What is an Event of Default?

If your business is negotiating a loan agreement with a bank, you will see repeated references to “events of default” in the draft loan agreement. As you probably know, not repaying a loan is the most obvious kind of default. However, most loans have several other events of default. If the event of default occurs, the bank can end the loan. Hence, this article will explain the common events of default you are likely to find in a loan agreement and some of the commercial and legal implications surrounding the events of default. 

What Happens if an Event of Default Occurs?

Under English law, if the other party breaches a term of the contract, your options for remedying the breach depend on how important the term is in the contract. If a breach is minor, both parties can continue their obligations under the contract. However, if the breach is substantial, this can end the contract. 

Banks often expressly indicate what event gives rise to a severe breach in loan agreements. So, if the circumstance arises, the bank can take quick action to end the loan and recover its money. These severe breaches are “events of default”. When an event of default arises, the bank can

• demand immediate payment of any outstanding principal and interest (this is called acceleration); and
• refuse to lend any further amount otherwise agreed to. 

What Are Some Common Events of Default?

When you think of an event of default, a late payment is one of the most common examples. Banks operate by maximising the amount of money they lend and borrow. So if your company misses a payment, it jeopardises the bank’s ability to balance its loan books adequately. 

Additionally, a late payment indicates that your company may suffer from cash flow problems. At best, delinquent payments suggest mismanagement and poor attention to detail. At worst, it suggests declining cash generation and early signs of a failing business. Therefore, late payments invariably constitute events of default. 

Beyond late payments, there are other events of default you should consider.  

Misrepresentations 

Banks lend to businesses they think are fundamentally sound and will repay the loan. To determine if a business is fundamentally sound, the bank will assess the business’ financial and operational performance and forecast based on information the business supplies.

If the bank decides to lend to the business, it will do so on the basis that the information it used to make that decision is factually correct. However, if it later turns out that the information was not factually correct, the bank will want to recover its money. 

Therefore, any misrepresentation — which is where a statement made by a company to the lender later turns out to be untrue — will almost always constitute an event of default.

Breach of Undertaking 

Specific terms in the loan require your company to promise to do (or not to do) certain things. These include promises:

• not to grant additional security interests in your company’s property (“negative pledges”); 
• to maintain a particular financial position or key performance metric (“financial covenants”); 
• to supply certain information to the bank when requested or on specific dates (“information undertakings”); 
• to obtain and maintain adequate insurance policies; and
• to comply with anti-money laundering rules and regulations.

A breach of some or all specified undertakings may constitute an event of default. 

Cross-Defaults

If your company has any other outstanding loans, these loans will contain their events of default. 

This is the principle behind cross defaults, and most loan agreements have cross-default provisions. 

Change of Control 

If your business changes ownership, lenders may view this as an unforeseen risk to the business. Therefore, they may want to preserve the right to accelerate the loan if the business changes control. 

This is important because what constitutes a change of control can be more subtle than simply changing ownership. For instance, if you adopt a new group structure, transferring shares from one group company to another can constitute a change of control and thus an event of default. 

Other Events of Default 

Other events of default include:

• changing the nature of your business; 
• initiating insolvency proceedings (or having an insolvency claim issued against your business); 
• certain legal actions and claims made against your business; and
• if your business activity becomes illegal. 

Key Takeaways 

An event of default refers to any circumstance that arises under the loan agreement terms that permits the bank to cancel the loan immediately. The effect of an event of default is that the bank has the right to demand immediate repayment of any outstanding amount plus interest. Additionally, the bank can also refuse to honour any other commitments it owes your business, such as loaning you additional money. The list of events that constitutes an event of default depends on the loan agreement. Still, late payments, material misrepresentations, breaches of undertakings, and change of control are typical examples of events that may constitute a default. 

If you need help with your loan agreement, our experienced business lawyers can assist as part of our LegalVision membership. You will have unlimited access to lawyers to answer your questions and draft and review your documents for a low monthly fee. So call us on 0808 196 8584 or visit our membership page.

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