Definition
A cross-default clause is a term in a loan agreement that makes a borrower’s default on one loan an automatic default on all other loans they have with the same or other lenders. This provision is designed to protect lenders by putting them in a stronger position to recover owed funds if the borrower starts to struggle financially and can’t meet their loan obligations.
Examples
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Corporate Borrowing
- A corporation has loans from multiple creditors. If the company defaults on any one of these loans, the cross-default clause triggers defaults on all the other loans, potentially leading to a collective enforcement of rights by the creditors.
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Mortgage and Business Loan
- An entrepreneur with both a mortgage and a business loan from the same bank may find that a default on the business loan can result in a default on the mortgage as well, due to the cross-default clause.
Frequently Asked Questions (FAQs)
What triggers a cross-default clause?
A cross-default clause is triggered when the borrower defaults on one loan agreement, causing defaults on other loan agreements as stipulated by the terms.
Why do lenders include cross-default clauses in loan agreements?
Lenders include cross-default clauses to protect themselves by ensuring they can call in other loans if a borrower is deemed high-risk due to defaulting on any loan, thus preventing further financial risk.
Can a borrower negotiate to exclude a cross-default clause from a loan agreement?
Yes, in some cases, borrowers can negotiate to exclude or modify a cross-default clause, but lenders may be resistant due to the increased risk.
Are cross-default clauses more common in corporate or personal loans?
Cross-default clauses are more commonly found in corporate and large-scale lending agreements due to the higher complexity and risk involved.
What happens if a borrower triggers a cross-default clause?
If triggered, the borrower may have to repay all loans immediately, which can lead to severe liquidity issues or even bankruptcy if the borrower can’t meet these demands.
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Event of Default
- An occurrence or condition that allows a lender to demand immediate repayment of a loan.
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Accelerator Clause
- A provision in a contract that empowers the lender to demand full repayment before the scheduled due date under certain conditions, such as default.
Online References
Suggested Books for Further Studies
- “Credit Risk Management In and Out of the Financial Crisis: New Approaches to Value at Risk and Other Paradigms” by Anthony Saunders and Linda Allen
- “Financial Risk Management: Applications in Market, Credit, Asset and Liability Management, and Firmwide Risk” by Francisco Javier Gonzalez Garcia
Accounting Basics: “Cross-Default Clause” Fundamentals Quiz
### What is the primary purpose of a cross-default clause?
- [ ] To give borrowers more flexibility.
- [x] To protect lenders from financial risk.
- [ ] To waive penalties for late payments.
- [ ] To offer lower interest rates on loans.
> **Explanation:** The primary purpose of a cross-default clause is to protect lenders by ensuring that if a borrower defaults on one loan, it can trigger defaults on other loans.
### Which type of loan typically includes cross-default clauses?
- [ ] Personal loans only.
- [x] Corporate and large-scale loans.
- [ ] Student loans.
- [ ] Payday loans.
> **Explanation:** Cross-default clauses are commonly found in corporate and large-scale lending agreements due to the higher complexity and significant risk involved.
### Can a borrower negotiate to modify or exclude a cross-default clause in a loan agreement?
- [x] Yes, but it may be challenging.
- [ ] No, it is mandatory in all loan agreements.
- [ ] Only for personal loans.
- [ ] Yes, and it is usually easy to do.
> **Explanation:** Borrowers can negotiate to modify or exclude cross-default clauses, but lenders may be resistant due to the higher associated risk.
### What happens when a borrower triggers a cross-default clause?
- [ ] They get an interest rate reduction.
- [x] Immediate repayment of all loans may be demanded.
- [ ] Loans get extended.
- [ ] They receive a grace period.
> **Explanation:** If a cross-default clause is triggered, it may lead to the immediate repayment of all outstanding loans, causing significant financial pressure on the borrower.
### What events typically lead to the activation of a cross-default clause?
- [ ] Reaching a borrowing milestone.
- [ ] Closing a loan.
- [x] Defaulting on one loan.
- [ ] Getting a loan approval.
> **Explanation:** Defaulting on one loan typically leads to the activation of a cross-default clause, affecting other loans held by the same borrower.
### Why might a lender resist the removal of a cross-default clause from a loan agreement?
- [ ] It decreases the loan utility.
- [x] It increases the lender's risk.
- [ ] It complicates the paperwork.
- [ ] It lowers the loan’s interest rate.
> **Explanation:** Lenders resist removing cross-default clauses as it increases their risk of financial losses if the borrower defaults on any loan.
### What kind of borrower is most likely to have a cross-default clause in their loan agreements?
- [ ] One taking out a small personal loan.
- [x] One taking out multiple large-scale loans.
- [ ] One who has perfect credit.
- [ ] One with no borrowing history.
> **Explanation:** Borrowers taking out multiple large-scale loans are most likely to have cross-default clauses to protect lenders from significant financial risks.
### When is a cross-default clause particularly beneficial to a lender?
- [x] When a borrower has several loans with high risk.
- [ ] When the borrower has a high credit score.
- [ ] When the borrower is short on income.
- [ ] When loans are spread across multiple borrowers.
> **Explanation:** Cross-default clauses are particularly beneficial to lenders when a single borrower has multiple loans with high risk, as it allows for immediate action on all loans if one defaults.
### Cross-default clauses can lead to what severe consequence for borrowers?
- [ ] Improvement in credit score.
- [ ] Lower interest rates on new loans.
- [x] Bankruptcy or severe liquidity issues.
- [ ] Eligibility for more loans.
> **Explanation:** Triggering cross-default clauses can lead to bankruptcy or severe liquidity issues for borrowers due to the demand for immediate repayment of multiple loans.
### Which of the following terms is related to a cross-default clause and indicates an occurrence that allows for immediate loan repayment?
- [ ] Grace period.
- [x] Event of default.
- [ ] Equity line.
- [ ] Debt covenant.
> **Explanation:** An "event of default" is a related term that signifies an occurrence allowing lenders to demand immediate repayment, similar to a cross-default clause's activation.
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