letter, the lender will seek to reserve any rights or remedies it may have under the loan agreement in connection with an Event of Default (or breach), even if it hasn’t taken immediate or prompt action in relation to the same. This should avoid a situation arising whereby the borrower can argue that the lender has waived the Event of Default (or breach) and therefore protects the lender’s ability to take action, later.