An event of debt default occurs when one or more terms in a loan agreement are violated (or breached) by a borrower.
When a lender extends credit to a borrower, both parties agree to loan terms by way of a loan agreement. These loan agreements typically include a section that clearly defines what constitutes an event of debt default, as well as what right(s) the creditor has in order to remedy the default.
Certain events, conditions, or circumstances may be considered a breach of contract and, therefore, an event of debt default. Events of default include, but are not limited to:
Non-payment or late payment of interest and/or principal
Changes in ownership or control
An event of debt default occurs when one or more terms of a loan agreement are violated by a borrower.
A missed interest (or principal and interest) payment is a delinquency; delinquent payments are an event of default, but the word “default” does not itself mean late or missed payment.
There are two kinds of debt default – financial defaults and technical defaults.
Understanding Debt Defaults
Outside of the finance and legal community, it’s common to use the terms default and delinquency interchangeably when referring to a “missed or late payment.” A missed or late payment is a delinquent payment, which is typically an event of debt default in most loan agreements. However, the word “default” does not mean late payment.
There are two categories of debt default:
Financial defaults. Delinquent payments are the most common example of a financial default.
Technical defaults, which may include:
Covenant breaches, such as late financial reporting (e.g., income tax filings for personal borrowers or accountant-prepared financial statements for corporate/commercial borrowers).
Breaches to important “representations and warranties,” meaning that a loan contract may have been entered into under certain circumstances or assumptions that were thought to be true on the contract date but that were later found to no longer be true.
A change of ownership or control (without the express written consent of the lender); this is specific to corporate/commercial borrowers.
When a borrower is in financial distress, it’s common for a number of terms to be used (and misused) with respect to the state of that borrower’s affairs. Some important terms to understand include:
Delinquency – A late or missed interest (or principal plus interest) payment.
Default – A default is triggered by an event or by a change in circumstances or conditions that constitute an express breach of the loan agreement between the borrower and the lender.
Illiquidity – When a borrower does not have sufficient cash (or near-cash assets like marketable securities that it can convert to cash) to pay its debt obligations. Liquidity (and illiquidity) are financial measures that are assessed by lenders using ratios like the current or quick ratio.
Insolvency – Insolvency means that the financial condition of an entity has deteriorated to a point where its total debt exceeds the aggregate fair market value of all its assets.
Bankruptcy – A legal term (and a legal status) that imposes court supervision and oversight of the financial affairs of an entity who/which is insolvent or otherwise in default of loan terms.
Consequences of Debt Default
An event of debt default is reported to the major credit bureaus. This can severely affect a person’s ability to borrow again in the future or, at minimum, impact the terms under which that person can borrow.
If the loan in question is a secured loan, like an automobile loan or a residential mortgage, then an event of debt default will often result in repossession or foreclosure of the underlying asset(s). Repossession is when a lender “takes back” a physical asset (like a vehicle); foreclosure is a specific legal process that transfers title back to a lender for the purpose of selling the asset (like a property).
Depending on the lender and the nature of the loan, it could be that a personal borrower’s wages get garnished (meaning that a portion of their paycheck is deposited directly into the account of a collection agency employed on behalf of the creditor). This is more common with a debt default on unsecured credit.
Commercial banks and other financial institutions that work with business borrowers typically approach events of default with a firm but collaborative approach. If the resolution strategy is too punitive, it could hinder the borrower’s ability to make payroll or settle vendor payments which, in turn, can cause the business to fail outright.
If a business can’t operate, it certainly can’t generate cash flow to service debt obligations; this can have a very serious trickle-down effect on the borrowing relationship and the lender’s ability to recover outstanding funds or to work out an otherwise mutually agreeable solution.
Typical consequences of financial and/or technical defaults for corporate borrowers include:
Heightened oversight by the lender, including more frequent reporting (maybe quarterly or monthly).
Management will structure a short, mid-term, and longer-term plan to outline steps and strategies to remedy the default and prevent others from occurring.
A lender may implement “mechanical” controls over the borrower’s accounts, like auto-payment of corporate credit cards or the use of a lockbox for customer payments to ensure cash dominion and tighter oversight of operating credit.
If problems persist, a lender may transfer the file to its restructuring group (sometimes called Special Assets or the “workout” team), which will result in even tighter oversight of the borrower and its operations.
If problems appear existential, the management team may seek to unwind operations and, with the support of their legal team and insolvency consultants, liquidate assets to repay creditors.
Bankruptcy is another potential consequence of debt default, which permits the firm to unwind operations and liquidate assets under conditions where they are temporarily protected by the court system from creditor interference.
Thank you for reading CFI’s guide to Debt Default. To keep advancing your career, the additional CFI resources below will be useful: