A technical default is a violation (often called a breach) of one (or more) terms of a loan agreement between a borrower and a lender.
When a lender (a creditor) extends credit to a borrower (a debtor), both parties agree to loan terms by way of a loan (or credit) agreement. While they vary by jurisdiction, these loan contracts generally outline a series of standard positive (or affirmative) and negative covenants; this is a legal term stipulating things that a borrower must (and must not) do, respectively.
If one of these “covenants” is not adhered to, it is considered an event of technical default by the borrower. The qualifier “technical” indicates that the event of default was non-financial in nature. An example of a financial default is a delinquent principal or interest payments.
A technical default occurs when a borrower violates a non-financial condition of their loan agreement.
It is usually a breach of covenant or of a Representation and Warranty, as opposed to a delinquent interest or principal payment (which is an event of financial default).
When a technical default occurs, the lender must formally document the event of default and decide if the firm wishes to tolerate the breach or if they want to accelerate repayment of the loan.
Understanding Loan Covenants
Technical defaults are a big consideration in corporate and commercial lending, and it’s impossible to understand them without first understanding loan covenants. Covenants come in many shapes and sizes, but broadly speaking they are either standard or non-standard, and they are either financial in nature or non-financial.
Standard covenants are things that many borrowers and lenders take for granted, but that must nevertheless be documented in a loan agreement or a credit contract. They can be worded as positive (or affirmative) covenants, including:
The borrower must maintain “good standing” (i.e., taxes up to date, annual proceedings filed for corporate borrowers, etc.).
The borrower must maintain adequate insurance on all assets that serve as collateral.
They may also be worded as negative covenants, including:
The borrower may not permit any change of ownership of the borrowing entity.
The borrower may not create or incur any additional liens or security interests against the assets of the business.
Non-standard covenants are those created within the context of a specific borrowing request (ie. based on the transaction “at hand”). Transaction-specific covenants are put in place to help align incentives between a borrower and a lender and to mandate certain behaviors or financial metrics.
Examples of non-standard financial covenants include (but are not limited to):
The borrower must maintain a minimum debt-service coverage ratio of not less than1.25x
The borrower must maintain a Funded Debt to EBITDA ratio of not greater than3x.
Examples of non-standard, non-financial covenants include:
The business owner(s) must provide personal tax returns within 120 days of calendar year-end.
The borrower must provide an inventory listing quarterly, within 30 days of quarter-end.
Consequences of Technical Default
By all accounts, a technical default is legal grounds for a lender to “accelerate” repayment (often referred to as calling the loan or demanding payment). Unless the nature of the technical default is very serious (like fraud), most lenders don’t lead with accelerated repayment.
Commercial banks and other financial institutions that work with business borrowers will usually approach technical defaults with a collaborative (but firm) approach. If a proposed resolution strategy is too punitive, it may impact management’s ability to continue operating the business (this, in turn, makes full repayment much less likely).
From the bank’s perspective, the steps are:
1. The Loan Officer must notify the financial institution’s Risk Management team to ensure the technical default is correctly documented internally and to seek their counsel. The Risk Manager will recommend that the firm either:
Tolerate the technical default (sometimes called a waiver), but provide a date upon which the default must be resolved. Or,
Not tolerate the technical default (a non-waiver), and provide instructions around the accelerated repayment date, etc.
2. The financial institution must document the technical default in writing to the client. This is especially important if the file turns into a problem loan and ends up in legal proceedings. A formal letter is typically produced and delivered to the client, acknowledging and detailing the specifics of the technical default(s).
3. The letter will include instructions to the client:
If it’s a letter of tolerance (or a waiver), clear expectations will be provided around a date of resolution, as well as what will happen next if the default is not resolved within the time limit provided.
If it’s a non-tolerance letter (sometimes called a non-waiver), the client must be made aware of what is expected of them and by when.
4. If the expectation is that the client’s repayment will be accelerated, the borrower must be given sufficient time to secure alternative funding (typically from another financial institution or from a non-bank, alternative lender). This may be a 60-120 day window.
5. If the financial institution determines that tolerating the technical breach is the best course of action, they may seek to implement tighter oversight of the file. This could include more frequent reporting or adding the client to the lender’s “watch report.”
Representations and Warranties
Another type of technical default is when a borrower breaches one (or more) of the standard Representations and Warranties outlined in the loan or credit agreement. This section of the agreement typically opens with something like: “The Borrower hereby represents and warrants….“
Representations and Warranties can be thought of as circumstances or assumptions under which a loan agreement was entered into. These conditions or circumstances (that are presumed to be true on the contract date) must remain true while there is principal and interest outstanding on the loan. If one of these conditions is breached, it is generally also considered an event of technical default.
Examples of representations and warranties include, but are not limited to:
That there is no litigation or other type of legal proceeding against the borrower.
That the financial statements and/or financial projections presented by the borrower to the bank fairly and accurately represent the actual financial condition of the borrower.
That taxes and any other form of government remittances are up-to-date, with no outstanding arrears.
Thank you for reading CFI’s guide to Technical Default. To keep learning and developing your knowledge base, please explore the additional relevant resources below: