In our lives we sometimes come across concepts that sound great in theory, but we do not really understand them. We would like to incorporate them into our world, but we are reluctant to do so because they kind of scare us.
If we do end up utilizing them, we either half-adopt the idea or lack sufficient comprehension to fully benefit from the new practice in our routine. In the commercial non-conventional lending space, two of the most misunderstood concepts are the “crosses”: cross-default and cross-collateralization loan provisions. Lending professionals often interchange the terms, intertwine their respective impact, and in some instances use them to describe something completely different altogether. Fortunately, the “crosses” are much easier to understand than NFTs and cryptocurrency.
What Exactly Are Cross-Default and Cross-Collateral Provisions?
A cross-default provision makes an event of default under one loan by a lender, or its affiliate (“Lender Parties”), to a borrower, guarantor, or their respective affiliates (“Borrower Parties”), an event of default under another loan by a Lender Party to a Borrower Party.
A cross-collateral provision makes collateral securing one loan by a Lender Party to a Borrower Party, security for another loan by a Lender Party to a Borrower Party. The term Cross-Collateral does not mean the addition of real property collateral to secure a loan to acquire another real property. This is just taking additional security as collateral for a loan.
To further illustrate each provision, consider the following loan scenarios:
- Loan A – Lending LLC extends a loan to Acme Inc. that will be secured by Real Property A.
- Loan B – Lender Inc., which is a subsidiary of Lending LLC, extends a loan to Acme Inc. that will be secured by Real Property B.
- Loan C – Lending LLC extends a loan to Developer LP, which is a subsidiary of Acme Inc., that will be secured by Real Property C.
Scenario 1
Loan A is cross-defaulted with Loan B. If Acme Inc. fails to make the monthly debt service payment required under Loan B, such Loan B default will also be an event of default under Loan A.
Scenario 2
If all three loans are cross-collateralized, in addition to being secured by the real property associated with each loan, each loan would be secured by all three real properties. Therefore, for example, Real Property A will not only secure Loan A, but it will also secure Loan B and Loan C.
Scenario 3
If Loan A contains cross-default provisions, but Loan C does not, a default under Loan C will constitute a default under Loan A. However, a default under Loan A will not be an event of default under Loan C.
When Would You Use These Provisions?
The most common instances where a lender includes cross-default and cross-collateralization provisions are where the business model of a borrower, and its affiliates, revolves around acquiring, rehabilitating and/or developing multiple real properties over time. By cross-defaulting the loans, the lender is protected from a borrower, and its affiliates, favoring payment of its obligations under one loan over payment of another. If the borrower attempts to selectively service one loan over the other, it will cause a default under all subject loans.
In addition to guarding a lender against a cherry-picking borrower, cross-collateralization also benefits a lender, because it allows a lender to relax loan-to-value requirements where a contemplated loan may not fit within a lender’s parameters because that lender can consider the aggregate value of all properties securing loans extended to Borrower Parties, rather than just one property in isolation.
Many lenders will include cross-default and cross-collateralization provisions in their loan documents for every transaction. There is no negative impact stemming from including them in instances where the parties to the loan and their respective affiliates will never enter another transaction. Lender Parties and Borrower Parties anticipate multiple loan transactions between them.
Although there is no harm in including these clauses in one-off transactions, there are occasions where it is not prudent to utilize them where it is likely that the crossed loans will be held by unrelated lenders in the future, including loan sales to multiple buyers and placement of some or all the loans in a collateralized loan obligation (“CLO”) or multiple CLOs.
Tips for Cross-Default and Cross-Collateralization Provisions
- The provisions should be drafted broadly enough to encompass all loans by lender, and its affiliates, to borrower, guarantor, and their respective affiliates. Crafting the adequate language is important, especially considering many borrowers will want to delete the relevant sections or at the very least, limit the scope.
- In addition to keeping the cross sections broad, a lender should identify specific lender affiliates, borrower and guarantor affiliates, loans, and properties where related loans have been or will be made.
Many lenders misunderstand the cross-default and cross-collateralization clauses in their loan documents, and as a result, when the time comes to enforce them, they find that the provisions do not cover the loans and parties that they believed. When effectively drafted, and included in loan transactions, the cross provisions provide a powerful tool to a lender that is looking to maximize its options in both underwriting decisions, as well as enforcement of its rights under its loan documents.
