What is a Technical Default?
A technical default is a violation of a financial covenant in a loan agreement, resulting from a borrower’s neglect to make timely debt service payments or breaching other loan terms. Failure to comply with the technical requirements in a credit agreement may indicate that the borrower is in financial difficulty.
The resultant impact of a default can be onerous, depending on several factors. For example, a technical default may trigger negative actions, such as foreclosure, heightened risk profile, or increased loan interest. News of a technical default would also have a negative stock market effect and possibly significant shareholder wealth losses.
- A technical default is a violation of any legal provision in a debt contract due to the borrower’s failure to fulfill the terms and conditions of the debt.
- Depending on the type of loan, lenders via the agreement will outline the terms and conditions for technical defaults.
- Lenders may waive or offer alternative remedies when a borrower triggers a technical default, as this relief can provide a better outcome or possibility for full repayment.
Understanding Technical Default
The term technical default can occur by violating a range of different financial covenants, and may not necessarily be from payment default. These covenants must be clearly understood at inception to ensure borrowers understand their obligations aren’t purely financial.
Through the debt agreement, lenders outline their contractual requirements, including those relating to representations and warranties, events of default, covenants, confidentiality, enforcement, and remedies. Such requirements aim to buffer lenders against legally enforceable claims to their funds and borrowers’ access to alternative remedies in the event of a default.
Borrowers are obliged to comply with all the debt contract’s standard provisions throughout the duration of their loan, lest they bear the burden of a technical default.
How It Works
Most lenders begin negotiations with preliminary covenant forms that outline important terms of the loan contract. These initial documents can vary from term sheets, engagement letters, or mandate letters and are not a binding obligation for either the lender or borrower.
In standard loans, borrowers are asked to indicate consent to the technical default provisions by countersigning. At this stage, borrowers can negotiate or clarify financial terms since lenders will often assume that their proposal lending terms and conditions are based on the initial document. The most prominent provision is outlining the scheduled debt payments.
The basic technical default terms used are typically standard for each type of contract and are inserted into the draft loan agreement. The reason behind the concept is that approval is always at the discretion of credit committees or other internal bodies based on the initial document. Depending on the type of loan, some lenders may insert more efficient remedies.
The types and strictness of default terms and remedies that are negotiated will depend on a borrowers’ creditworthiness, collateral offered, or other situation circumstances.
Types of Technical Defaults
1. Business Loans Defaults
Business loan agreements may include requirements to maintain certain financial ratios. For example, technical default provisions for a business loan agreement may focus on a company’s liquidity using the quick ratio, working capital levels, or current ratio. For this reason, a company can be a victim of a technical default if it fails to meet these ratios.
2. Real Estate Mortgage Loans Defaults
Technical default provisions are also contained in mortgage loans. A typical example of terms and conditions for commercial and residential borrowers is to ensure the borrower has paid its insurance premiums and property taxes. The real estate owner must ensure strict compliance with such technical default requirements.
Early Warning System for a Technical Default
Financial covenants are tailored to suit the unique business situation of both the lender and the borrower and govern the relationship between the two parties. While lenders are equipped to weather storms of defaults, they generally resent getting blindsided by negative news, especially when such an event could be communicated early, as required in the loan agreement.
Such an omission, to the lender, may signal a lack of transparency. In any case, failure to proactively communicate negative news to the lender fuels mistrust. Consequently, the lender may be forced to conduct a thorough background check on the borrower to ensure all the technical agreements are strictly adhered to.
Most lenders do not condone minor technical defaults that could have easily been avoided by providing a required notice of a material event in a timely fashion. However, given the prevalence of technical defaults, lenders must scrutinize whether a technical default was inevitable, affects the credit’s risk profile, or whether the breach deserves a formal response, such as a waiver, loan amendment, or consent.
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