Default interest provisions are often included in subscription credit facilities, and there are various ways parties can handle default interest in the loan documentation. In this Legal Update, we share the different types of default interest provisions and walk through practical considerations and best practices regarding default interest.
What Is “Default Interest”?
Default interest refers to any increase in interest payable by the borrower due to a breach under loan documentation. Default interest provisions can vary significantly depending on the relationship between the lender and borrower, the number of lenders, and the jurisdiction of the parties.
The applications of default interest vary with the level of risk a borrower presents and the lender’s motivation. On the one end of the spectrum, default interest is a transactional remedy used as an incentive for the lender to make a loan; on the other end, when the parties have a long-standing relationship, default interest is about relationship management.
Default interest can be used as a reward or punishment depending on the relationship between the parties. “Default interest” may be used for various purposes, such as:
- Deterring late payments
- Promoting compliance with loan documentation
- Compensating a lender or lenders for the increased risks associated with lending to a borrower that has defaulted on its obligations
- Accounting for the opportunity cost to a lender for loaning money to a defaulting borrower
When default interest is used as a “reward,” it often won’t be applied automatically in the event of a default; instead, the application of default interest will require an affirmative action by the lender or group of lenders. As a punishment, however, default interest will be incurred automatically in the event of a borrower’s default without action by the lender or lenders.
Types of Default Interest Provisions
The most significant distinction is whether the interest bump applies to the total loan amount or only the portion of the loan impacted by the borrower’s breach.
- Overdue rate: When a subscription credit facility includes an overdue rate, the interest increase is applied only to those amounts not paid when due. Overdue rate is a high-quality credit concept used for borrowers with a strong balance sheet and stable performance measurables. An overdue rate often is documented along with a requirement that the default interest be triggered by an affirmative action by the lender (or lenders) rather than automatically upon default. For instance, if the borrower is a couple of days late in making a payment due under the loan, the lenders would need to vote to trigger the overdue rate.
- Default rate: With the default rate approach, the interest rate increase applies to the total amount of the loan. Default rate interest is intended to compensate the lender or lenders for the increased risk they’ve assumed due to the borrower’s breach, whether a late or missed payment or an unattained performance measurable.
When Default Interest Provisions Are Triggered
Default interest triggers run the spectrum and include:
- Late payment of amounts due
- A breach of specific covenants in the loan documentation (such as the failure to comply with financial performance covenants)
- Any breach under the loan documentation
High-grade credit facilities are likely to apply default interest only in the event of a missed payment. Riskier facilities, new borrowers, or one-off lending relationships will likely have additional default interest triggers.
Commercial Considerations and Best Practices When Negotiating Default Interest Provisions
Often, a lender or a borrower will come to the table with a form document, leaving little room for negotiation. When the loan documents are negotiated, however, keep in mind the following commercial considerations and best practices:
- Consider the lending relationship and the number of lenders. In bilateral loans, especially when the lender has a long-standing relationship with the borrower, there may be a disconnect between what the parties intend and what is documented in the financing agreements. For instance, the parties may agree that only missed payments will trigger default interest, but the loan documentation may say something different. Therefore, it is essential to review the documents carefully to ensure that they accurately reflect the parties’ intentions, especially when form documents are used.
In syndicated loans, the lenders might not want the lender’s agent to have control over triggering questions, so it’s more likely for the loan agreements to require a majority vote by the lenders for the default interest to be incurred rather than have an automatic trigger upon default.
- Be mindful of where you place default interest provisions in the loan documentation and how the provisions are crafted. Some courts have held that default interest isn’t enforceable against the entire balance of the loan – even when this was the lender’s intent – because the loan documentation wasn’t drafted clearly.
- Take care not to apply default interest that could be considered a penalty. Courts have applied various factors when determining whether a particular default interest rate is acceptable. However, a consistent theme has been to invalidate default interest provisions when the default interest rate is arbitrary or out of proportion to the harm caused by the borrower’s default. The higher the rate increase in a default interest provision, the more careful you need to be about staying within the limits of what is acceptable in your jurisdiction. Also, in California, courts have held that default interest applied to an entire loan balance, as opposed to merely amounts past due, is a penalty and violates public policy.
Default interest provisions are often included in the loan documentation for subscription credit facilities, but parties may not give these provisions the attention they deserve. There are various ways parties can handle default interest in the loan documentation, and it’s crucial to ensure that the loan documentation accurately reflects the parties’ intentions.
Additional Information:Default Remedies under Subscription Credit Facilities: Guide to the Foreclosure Process