Borrowing is an integral part of doing business. Whether it’s to fund growth, cover working capital, or invest in equipment, most companies of any size use borrowed funds as part of their capital structure. So what happens when those loan obligations aren’t met?

Defaults can shake even the strongest businesses and create ripple effects for lenders, employees, and investors. For borrowers, understanding what default means, how lenders react, and what legal and financial tools are available can make the difference between survival and collapse.

Payment Defaults vs Covenant Defaults

Not all defaults are created equal. A missed interest payment may look very different to a lender than a technical violation of a loan covenant.

Jonathan Friedland of Much Shelist draws a clear distinction between a payment default and a covenant default:

• A payment default occurs when interest and/or principal are not paid when they are due. It’s easy to determine whether a payment default has happened, thus making it very black and white.
• In contrast, a covenant default is a non-payment default of any other kind, such as a breach of a covenant, a representation, or a warranty.

Payment defaults often trigger quick and aggressive lender responses, including acceleration of the entire loan. Covenant defaults, in contrast, may involve breaking financial ratio requirements, missing reporting deadlines, or violating negative covenants (such as taking on more debt without permission), and can trigger negotiations or waivers.

It’s important for business owners to monitor both types of defaults carefully, as ‘technical’ breaches can still empower a lender to declare default.

The Lender’s Perspective: Cash Flow and Collateral

Most lenders simply want to be repaid. That being said, when a default does occur, lenders tend to focus heavily on what Phil Buffington of Balch & Bingham LLP highlights as two key issues: cash flow and collateral value.

Cash flow tells the lender whether the borrower can realistically service debt going forward. Jacqueline Brooks of Duane Morris LLP flags that external forces such as tariffs, supply chain disruption, or inflation can impact cash flow. Lenders factor these realities into both their willingness to restructure existing debt and their appetite for new deals.

Collateral value determines what the lender can recover if repayment fails. As part of their considerations, lenders will analyze collateral types: accounts receivable, inventory, real estate, or even intellectual property. Some collateral are more liquid than others, meaning their real-world value can swing dramatically depending on markets.

Lenders will also assess whether enforcing rights will produce meaningful recovery. If liquidation of collateral is likely to return pennies on the dollar, they may prefer to negotiate amendments, extensions, or forbearance agreements instead.

For businesses, transparency is critical. Document and explain your cash flow challenges clearly. Rising costs, tariffs, and supply chain shocks can all be persuasive reasons for lenders to renegotiate terms, if you present them upfront. Hiding bad news from a lender will only erode their trust. When financial problems surface, proactive communication about cash flow challenges and collateral valuations can make all the difference between restructuring and foreclosure.

Borrower Beware: Predatory Practices and Loan-to-Own Tactics

Not all lenders play fair. While most operate in good faith, some structure loan terms in ways that make it difficult for borrowers to stay compliant. This can push businesses into default even when they are otherwise healthy.

Harvey Gross of HSG Services advises businesses to shop around and compare a few lenders before committing: “You should get a few deals. You should look at those deals not just for pricing, but the confidence, and also have a history of how those lenders treat their borrowers.”

This advice is crucial. Beyond interest rates and fees, borrowers should evaluate how a lender has behaved with troubled clients in the past. Some lenders have reputations for working collaboratively when businesses stumble. Others are less forgiving.

One aggressive tactic is the loan-to-own, where a lender or investor provides financing with the hidden goal of taking control of the company’s assets if (or when) the borrower defaults. The loan may be structured with strict covenants, short maturities, or unrealistic repayment schedules, making default likely. Once triggered, the lender enforces its rights and positions itself to acquire the business at a distressed value. While not unlawful, loan-to-owns can feel predatory, especially for borrowers who didn’t fully understand the risks.

For business owners, the lesson is simple: never choose a lender based only on the cheapest price. Reputation, history, and approach to defaults matter just as much, if not more, than the interest rate on the page.

Negotiating Solutions: Tools for Distressed Businesses

Default doesn’t always mean the end. In fact, many lenders prefer restructuring over liquidation. The key for borrowers is to understand the tools available and to approach negotiations early and openly.

Options include:

• Amend-and-Extend: Requesting new repayment schedules or modified covenants.
• Forbearance Agreements: Asking lenders to hold off on enforcing remedies while you stabilize.
• Covenant Waivers: Negotiating temporary relief from financial ratio requirements.

Negotiation often depends as much on the broader economy as the borrower’s specific situation. In periods of economic stress, lenders may be more willing to extend terms rather than risk costly enforcement.

The best approach is to bring advisors into the conversation early. Lawyers, accountants, and restructuring professionals can help frame proposals credibly and increase the chances of a cooperative resolution.

Strategic Alternatives for Distressed Businesses

When workouts fail, borrowers and lenders must consider formal remedies. These may sound intimidating, but they are tools designed to preserve value and provide a structured path forward.

• Chapter 11 Reorganization: The company continues to operate as ‘debtor in possession,’ with breathing room provided by the automatic stay. Sales through Chapter 11 are often made ‘free and clear’ of liens, a major advantage for buyers.
• Assignment for the Benefit of Creditors (ABC): A state-law alternative where assets are assigned to a fiduciary who liquidates them. Faster and less expensive than bankruptcy, but not available everywhere.
• Receivership: A court-appointed receiver manages operations or liquidation. Receiverships are often more flexible than bankruptcy.
• Article 9 Sales: Under the UCC, a secured creditor can sell collateral directly, provided the sale is ‘commercially reasonable.’ These are fast and relatively inexpensive, though they raise questions about valuation and fairness.

Each option comes with trade-offs. Bankruptcy offers a comprehensive solution, but at high cost and stigma. Receiverships and Article 9 sales may be quicker, but they lack the same creditor protections. Choosing among these options depends on many factors, such as the size of the business, its industry, creditor relationships, and whether key customers or vendors will stick around.

Guardrails for Borrowers in Default

Default is stressful, but businesses still have rights. Knowing them can prevent lenders from overreaching and can improve your negotiating position.

Practical steps include:

• Insist on clear communication from your lender. Sudden moves may not be legally justified.
• Keep records of every conversation and written exchange.
• Watch for lenders taking too much control. If they act like management, they may create fiduciary duties.
• Be cautious about deficiency claims after collateral sales; these can sometimes be challenged.

Lender liability claims remain a powerful defense tool. While litigation should be a last resort, simply being aware of these risks can give distressed businesses leverage in negotiations.

Turning Defaults Into Second Chances

Surviving a default starts with understanding obligations and acting early. Even small covenant breaches can have big consequences, but open communication with lenders often creates space to restructure instead of collapse.

While default feels overwhelming, tools like forbearance agreements, covenant waivers, Chapter 11 reorganizations, and assignments for the benefit of creditors exist to give companies a way forward. With preparation, transparency, and the right advisors, a default can become less of an ending and more of a turning point for your business.

To learn more about this topic, view Dealing With Defaults. The quoted remarks referenced in this article were made either during this webinar or shortly thereafter during post-webinar interviews with the panelists. Readers may also be interested to read other articles about borrowing and lending.

This article was originally published here.

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