92 4 Debt
The consequences of the occurrence of an event of default are serious.^25 The oc-
currence of an event of default gives the lender a right to declare that: (1) the
lender’s obligation to pay the loan amount that remains to be paid to the borrower
will cease: (2) the entire amount paid by the lender and the interest thereon and
any other sum payable by the borrower becomes due and payable to the lender
immediately (acceleration); (3) the borrower becomes liable for the interest for the
defaulted period at the enhanced rate called default interest rate; and (4) the lender
will use other remedies available to it under the contract and the applicable laws
(remedies cumulative and not exclusive clause). The existence of a cross-default
clause would increase the impact of an event of default even more.
Mitigation of the risk of default. The borrower (the firm) can do many things to
mitigate the risk of its own default.
First, the firm should ensure that it can repay the loan capital and make interest
payments when due. For example, a start-up with little income might not be able
to service a loan with interest payments and repayments monthly or quarterly.
Second, the firm should generally ensure that the terms of the loan facility
leave the firm enough managerial discretion to carry on its business in the normal
way without the consent of lenders.
Third, the firm should ensure that the representations and warranties are quali-
fied and diluted by suitable materiality thresholds. In addition, the firm can use
disclosure against the representations and warranties (for disclosure as way to di-
lute contractual obligations, see Chapter 13 on due diligence). The firm should re-
view carefully which warranties are deemed repeated after the initial drawdown
and therefore may subsequently trigger an event of default.^26
Fourth, after reaching an initial understanding about the loan facility, the firm
should review the terms of its existing contracts in order to screen existing obliga-
tions that limit its rights to agree on a new loan facility and its terms. Failure to
carry out an internal due diligence may, in the worst case, lead to an event that
makes certain rights available to the firm’s other lenders or contract parties. For
example, a new loan facility can amount to a covenant default or be regarded as a
material adverse change that lead to acceleration of an existing agreement.
Fifth, the firm should examine the proposed wording of the events-of-default
clause very carefully. (a) The risk of default is increased where the events-of-
default clause is broad. The firm should ensure that normal business activities will
not trigger an event of default. (b) The risk of default is increased where the de-
fault clause is not limited to just one corporate entity and one transaction but cov-
ers many corporate entities (such as subsidiaries and affiliated companies) and
many transactions (such as other loan facilities). For example, the borrower should
try to avoid the inclusion of a cross-default clause (sections 4.3 and 8.3.2 and Vol-
ume II). (c) The firm can try to dilute the events of default in various ways. Pref-
erably, the agreement should provide for grace periods varying, say, from 15 to 60
days wherever time limits are prescribed or payment obligations are involved. In
(^25) Ibid.
(^26) See Gayle C, op cit, pp 303–304.