What Is Cross Default?
Cross default is a provision in a bond indenture or loan agreement that puts a borrower in default if the borrower defaults on another obligation. For instance, a cross-default clause in a loan agreement may say that a person automatically defaults on his car loan if he defaults on his mortgage. The cross-default provision exists to protect the interest of lenders, who desire to have equal rights to a borrower's assets in case of default on one of the loan contracts.
How Cross-Default Works
Cross-default happens when a borrower defaults on another loan contract, and it provides the benefit of the default provisions of other debt agreements. Thus, cross-default clauses can create a domino effect in which an insolvent borrower may be in default on all his loans from multiple contracts if all lenders include cross-default in their loan documents. Should cross-default be triggered, a lender has the right to refuse more loan installments under the existing debt contract.
Cross-default is caused by an event of default of a borrower on another loan. Default typically occurs when a borrower fails to pay interest or principal on time, or when he violates one of the negative or affirmative covenants. A negative covenant requires a borrower to refrain from certain activities, such as having an indebtedness to profits above certain levels or profits insufficient to cover interest payment. Affirmative covenants obligate the borrower to perform certain actions, such as furnishing audited financial statements on a timely basis or maintaining certain types of business insurance.
If a borrower defaults on one of his loans by violating covenants or not paying principal or interest on time, a cross-default clause in another loan document triggers an event of default as well. Typically, cross-default provisions allow a borrower to remedy or waive the event of default on an unrelated contract before declaring a cross-default.
- Cross default is a clause added to certain loans or bonds that stipulate that a default event triggered in one instance will carry over to another.
- For instance, if somebody defaults on their car loan a cross-default would also cause a default on their mortgage.
- Cross default provisions are included by lenders to encourage repayment, but may actually lead to negative domino effects.
Mitigating Factors for Cross-Default
When a borrower negotiates a loan with a lender, several ways exist to mitigate the effect of cross-default and provide room for financial maneuvering. For instance, a borrower may limit cross-default to loans with maturities greater than one year or over a certain dollar amount. Also, a borrower may negotiate a cross-acceleration provision to take place first before a cross-default, in which a creditor must first accelerate payment of principal and interest due before declaring an event of cross-default. Finally, a borrower may limit contracts that fall under the scope of cross-default, and exclude debt that is being disputed in good faith or paid within its allowed grace period.