Guidance for lenders and borrowers on events of default, reservation of rights and enforcement

Facts

Pursuant to a loan agreement (the Loan Agreement), Lombard (the Lender) provided Skyjets (the Borrower) with a loan (the Facility). As security for the Facility, the Lender acquired a first priority legal charge (the Legal Charge) over one of the Borrower’s aircraft (the Aircraft). The Borrower fell behind on its payments under the Loan Agreement and the Lender in its correspondence with the Borrower expressly provided the Borrower with additional time to regularise payments and also continued to periodically accept late payments. Subsequently, and as a result of the payment defaults, the Lender served on the Borrower a notice (the Notice).

The Notice provided that the Facility be terminated and stated the Lender’s intention to exercise its power of sale over the Aircraft pursuant to the Legal Charge. The Lender argued that the event of default which formed the basis of its authority for issuing the Notice was the Borrower’s failure to make timely and complete payments under the Loan Agreement. The Notice was narrowly drawn and referred to only one event of default – the payment defaults.

The Lender later sold the Aircraft and brought a claim against the Borrower for the outstanding balance.

The Borrower rejected the Lender’s claim and filed a counterclaim for damages arguing that the Lender had acquiesced to – and therefore waived – the event of default cited in the Notice (the payment defaults) by allowing the Borrower additional time to make payments and accepting the late payments. It followed for the Borrower that the termination of the Facility and the sale of the Aircraft were unlawful.

Key points

Events of default:

(1) Must an event of default be continuing at the date of the termination?

The court considered whether or not it was a pre-condition under the terms of the Loan Agreement that in order to issue the Notice, the Borrower must have been in default at the time of the Notice.

The Loan Agreement provided that an event of default would occur if the Borrower defaulted “in the payment of principal or interest”, and that “at any time after the occurrence of an event of default the Lender may by notice to the Borrower … cancel the facility [and require immediate repayment]”.

As a matter of construction, the court determined that the terms of the Loan Agreement did not require that the Borrower be in default at the time of the Notice.

Although the court acknowledged that such an interpretation risked the Lender being able to sit on a right of termination for an indefinite period of time before exercising it, the court concluded that the potential harshness of such an interpretation was tempered by the doctrine of waiver (see below).

(2) Waiving events of default

The “no waiver” clause in the Loan Agreement provided that “no failure and no delay” on the part of the Lender in exercising its termination rights “shall operate as a waiver thereof”, and the express reservation of rights statements made by the Lender in some of its correspondence with the Borrower made clear that the Lender fully reserved any and all of its rights arising from the arrears under the Loan Agreement.

The court found that neither the “no waiver” clause nor the express reservation of rights statements were sufficient to prevent the Lender’s conduct from being construed as a waiver of the payment event of default.

As the Lender afforded the Borrower additional time to regularise its position in respect of the repayments and also continued to periodically accept the Borrower’s late payments, taken together, the court characterised this as positive action. This was significant for two reasons: first, it put the Lender’s conduct beyond the scope of the “no waiver” clause, which preserved the Lender’s termination rights only where the Lender failed to act or was delayed in acting, and second, it produced an objective effect which overrode the Lender’s reservation of rights statements.

(3) Could the Lender rely on a further event of default, even if that event of default was not cited in the notice?

The court noted that under the Loan Agreement, the only conditions which needed to be satisfied for the Notice to be effective were:

• (1) that the Notice be sent after the occurrence of an event of default; and
• (2) that the Notice cancel the Facility and require the Borrower to immediately repay the loan together with accrued interest.

The court held that there was no requirement – either as a matter of construction under the Loan Agreement or that could be otherwise implied – for the Notice to refer specifically to a valid event of default. On that basis, although the Notice referred to an event of default which had been waived (i.e., the late and incomplete payments), it remained effective because other events of default had occurred (such as a material adverse change in the Borrower’s business, assets, operation or prospects) which could not be taken to be waived by the Lender’s conduct.

(4) Is there a duty to act in good faith when exercising termination rights?

The court also held that the Lender’s right of termination did not attract the implied common law duty to act rationally and in good faith when exercising contractual rights (the Braganza Duty). Referring to the Lender’s termination right as an “absolute contractual right”, the court said that the Lender had an unfettered discretion to exercise its termination rights for “its own purposes” and “as it sees fit”.

Comment

Whilst the findings in this case are specific to the language of the Loan Agreement and the actions taken by the Lender, it is clear that borrowers and lenders should take care over the specific language used when drafting and negotiating enforcement provisions.

The judgment in Lombard v Skyjets is a stark reminder that “no waiver” clauses and reservation of rights statements are not definitive and are subject to a lender’s conduct, and whilst they may protect a lender from an omission to act, they are unlikely to protect a lender from its own positive, affirmative actions; neither apply within a vacuum and both will be interpreted with close reference to the context of the wider transactional relationship. It follows that lenders should be conscious of the risk of accidentally waiving their termination rights by their conduct (by, for example (and as was the case in Lombard), continuing to accept payments after exercising their right of termination, or offering borrowers additional time or opportunities to clear any arrears) and should also be careful not to be over reliant on “no waiver” clauses or reservation of rights statements.

When drafting loan agreements, lenders should seek to include enforcement provisions which allow enforcement at any time after the occurrence of an event of default – and not only when an event of default is continuing. If, however, the drafting provides that events of default can only be enforced if they are continuing (i.e., have not been remedied or waived), before taking enforcement action a lender should satisfy itself that the event of default which it seeks to rely on is continuing (and has not been waived by it in writing or by its conduct).

For borrowers, Lombard illustrates the importance of seeking enforcement provisions which only allow events of default to be enforced if they are continuing. This will prevent historic events of default from being used as a basis for enforcement.

Additionally, borrowers should also try and identify all of the events of default – potential and actual – which have occurred over the course of the transactional relationship and seek a written waiver covering each of them. Ideally, such written waivers should cover all of the events of default which might have been triggered – even those which may have been waived by the lender by its conduct – as a waiver through conduct is less objective and certain than a waiver in writing. This will allow borrowers to further protect themselves against lingering events of default which have not been waived being used as a basis for enforcement.

If you are concerned about a reservation of rights letter or any other issues raised in this note, please get in touch with one of the experts in our Banking & Finance team.