Simone Lawson
Default is the failure to make required interest or principal repayments on debt. Individuals, businesses, and countries can default on their debt obligations. Default risk is an important consideration for creditors, who will often include a contract provision covering events of default to protect themselves. An event of default is a pre-specified condition that, if met, allows the lender or creditor to demand immediate and full repayment of a debt or obligation. While non-payment is the most obvious kind of default, there are several other events that can constitute a default.
| Characteristics | Values |
|---|---|
| Non-payment | Failure to make required interest or principal repayments on debt |
| Breach of a financial covenant | Failure to meet and maintain an agreed financial position throughout the loan period |
| Cross default | Default under any other agreement with a third party |
| Misrepresentation | Where a statement made by a company to the lender later turns out to be untrue |
| Breach of some or all specified undertakings | May constitute an event of default |
| Change in the nature of the business | Without the bank's consent |
| Insolvency | The borrower's inability to pay debts as they fall due |
| Cessation or threatening to cease business | Enforcement of other security and steps taken by way of winding up or receivership |
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What You'll Learn
Non-payment of interest or capital
For individuals, non-payment of interest or capital on a mortgage, student loan, or personal loan can affect their credit rating, their ability to secure future loans, and could even result in the seizure of property or wages. For example, about one-third of all federal student loan borrowers in the US have defaulted on their loans at some point, leading to potential withholdings of tax refunds and garnishments of up to 15% of their take-home pay.
Corporations can default by failing to meet coupon payments on bonds. However, it's important to note that a corporation is not considered to be in default if it fails to pay interest on an income bond, as these bonds only require interest payments when the issuer has sufficient earnings. In contrast, other types of bonds, such as mortgage bonds, debentures, and convertible bonds, require interest payments regardless of the company's earnings.
Lenders may be reluctant to immediately exercise their rights upon the occurrence of a default event, as they may prefer to negotiate with the borrower to remediate the position. This could involve introducing more restrictive terms rather than demanding immediate full repayment.
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Misrepresentation
A "default" generally refers to the failure to make required interest or principal repayments on a debt. However, the term "default" can also be used in the context of "events of default," which are predefined circumstances that allow lenders to demand full repayment of an outstanding balance. These events are typically outlined in loan and lease agreements and can include non-payment, breach of a financial covenant, or cross-default, where the borrower defaults with a third party.
In the context of "events of default," misrepresentation can be considered an event of default by a lender, especially in credit agreements. Misrepresentation refers to a false statement of material fact made by one party that influences the other party's decision to agree to a contract. For example, a seller advertising a used car as having only 50,000 miles on the odometer when it actually has 150,000 miles. This false statement of fact can void the contract and allow the other party to seek damages.
There are three types of misrepresentations: innocent, negligent, and fraudulent. Innocent misrepresentation occurs when a party makes a false statement without knowing it is untrue, such as in the case of a seller who mistakenly informs a buyer that there is planning permission for a development when it had been denied. Negligent misrepresentation is a violation of the concept of "reasonable care," where a party does not attempt to verify the truth of a statement before executing a contract. Fraudulent misrepresentation is when a party makes a false statement knowingly or recklessly to induce the other party to enter a contract.
In some situations, misrepresentation can occur by omission, such as when a fiduciary fails to disclose material facts or correct statements of fact that are later found to be untrue. Statements of opinion or intention typically do not constitute misrepresentation, as it would be unreasonable to treat personal opinions as facts. However, exceptions can arise when opinions are treated as facts, such as when an opinion is expressed but not actually held by the representer, or when it is implied that the representer has facts to base their opinion on.
The law of misrepresentation is a combination of contract and tort law, with sources in common law, equity, and statute. In England and Wales, the Misrepresentation Act 1967 amended the common law, and this has been adopted by the United States and other former British colonies. An action in misrepresentation can only be brought by the misled party, and it is essential that the untruth originates from the defendant. The misled party must show that they relied on the misstatement and were induced into the contract because of it.
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Breach of contract
A breach of contract occurs when one party breaks the terms of an agreement between two or more parties. This includes when an obligation that is stated in the contract is not completed on time, or when it is not fulfilled at all. A contract is binding and will hold weight if taken to court. If it can be proven that a contract was breached, the remedy would generally be to give the victim what they were initially promised.
There are different types of contract breaches, including a minor or material breach, and an actual or anticipatory breach. A minor breach of contract occurs when the non-breaching entity is merely entitled to the actual damages resulting from a breach. A material breach is the failure to fulfil an important part of the contract. The effect of a material breach will be serious enough that it has a substantial detrimental effect on the benefit that the innocent party should have received. An actual breach occurs when one party breaks the terms of a contract agreement, and an anticipatory breach happens when a party communicates their intention not to fulfil their contractual obligations.
There are several defences to a breach of contract. For example, if the contract is supposed to be in writing but is not, a court may find that the contract is not enforceable. If one party made a mistake regarding a basic assumption on which the contract is based, they may be entitled to rescind the contract. If the contract does not include specific provisions for ending it when terms are breached, caution is needed. The contract is not automatically terminated in the case of a breach, so until you are certain that it has ended, you must proceed in accordance with its terms.
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Insolvency
There are two types of insolvency: balance sheet insolvency (or accounting insolvency) and cash-flow insolvency. Balance sheet insolvency occurs when a company's liabilities exceed its assets. In other words, the company does not have enough assets to pay all of its debts. Cash-flow insolvency, on the other hand, occurs when a company has enough assets to pay what is owed but does not have the appropriate form of payment. For example, a company may have valuable assets but not enough liquid assets to pay a debt when it falls due.
When a company becomes insolvent, formal procedures are initiated, which usually involve legal action against the insolvent business. This often leads to the liquidation of assets to pay back creditors in a process known as Chapter 7 bankruptcy. However, insolvency does not always lead to bankruptcy. Businesses have several options to deal with insolvency, such as negotiating repayment options with creditors or restructuring their debt to continue operating and become profitable enough to repay debts.
Individuals can also become insolvent if they can't pay their debts, such as credit card bills, student loans, medical bills, or mortgages. While insolvency can lead to bankruptcy for individuals, it is not always the case. Individuals can take steps to improve their financial situation, such as improving income streams, sticking to a realistic budget, and not spending beyond their means.
It is important to distinguish between insolvency and default. Insolvency refers to the inability to pay debts, while default refers to the situation where debtors have passed the payment deadline on a debt that was due. Default can be of two types: debt services default, where the borrower has not made a scheduled payment of interest or principal, and technical default, where an affirmative or negative covenant is violated.
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Change in the nature of the business
A change in the nature of a business can occur due to various factors, such as shifts in the market, technological advancements, or strategic pivots by the company itself. Here are some detailed paragraphs explaining this concept:
Paragraph 1:
Market Dynamics and Consumer Trends: The market landscape is constantly evolving, driven by shifting consumer preferences, demographic changes, and economic trends. Businesses need to adapt to these dynamic market forces to remain competitive. For instance, a company may need to diversify its product offerings or tap into new markets to meet changing consumer demands. This strategic shift in operations can be deemed a change in the nature of the business as it involves exploring new avenues and potentially transforming its core focus.
Paragraph 2:
Technological Advancements: The rapid pace of technological innovation can significantly impact the nature of a business. For example, the advent of digital transformation has revolutionized numerous industries. Companies that fail to embrace these technological advancements may lag and be forced to alter their fundamental approaches to staying afloat. This could involve adopting new production methods, automating processes, or transitioning to digital platforms to enhance efficiency and better serve modern consumers.
Paragraph 3:
Strategic Pivots: Sometimes, businesses intentionally initiate strategic pivots to stay relevant and seize new opportunities. This could involve expanding into new industry sectors, acquiring or merging with complementary businesses, or repositioning their brand. Strategic pivots often lead to substantial transformation in the nature of a business as they venture into new territories, target diverse customer segments, or fundamentally shift their operational model.
Paragraph 4:
Regulatory and Compliance Landscape: Changes in government policies, industry regulations, and compliance standards can also drive alterations in the nature of a business. For example, new environmental regulations might compel a manufacturing company to invest in sustainable practices and eco-friendly production methods. Similarly, data privacy laws might require companies to restructure their data handling processes and implement stringent security measures, thereby influencing their day-to-day operations and overall strategic direction.
Paragraph 5:
Economic Factors and Market Disruptions: External economic factors, such as recessions, economic booms, or disruptive innovations, can also contribute to a change in the nature of a business. During challenging economic periods, companies may need to downsize, restructure, or explore cost-cutting measures to ensure survival. Conversely, during economic booms, businesses might expand, diversify, or focus on innovation to capitalize on favorable market conditions. Market disruptions caused by innovative startups or groundbreaking technologies can also force established businesses to adapt and evolve to maintain their market share.
In conclusion, a change in the nature of a business is multifaceted and can be driven by internal strategic decisions, external market forces, technological innovations, regulatory shifts, or economic factors. Businesses need to be agile and responsive to these influences to ensure sustainability and success in a dynamic marketplace.
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Frequently asked questions
An event of default is a predefined circumstance that allows a lender to demand full repayment of an outstanding balance before it is due.
Non-payment of any amount of the loan (including interest), breach of a financial covenant, and cross-default (when the borrower defaults under any other agreement with a third party).
The lender can cancel any outstanding commitments, accelerate the loan by demanding immediate repayment of all amounts outstanding, or enforce any security granted by the borrower or guarantors.
