An event of default is any of the triggers listed in the loan agreement that let the lender exercise its remedies. Missing a payment is one. The others usually include breaking a financial covenant, failing to deliver financial statements, a false representation, a default on other debt, an unpaid judgment, insolvency or bankruptcy, and a change of control. Some have a grace or cure period; financial covenant breaches and bankruptcy usually do not. Once an event of default occurs, the lender may charge default interest, stop lending and demand repayment of the whole loan, though most negotiate first.
- What it is
- A listed trigger that lets the lender use its remedies
- Most common in practice
- Financial covenant breaches and late reporting, not missed payments
- Cure periods
- Short or none for payments and financial covenants; longer for other covenants after notice
- Main remedies
- Default interest, stopping advances, acceleration, enforcing collateral and guarantees
- What usually happens
- A reservation of rights letter, then a waiver, amendment or forbearance
Default and event of default are not the same thing
Credit agreements usually define two terms. A Default is something that will become an event of default once any grace period runs out or notice is given. An Event of Default is the finished article: the point at which the lender's remedies become available. The distinction matters because the loan agreement often restricts what a borrower may do while an unmatured Default exists. A borrower may be barred from paying a distribution, drawing on a line or making an acquisition during a grace period, even though the lender cannot yet accelerate.
The list itself sits in one section of the agreement, usually titled Events of Default, and it is worth reading line by line before signing. The provisions below appear in almost every business loan, in some form.
The common events of default
| Event of default | What triggers it | Usual grace or cure | What to check or negotiate |
|---|---|---|---|
| Payment | Principal, interest or fees not paid when due | None or a few business days, often shorter for principal than for interest and fees | A short grace period for administrative errors |
| Financial covenant | A coverage, leverage, liquidity or net worth test is missed | Usually none, unless the agreement gives an equity cure | Headroom in the covenant levels; an equity cure right |
| Other covenants | Late financial statements, missing insurance, a prohibited act | A cure period that starts on notice or on the borrower's knowledge | A cure period for reporting and other curable breaches |
| Representations | A statement in the loan documents or a certificate was materially untrue when made | Usually none | A materiality qualifier |
| Cross-default | A default on other debt above a threshold | Follows the other debt's grace period | A threshold scaled to the business; cross-acceleration instead |
| Judgments | An unpaid, unstayed judgment above a threshold | A period to pay, bond or appeal it | A threshold, and an exclusion for amounts covered by insurance |
| Insolvency and bankruptcy | A bankruptcy filing, receivership, assignment for creditors | None; acceleration is often automatic | A period to dismiss an involuntary petition |
| Change of control | A sale, a new controlling owner, or a named person leaving | None | Permitted transfers for estate planning and minority stakes |
| Collateral and guarantees | A lien loses priority, a guarantee is challenged, a guarantor dies or defaults | Sometimes a period to replace a guarantor | Time to substitute a guarantor or collateral |
Some agreements add more: a material adverse change, loss of a license the business needs to operate, a government action or an uninsured casualty loss. SBA loans use SBA's standard note, which includes defaults that many bank notes do not, such as failing to account for collateral to the lender's satisfaction or a default with another creditor that the lender believes may affect repayment.
The defaults that actually happen
Payment defaults get the attention, but they are rarely where trouble starts. A business that is still paying on time can be in default for reasons it has not noticed:
- A covenant test missed at quarter-end. A fixed charge coverage or leverage test calculated on a trailing basis can fail on a single weak quarter. There is usually no cure period for a financial covenant, so the default exists from the day the test is failed, not from the day the lender finds out.
- Late reporting. Annual statements from the accountant arrive after the agreement's deadline. The compliance certificate is not delivered. These are defaults, usually curable, but they give the lender the right to start asking questions.
- A new loan the lender did not approve. An equipment loan, a merchant cash advance or a new line taken out without the lender's consent can breach the debt and lien limits in the negative covenants. The new lender's UCC filing is often how the first lender learns about it.
- A distribution that should not have been paid. Owner distributions above what the restricted payments covenant allows.
- A default somewhere else. A missed payment on a small equipment note that pulls the main loan into default through a cross-default clause.
The lender's remedies exist from the moment an event of default occurs, whether or not the lender has noticed. Raising a problem first is almost always better than having it found.
What the remedies mean in practice
The remedies section reads as though the lender will seize everything the day after a default. That is rarely what happens, but each remedy is real, and knowing what each one does helps a borrower judge the lender's leverage.
- Default interest. The rate steps up by a margin set in the agreement, from the date of default until it is cured or waived. See default interest rate. Lenders often charge it quietly while negotiating, and waiving it becomes part of the settlement.
- Stopping advances. On a line of credit, the lender can refuse new draws. For a business that runs on its revolver, this is the most immediate consequence of any default.
- Acceleration. The lender declares the whole loan due now, not on the schedule. Most defaults give the lender the option to accelerate by notice. Bankruptcy usually accelerates automatically. Acceleration is the step that turns a default into a crisis, which is why lenders use it as leverage more often than they use it outright.
- Setoff and cash control. A lender that holds the business's deposit accounts can apply balances to the debt, and on an asset-based line it can switch on cash dominion.
- Enforcing collateral and guarantees. Collecting receivables directly, taking and selling assets, and calling on the personal guarantees. These come last, after negotiation has failed.
What usually happens after a default
The first formal step is usually a reservation of rights letter: the lender states that a default exists, that it is not waiving anything, and that it may act later. It is not acceleration, but it preserves the lender's position and often starts default interest. The file may then move to a workout team; see what it means when a loan moves to special assets.
From there, the outcome is usually one of three. A waiver excuses the specific default, often for a fee. An amendment resets covenant levels or changes terms going forward, often with a higher rate or tighter reporting. A forbearance agreement leaves the default in place but has the lender agree not to act for a period while the borrower refinances or recovers. If none of those is available, the borrower's best path is often to refinance out; see what to do when you breach a covenant.
A lender deciding which of those to offer looks at the same things it looked at when it made the loan: current cash flow, the trend, collateral coverage and whether management has been straight with it. A borrower who arrives with current figures, a clear explanation and a plan is in a very different position from one whose lender found the problem in a late compliance certificate.
Negotiating the list before you sign
The events of default are negotiable at the term sheet and document stage, and almost never afterward. The points that matter most to a lower-middle-market borrower are cure periods for curable breaches, headroom in the financial covenants, an equity cure where the lender will give one, sensible thresholds on cross-default and judgments, materiality qualifiers on representations, and a change of control definition that allows estate planning. When Transparent compares term sheets for a borrower, these sit alongside rate and structure, because a cheaper loan with no room to cure can cost more in a bad year than a slightly dearer one with room.
Common questions
- Is missing one loan payment an event of default?
- Usually yes, once any grace period in the agreement runs out. Many agreements give only a few business days, or none, for principal.
- Can I be in default if all my payments are current?
- Yes. Breaking a financial covenant, reporting late, taking on unapproved debt or defaulting on another loan can all be events of default while payments are on time.
- What does acceleration mean?
- The lender declares the whole outstanding loan due immediately rather than on the payment schedule. It is usually optional for the lender, except on bankruptcy, where it is often automatic.
- Does the lender have to tell me I am in default?
- Not always. Some defaults need notice to start a cure period, but many, including financial covenant breaches, exist as soon as they happen. The agreement usually requires the borrower to notify the lender.
- What is a reservation of rights letter?
- A notice from the lender that it knows of a default and is not waiving it, while choosing not to act yet. It usually precedes a waiver, amendment or forbearance negotiation.
- Can an event of default be waived?
- Yes, in writing by the lender, often for a fee and sometimes with changed terms. A lender that simply keeps accepting payments has not necessarily waived anything; most agreements say so expressly.