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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.
There are a few common reasons why a business may default on a loan payment:
No matter what causes it, a loan default is usually a sign of financial distress that requires legal advice.
Most commercial loan agreements contain default provisions that outline the lender’s remedies in case of missed payments. Common provisions include:
Understanding these default provisions upfront allows businesses to anticipate lenders’ legal rights if the company later struggles to make payments.
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:
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.
Upon default, lenders have several legal options to recover amounts owed or enforce loan covenants:
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.
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.
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.
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.
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.
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.
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:
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.
Once past due payments trigger default proceedings, borrowers do have certain legal defenses they may use to contest the default or mitigate outcomes:
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.
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.
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.
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.
If lenders undervalued seized collateral when selling it and crediting loan balances, defaulting borrowers can dispute the amounts credited to the outstanding debt.
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.
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.
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