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 or does not intend to repay 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 balance of 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 the other.
- Events of fault are defined within contracts.
- Creditors will often introduce more restrictive terms when an event of default occurs instead of demanding immediate and full repayment in the event of a default.
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. 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 listed 11 different events of default for the struggling retailer.
Unambiguous terms are customary in a properly-drafted credit agreement; however, the agreement for Sears was exceptionally detailed and restrictive because the lending syndicate took extra precautions to protect its interests.
Event of Default in Credit Default Swaps
A credit default swap (CDS) is an agreement between parties in which one pays to the other party a premium for a type of credit default insurance, which protects against certain defaults. 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 International Swaps and Derivatives Association (ISDA) published a master agreement to govern over-the-counter (OTC) derivative transactions. The contract lists and defines eight standard events of default for which the agreement may be terminated:
- Failure to pay or deliver
- Breach/repudiation of agreement
- Credit support default
- Default under specified transaction
- Merger without assumption.
How can an event of default be cured?
Agreements typically allow the defaulting party an opportunity to cure or remedy the default within a certain period before negative consequences apply. The grace period could be days, weeks, or longer, and some agreements allow for a maximum number of cures. If the default is not remedied as specified in the contract, the agreement is terminated and the defaulting party is liable for any amounts due.
What is the difference between default and event of default?
A default is a breach of a contract or agreement. It occurs when one party fails to uphold their contractual duties. An event of default is a specific event or occurrence that allows the non-defaulting party the ability to terminate the contract or accelerate the debt owed by the defaulting party.
What is a potential event of default?
A potential event of default is an event or occurrence that would become an event of default if not cured within a certain time or under certain conditions.