Cross-default provisions in financing and derivatives transactions

Banking Law Journal

Volumn 113, Issue 3, 1996, Pages 216-240

  Kruft, Stephen R ^a  

^a Chase Manhattan Bank   (United States)

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EID: 24944532683     PISSN: 00055506     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (38)

1. Lee C. Buchheit, "How to Negotiate Cross-Default Clauses," 12 Int'l Fin. L. Rev. 27 (1993). This is a brief and useful article on the dynamics of negotiating cross-defaults.
2. An Event of Default, usually found in an agreement provision of the same title, is a specified fact or circumstance. If it exists at any time, or for a specified period, either the obligations of the defaulting party immediately become due and payable or the nondefaulting party may immediately declare them so. This is a process known as "acceleration" of such obligations. The occurrence of an Event of Default under a revolving credit agreement also prevents further borrowing. Events of Default that automatically cause acceleration are usually in the nature of bankruptcy or insolvency. Circumstances that may become Events of Default after notice or lapse of time or both are generally referred to as "defaults" or informally as "small-d defaults."
3. It is important that cross-defaults be both carefully structured to suit each transaction and precisely set out. A cross-default is of no value if it is not effective, or if it is worded so as to contain ambiguities that can be seized upon and construed against any creditor that attempts to exercise the provision. It is not uncommon to find serious errors in cross-default language, perhaps most often caused by careless changes to language that operated properly in its original form.
4. Once a cross-default is triggered, the Lender's decision whether to take action generally depends on its overall assessment of the Borrower's ability to meet its obligations to the Lender.
5. Occasionally, a borrower will try to do this even if there are other creditors who have such power but who have not responded as quickly as others. The author has been involved in cases in which only the acceleration of debt, and the initiation of foreclosure proceedings, would "get the attention" of borrowers and prevent their closing preferential work-out arrangements with other creditors. These actions should, of course, be taken only in good faith and when the lender intends to pursue the appropriate remedies. This underscores the need for swift and sometimes forceful action in potential work-out situations. Generally speaking, single lenders can act most quickly. Large banks, grouped in "agented" loan syndicates and equipped with business units designated to handle troubled loans, are able to communicate and act promptly. Groups of private placement investors, with no agent, no standard procedure, and often no specialized personnel in place, are at a disadvantage because they have greater difficulty in organizing and acting collectively.
6. A negative pledge is a provision stating that the Borrower will not grant security interests in its assets, or that it will do so only in certain circumstances, or that it will do so only if its obligations to the Lender are secured "equally and ratably."
7. A "Restricted Subsidiary" is a subsidiary of the Borrower (referred to here, as in some credit and most note purchase agreements, as the "Company") whose assets and liabilities have been taken into account in credit evaluation and for purposes of covenants under the Agreement, so that defaults committed by the subsidiary affect the combined credit and are treated the same as defaults by the parent company. Credit agreements contain definitions of the term, in which the range of subsidiaries that are included is described.
8. In the ISDA Master Agreement, which is the basic swap agreement form published by the International Swaps and Derivatives Association, the applicable term is "Threshold Amount."
9. A composite currency is an artificial combination of currencies, the most common of which is the European Currency Unit or "ECU."
10. The author has seen agreements with dollar amount thresholds ranging from zero to $250 million.
11. For example, a Borrower may be in default under a $100 million term loan because of violations of financial covenants or for many other reasons besides failure to pay. Also, the Borrower may be in default of the same loan for failing to make a $1,000,000 interest payment. The cross-default language must permit easy determination of whether the Borrower is considered, in these circumstances, to be in default in the amount of zero, $1,000,000, or $100 million for purposes of the cross-default threshold.
12. The origin of thresholds of this sort is unclear. They have appeared in credit agreements at least since the late 1970's. The author first found them in equipment financing, where they are often used not as cross-default thresholds but to trigger such obligations as maintaining full insurance coverage on leased aircraft. They are very effective and desirable in that role because they provide appropriate protection to lessors and lenders without imposing unnecessary expenses upon lessees.
13. An alternative that is sometimes used to allay this concern is to set the threshold at the greater of a relatively small fixed amount and a variable amount.
14. Shareholders' equity may also include other items such as unrealized gains and losses on investment securities available for sale and foreign exchange translation adjustments.
15. Some extraordinary items are often excluded for purposes of credit agreement provisions so as to avoid a distorted view of the borrower's financial condition.
16. An example of this is seen in some swap master agreements, where the cross-default applies only to defaults in borrowed money but the threshold is reduced by the amounts of defaults under derivatives contracts.
17. In ISDA Master Agreements relating to swaps and like derivatives, the relevant term is "Specified Indebtedness."
18. It is common for large users of natural gas, such as public utilities, to enter into long-term contracts to buy certain quantities, for which they must pay whether or not they actually choose to take delivery. These contracts, the details of which are outside the scope of this article, are significant to the financial condition of producers and users of such fuels.
19. This can be done in at least three ways: (1) by describing the derivative instruments in the cross-default; (2) by using a defined term such as "Derivative Agreements" or "Interest Rate Protection Agreements"; or (3) by using a defined term, such as "Material Transactions," that encompasses both traditional indebtedness and derivatives.
20. When this is done, defaults under derivatives contracts cannot by themselves trigger the cross-default provision, but they have the effect of reducing the threshold amount.
21. The replacement cost of a derivative is the cost that would have to be paid by a party to enter into the identical transaction with a new counterparty. Depending on the terms of the derivative and the state of the financial markets, the amount may be positive, zero, or negative.
22. The best solution is to include a detailed provision specifying exactly how and when swap exposure will be calculated for this purpose. The most common method, which is to make reference to the amount, if any, that would actually be payable on early termination of swaps, is not practicable because the mechanisms used in swap agreements to make this calculation are often too cumbersome to impose upon the Borrower on a periodic basis.
23. A "notional amount" (or "notional principal") is an amount, expressed in a currency or otherwise, that is selected by the parties and used in determining the amounts paid under a derivative contract. It does not reflect an actual investment of money, although it does often correspond to the amount of another obligation that is being hedged. Notional amount, standing alone, is not the best cross-default criterion, because it is only one factor in determining the amount, if any, that a party in default under a swap or like agreement owes to its derivatives counterparties at the time. Chances are reasonable that if a master swap agreement or like agreement is terminated early, the defaulting party will actually be "in the money" at the time, meaning it is owed money. Most of these agreements now contain provisions known as "full two-way payments" clauses, providing that defaulting parties must be paid the net amounts that they are owed under agreements terminated early, even for default. Therefore, if notional amount is used at all, the provision should require that the party default in making payments due under such agreements, or that it default in a manner that permits early termination.
24. It may be appropriate to include language distinguishing Events of Default under swap agreements from other events that are specified not to be defaults but which nevertheless permit early termination of the derivatives. Swap agreements and the like generally provide for early termination in some circumstances, often called "Termination Events," that are not the fault of either party. These include events such as illegality or changes in tax consequences. Of particular concern are provisions, considered old-fashioned today but still occasionally seen, permitting early termination of swap agreements purely because a party's credit rating has fallen below a certain point. These provisions are often loosely worded, so that termination may occur at any time and a party is encouraged to "play the market," terminating at a time when it stands to collect a particularly large amount from its counterparty, regardless of any real credit concerns.
25. In the typical derivative, such as an interest rate swap, a party may at any time be "in the money," meaning that it is entitled to a payment from its counterparty, or "out of the money," meaning that it will be required to pay its counterparty. It is possible to "value" all of a party's derivatives transactions to determine whether, if they were all terminated, the party would, on a net basis, be entitled to receive payment or required to make payment. It is also possible to determine the net "replacement cost" of a party's transactions, meaning whether, if a counterparty (or all counterparties) desired to go to derivatives dealers and ask them to replace the transactions immediately, they would be entitled to receive payments or required to make payments, and the amounts thereof.
26. Financial covenants (as opposed to cross-defaults) can take proper account of derivatives exposures only by providing for calculation of potential exposure on a periodic basis, so that periodic determinations may be made as to whether the Borrower is maintaining the prescribed figures or ratios. The credit documents must therefore include very precise methods of calculating the Borrower's derivatives exposures for purposes of making those calculations. Some such provisions contain serious deficiencies, the most common being (1) errors in the prescribed methods of calculating of swap exposures, (2) providing for calculations to be made so infrequently that extremely volatile derivatives exposures could move dramatically in the interim periods, (3) making incorrect references to the swap master agreements or incorrect attempts to incorporate their provisions, and (4) incorporating, failing to take account of the actual operation of, the swap master agreements, which contain their own provisions with respect to the amounts, if any, that each party would be required to pay if the master agreements were terminated early. Lawyers preparing financial covenants of this type should consult their derivatives experts in respect of these provisions.
27. In derivatives, the printed form of ISDA Master Agreement contains a very limited provision of this nature, essentially triggered by actual early termination or acceleration of, or failure to make the last payment on, "Specified Transactions," a term normally defined to mean only derivatives and like obligations that do not fall under the same Master Agreement. For this reason it is common to provide, in the schedule attached to each Master Agreement, separate Events of Default triggered by defaults under other obligations between the parties or, less commonly, to amend the provisions relating to "Specified Transactions."
28. It is most common to see cross-defaults of this nature in credit documents other than the Borrower's primary credit agreement.
29. In the negotiation of covenants and Events of Default, inexperienced negotiators occasionally argue by positing very extreme scenarios in which a provision of this type could, in theory, be applied unfairly or in bad faith. These situations can be raised in respect of virtually any credit provision. Such an argument has appeal only to the extent that the scenario that is presented is realistic. In this context, for example, it is reasonable to suppose that a lender would use a cross-default triggered by a borrower's failure to pay another debt as an excuse for requesting concessions, but silly to think that a lender would even consider accelerating a loan for an inadvertent and promptly remedied failure to deliver a balance sheet to another lender on time.
30. Some modern credit agreements also provide an automatic increase in the interest rate as a means of encouraging compliance with minor covenants because lenders know that in many such cases, there is unlikely to be an effective way to compel compliance.
31. A variation that is sometimes seen (but that adds little) is a trigger based on payment defaults, combined with a general cross-acceleration. This way, the Lender can take action if the Borrower actually misses a payment on the Other Obligations, or if they are accelerated for other types of defaults. See the discussion of cross-acceleration at infra p. 237.
32. Note that when cross-defaults refer to acceleration or to possible acceleration of other obligations, it is necessary to provide separately for the "ultimate" default, which is failure to pay an obligation at its stated maturity, because acceleration at that time is impossible. In the following provision, this situation has been covered in item (i).
33. Errors have occurred in the drafting of cross-default provisions when language of this sort has been carelessly amended. For example, if the drafter intending to create cross-acceleration provisions, which are discussed below, is not careful in making changes, it is easy to modify this provision into a cross-acceleration that would arguably be triggered only if the other obligations were automatically accelerated, not if the Other Lenders declared an acceleration.
34. A still more specific variant applies only to debt securities with reset provisions that automatically adjust the interest rate in order to maintain a certain market price in relation to the par or stated value of the securities.
35. Even in the case of a cross-acceleration, failure to pay at final maturity must be separately provided for because acceleration at that point is impossible.
36. There are rare situations in which these agreements are used only to permit one party to purchase "caps" or "floors" from its counterparty for up-front premiums. In those cases the credit exposure is in only one direction. A cap or floor is a transaction, economically equivalent to an option, that requires a party to pay the other if at any time a specified price or rate rises above (in the case of a cap) or falls below (in the case of a floor) a specified level.
37. Two differences that are generally considered acceptable in the swap market are thresholds that are different for each party and, in cases of agreements between swap dealers and lower-rated end-user counterparties, cross-defaults that apply only to the end-user and not to the dealer. An "end-user" is a counterparty that uses derivatives only for its internal purposes (which may be hedging or generation of income) rather than acting as a dealer.
38. For example, the ISDA Master Agreement cross-default is triggered only by a default in an agreement relating to borrowed money, and then only if it currently permits acceleration or is a failure to pay at maturity. It is, however, standard practice in the swaps market to amend the standard cross-default provision to apply to defaults under other swap agreements as well as to borrowed money.