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Cross-Default Provisions: Borrower Beware

December 18, 2018

Bonds, loans, notes, and promissory notes are the debt instruments predominantly traded in financial markets. No one denies that debt has a strong impact on a country’s economy. A decade ago, the bubble in the United States financial market arising from subprime mortgages that were bundled together through securitization was the main cause of the financial crisis in 2007-2008.

 

In a recent article published by the New York Times, the primary problem faced in the financial market – no matter how sophisticated the debt instruments are – is that investors like risky debt instruments, and currently, most investors are going after high-risk companies. Whether it be in the financial market or in private business transactions, it is commonly understood that debt financing creates risk for the business environment.

 

Usually, in order to reduce the risk of nonperforming debt, most transactions will be structured to have collateral. In case a debtor defaults, the collateral will be enforced, either in accordance with the Uniform Commercial Code or real estate law. However, in sophisticated financing transactions, the use of collateral might not be enough, and cross-default provisions might be needed. To understand the role of cross-default provisions, it is important to understand the importance of cross-default provisions in financing arrangements and how to structure a cross-default provision.

 

The Necessity of Cross-Default Provisions

 

There are several ways in which cross-default provisions are used in financing transactions. In sophisticated financing transactions where financing is channeled by several lenders to a debtor, the lenders will compete with each other for priority regarding repayment from the debtor. No lender wants to be last in line. In that case, the cross-default provision is used to trigger the borrower’s default in a financing arrangement when the borrower is in default on another obligation.

 

For example, a corporation (Borrower) receives financing from Bank A (Lender A) under Loan Agreement A and Bank B (Lender B) under Loan Agreement B. Instead of competing with each other, Lender A and Lender B use cross-default provisions to ensure both of them get equal rights if the Borrower fails.

 

Similarly, where financing is channeled to a certain part of the business that interrelates with other parts of the business, a default in one part will eventually impact the whole business. In that case, lenders usually do not want to wait until the whole business fails. Thus, cross-default provisions are used to ensure that the lender can be repaid when one part of the business fails.

 

For instance, the same Borrower receives financing from Lender A to build a car factory where the Borrower will engage with a contractor under the construction service agreement. Typically, Lender A wants to ensure that if there is a default on the construction service agreement, Lender A will get repayment directly. Thus, Lender A requires a cross-default provision in the loan agreement so Lender A can collect repayment directly without waiting until the Borrower is unable to repay Lender A.

 

It is clear from the above examples that cross-default provisions are necessary to reduce the risk to a lender of not being repaid by a borrower.

 

Structuring Cross-Default Provisions in Financing Arrangements

 

Indeed, cross-default provisions protect lenders. The problem with cross-default provisions, however, is that they may harm the borrower. Hence, in drafting cross-default provisions in financing arrangements, there are some issues that need to be taken into account: (a) whether or not a cross-default provision is enforceable; (b) whether or not entering into cross-default provisions may constitute a breach of fiduciary duty for the Company’s directors.

 

The Validity and Enforceability of Cross-Default Provisions

 

In In Re Kopel, the harm raised by the United States Bankruptcy Court is that enforcement of cross-default provisions would contravene the policy of providing debtors with an unrestricted right to assume and assign valuable contracts. According to the court, cross-default provisions should be enforced depending on facts and circumstances surrounding the particular transaction.

 

In In re T & H Diner, Inc., the court reached the conclusion that cross-default provisions can be enforced because the court found that the cross-defaulted agreements were indivisible. Pursuant to In Re Kopel, courts have refused to enforce cross-default provisions in situations where the cross-defaulted agreements are not interrelated. In Sanshoe, the court declared that the cross-default provision is unenforceable when the relevant agreements constituted separate agreements that are not to be construed as a single contract under the factual circumstances of that case.

 

Breach of Fiduciary Duty and Cross-Default Provisions

 

Another problem faced with respect to cross-default provisions is that incorporating such provisions may result in a breach of fiduciary duties by the borrower’s board of directors.

 

In general, the fiduciary duty of the board of directors covers the duty of care, the duty of good faith, and the duty of loyalty. One argument is that the use of cross-default provisions will breach the duty of care. These provisions in a financing agreement can be harmful to a company because they significantly increase the company’s obligation in the event of a default on one loan. Instead of just one loan going into default at a time, the existence of cross-default provisions in multiple loan agreements means that multiple loans of the company all go into default at the same time. Thus, one can contend that the board of directors is neglecting its duty of care towards the company’s business by letting the company simultaneously incur more debt.

 

One defense for the board of directors with respect to this is that decisions to incur more debt fall under the scope of the business judgment rule. This is a valid defense. The rest is then up to the board of directors to ensure that when they enter into financing arrangements, they have considered the business judgment rule.

 

In conclusion, parties to financing arrangements need to make sure that they use cross-default provisions if it is necessary and applicable. In doing so, the parties also need to consider the validity and enforceability of cross-default provisions, as well as how the board’s fiduciary duties will be implicated.

 

Rizky Raditya Lumempouw is an LLM candidate for the Traditional LLM at NYU Law. Prior to NYU, Rizky practiced banking and finance law at Assegaf Hamzah & Partners, the largest law firm in Indonesia. After several years there, Rizky decided to continue his career as a corporate lawyer at S&B Law Firm, a boutique law firm in Indonesia. Rizky was also a teaching assistant for the business law program at Jentera School of Law. He is admitted to practice law in Indonesia.

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