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Defined fault event

What is a fault event?

An event of default is a predefined circumstance that allows a lender to demand full repayment of an unpaid balance before its due date. In many agreements, the lender will include a contractual clause covering the events of fault to protect itself in the event that it appears that the borrower will not be able or does not intend to continue to repay the loan in the future. An event of default allows the lender to seize any collateral which has been pledged and sell it to recover the loan. This is often used if the default risk is beyond a certain point.

Key points to remember

  • An event of default is a predefined condition or threshold which, if reached, allows the lender or creditor to demand immediate and full repayment of a debt or obligation.
  • An event of default may include default or non-payment of principal or interest due, breach of a covenant, or insolvency, among others.
  • Credit default swaps (CDS) contain specific events of default that can induce one counterparty to the contract to pay the other.

Understanding Fault Events

An “Event of Default” is a defined term in the Loan and Lease Agreements. The following would constitute an event of default in a typical term of a credit agreement:

  • non-payment of any loan amount (including interest)
  • financial commitment infringe
  • material misrepresentation or breach of warranty
  • cross fault
  • material adverse change (MAC)
  • insolvency

The clause may contain more circumstances that would allow the obligee to invoke its rights in the event of default. These events would be tailored to the borrower’s unique situation. Although a creditor can legally demand immediate repayment in the event of default, in practice it rarely does. Instead, he usually works with the troubled borrower to rewrite the terms of the loan agreement. If the parties agree, the lender will produce a amendment to the loan agreement which contains stricter terms and, in most cases, increase the loan interest rate and levy a modification fee.

Fault Event Example

On January 10, 2018, Sears Holdings Corp. entered into a $100 million term credit agreement with various lenders. Section 7.01 includes 11 different events of default, including those listed above with the exception of MAC, for the distressed retailer. Unambiguous terms are usual in a well-drafted credit agreement, but the agreement for Sears is particularly detailed and restrictive because the loan union takes extra precautions to protect its interests.

Events of Default in Credit Default Swaps

A credit default swap (CDS) is a transaction in which one party, the “protection buyer”, pays the other party, the “protection seller”, a series of payments during the term of the agreement. Essentially, the buyer buys a form of Assurance on the possibility that a debtor suffers an event of default which would compromise its ability to honor its payment obligations.

The three most common such events, as defined by the International Swaps and Derivatives Association (ISDA), are 1) bankruptcy filing, 2) default and 3) debt restructuring. Less common credit events are bond default, bond acceleration and repudiation/ moratorium.

  1. Bankruptcy is a legal process and refers to the inability of an individual or organization to repay outstanding debts. Generally, the debtor (or, more rarely, the creditor) files for bankruptcy. A bankrupt company is also insolvent.
  2. Default of payment is a specific event and refers to the inability of an individual or an organization to pay its debts in a timely manner. Continuing defaults could be a precursor to bankruptcy. Default and bankruptcy are often confused: bankruptcy tells your creditors that you will not be able to pay them in full; a payment default indicates to your creditors that you will not be able to pay when due.
  3. Debt restructuring refers to a change in the terms of the debt, which makes the debt less favorable to creditors. Common examples of debt restructuring include a decrease in the principal amount payable, a decrease in the coupon rate, a postponement of payment obligations, a longer maturity or a change in the priority of payment.