May 28, 2017

Non-Monetary Default: A Potential Bankruptcy Time Bomb

Everyone knows that in the event payments are missed, there has been a default.  However, many business people overlook the fact that there can and often are other contract provisions that do not involve the payment of money which can trigger a default.  These are known as non-monetary defaults.

Bank loan agreements, leases, and other types of commercial contracts provide for events of default that entitle the lender, landlord, or the other party to the contract to declare a default in the event that one or more terms of the agreement are not met.

How non-monetary defaults occur

A recent example of a non-monetary default involving a lender is the case of a kitchen showroom.  In this case, its loan agreement with the bank provided that it was required to maintain a certain value of assets to liabilities.  The asset value fell below the required amount, and the bank called the loan.  The fact that the bank held a debt secured by the showroom building and the operating loan both totaling approximately $1,000,000 were current and had never been past due made no difference.  The business filed for bankruptcy after 26 years in business.

One of our clients with a lease ran in to problems with non-monetary default when it cut its hours of operations contrary to covenant in the lease.

We see commercial foreclosures take place when occupancy rates fell and all manner of loan covenant failures.

The long and short of the matter is that a party to a contract has a right to enforce the terms of the contract.  If the lender or landlord wants to enforce the terms that provide for non-monetary defaults, it can do so.  The result can be disaster.  A business person is well advised to review contracts for non-monetary default provisions in contracts and leases and to plan accordingly.

A consideration in Chapter 11

Finally, one contractual provision regarding non-monetary default is extremely important to an entity considering bankruptcy reorganization under Chapter 11.  If a contract says that that the filing of a bankruptcy is a default under a contract, the provision states that a bankruptcy filing alone is enough to trigger a default even though a default has not otherwise occurred.  These provisions are known as ipso facto clauses.

If this sounds to the reader like it is contrary to the goal of encouraging reorganization rather than liquidation, the United States Congress agreed.  It included a section in the Bankruptcy Code which provides that ipso facto clauses are unenforceable as a matter of law.

I always recommend that business owners consult with a qualified bankruptcy attorney well BEFORE they miss a milestone or loan covenant.