As lender’s counsel in commercial loan transactions, we are often asked to explain and document the following types of provisions in loan documents: (i) Cross-Default, (ii) Cross-Collateralization, (iii) Cross-Termination or Cross-Payout, and (iv) Cross-Guaranty. These terms often show up in a lender’s loan approval and the term sheets or commitment letters issued to potential borrowers and so it is important to understand what they mean and the differences between these provisions.
“Cross-default” means that an event of default under one obligation of a borrower to a lender will cause an event of default under other obligations of the same borrower. It is best if the cross-default language is included in a commercial loan agreement as a specific event of default and not just a general statement such as “[T]he loans of Borrower to Lender are cross-defaulted”. The crucial detail to remember with cross-default provisions is to include clear and specific language stating which loans or debts of a borrower would be affected if a default or an event of default occurs under the loan being reviewed or negotiated. The following event of default example shows how we would typically document a cross-default provision in a credit agreement:
“An Event of Default shall have occurred, as such term is defined pursuant to any of the Term Loan Documents or the Revolving Loan Documents.”
Although the level of specificity presented in the above example is a best practice, lenders should not panic if their existing loan documents only include general (non-specific) cross-default language such as the example presented below:
“There is a default by Borrower or any Guarantor under any other indebtedness of such parties to the Lender or any other creditor.”
During our years representing lenders in commercial loan transactions, the use of such broad cross-default language has proven enforceable. As a result, we have successfully assisted our clients in declaring events of default on this basis. The reliance on general default language when declaring an event of default, however, can potentially lead to litigation by borrowers or guarantors who seek to challenge such cross-default language. While such litigation is almost always unsuccessful, borrowers and guarantors may look towards the courts for relief by claiming that they never intended that their loans be cross defaulted.
In addition, if a lender seeks to have loans made to different but related borrowers be cross-defaulted, it is essential that each set of loan documents contains a specific cross-default provision similar to the example presented above. This is often overlooked when the lender makes subsequent loans to related entities and fails to amend the earlier loans to include the necessary cross-default provisions. Lenders should remember the importance of expressly documenting the intended cross-default language in loan documents in order to avoid future confusion and to save time and money by potentially avoiding future litigation.
“Cross-collateralization” typically refers to when the collateral pledged by a borrower for one loan also secures the obligations of the same or another related borrower under another loan. Contrary to popular belief, however, cross-collateralization is not accomplished by simply stating in the loan documents that “the loans are cross-collateralized.” In order to properly achieve cross-collateralization, each of the collateral loan documents (i.e., mortgages, security agreements, and/or pledges) need to specifically describe which obligations of the borrower to the lender are being secured by the collateral described therein. This can include the various loans made by a lender to the borrower as well as any other banking products offered by lenders to borrowers such as letters of credit, cash management products, credit cards and hedging obligations. We typically document this situation by including (i) a provision in the applicable collateral document that creates a security interest in the collateral intended to secure the payment and performance of the “Obligations,” and (ii) a clear definition of the term “Obligations.” For example, a mortgage that is intended to secure multiple loans or guaranties will include a definition of “Obligations” similar to the following:
“Obligations means, collectively (a) the repayment of all principal and interest and other charges outstanding under the Revolving Note, the Mortgage Note and the Term Note (collectively, the “Notes”) including all extensions, refinancings, restatements, and amendments of the Notes and all notes issued in substitution therefor, (b) the payment of all Guarantied Obligations under the Guaranties, (c) the payment and performance of all provisions of Loan Documents; and (d) the payment and performance of all other indebtedness, obligations and liabilities of the Borrower to the Lender whether existing on the date hereof or arising hereafter, absolute or contingent, matured or unmatured, and secured or unsecured.”
We have found that the improper documentation of cross-collateralization seems to occur most frequently in so-called “owner-occupied” deals where the lender has given a revolving line of credit to an operating business entity secured by all business assets and a separate mortgage loan facility to a related real estate holding entity secured by the real estate. The lender typically intends that the mortgage loan be secured by the business assets as well as the real estate and that the revolving line of credit be secured by the real estate as well as the business assets. The best way to properly document this loan structure is to create “crossing” guaranties such that the operating entity guaranties the repayment of the mortgage loan and the real estate entity guaranties the repayment of the revolving line of credit. It is then necessary to specifically state in (i) the security agreement (given by the operating entity) that such security agreement secures the obligations of the operating entity under its guaranty, and (ii) the mortgage (given by the real estate entity) that such mortgage secures the obligations of the real estate entity under its guaranty.
As such, when thinking and analyzing cross-collateralization, it is important to keep in mind which collateral is intended to secure which obligations and to ensure that the loan documents clearly express this intent.
Just as it sounds, “cross-termination” is the termination of a loan (usually in the discretion of the lender) when either the borrower or the lender decides to terminate another loan within a borrowing relationship. This situation is also often referred to in banking circles as a “cross-payout”. Cross-termination language is typically included in loan documentation involving both a revolving line of credit as well as one or more term loans. The goal of the lender when requiring cross-termination as a loan term is to avoid the so-called “orphan term loan” problem. If a borrower or lender does not wish to continue a revolving line of credit relationship and the borrower then seeks to move its revolving line (and its operating accounts and deposits) to another lender, the original lender does not want to be “stuck” with the remaining term loans since it no longer has the full banking relationship with the borrower. A lender, therefore, will include cross-termination provisions in its loan documentation so that the borrower is required to refinance (or pay off) the entire loan relationship rather than just move the line of credit. Borrowers will often object to cross-termination language particularly when the loan facilities involved have different maturities since revolving lines of credit typically are either demand or shorter term committed facilities than the related term loans. As a result, cross-termination language can become a heavily negotiated business point during the loan documentation phase, and we therefore recommend that this be addressed between the borrower and lender at the term sheet or commitment phase of a lending transaction in order to avoid disagreement and increased legal fees battling over this language.
We note that cross-termination is often effectively achieved even without express cross-termination language in the loan documents if a loan relationship consisting of multiple loan facilities has the proper cross-collateralization language and the typical negative covenants prohibiting a borrower from incurring additional indebtedness. Pragmatically, a borrower will not be able to refinance only one of its existing loans (i.e., a revolving line of credit facility) without refinancing the other term loans since (i) it would not be permitted to incur additional debt without the lender’s prior consent under the credit agreement, and (ii) the borrower would be unlikely to find a new lender willing to provide it with a new loan where such new lender would not be able to receive a first priority security interest in the assets of the borrower.
As described above in the owner-occupied loan example, the term “cross-guaranty” describes the situation where related entities are required to provide guaranties to a lender in which they guaranty the obligations of each other in loan transactions. While it is not always necessary to have cross-guaranties in order to achieve cross-collateralization (i.e., an entity can pledge assets to a lender without being fully liable for the underlying debt), it is essential that a related entity provide a guaranty if the lender intends to be able to look to that entity for full repayment of a borrower’s loan obligations. This often occurs when a lender is relying on consolidated financial statements for its underwriting of a loan transaction and wants all related entities to be “on the hook” for repayment of the debt. This can also bring up questions about when an entity should be a co-borrower as opposed to a guarantor but that will be a topic for another post.
Cross-default, cross-collateralization, cross-termination, cross-payout and cross-guaranty are technical terms which are critical to the proper documentation of a loan transaction, but which are sometimes used too casually in term sheets and loan approvals, without a full understanding by either the borrower or the lender of the differences between such terms. The precise use of these terms and the proper documentation of the intent of the lender in the use of these terms will lead to less confusion or potential frustration, resulting in lower legal fees for both lenders and borrowers and more efficient loan transactions.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.