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Dealing with Default
June 12, 2008
It's been said that every lawyer who drafts a set of loan documents is a great lawyer-until that deal goes into default. Not until that point does everyone involved begin to pay close attention to what such documents really say.
"Default" and "Event of Default" are two terms that raise concern and confusion in the minds of lenders and their respective counsels. Given that the road beyond such terms has been less travelled until very recently, it is unsurprising the issues surrounding default are not well understood.
What follows is not a discussion of legal principles applicable to certain remedial actions available to the lender. Rather it is an analysis of the lender's post-default procedures up to the point of initiating the exercise of applicable remedies. Why is it important for each lender and his or her lawyer to understand these procedures? The foundation for actions that may or may not be available upon default are laid, intentionally or otherwise, during the drafting and negotiation of loan documents, and every proposed loan and credit facility is the new benchmark for all future transactions.
Definition of Default
The term "default" is defined by Black's Law Dictionary1 as the omission or failure to perform a legal or contractual duty. Many jurisdictions have further incorporated this concept into their body of case law. In Texas, for example, one court held that a "default" is a failure to perform a legal duty.2 The Uniform Commercial Code (UCC), however, does not define the term but provides the parties to an agreement may decide what constitutes a "default." In adopting the UCC, Texas commentators specifically stated3 that the particular circumstances giving rise to a default, as well as whether a default has occurred or has been waived, are each left to the agreement of the parties as supplemented by other applicable law.
Based upon the foregoing, then, a default occurs when one party to a set of loan documents omits or fails to perform a duty to which the parties have contractually agreed. As a result of the deference given the parties by law regarding this concept, lenders and lawyers alike should actively participate in the negotiation, and closely scrutinize the drafting, of specific defaults set forth in the documents evidencing the transaction.
Further, lenders must decide exactly what will necessitate steps to be taken immediately prior to legal action. Which acts or omissions will constitute a default under the applicable loan documents? Which event(s) will lead to the giving of notice and the opportunity to cure prior to the lender being able to exercise its applicable remedies? In any case, the lender should become intimately familiar with the specific provisions applicable to such an event in order to determine the contractual effect of its occurrence and whether or not a notice from the lender is required in connection to it.
Acting after Default
After determining with assurance that a default has in fact occurred, the lender must decide the most reasonable strategy to realize the payment of the debt. This may or may not include exercise of such lender's contractual and/or judicial remedies. Regardless of the path chosen, the lender should fully understand that, from the point at which the lender becomes aware of the event, everything which occurs is significant.
First, many critical issues related to the actions which a lender can or cannot take upon the occurrence of a default are tied to specific time periods. For example, the Texas and Business Commerce Code prescribes certain time periods in connection with specific notices to be delivered to the debtor when a secured party commences exercising remedies over the applicable collateral. Additionally, the United States Bankruptcy Code establishes various periods of time regarding transfers of assets from a debtor that subsequently files or is forced into bankruptcy.
Second, because of the disparate bargaining position of a debtor in default and its creditor, courts will look closely at the actions of creditors in such circumstances including, without limitation, any agreements between debtor and creditor entered into at such time. A lender must also be particularly careful regarding its conduct during the period following a default in light of the defense of waiver.
The term "waiver" is defined as the voluntary relinquishment or abandonment—express or implied—of a legal right or advantage.4 This is another concept which has been incorporated into the laws of most jurisdictions by the courts. In Texas, the defense of waiver arises against a party when such party intentionally relinquishes a known right or engages in intentional conduct inconsistent with claiming that right.5 Furthermore, silence or inaction for so long a period of time as to show an intention to yield the known right, is also enough to prove waiver.
Lenders must be particularly wary when the applicable borrower has permitted or caused the occurrence of a default or an event of default beyond all applicable notice, cure and/or grace periods. At this point, nothing can cure such a default except a waiver by the lender. Many lenders take this for granted, but the results can be significant from a legal perspective. The lender must waive such default or take steps consistent with its post-default rights under the loan documents. If such lender permits the borrower to continue business as usual, that lender's course of conduct is inconsistent with the rights of the lender post-default and, as such, arguably establishes a waiver of such default. Because inaction can have far-reaching ramifications, in such circumstances lenders should seek to enter into an agreement in which the lender and the borrower(s) acknowledge the default as well as the preservation of the lender's rights with respect to the default.
1449 (8th ed.2004)
2Easterwood v. Willingham 47 S.W. 2d 393 (Tex. Civ. App.-Dallas, February 13, 1932
3Comment 3, Section 9.601, Texas Business and Commerce Code, O'Connor's 2007-2008
4Black's Law Dictionary, 1611 (8th ed. 2004)
5Tenneco Inc. v. Enterprise Products Co., 925 S.W.2d 640 (Tex. 1996), rehearing overruled (August 16, 1996)