Cross default is a provision of a bond or loan agreement that causes the borrower to become insolvent if the borrower defaults. The default clause is to maintain lenders' equality. Such clauses usually have two forms. One allows the lender to take advantage of simple remedies for any other debt. The second requires that other lenders accelerate the loan to activate the default clause. The purpose of insolvency clauses, irrespective of their form, is to maintain a level playing field between creditors in terms of legal remedies and negotiations. The theory is that one creditor is seeking remedies against the borrower, other creditors should be able to do so. Creditors may have two concerns:
- if there is default in one contract, the creditor may seek to negotiate preferential terms in exchange for not accelerating the loan,
- since default clauses would give other lenders the right to accelerate their loans, there would be the limited ability of the creditor and borrower to accept such a contract
Cross default in bank finance
It is the default leading anticipatory event: if the lender has defaulted on another loan, it may only be a matter of time before the default of the borrower on this loan. It gives the bank the ability to be present at the table in negotiations on debt restructuring. It seeks to establish non-discriminatory treatment, e.g. in practice, the clause limits preferential payments to other overdue creditors as each creditor can accelerate and thus stop the business. The cross-default has an effect of inertia in practice. Since this spells bankruptcy, no one can accelerate if everyone can. Extension of security collateral (where the borrower gives security without personal liability-if this is allowed under the negative pledge is to catch asset erosion: but the borrower himself is not in default.
Sometimes banks will seek additional protection from a guarantee that will immediately cause a default on any other loan or banking agreement if the lender is in default on any of its loans or banking transactions above a certain amount, this will create a default automatically on every other loan or banking contract. This form of contract is referred to as a cross-default clause. Normally a cross-default clause is quantified to some degree, so a minimum default size must exist before triggering cross-default. This could be a percentage, like 1% or 2%, of investor assets, or a financial limit, like $1 million to $10 million.
For example, a company that does not automatically repay a $7.5 million loan would be in default on all its other loans and guarantees subject to a cross-default agreement with a threshold exceeding $7.5 million. The financial position of a company is often irrecoverable when cross-default is triggered. Usually, there is a grace period specified in the covenant before the default event becomes the non-payment of interest or principal. This means that missed or misdirected payments and other administrative errors can be allowed.
The default cross provision should protect a company's creditors against a selective default. The provision allows bondholders to claim 101 percent of the accrued interest plus if the issuer defaults on any other bond, often over $10 million. If an issuer defaults on any material obligation, the company is likely to have limited liquidity and the remaining debt will have difficulty servicing.
Factors of mitigating cross-default
There are several ways in which a borrower negotiates a loan with a lender to mitigate the effect of cross-default and provide room for financial maneuver. A borrower, for example, may limit cross-default loans with maturities exceeding one year or more than a certain amount of dollars. A borrower may also negotiate a cross-acceleration provision first before a cross-default, whereby a creditor must first accelerate the payment of principal and interest due before declaring a cross-default event. Finally, a borrower may restrict cross-default contracts and exclude debt that is disputed in good faith or paid within its permitted grace period.
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Author: Aleksandra Walawska