As a result of the financial institutions' desire to involve new players in the game and to speed up the flow of money, loan transactions and contracts dealing with these transactions are becoming widespread each passing day. While creating opportunity for real or legal persons, these institutions are in need of guaranteeing their interests against the issues that may arise as a result of loan extension transactions. One of the most common mechanism used by finance institutions for this objective is drafting loan agreements with cross-default clauses.
Cross-default is basically a provision in a loan agreement that puts the borrower in default if the borrower defaults on another loan. In other words, if the borrower defaults on one loan, he/she will be deemed to be in default on his/her other loans and the debts arising from other loans will become immediately due and payable even if there is no breach of other loans. For example, if a borrower defaults on his/her bank loan, the cross-default clause would cause him/her to be in default for his/her mortgage loan as well. Thus, cross-default clauses in loan agreements can easily create a domino effect for the borrowers.
Default may occur in a loan agreement in several ways. It may occur in an event that the borrower fails to pay the agreed value as well as the cases that the borrower violates the positive or negative covenants of the agreement. A positive covenant requires the borrower to perform certain operations whereas a negative covenant requires the borrower to avoid certain operations. A cross-default clause that is tied to the payment of the agreement value is called "Payment Cross-Default" and a cross-default that is tied to fulfilment of other contractual obligations is called "Covenant Cross-Default".
Although the cross-default clauses are frequently used in loan agreements between various financial institutions and natural or legal persons, it is not possible to involve these clauses in agreements to be made with public institutions. There are certain reasons that keep the public institutions from entering into loan agreements with cross-default clauses. Firstly, the obligation of public institutions to conduct public policies may prevent such institutions to fulfill their contractual obligations arising from the loan agreement. Secondly, the limitations over the public institutions' bugdets and the nonindependent structure of such institutions may keep them from fulfilling their contractual obligations freely. Lastly, such intitutions, whose reputations are based on their solvency and creditworthiness, would not like to be engaged in such risky and burdensome agreements that may cause them to lose their solvency and creditworthiness.
As briefly mentioned above, the cross-default clauses are highly in favour of the debtors of the agreements since they are sufficient for minimizing the risk of default in the agreement, however these clauses may cause quite negative effects on the borrowers. For example, as a result of the domino effect created by cross-default clauses, a borrower who got several loans may default on all of his/her loans as a result of defaulting on a single loan and lose all of his/her financial advantage and power. In order to protect the borrowers from such negative situations, the parties should negotiate and take certain actions.
Firstly, the borrower can mitigate the risk of default by limiting the default cases. For example, the parties can decide that the cross-default clause will only be triggered if the borrower fails to pay a certain amount of money or fails to fulfil certain covenants of the agreement. Also, the parties can decide that the default clause will only trigger the loans of the borrower arising from the same agreement or loans got from the same creditor. By this way the borrower can minimize the risk of being in default on other agreements made with third parties. Also, the default actions may be limited to the ones that are resulting from the borrower's gross negligence or intent.
Another option for the borrower to minimize the risk of default would be determining the grace periods as far as possible in the agreement which could prevent the borrower from defaulting on fulfilment of payment obligations. Finally, the provisions regarding cross-default conditions in the agreement should be stated clearly and far from subjectivity in order to prevent any dispute resulting from this issue.
In conclusion, the cross-default clauses are indispensable for the debtor parties of the loan agreements with regard to their function of preventing the borrowers from defaulting on contractual obligations frequently. However, as mentioned above, these clauses may result in huge disadvantaged situations for the borrowers. At this stage, the most equable way for both parties would be negotiating on such clauses and mitigating them for the benefit of both parties since the cross-default clauses are likely to be preferred and insisted on by the debtors.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
