What Is Event of Default?
An event of default is a predefined circumstance that allows a lender to demand full repayment of an outstanding balance before it is due. In many agreements, the lender will include a contract provision covering events of default to protect itself in case it appears that the borrower will not be able to or does not intend to continue repaying the loan in the future. An event of default enables the lender to seize any collateral that has been pledged and sell it to recoup the loan. This often is employed if the default risk is beyond a certain point.
- An event of default is a pre-specified condition or threshold that, if met, allows the lender or creditor to demand immediate and full repayment of a debt or obligation.
- An event of default may include delinquent or non-payment of principal or interest due, a breach of a bond covenant, or insolvency, among others.
- Credit default swaps (CDS) contain specific events of default that can trigger one counterparty to the contract to pay up to the other.
Understanding Events Of Default
An "event of default" is a defined term in loan and lease agreements. The following would constitute a default event in a typical credit agreement clause:
- non-payment of any amount of the loan (including interest)
- financial covenant breach
- material representation inaccuracy or warranty breach
- material adverse change (MAC)
The clause can contain more circumstances that would permit the creditor to invoke its rights in the event of default. These events would be custom-tailored for the unique situation of the borrower. Although a creditor can legally demand immediate repayment in the event of a default, in practice it rarely does so. Instead, it usually works with the distressed borrower to rewrite the terms of the loan agreement. If the parties agree, the lender will produce an amendment to the loan agreement that contains tighter terms, and in most cases, raise the interest rate of the loan and collect an amendment fee.
Example of an Event of Default
On January 10, 2018, Sears Holdings Corp. entered into a $100 million term loan credit agreement with various lenders. Section 7.01 comprises 11 different events of default, including the ones cited above except MAC, for the struggling retailer. Unambiguous terms are customary in a properly-drafted credit agreement, but the agreement for Sears is particularly detailed and restrictive because the lending syndicate is taking extra precaution to protect its interests.
Event of Default in Credit Default Swaps
A credit default swap (CDS) is a transaction in which one party, the "protection buyer," pays the other party, the "protection seller," a series of payments over the term of the agreement. In essence, the buyer is taking out a form of insurance on the possibility that a debtor will experience an event of default event that would jeopardize its ability to meet its payment obligations.
The three most common such events, as defined by the International Swaps and Derivatives Association (ISDA), are 1) filing for bankruptcy, 2) defaulting on payment, and 3) restructuring debt. Less common credit events are obligation default, obligation acceleration, and repudiation/ moratorium.
- Bankruptcy is a legal process and refers to the inability of an individual or organization to repay their outstanding debts. Generally, the debtor (or, less commonly, the creditor) files for bankruptcy. A company that is bankrupt is also insolvent.
- Payment default is a specific event and refers to the inability of an individual or organization to pay their debts in a timely manner. Continual payment defaults could be a precursor to bankruptcy. Payment default and bankruptcy are often confused with one another: A bankruptcy tells your creditors that you will not be able to pay them in full; a payment default tells your creditors that you will not be able to pay when it is due.
- Debt restructuring refers to a change in the terms of the debt, which causes the debt to be less favorable to debtholders. Common examples of debt restructuring include a decrease in the principal amount to be paid, a decline in the coupon rate, a postponement of payment obligations, a longer maturity time, or a change in the priority ranking of payment.