Cross Default
Contents
Deciphering Cross Default: Exploring its Impact on Borrowers and Lenders
Unraveling the Concept of Cross-Default
Cross default, a provision frequently found in bond indentures and loan agreements, acts as a safeguard for lenders by triggering a default event if the borrower defaults on another obligation. This clause ensures that lenders maintain equal rights to a borrower's assets in the event of default, thereby protecting their interests.
Understanding the Mechanism of Cross-Default
When a borrower defaults on one loan contract, cross-default clauses enable the default provisions of other debt agreements to come into effect. This can result in a cascading effect where the borrower becomes insolvent across multiple contracts, leading to defaults on all loans involved. Lenders are then entitled to withhold further loan installments as per the terms of the existing debt contract.
Cross-default typically arises from events such as failure to make timely interest or principal payments, or violation of negative or affirmative covenants. Negative covenants restrict certain borrower activities, while affirmative covenants mandate specific actions, such as providing financial statements or maintaining business insurance. A breach of these covenants triggers cross-default clauses in other loan documents.
Strategies for Mitigating Cross-Default Risks
Borrowers have several strategies at their disposal to mitigate the impact of cross-default provisions and maintain financial flexibility. Negotiating limitations on cross-default to loans with specific maturity periods or dollar amounts can restrict the clause's applicability. Additionally, borrowers may prioritize cross-acceleration provisions, requiring creditors to accelerate payment before declaring cross-default. Furthermore, borrowers can exclude disputed debts or those within grace periods from the scope of cross-default clauses.