Most financing agreements define “Events of Default” as being triggered not only by serious defaults, such as a borrower’s failure to repay its debt, but also by relatively minor or technical “secondary” defaults not involving debt repayment. Typical examples of the latter include a borrower’s delay in paying property taxes or in delivering audited financial statements, a decline in the value of current assets, or the failure to insure a mortgaged property.

The triggering of an Event of Default would permit the lender to terminate any outstanding financing commitments, to accelerate the maturity dates of the outstanding indebtedness, and to exercise foreclosure remedies with respect to any collateral. The exercise of one or more of these remedies could well lead to the borrower’s bankruptcy.

Courts are split on whether a secondary default alone should justify the enforcement of these remedies. In the seminal case of Graf v. Hope Bldg. Corp., the New York Court of Appeals enforced foreclosure remedies notwithstanding a minor and unintended breach. Chief Judge Cardozo, joined by two other members of the court, dissented. Since then, the jurisprudence on enforcing remedies for secondary defaults remains unsettled.

In a new article, I seek to derive a normative but pragmatic framework for identifying secondary defaults and analyzing secondary-default remedies. Identification by itself can be critical. In public bond issues, for example, an indenture trustee sometimes has to make decisions about pursuing remedies and can be second-guessed and sued if investors later disagree. Furthermore, the determination that a secondary default triggers an Event of Default could significantly increase the indenture trustee’s duties to that of a reasonably prudent person in like circumstances.

The article starts by reviewing the history of secondary default provisions. Covenants imposing secondary obligations originally were included in financing agreements merely to provide an early indication of whether loan repayment might ultimately be at risk. Their breach did not trigger Events of Default. Rather, a breach typically permitted lenders to accrue interest at a stepped-up “default interest” rate. The payment of default interest was intended to compensate the lender for the increased risk.

Eventually, though, the redress for secondary defaults transformed from default interest to Event-of-Default remedies. The impetus for this transformation resembled a race to the bottom; as unsecured financing became more common, lenders wanted to protect their options in case a borrower defaulted. Including secondary defaults as Events of Default could advantage a lender by maximizing its potential remedies and negotiating power.

Many courts have enforced severe remedies for secondary defaults, reasoning that lenders assess risk ex ante and that judicially altering the risk allocation ex post could breed costly litigation. The minority of courts have refused to enforce those remedies, arguing that even sophisticated borrowers may not have consciously bargained to include secondary defaults as Events of Default or may have regarded that inclusion as boilerplate without fully recognizing its significance.

The article also engages in a more normative analysis. Including secondary-default provisions in financing agreements has a legitimate business purpose: to provide an early indication of whether loan repayment might ultimately be at risk. But should a breach of those provisions justify enforcement of severe remedies that threaten a firm’s existence and potentially affect the public?

To answer this, the article examines enforcement from the standpoint of the criteria that generally govern contract enforceability: good faith, reasonableness, and economic efficiency. The article also seeks to design more reasonable secondary-default remedies, reviewing (among other things) the development of such remedies in the high-yield debt market.

The article concludes with two proposals. Even for loan agreements where the following condition is not explicit, courts should use the implied contractual obligation of good faith to condition the enforcement of severe secondary-default remedies on notice and reasonable grace periods. For new loan agreements, parties should consider substituting alternative remedies for secondary defaults. One such alternative—charging a higher interest rate until the default is cured—would compensate lenders for any increased risk while motivating borrowers to try to avoid creating, and if created, to try to quickly cure, any such default. Another possible alternative—restricting dividends during that same period—would further encourage borrowers to avoid and, if created, to promptly cure the default.

Some might ask why these proposals are needed. After all, setting a severe remedy for a secondary default appears to be a penalty default rule, which should encourage compromise because neither the borrower nor its creditors should want the default to cause the borrower’s bankruptcy and possible liquidation. In practice, though, there are at least two reasons (illustrated by real life examples) why that penalty default rule may not lead to a fair compromise.

The first reason is that the consequences of enforcing severe remedies for a secondary default—bankruptcy and possible liquidation—would likely be much worse for the borrower than for its creditors, which can (and normally do) diversify their lending. Therefore, even if a borrower liquidates, the reduced repayments to its creditors should not threaten their ongoing viability. The creditors, in other words, may well have extortionate, or at least much greater, negotiating power.

Another reason is that lenders may actually want to use the secondary default as a justification to terminate a financing commitment. This could occur, for example, if the borrower’s bankruptcy (caused by terminating financing) would be less onerous to the lender than putting significant additional money at risk.

This post comes to us from Steven L. Schwarcz, the Stanley A. Star Distinguished Professor of Law & Business at Duke University School of Law. It is based on his new article, “Secondary-Default Remedies: Should Harshness Limit Enforcement?” forthcoming in The Journal of Corporation Law and available here.