In finance, deals require dependable behavior by all parties. But all too often, one or more parties default on their obligations jeopardizing the transaction. Therefore, borrowers and lenders have, with the help of attorneys, developed provisions to protect themselves. Accordingly, this article addresses the cross default (CD) provision and how it protects lenders from undue risk of loss. We’ll explore the meaning of CD and provide a sample of a cross default clause. Next, we’ll give an example of cross default and show how Assets America® can help. Finally, we’ll answer a few frequently asked questions about the cross default provision.
What is Cross Default?
A CD provision or cross default clause can appear in a loan agreement. It states that a loan is in default if the borrower defaults on another of its loans. A default occurs when a borrower fails to make timely payments of principal and/or interest. Also, it occurs when a borrower violates a loan covenant. An example would be a covenant that controls the lender’s maximum debt ratio. For example, a cross default clause may say the following: A developer defaulting on a loan for Property A automatically defaults on Property B. The reason for the cross default provision is to protect lenders from a deadbeat borrower. That is, all lenders should have equal access to all the borrower’s assets. Without the cross default clause, the lender for Property A could exclusively recover assets from the borrower. Naturally, that would leave the lender for Property B high and dry. The risk is that the first default will trigger a set of negative and avoidable follow-on events. For instance, a triggered cross default can cause a borrower to stop making loan installments, an event with serious consequences.
Video: What is a Cross Default Clause?
As mentioned earlier, covenant violations can trigger CD. Violations of two covenant types can occur:
- Negative Covenants: This type of covenant restricts the borrower’s activities. For example, a negative covenant might restrict a company from borrowing beyond its profits.
- Affirmative Covenants: Under an affirmative covenant, the borrower must perform specified actions. For example, the company might have to buy various types of business insurance.
Normally, cross default provisions allow borrowers to remedy or mitigate the default on an unrelated agreement before triggering CD. Mitigating provisions give borrowers some breathing room before enduring CD, such as:
- A provision may restrict CD to loans of a minimum size or maturity. A cross default threshold may state that only defaults exceeding an arbitrary amount will trigger CD.
- Another provision may specify cross acceleration. Loan acceleration describes a lender bringing forward the due date for interest or principal repayments. For example, suppose a default on Loan A causes Lender A to accelerate Loan A. Under a cross acceleration clause, this triggers default on Loan B for Lender B.
- A provision may narrow the scope of CD. For example, the provision may exclude CD for debt that the borrower repays within a grace period. Another example might be a provision that excludes CD for good-faith loan disputes.
Effect on Borrowers
Obviously, if CD favors lenders, it cannot be good news for a borrower. Clearly, a borrower loses when its loan goes into default because of another loan. Therefore, borrowers might be resistant to the inclusion of a CD provision within a loan contract. To that end, some issues in the financing arrangement need resolution. For instance, the parties should establish whether a loan contract’s CD provisions are enforceable. Another is whether entering into a contract with a CD clause breaches a company director’s fiduciary duty. Specifically, a CD clause can increase a company’s obligations if triggered. Borrowers require the services of experts (read lawyers) to resolve thorny issues such as these.
Cross collateralization (CC) often accompanies CD, but they are not the same. CC involves multiple loans between the same lender and borrower. It specifies that collateral for Loan A can also partially or fully collateralize Loan B, and vice versa, when CD occurs.
For example, consider a case where the borrower defaults on Loan A, which Property A collateralizes. A CD provision triggers default on Loan B, which Property B over-collateralizes. Two possibilities exist:
- Without CC: With no CC clause, the lender cannot apply any of Property B’s excess collateral to Property A.
- With CC: If a CC clause exists, the lender can apply Property B’s excess collateral value to Property A.
Cross Default Clause Sample
The following cross default clause samples come from Law Insider.
Cross-Default Provision. Any default by Grantor in the performance or observance of any covenant or condition hereof shall be deemed a Default under each of the Loan Documents, entitling Administrative Agent, for and on behalf of the Loan Parties, to exercise all or any remedies available to Administrative Agent and the Loan Parties under the terms of any or all Loan Documents, and any Default under any other Loan Document (subject to any applicable grace periods) shall be deemed a Default hereunder, entitling Administrative Agent, for and on behalf of the Loan Parties, to exercise any or all remedies provided for herein.
Here is another:
Cross-Default Provision. It is expressly understood and agreed that, should Grantor default or commit an event of default under or pursuant to any agreement which is secured by a lien or liens on any portion of the Property, the Obligation hereby secured, at the option of the Holder, shall become due and payable.
Video: Cross Default – The Most Dangers Contract Provision
Example of Cross Default
We’ve already given you a couple of examples of CD. Here is another example.
A Borrower receives a loan from Lender A to build a steel factory. Furthermore, the Borrower contracts with a contractor under a construction service agreement. Normally, Lender A seeks to guarantee direct repayment if a default of payments to the construction service agreement occurs. Therefore, Lender A mandates a CD provision in the loan contract. The provision states that Lender A receives repayment directly without waiting until the Borrower defaults on Lender A’s loan.
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Frequently Asked Questions
What is a cross default threshold?
A cross default threshold is the minimum loan amount that can be subject to CD. With this clause, loan amounts below the cross default threshold will not trigger a loan’s cross default provisions.
What is a cross collateral cross default agreement?
In a cross collateral cross default agreement, collateral for one loan can secure another loan when a cross default occurs. A cross collateral cross default agreement helps protect lenders by providing more protection should CD happen.
Is cross collateralization legal?
Cross collateralization is legal in states that allow it. The Uniform Commercial Code (Article 9, section 204(c)) specifically permits cross collateralization. Furthermore, courts have ruled that CC is legal, provided that each party was aware of the CC provision.
What is a cross acceleration clause?
A cross acceleration clause governs when one lender accelerates a loan’s payments and/or interest and triggers a cross default. The cross default is on another loan linked via the cross acceleration clause.