Cross-defaults: Overview, definition, and example
What are cross-defaults?
Cross-defaults are clauses typically found in financial agreements, such as loans or bond indentures, that specify that if a borrower defaults on one obligation, it will trigger a default on other obligations as well. In other words, a default under one contract or loan agreement can automatically lead to a default under other contracts or loans that contain cross-default provisions. These provisions are used to protect lenders or creditors by ensuring that if a borrower is unable to meet one of their financial obligations, they can take action across all of the borrower’s outstanding debts.
Cross-default clauses are common in situations where a borrower has multiple loans, credit lines, or other financial obligations with different lenders. The goal is to prevent a borrower from prioritizing one debt over another or avoiding the consequences of default on other obligations.
Why are cross-defaults important?
Cross-defaults are important because they help lenders manage risk by providing a way to address financial distress early on. If a borrower defaults on one obligation, the lender can trigger defaults on all related debts, thereby protecting their position and minimizing the chance of further non-payment. This mechanism allows creditors to take swift action, including calling in loans, accelerating payments, or pursuing legal remedies, if a borrower’s financial situation begins to deteriorate.
For borrowers, cross-default clauses mean that missing a payment on one debt can have far-reaching consequences, impacting their ability to access further credit or resulting in severe financial penalties across multiple agreements.
Understanding cross-defaults through an example
Imagine a company that has taken out multiple loans from different lenders. One of the loan agreements includes a cross-default clause, meaning that if the company defaults on one of the loans (for example, by failing to make a payment), all other loans governed by contracts with similar cross-default provisions would also be considered in default. This allows the lenders to demand immediate repayment or take other actions to recover their money.
For example, if a company defaults on a loan from Bank A, the cross-default clause might trigger defaults on loans from Bank B and Bank C as well, even if the company was making timely payments to these other banks. This protects the lenders from the risk of the borrower selectively defaulting or favoring certain creditors.
Example of a cross-default clause
Here’s what a cross-default clause might look like in a loan agreement:
“In the event that the Borrower fails to make any payment when due under any other indebtedness or liability for borrowed money or violates any material term or condition of any other agreement relating to financial obligations, such a default shall be deemed a default under this Agreement, and the Lender may declare the entire principal amount, together with any accrued interest, immediately due and payable.”
Conclusion
Cross-defaults are a key provision in financial agreements, offering protection to lenders by ensuring that a borrower’s default on one obligation can trigger defaults across multiple obligations. These clauses help manage risk by allowing creditors to act quickly in the event of financial distress.
For borrowers, understanding the potential impact of cross-defaults is crucial, as a single default can result in severe financial consequences. For lenders, cross-default provisions are essential to safeguard against the risk of non-payment and ensure that they can take prompt action to protect their interests.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.