What is a Default?
Default is the failure to meet the obligations of a loan, either required by law or agreed upon by the parties involved (typically the debtor and creditor). The loan covenants often include terms on the interest and deadline of repayment.
The exact legal definition of default may vary in wording, and specific semantics may differ slightly. However, the definition above provides the essence of default in most countries. The term itself can be used as a noun and a verb with a similar meaning. That is, a debtor can “avoid default” (noun) or “avoid defaulting” (verb).
- A default is incurred when a debtor fails to meet one or more of the contract terms agreed upon by all parties.
- There are two types of defaults – debt services default and technical default.
- Defaults are distinct from illiquidity, insolvency, and bankruptcy.
Types of Defaults
As the definition of a default is to violate the terms of the loan between the debtor and the creditor, there can be an array of terms that can be infringed upon. In general, two types of defaults pertain to different natures of the covenants contravened:
1. Debt Services Default
Debt services defaults are incurred when a debtor misses a scheduled payment on interest, principal, or both. Among the general public, debt services default is what is typically thought of when the term “default” is used.
2. Technical Default
Technical defaults are those that are incurred when an affirmative or negative covenant is breached. Affirmative and negative covenants cover all contractual terms outside of payment clauses.
Affirmative covenants are terms or clauses that specify a minimum (or maximum) financial or capital ratio that the lender (a corporation or an individual) must keep before the loan is paid back.
Some examples of affirmative covenants are:
- Tangible net worth
- Working capital/short-term liquidity
- Debt services coverage
If a ratio falls out of a specified range in the loan contract, the affirmative covenant is breached, and a technical default is incurred.
Negative covenants are terms or clauses in a loan contract that limit or prohibit certain corporate activities that are deemed to be possibly harmful to creditors.
Examples of negative covenants include:
- Sale of a certain amount/type of asset
- Payment of dividends
- Share buyback
Although technically possible, infringements upon negative covenants occur far less frequently than infringements upon affirmative covenants due to the nature of the clauses. Whereas negative covenants simply prevent a corporate action that is fully within the management’s authority, affirmative covenants depend on performance, which is not within the control of a company’s management.
Distinction From Related Terms
Often confused with default are the following terms:
The above terms carry related meanings to default, but with a clear – although sometimes subtle – distinction. They are defined below briefly to outline the subtle differentiations. However, feel free to check out the articles linked above for an in-depth look at these terms.
- Illiquidity is the state of experiencing insufficient cash or other forms of liquid assets to pay debts owed. In isolation, it does not refer to a particular point in time.
- Insolvency is a legal term for the inability of a debtor to pay the debt owed.
- Bankruptcy is a legal status and process that insolvent debtors attain and enter as a method to seek relief from the debts owed.
Interestingly enough, sovereign governments can also default, which is known as a “sovereign default.”
By definition, sovereign governments are in control of their own state affairs, and thus, there is technically no international arbitrator to enforce repayment. Yet, creditor nations will often exert pressure through diplomatic strategies, such as trade limits and even threats of war.
Fortunately, within the last seventy years, the threats of acute diplomatic hostility have been alleviated through the ratification of the Charter of the United Nations in 1945.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: