What is a Cured Default?
In the world of credit agreements, breaches will inevitably occur. A cured default occurs when a borrower violates a term of the credit agreement but takes corrective actions to rectify the breach and return to compliance with the agreed terms. In essence, it’s a chance for the borrower to fix the mistake and avoid facing the consequences of a default. Most credit agreements will have a “cured default” provision that outlines the steps a borrower must take to cure a default.
As a credit professional, you should be checking your customer’s liquidity position regularly. This includes collecting data on credit agreements, loans, and deposit accounts. If you uncover a violation, follow-up information will be needed to get a complete picture of its risk profile. As explained by Martin LLP, the repercussions of a lender declaring an “Event of Default” under a loan can be severe and may include such potential lender rights and remedies as:
- Refusing to make further advances of any undrawn portion of a committed loan facility
- Increasing the applicable interest rate to a “default rate”
- Accelerating the loan and demanding immediate repayment of all outstanding loan amounts
- Commencing litigation in hopes of seeking payment on the loan
- Foreclosing on or exercising rights concerning collateral securing the loan
Common Causes of Defaults:
Missed payments: This is one of the most common reasons for default. It can be a late payment, a partial payment, or a complete failure to make a required payment. If a borrower misses a payment, lenders will often provide them a “grace period.” This gives them an extended period to make their payments before defaulting on the loan. Grace periods normally range from 5 to 30 days.
Financial covenant violations: Companies that take on debt in the form of a loan or credit agreement are usually subject to loan covenants set by the lender. Financial covenants are meant to regularly test the financial strength of a borrower. A covenant breach acts as an early warning sign to a lender that a borrower’s financial position is deteriorating and that it may be unable to meet its repayment obligations. A borrower’s unresolved breach of one or more financial covenants may trigger an Event of Default.
Negative covenant violations: Negative covenants require borrowers to refrain from performing a particular act. Examples of negative covenants include incurring additional debt or making restricted payments without lender consent.
Remedies (Forbearance vs. Waiver):
Lenders will likely work with their borrowers to provide some cure for the covenant violation. While both agreements offer temporary relief, a forbearance agreement doesn’t erase the default. The lender simply postpones exercising its legal rights against the borrower, contingent on the borrower meeting specific requirements outlined in the agreement. These requirements might involve accelerated payments, restrictions on new debt, or limitations on owner distributions. In severe cases, the agreement could allow the lender to seize collateral or initiate foreclosure proceedings if the borrower fails to comply.
On the other hand, a waiver agreement effectively forgives the covenant violation and restores the borrower and lender to their pre-default positions. This can be beneficial for borrowers, allowing them to maintain the loan and address the underlying issues preventing compliance. The lender may also consider amending the covenants to better reflect the borrower’s current circumstances.
From a credit professional’s viewpoint, a customer seeking a waiver or forbearance agreement is a red flag. Companies in sound financial health typically wouldn’t require such concessions. However, a waiver is more favorable; it allows the borrower to maintain the loan for an extended time to take the necessary steps to become compliant for future periods.
This is why it is vital to understand your customer’s credit agreements and loans. Uncovering and knowing the company’s cure provisions could help you avoid a major loss.
