Hot Topics in Commercial Lending: Cross-Default and Cross-Collateralization
As lenders’ counsel in loan transactions, we see a variety of transaction structures and methods for securing loans. This article is meant to highlight some of these provisions and to offer practice tips for handling such provisions, along with amendments to loan documents.
Cross-Default
It is relatively common for a commercial loan agreement to contain a cross-default provision, which provides that a borrower is in default under the current loan if the borrower defaults on another loan. Cross-default provisions may relate to all loans of the borrower with the lender, or they may relate to a specific loan. The enforcement of these provisions is highly dependent upon careful drafting and proper inclusion within the loan documents.
One manner of cross-defaulting a loan is to include a broad standalone provision in the loan agreement or security instrument stating that a default by the borrower under another loan results in a default under the current loan.
Another stronger manner of cross defaulting a loan is to include across default provision in the events of default section of the loan agreement and/or security instrument. To enhance the effectiveness of the cross-default provision, the lender may make specific reference to the loan by date, amount. collateral secured by the loan, and other defining characteristics of the loan. Doing so provides the lender with an enhanced basis for enforcement especially the only event of default is a default under the Cross defaulted loan.
Practice Tip: Cross-defaulting is a tool that can be utilized by lenders to call a loan in default when a related loan is not performing, so that all loan defaults with a common principal can be dealt with at one time.
Practice Tip: Given that many borrowers form special purpose entities, the lender should consider crafting cross-default language to include guarantors and/or common principals .
Cross-Collateralization
Cross-collateralization clauses provide that collateral for one loan is used as collateral for two or more loans made by the lender. Cross-collateralization can be achieved using various methods. One method is to add language in the security instrument that the collateral shall serve as security for two or more loans. Another method is to draft an additional security instrument, with the additional security instrument utilizing collateral from another loan to secure the new loan. A third method is to combine borrowers and loans in the security instruments themselves. The last method is more complex and time consuming to document and may be resisted by borrowers as unrelated borrowers are now making representations, covenants, and warrants arguably for the other borrower and its property.
Cross-collateralization is a useful tool for underwriting purposes and for solving collateralization issues, but it can also lead to additional complexity and confusion for borrowers and the lender.
Practice Tip: Lenders must be careful to properly and adequately document the cross-collateralization of risk unnecessary complexity and potential enforcement issues in the future.
Loan Amendments
In recent years, there has been an increase in the utilization of cross-collateralization of loans. During the count of a loan, certain collateral may become stronger or weaker, be sold or exchanged, and depreciate or appreciate in value. Most notably for this discussion, when amending a loan, the lender sometimes will add collateral to or remove collateral from the loan or seek to use collateral from another loan as security for the current loan. There are risks and pitfalls that can occur under all of these scenarios. Therefore, the lender must be careful to correctly document changes to loans and collateral as failure to do so can cause issues enforcement becomes necessary.
One example is when the lender attempts to modify or extend an existing loan to add collateral from another loan. Another example is when the lender attempts to utilize collateral and an existing security instrument as security for a new loan. When this occurs the lender may seek to simply add a reference to a prior security instrument in the amended or new loan agreement or promissory note, and then declare the same to be collateral for the amended or new loan. However, this method of collateralizing the amended or new loan is insufficient, and often can lead to enforcement issues down the road. The lender must not skip over the requirement of amending the security instrument is to refer to the loan for which it will be security and, when applicable, recording or filing the amendment documents.
Practice Tip: When amending a loan to add remove or replace collateral, it is important to determine what amendment to the underlying security instruments is warranted. When the underlying security instrument contains specific references to a loan, the underlying security instrument should be amended to add the additional loan for which the collateral will serve as security.
Conclusion
Lenders certainly will continue to utilize cross default and cross collateralization as tools for securing and enforcing loans in a highly competitive market. However, lenders should carefully and properly document such provisions in loan documents, and when amending loan documents so as to ensure the viability and enforceability of such documents and provisions.
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