We are sure most, if not all of our readers are familiar with concept of cross-default and its use in loan and bond documentation; and that you have come to accept and expect it to be “there” in any documentation governing counterparty or investment exposure.
But why does its inclusion matter? Why should an underwriter or portfolio manager care?
Paradoxically, the concept received a brief moment of fame in the “stand-off before last” over the raising of the US Federal debt ceiling, when there was legitimate concern that the US Treasury might actually default on its obligations in the sense of failing to pay interest or return principal when due. Because most people had never expected that the US might actually default, we suspect that they had probably not paid much attention to the “fine print” of a US Federal bond obligation. If they had, they would have realized (and probably been surprised) that US Federal debt obligations do not actually contain any cross-default language. This means that, had the US government actually defaulted, holders of obligations maturing far into the future would have had no ability to enforce an obligation to pay before maturity, even if they received no interest payments and the US Federal government’s “promise to pay” would have been found to be truly hollow.
Fortunately, the consequences of such an event were not tested; and the recent congressional deal appears to have deferred the problem for another day. As an aside, in the Great White North, the Federal Government was apparently able to slip a clause into an omnibus budget bill that took the right to control federal debt limits out of the hands of Parliament and into that of the Federal Cabinet. We are sure that President Obama must have sighed “If only…!”
We at Awbury have been around long enough to be able to remember the days when “AAA” corporates were a little more prevalent than they are now and when a number of the supposedly “undoubted” ones were themselves able to borrow without having to accept cross-default language. Fortunately, “undoubted” being a somewhat suspect concept and “risk free” a joke, those days are gone.
Cross-default is important, because, properly drafted, it enables a creditor to take action and have some say in the event of a default or failure to pay- subject, of course, to the constraints imposed by the governing bankruptcy regime.
However, one should beware of Cross-Default’s bastard relative, Cross-Acceleration, which some bond salespeople, in these days of “covenant-lite” may try to argue differs little from its legitimate sibling. Not so! If those in a position to control an obligor’s destiny do not accelerate (often a banking syndicate) choose not to call a default and accelerate payment (because they are harvesting the debtor for fees and other concessions), there is little the hapless debt holder can do, becoming potentially at the mercy of those whose interests are definitely selfish and partisan.
Moral of this post: Read and understand the “fine print”, so that you can properly evaluate the risk/reward ratio.
-The Awbury Team