Cross Default

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:

1. if there is default in one contract, the creditor may seek to negotiate preferential terms in exchange for not accelerating the loan,
2. 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.

Corporate Bonds

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.

Examples of Cross Default

• A Cross Default clause in a contract is an agreement between two parties where if one party defaults on its obligations to the other, then the other party is automatically in default as well. For example, if a company has borrowed money from a bank and is unable to make payments on the loan, the bank could invoke the Cross Default clause, which allows them to take action against the company for defaulting on the loan.
• In a loan agreement, a Cross Default clause can specify that if the borrower is in default on any of its other loans, then the lender has the right to declare the borrower in default of the loan agreement. For example, if a company has taken out several loans from different banks, and fails to make payments on one of the loans, the other banks can invoke their Cross Default clause and demand payment on their loans.
• In a lease agreement, a Cross Default clause can be used to ensure that the tenant remains in good standing with all of their other leases. For instance, if the tenant has multiple leases with different landlords, and fails to make payments on one of the leases, the other landlords can invoke their Cross Default clause and demand payment on their leases.

Advantages of Cross Default

Below are the advantages of cross default clauses:

• Cross default clauses provide creditors with a greater level of protection against default by a borrower. This allows lenders to take action upon default of a single loan, rather than waiting for multiple loans to enter default.
• Cross default clauses can help to reduce the risk of a borrower being unable to meet the obligations of multiple loans. By having one clause that covers all loans, lenders can more easily manage the borrower’s debt load.
• Cross default clauses can be useful for borrowers who may be unable to pay back multiple loans at once. By having one clause that covers all loans, lenders can more easily work out a payment plan with the borrower.
• Cross default clauses can provide an incentive for lenders to offer more competitive terms on loans. This can be beneficial for borrowers, as it allows them to take advantage of lower interest rates, longer repayment periods, and other favorable loan conditions.

Limitations of Cross Default

Cross default is a financial agreement that links multiple debt obligations, such that defaulting on one obligates the debtor to default on all related debt. While this type of agreement can have numerous advantages, it is also important to note its limitations. These limitations include:

• Inability to account for individual circumstances: The terms of a cross default agreement are structured in a one-size-fits-all manner, making it difficult to account for the individual circumstances of each creditor. This can lead to unfair outcomes and difficulties when attempting to negotiate with creditors.
• Difficulty to amend: Once a cross default agreement has been established, it can often be extremely difficult to amend or renegotiate its terms. This can lead to situations where a debtor is unable to adjust the terms of their agreement, even if their financial circumstances have changed.
• Increased risk of default: Because a cross default agreement links multiple debt obligations, it increases the overall risk of default. This is because a single default event can cause multiple obligations to become immediately due, potentially leading to financial difficulties for the debtor.
• Lack of flexibility: Cross default agreements are often rigid and inflexible, making it difficult for the parties to adjust their obligations as needed. This lack of flexibility can be problematic, particularly in cases where financial circumstances have changed and new arrangements are needed.

Other approaches related to Cross Default

Financial management in regards to Cross Default involves various approaches such as risk management, credit management, and liquidity management. More specifically, these approaches include:

• Risk management: Risk management involves assessing the potential future risks of a cross default, such as the risk of defaulting on payments or the risk of a credit event. It also involves implementing strategies to mitigate these risks, such as setting up collateral arrangements or establishing credit lines.
• Credit management: Credit management involves understanding the current creditworthiness of the parties involved in a cross default, as well as their ability to meet their payment obligations. This involves obtaining credit reports, assessing credit scores, and establishing credit limits.
• Liquidity management: Liquidity management involves monitoring and managing the available cash flows of the parties involved in a cross default. This involves forecasting cash flows, setting up payment schedules, and establishing liquidity buffers.

In conclusion, financial management in regards to Cross Default involves various approaches such as risk management, credit management, and liquidity management. These approaches help to mitigate the risks of default, understand the creditworthiness of the parties involved, and manage the available cash flows.

Cross Default — recommended articles

Spendthrift clause — Corporate guarantee — Bankers lien — Assignment of insurance — Subrogation clause — Counter guarantee — Shareholder loan — Equitable lien — Mortgage deed

References

• Coyle B., (2002), Bank Finance, Global Professional Publishig, United Kingdom
• Fabozzi F. J., (2001), Bond Credit Analysis: Framework and Case Studies, John Wiley & Sons, United States of America
• Klein T. M., (1994), External Debt Management: An Introduction, World Bank Publications, United States of America
• Matri D., (2017), Covenants and Third-Party Creditors: Empirical and Law & Economics Insights Into a Common Pool Problem, Springer, United States of America
• Vernimmen P., (2014), Corporate Finance: Theory and Practice, John Wiley & Sons, Great Britain
• Wood P. R., (2007), International Loans, Bonds, Guarantees, Legal Opinions, Sweet & Maxwell, Great Britain

Footnotes

Author: Aleksandra Walawska