Modern Designs of Cross-Default Clauses - Germany
Cross-default clauses are part of the customary tools and modules of international banks. Their operational area covers credit agreements with enterprises, as well as governments and governmental agencies all over the world.
Cross-default means that a default on one loan automatically constitutes a default on all loans covered by this clause. As a result, debt obligations under a credit agreement and indentures could become immediately due and payable even if there is no breach of other covenants or default of payment on the loan. A cross-default clause gives the creditor the benefit of the default provisions in other credit agreements with the debtor. These provisions can therefore create a domino effect.
Generally, cross-default provisions are limited to counter-party defaults. However, they can be further extended and may then be triggered by counter-party affiliate defaults or even defaults under agreements with specific unaffiliated third parties.
In practice, two typical contract constructions must be differentiated. On the one hand, a cross-default can be agreed upon in the event that the creditor becomes insolvent (Payment Cross-Default). On the other hand, the cross-default can be tied to the fulfillment of other contractual obligations of the debtor (Covenant Cross-Default), such as representations and warranties, financial ratios, and information obligations.
Since loyalty to one’s own existing agreements is a traditional commercial behavior, a typical cross-default clause is often qualified as merely a formal, rather than a substantial, burden for the debtor. He intends to perform under the contract faithfully “anyway” and, therefore, expects to be in-line with his other credit obligations, even if this is not an additional obligation of the new contract. From such a business point of view, the clause seems to be non-incriminating. The following remarks show, however, that this view is deceptive.
The legitimate objective of such a clause lies in the time gained for the enforcement of the creditor‘s rights. Typical examples for such scenarios are long-term financing agreements between major banks or in relation to less developed countries. In such an agreement, it might be unacceptable for the creditor to face a general one-sided debt moratorium or an objectively provable inability on the part of the debtor to pay while waiting for a specific default of each individual credit agreement before being able to take any action. Notwithstanding long-term payment intervals, an equal treatment of each creditor can be achieved by a clause which is not focussed solely on its own repayment and interest dates, but refers to a default under other comparable loans with other creditors.
Experience shows that cross-default clauses are sometimes used, and often abused, to avoid the time-consuming negotiation and proper design of corporate financial covenants. In such cases, the bank wants to benefit from favorable clauses, which other creditors have agreed upon with his debtor. Such free-riding seems to be inadequate. The specific financial covenants in a credit agreement in general reflect lower interest rates and other favorable credit conditions for the debtor. Therefore, the debtor should reject such cherry-picking requests. The intention of the creditor, to be able to find a basis to terminate any credit agreement in each situation in which the creditor no longer feels comfortable with his debtor, is not an acceptable approach for a long-term, good faith relationship.
Purported industry standard model provisions are in many cases improper, because they do not consider the specific needs and circumstances of the parties to the credit agreements. Instead, a case-by-case valuation and design are required.
On the one side, a cross-default clause is generally appropriate if the debtor is a single purpose company that enters into a bundle of separate agreements deemed to be in the aggregate part of the financing package. Typical cases involve project financing and similar arrangements. In general, such clauses might also be acceptable for banks, because they typically have as their main objective assuring at any time a fulfillment of the debtor’s obligations on the due date. Therefore, the use of a cross-default clause is not generally improper.
On the other side, a cross-default clause seems to be generally unacceptable with respect to public institutions, such as states, municipalities, governmental agencies, and other administrative bodies. This is based upon the fact that the governmental body:
1. typically has to satisfy certain public law functions and governmental policies, which may in some cases limit its ability to fulfill each and every contractual obligation with third parties;
2. has budgetary limitations which, for example, in the event of a budget freeze, might affect its loyalty to certain types of contracts;
3. has an unforeseeable, indeterminable, and often unmanageable range of existing and future obligations, over which control and monitoring obviously cannot be perfect, reliable or complete in each individual case;
4. often has aged and old-fashioned bookkeeping standards and regulations, no double entry accounting, and, in addition, no access to the latest control, proof and electronic data processing tools; and
5. due to its specific solvency, creditworthiness and often insolvency remote structure, has no sound business reasons to accept such burden-full clauses.
When discussing the necessity of a cross-default clause in a credit contract, the creditor typically argues that such a clause can be designed to minimize the risk of default. However, experience shows that the debtor is well advised to reject any discussion regarding the implementation of such a clause and not to open the door for long and painful negotiations regarding its design.
When the debtor is not in a position to reject or avoid a cross-default clause completely, the parties should agree upon an appropriate and differentiated arrangement. The debtor should heed the following guidelines:
1. Due to the special relationship between consolidated enterprises, any defaults within a group of companies have to be excluded from the cross-default clause. Regarding financial market transactions, the parties must agree in each case which transactions may trigger the cross-default clause of a credit agreement.
2. Each cross-default clause must include clear and effective materiality concepts and limitations with respect to threshold and de minimis amounts so that the clause will apply only to substantial and mature defaults. Such limiting language must characterize the business transaction, volume, extent of the damage required to trigger a cross-default.
3. The cross-default should depend upon an event of default positively claimed by the third party creditor. Any waiver or subsequent contractual modification, as well as notice requirements and grace periods, should favor the debtor not only vis-a-vis the third party creditor, but also with respect to the cross-default clause.
4. The debtor must have the opportunity to reject and defend an unjustified claim. To that extent, a non-payment is innocuous as long as it is in accordance with the terms of a contest clause.
5. The cross-default clause must contain a clearly predetermined time period during which a claim must be asserted. This time period should start with the occurrence of the default or the assertion of an event of default by the third party, not with knowledge of the event by the creditor under the cross-default clause.
Corporate debtors with no clear and consistent strategy to negotiate, accept and manage cross-default clauses will easily end up in a jungle of different terms and conditions. This might result in chains of cross-defaults arising by virtue of a merely insignificant default.
To save the business from collapsing by going into cross-default with its debtors, the cross-default risks must be controlled during the whole term of the credit agreement. Such a risk management system should cover:
1. the identification of the cross-default risks and an evaluation of the probability and amount of potential damages;
2. the establishment of tools to control and steer payments and financial data, even in case of a financial crisis;
3. a steadily and reliable communication and documentation of each and every parameter that might influence the occurrence of a cross-default; and
4. the integration and control of all aspects at a central hub (“Risk Management Cockpit“).
The risk management system must also consider clauses that have the legal or economic effect of a cross-default provision. Such hidden cross-default clauses often need more control and monitoring than the industry standard provisions.
For the debtor, the bottom line may be to avoid a cross-default clause at all costs. However, based upon an individual design and a proper handling of the risk management for long-term contractual covenants, a cross-default is manageable. Its general acceptance may open the door to favorable financing conditions.
ABOUT THE AUTHOR: Dr. Ulrich Eder
Dr. Ulrich Eder studied German law at Friedrich-Alexander-Universität in Erlangen, Bavaria and Westfälische-Wilhelms-Universität in Münster, North-Rhine Westphalia. He received his Dr. jur. in 1990 from Westfälische-Wilhelms-Universität in Münster. Dr. Eder is a German lawyer (Rechtsanwalt) and a member of the Düsseldorf Bar Association (Rechtsanwaltskammer). He is also admitted within the Federal Republic of Germany to practice as tax advisor (Steuerberater) and is a member of the Tax Bar Association (Steuerberaterkammer) of Düsseldorf.
Copyright Pugnatorius Ltd.
More information about Pugnatorius Ltd.
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.