Lawyers Discuss the Legal Implications of Defaulting on a Business Loan

Defaulting on a business loan can have serious legal and financial consequences. As business lawyers, we often advise clients on the legal risks of falling behind on loan payments. In this article, we’ll provide an overview of common legal implications of business loan defaults from a lawyer’s perspective.

Common Causes of Business Loan Defaults

There are a few common reasons why a business may default on a loan payment:

• Insufficient cash flow – If a business struggles to generate enough revenue to cover its operating costs and loan payments, it can quickly fall behind. Economic downturns that reduce customer demand are a common trigger.
• Poor financial management – Failing to budget properly for loan payments or mismanaging finances can result in missed payments.
• Overexpansion – When businesses grow too fast, they may overextend themselves financially and end up defaulting if growth projections fail to materialize.

No matter what causes it, a loan default is usually a sign of financial distress that requires legal advice.

Typical Default Provisions in Business Loan Contracts

Most commercial loan agreements contain default provisions that outline the lender’s remedies in case of missed payments. Common provisions include:

• Late fees – A set fee, often 5-10% of the missed payment, charged for overdue payments.
• Default interest rates – Increased interest rates once the loan enters default, often an additional 5-10%.
• Acceleration clause – Allows the lender to demand full immediate loan repayment upon default rather than collecting periodic payments.
• Security interests – Collateral like real estate, equipment, or accounts receivable that the lender can seize and sell off to recover unpaid balances.

Understanding these default provisions upfront allows businesses to anticipate lenders’ legal rights if the company later struggles to make payments.

Strategic Default vs Accidental Default

When advising clients who have fallen behind on payments, we typically categorize cases as either strategic defaults or accidental defaults.

Strategic defaults occur when borrowers decide the costs of continuing payment outweigh the benefits. This may happen if:

• The business failed and has no assets left to protect by paying the loan.
• Other obligations like payroll, suppliers, or taxes are prioritized over the loan.
• The borrower calculates that allowing foreclosure or repossession now costs less long-term than continuing payments.

Accidental defaults stem from cash flow mismanagement, economic problems, or unrealistic growth assumptions. The business wants to pay but lacks the financial capacity to maintain payments.

The optimal legal strategies differ substantially between deliberate and accidental default situations.

Legal Implications and Possible Lender Reactions

Upon default, lenders have several legal options to recover amounts owed or enforce loan covenants:

Demand Full Repayment

Lenders can legally demand the full outstanding loan balance be repaid immediately when borrowers default. This typically leaves struggling businesses without enough capital to pay back the balance, forcing them into bankruptcy.

Seize Collateral Assets

If the loan is secured by real estate, equipment, accounts receivable or other assets, lenders can take possession of these items and sell them to cover unpaid balances. The remaining loan balance may still need to be repaid.

Sue for Breach of Contract

Lenders can file a lawsuit against the borrowers alleging breach of the loan agreement. The goal is usually to obtain a court judgment ordering repayment of the balance owed. Before pursuing this option, lenders typically send default notices giving borrowers 30-90 days to become current on payments before going to court.

Report to Credit Bureaus

Lenders almost always report defaults to business credit reporting agencies. This damages the business’s credit rating and score, making it harder to secure financing in the future.

Seek Receivership

If the lender believes the business has enough incoming cash flow or assets to pay back the loan, but the borrower is failing to make adequate payments, they may petition a court to appoint a receiver. This third party then takes over management of the company’s finances and oversees repaying the lender from available funds.

File Involuntary Bankruptcy

In extreme cases, secured lenders can take the aggressive approach of forcing a defaulting business into bankruptcy involuntarily through filing legal petitions alleging the company is generally unable to pay its debts. Doing so gives the lender greater control via the bankruptcy process compared to suing or seizing collateral.

First Steps for Borrowers Facing Default

If your business expects to default soon or has begun missing payments, prompt legal advice can help minimize damage. The first steps we’d recommend include:

• Assess the situation – Figure out if default is unavoidable or still avoidable so you know whether to prioritize damage control or explore alternatives like loan modifications.
• Review loan documents – Carefully check your loan agreement and security contracts to understand timelines, late fees, default interest rates, and the lender’s exact rights. Also review any personal loan guarantees.
• Open communication – Contact your lender before you miss payments if possible and let them know about financial difficulties. Transparency and willingness to work together generally leads to better outcomes.
• Consider restructuring request – Renegotiating your original loan terms through an amendment giving you lower payments or extended repayment timelines is preferable to entering formal default.
• Prioritize other obligations – If default is inevitable, begin prioritizing payroll, suppliers, rent, taxes and other obligations ahead of loan payments so critical business relationships remain intact.

By seeking legal counsel early when struggling to pay loans, defaulting businesses can carefully evaluate all options and develop smart negotiation strategies. The worst approach is ignoring loan payment problems until the lender takes aggressive legal actions like seizing assets or demanding liquidation through the courts.

Legal Defenses Borrowers Can Potentially Assert

Once past due payments trigger default proceedings, borrowers do have certain legal defenses they may use to contest the default or mitigate outcomes:

Improper Notice

If the lender failed to send proper written notice of default giving 30-90 days to become current on payments before imposing consequences, those consequences could be invalidated due to improper notice.

Unconscionability

Courts can refuse to enforce overly harsh default provisions that seem designed to trap borrowers rather than secure reasonable collateral protection for the lender. However, this argument rarely succeeds.

Equitable Extensions

Borrowers can request added time to repay by arguing immediate seizure of assets or bankruptcy filing imposes undue hardship compared to the temporary default. Courts will weigh fairness in considering this defense.

Economic Distress

Evidence that default stemmed from circumstances outside the borrower’s control like recessions, disasters, or industry collapse may persuade courts or lenders to offer leniency. But borrowers generally remain obligated to eventually repay principal owed.

Collateral Valuation Disputes

If lenders undervalued seized collateral when selling it and crediting loan balances, defaulting borrowers can dispute the amounts credited to the outstanding debt.

Technical Violations

If lenders violated technical procedures in the default process like timing of notices or not properly safeguarding collateral, those procedural defects could be used to contest default consequences.

While valid legal defenses are situationally helpful, they rarely eliminate the obligation to repay so focusing on negotiated settlements is usually more constructive for borrowers.

Key Takeaways

• Loan defaults have serious legal and financial consequences for struggling businesses.
• Understanding default provisions in loan contracts allows businesses to anticipate lender’s rights and reactions.
• Seeking prompt legal advice helps defaulting borrowers evaluate options and develop smart negotiation strategies with lenders.
• Certain legal defenses around improper notice, valuation disputes or technical violations may help reduce default penalties if effectively asserted.

Overall, working closely with business lawyers helps protect owners’ interests if their companies ever fall behind on loan payments and enter default. Through open communication and harnessing available legal defenses, default outcomes can potentially be managed to the borrowers’ ultimate benefit.

Resources

• Reasons Small Businesses Default on Loans: https://www.fundera.com/business-loans/guides/reasons-small-businesses-default
• Commercial Loan Default Provisions: https://www.nolo.com/legal-encyclopedia/consequences-when-business-defaults-loan.html
• Strategic Default Versus Accidental Default: https://www.avvo.com/legal-guides/ugc/when-to-strategically-default-on-a-business-loan
• Lender Remedies Upon Default: https://smallbusiness.findlaw.com/finance/when-a-business-defaults-on-a-loan-an-overview-of-the-lender-s-remedies.html
• What To Do If You Default on a Business Loan: https://www.thebalancesmb.com/what-to-do-when-you-default-on-a-business-loan-393071
• Borrower Defenses Against Default: https://www.nolo.com/legal-encyclopedia/defenses-foreclosures-other-lender-remedies.html