Cross-Collateralization: 6 Reviews Before One Default Affects Other Financing

Do you have a term loan? A business line of credit? A personal loan at the same bank? Each new credit arrangement contains some risks. What you may not know are the risks associated with cross collateralization and cross default of your borrowings. Not surprisingly, few borrowers really understand this. Even if you do, how many times do you have your attorney read each and every term of all of the financial agreements you sign?

Cross default and cross collateralization of your loan agreements can allow one bad loan default to bring down all your loans. A cross-default clause says that if you default on one credit arrangement, all the other cross-defaulted loans are in default too. A cross-collateralization clause means that lenders can pursue their collateral for other loans that are not yet in default - even if the collateral was pledged originally to secure a different loan.

Each type of clause is different and each agreement can be crafted in different ways, making it difficult to know all the consequences of what you are signing. If you have a term loan, a business credit line and some credit cards all at the same bank, you want to read the provisions of these three agreements to make sure one bad apple does not spoil the whole barrel.

First, the cross-default clause: You will probably want to read the whole agreement and find the part called ”Events of Default.” Does it refer to just one loan or to every loan you have with that lender? Does it refer only to term loans or does it include credit card debt and others? Lenders often use terms like ”any other indebtedness”, but the meaning of the words often fail to get defined. If the definition of the terms “any other indebtedness” is not defined, a court will probably still give it an expansive reading and assume it refers to everything you owe that creditor.

Second, the collateral documents: The collateral agreement determines what loan (and its charges) is covered by each part of your pledged collateral. Cross-collateralization only happens if each security agreement identifies the debts it secures. A term sheet stating that “the loans are cross-collateralized” will have little effect. Look through each agreement and see if these provisions are defined. Look for things like ”Obligations”. Do the clauses also reference ”any future indebtedness”? Under the Uniform Commercial Code (UCC) a security agreement can reach assets you buy later and it can include future advances, even ones that the lender never promised.

Third, the lender’s own list: If an agreement is fuzzy about some of these terms, ask the lender to list what it considers to be the collateral for each obligation. If you ask the lender to define its security interests, it must respond within 14 days. Assuming you get this list, this may tell you if the collateral that was pledged for one debt has been placed on top of all your debts. The lender must answer one such request per six months for free; after that it can charge up to $25 per extra request.

Fourth, related companies: If you and your partners own other companies that have loans with the same lender, it might be wise to bring those contracts to your attorney also. It is possible that if you are the owner or guarantor of any other companies, that those business interests will also suffer cross-collateralization and cross-defaulting. If your companies each use each other’s assets to collateralize separate obligations, failure in one company can trigger cross-default in the other. Cross-default clauses are required for each set of loans to two separate companies. Lenders often agree to new loans without finding the old loan contracts and amending them. With a pledge, the lender can only go after the pledged assets for repayment. With a guaranty, the lender can demand repayment from the guarantor directly. An SBA loan generally puts this obligation on all owners of at least 20% of a business.

Fifth, refinancing: Many of these agreements limit a borrower’s right to refinance without the lender’s consent. Look for the part of the agreements called ”Negative Covenants”. If your term loans have a cross-termination clause, you may be in trouble. This means that your banker could tie the fates of the loans together. If a bank closes the credit line, the term loans may also be closed. You may have to refinance or pay off everything. Moving only a credit line to a new lender rarely works. The old lender won’t leave an “orphaned” term loan on its books. New lenders will often want to be in a first-priority lien position.

Repossess Property and Sell It

Sixth, the endgame: What can a lender do to you if you default on a single agreement that triggers cross-default? The UCC allows lenders to repossess property and sell it to offset a debt. But they can’t breach the peace. And if they sell it, they generally send notice at least 10 days ahead of time. If a sale brings less than the debt, you owe the rest. You can redeem collateral before the sale by paying every obligation it secures, plus costs.

If you can gather all your existing documents it may be easier to see the whole picture. Better yet, take them to your attorney and ask for advice about which obligations are covered and who might owe on them. Getting all these provisions clarified up front can help avoid a death spiral.