Reservation of Rights Letters: what decisions need to be made?

When a bank or other lender agrees to provide funding to a borrower, they usually require a number of events of default to be included in the facility documentation.

The obvious event of default is non-payment of money owed under the agreement. However, there are likely to be numerous other default triggers such as non-compliance with financial covenants, a change of control or steps which may result in the borrower being placed into an insolvency process.

Decisions, decisions…

If an event of default occurs, a lender has a number of options.  It can waive the default and take no action against the borrower. This is most likely to happen where the event of default is minor and has been remedied to the lender’s satisfaction, this could include where a winding up petition has been filed but the debt on which that petition was based has since repaid. At the other end of the scale, the lender could take a more robust approach and choose to demand repayment of the facilities and refuse to make further advances (depending on the wording of the facility).

The lender may need time, after learning of the circumstances leading to the event of default, to gather further information, take advice and consider its options. However this can be a bit of a balancing act as, if there is any delay by the lender in exercising its rights relating to the event of default, the borrower might argue that the lender has waived its rights under the agreement and should be ‘estopped’, or prevented, from taking any further action against the borrower in respect of that event of default.

What is estoppel?

Estoppel occurs where one party makes a representation which is relied upon by the other party to their detriment. The representation can include not taking any action, or any delay in taking action. This is particularly difficult for banks and other large lenders where a number of employees may be speaking with the borrower on a regular basis.

Imagine a situation in which a winding up petition is filed against a borrower company causing an event of default. The borrower notifies their contact at the bank and the contact confirms to the borrower that no action will be taken against it provided that the relevant debt is repaid and the petition withdrawn. In reliance on this, the borrower makes the required payment but the winding up petition is the latest in a long line of winding up petitions filed against the company which indicate a deeper issue.  The bank therefore decides, after further investigation, that it wishes to exercise its rights under the facility agreement and accelerate repayment of the loan. The borrower argues that the statement made by the bank employee has created an estoppel which prevents the bank from taking any further action against the borrower.

Whether this is correct or not, the argument makes matters much more difficult for the bank than they need to be. A similar situation could be created where the bank makes no such statement to the borrower but borrower relied on what wasn’t said or done when it made the payment.

Protecting the lender

To avoid any argument that the delay by the lender means it is estopped from enforcing its rights against the borrower, the lender must ensure that its rights under the facility agreement are preserved.  To do so, the lender should issue a reservation of rights letter to the borrower as soon as they become aware of the event of default.

A reservation of rights letter typically outlines the details of the event of default, the circumstances leading to it and which clause of the facility agreement has been breached.  The letter then states that the lender is reserving all of their rights or remedies under the facility agreement and that there has been no waiver of the event of default.

Once the letter has been issued to the borrower, the lender can take some time to consider its position and decide on the appropriate cause of action.