This article is written by Preeti Bhandari, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho.com.
Table of Contents
Introduction
In today’s world with ever increasing need to explore new opportunities and spread their wings into new ventures, the organisations, public and private, are in need of funds and investment. The resources available with them are limited and therefore organisations/individuals which have funds with them come into picture.
While lending funds to the individuals or organisations, the rights of these entities, lending funds, need to be protected. For the same the parties enter into an agreement governing their relationship. Apart from the other terms the agreement so entered (Loan Agreement) as captures the situation of default and its consequences.
Default under Loan Agreement
A Loan Agreement enumerates a list of events when a Borrower will be considered under a default-
- Non- payment of instalment
- Material breach of facts
- Not performing the tasks as enumerated under the agreement
- Defaulting in financial covenants
- Cross Default
Points i to iv arise due to default of the terms and conditions agreed upon in the agreement. However a cross default clause becomes effective if the borrower has defaulted in altogether different loan transactions. The Clause is explained in detail herein below-
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- Cross Default-As the name suggest, cross default in a loan agreement comes into picture in case of default by the borrower of his loan. The clause in the agreement gives the lender of the loan to suspend the payment if there is a default of payment in another loan. Under the clause the borrower has the right to deny access to the borrower of his other loan accounts if there is a default in one loan account.
- If a Lender has forwarded a large amount of money to some person and they have decided a manner of repayment of loan that may be spread over a period of time. It may be yearly, quarterly or monthly. It may as well happen that parties may agree to defer the payment of instalment by the Borrower to the Lender for a year after which the repayment may start. In the meantime, it may happen that the Borrower may default in some other loan which he has taken. Now the Lender may be in a fix as the Borrower has not defaulted in his payment. However knowing the financial condition of the Borrower and doing nothing may lead to loss of the Lender. Under such a condition it may happen that the Borrower may want to speed up the process of repayment for his loan. It is when the principle of cross default comes into picture. It provides the Lender an option that if the Borrower defaults on any loan to another lender, the Lender will consider default of his loan as well.
- The clause becomes automatically operational for agreement B if the borrower defaults in agreement A. For eg. A has taken a car loan and a house loan from ABC Bank and XYZ Bank and A defaults in the payment of interest and principal towards the car loan. Under such circumstances disbursement of his house loan will also be suspended till the time he makes the default good.
- Once the Cross-default Clause is triggered, the Lender can stop making payment of loan instalments to the Borrower.
- Applicability- Cross Default clauses generally form part of the loan agreement by private persons, be it individual, firm or company. The agreement is entered into for project financing or similar transactions. Banks lending to different persons, natural or legal, prefer to include the clause to protect their interests in the long run. However, such a clause generally does not find place in agreements with government institutions or administrative bodies. The main reason behind the same is that the government agencies or the administrative bodies are involved in a number of transactions for public functions and including such a clause will limit the functions of the government.
Government institutions work towards public policies and such a clause may prevent the organisation to fulfil its obligation. Further the government institutions have limited budgets within which framework they have to undertake the task.
Effect of Cross Default Clause
On Lender
From Lender’s point of view, it is important to have the clause to protect his interest. The Lender will never want to be the last one when it comes to repayment of the loan. He would want his rights to be placed in the same position as of the other lenders. After this clause the Lender will have equal opportunity to access the assets of the borrower. So to ensure the protection of the rights of the Lender, the loan agreement should require the borrower to disclose details of his loan and default if ever made.
One of the main reasons of cross default clause is to ensure that equal treatment is given to all the lenders and that all are placed in the same position.
For ex. A Borrower receives construction finance from Lender A under Loan Agreement A for his one project and Lender B under loan Agreement B for another project. So in case there is a default in loan A due to financial constraints which eventually will impact the other loan B, in that case lenders usually do not want to wait until the whole business fails. So the cross default helps Lender B to get his repayment even if there is not a default of his loan or to stop the payment till the time the default continues.
On Borrower
The Cross Default has a negative impact on the Borrower and limits the rights of the Borrower. The clause may expose the Borrower to a situation where technical considerations may supersede the financial considerations. Therefore, the Borrower while entering into an agreement should ensure that there is a cap to the implementation of the cross-default clause. For eg. If A has a loan from Lender B through Loan Agreement B and lender C through Loan Agreement C respectively and there is a default in a Loan Agreement A due to technical aspects. The provision of cross default clause will impact the Loan Agreement C as well, though default in Loan Agreement A does not have financial implications.
Therefore, a cross default clause should be drafted and included with utmost care and protecting the rights of the Lender and the Borrower at the same time.
Reducing risk of Cross Default
Cross Default Clause is beneficial for the Lender and protects his rights. However, a Borrower can reduce the impact of cross default clause on him in the following ways:
- To ensure that cross default clause comes into existence only in case of financial default and is not a result of technical default.
- To place a limit only after which a cross default clause can be triggered. For eg. The clause may be triggered if the Borrower fails to pay a certain amount of money or fails to fulfil certain conditions in the agreement.
- To include a grace period to cure the default. The Borrower may negotiate to include a clause wherein grace period is given to him before activating the cross- default clause. Including grace period will give Borrower a time to take necessary actions if he can without hampering his rights under other loan agreements.
- The clause should activate only under the circumstances the borrower did not cure the problem when he had the opportunity and the remedy to do so.
- To ensure that the clause is effective only in certain transactions and not in general.
- Cross Default Clause should trigger from the day of occurrence of the default and not from the day it comes within the knowledge of the Lender.
- The clause should consider matters important to the Borrower and not to the Lender or third party.
- Default occurring due to gross negligence of the Borrower.
- The cross- default clause may be limited to transactions from the same Lender only meaning thereby that the clause will only be activated if the Borrower has taken multiple loans from the same Lender.
- Triggering a cross acceleration clause before the cross-default clause. Under a cross acceleration clause, the Lender advances the due date of payment of principal and the interest, if the Borrower has defaulted in the payment. Upon triggering the clause, the cross-default clause in the other agreement will automatically become applicable for the other loan.
Conclusion
To sum up Cross Default Clauses are tilted towards lenders and is a sensitive arrangement between the parties. It puts a Borrower into a disadvantage, if not drafted carefully. The clause needs to be drafted with utmost care and taking into consideration the effects on both the parties into an agreement. The parties to the arrangement should include the ways to reduce the risk of the borrowers and in that way may be preferred by the borrowers.
References
- https://www.investopedia.com/terms/c/crossdefault.asp
- https://www.mondaq.com/turkey/Finance-and-Banking/903472/Cross-Default-Clauses-In-Loan-Agreements
- http://www.aalco.int/26thsession/Part%2036.pdf
- https://www.lexology.com/library/detail.aspx?g=6f5797ce-ca35-47d0-9fed-458dc4b1c141
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