As credit markets rebound, companies will increasingly seek financing for their businesses. Financing may take many forms: revolving credit loans, loans to finance the acquisition of a target company, or construction loans, to name a few. Loans may be short- or long-term, may fully amortize, or may have a balloon maturity date.
This article stresses the critical importance of the initial steps when approaching a loan commitment and outlines effective approaches for a borrower negotiating a commitment for the most common type of credit agreement: a facility that the company will use for most of its credit needs. Common components of such a facility will include (1) an agreement to borrow and repay loans from time to time for use as the borrower's working capital; (2) an agreement for an amortizing term loan, often for capital items such as equipment purchases; and (3) an agreement by which the lender agrees to issue letters of credit to third parties as requested by the borrower, typically suppliers to the borrower. These loans will almost invariably be secured by most, if not all, the property of the borrower.
Negotiate Critical Terms Before Signing
Loan agreements are always one-sided in favor of the lender. No matter how persistent the borrower, the final documents will impose numerous covenants and restrictions on the borrower and afford the lender a wide range of rights. It is important for any borrower to be realistic about what it can hope to achieve.
The borrower's most important strategy, by far, is to negotiate critical loan provisions before it signs the commitment, not after. Never forget that what the lender is selling is fungible: money. At the commitment stage, the borrower may actually or purportedly be negotiating with other lenders. This is the moment when the loan officer will be the most flexible in order to get the loan in the door. It is important that the borrower recognize this and negotiate its wish list early before signing anything or making any kind of deposit. Engaging counsel is also critical. Many a borrower has lived with an oppressive loan agreement because its lawyer arrived only in time to review final loan documents, which by then memorialized a deal cast in stone.
Who Is Committed to What?
A loan commitment is like any other contract: a binding agreement enforceable in accordance with its terms.
A borrower often relies heavily on the lender's funding commitment. An existing loan might be maturing. The borrower may have signed a contract to purchase a company or a piece of land, and the closing date is rapidly approaching. The borrower can never have complete assurance that the lender will close the loan when needed because of various conditions precedent that the borrower must meet. But there are still several ways to mitigate this risk.
Loans, particularly large loans, are frequently syndicated--meaning that an arranger will act as the lead for a consortium of lenders. Loan commitments often condition the lender's obligation on its ability to assemble such a syndicate, but this condition should be resisted. The borrower cannot control the syndication process and does not want to discover at the 11th hour that the lead lender's syndication efforts were unsuccessful. The borrower should insist that the lead lender bear the risk (if it can legally do so within its lending limits) of its failure to syndicate, perhaps initially funding more than it might like but retaining the right to syndicate the rest later. If need be, the early addition of a second lender might enable the two to fund the facility within regulatory limits.
It is critical to obtain lender preclearance of problems or bad facts. Such matters may include pending litigation, title issues on real estate, environmental conditions, or important clauses in critical contracts (such as employment or supply contracts). The borrower should front-end these issues for several reasons: first, to establish its credibility with the lender; second, to obtain preapproval if possible; and, finally, to give everyone time to solve them should that be required.
The borrower also should seek to delay paying the commitment fee until closing. If this is not achievable, the borrower should negotiate for the right to a refund of the fee if the loan fails to close for any reason other its own willful default. This means the borrower will be exposed (and ought to be exposed) to loss of the commitment fee if it simply finds another loan it prefers. On the other hand, if the loan does not fund because of any of the escape hatches in the loan commitment, the borrower should receive a refund. The borrower will need to concede that the lender can deduct from the refund its reasonable out-of-pocket expenses to third parties, such as lawyers and appraisers. Any fees that are deposited should bear interest for the benefit of the borrower.
Loan commitments typically have a drop-dead date after which the lender need not fund for any reason. In addition to negotiating a commitment fee refund in such an instance, consider requesting extension rights, even if such extensions come at a price.
Most borrowers incorrectly view their commitment as an option to borrow if the borrower so chooses. Most well-drafted commitments, however, will contain language something like the following: "Lender agrees to lend to Borrower, and Borrower agrees to borrow from Lender, the full amount of the Loan." Borrowers have been successfully sued by lenders for failure to close loan transactions. The commitment letter should recite that forfeiture of the commitment fee is the sole and exclusive remedy of the lender against the borrower for failure to close the loan.
Negotiating at the Commitment Stage
From the borrower's perspective, the entire set of loan documents would be negotiated before it signed anything. This result is rarely obtainable or even desirable, however, because the parties want to determine whether they can sketch even a broad outline of their agreement before undertaking the additional legal and due diligence expenses attendant to closing a loan. The issues that should be negotiated up front will vary from transaction to transaction, so the following items should not be viewed as the definitive list. All are important enough, however, to warrant serious early consideration.
The basic financial terms must always be spelled out. These terms would include:
- The amount that may be borrowed.
- The applicable interest rates. Any fixed rate of interest should be stipulated. If the rate will vary, specify the underlying index. For a "prime-based" loan, specify whether it is based on the lender's "announced" prime rate or a widely quoted rate from some other major financial institution.
- The maturity date of the loan.
- Any rights to extend the maturity date and the conditions for doing so. Be sure the lead time required is not too onerous.
- A description of the fees and their due dates. When will fees be deemed to have been earned? Can the bank's outside legal fees be capped, or at least estimated?
- Financial covenants such as debt service coverage ratios, tangible net worth requirements, or capital expenditure limitations.
- Calculation of interest. On what basis will interest be calculated? For example, will it be based on a 365/6-day calendar year, a 360-day year of equal 30-day months, or some other convention?
Almost all commercial credit facilities are secured by personal property of the borrower: typically accounts receivable, equipment, and inventory. The lender will want a cushion for each collateral class and will agree to lend only against pre-agreed percentages of eligible collateral. Further sublimits are common. A typical lending formula for a $10,000,000 loan might read as follows: "85% of Eligible Accounts (but in no event more than $6,500,000) plus 70% of Eligible Inventory (but in no event more than $2,500,000) plus 70% of the value of Eligible Equipment (but in no event more than $1,000,000)."
The definitions of items such as "Eligible Accounts" can be a trap for the unwary. Lenders have legitimate reasons for limiting the kinds of accounts they will consider eligible. Accounts due from affiliates or an overconcentration of accounts from one supplier are but two types of accounts that might be defined as ineligible. There is no substitute for having the borrower's chief financial officer obtain, at the earliest possible stage, the lender's definitions and formulas, then computing how much the company will be able to borrow. Borrowers often realize too late that the actual loan proceeds to be delivered into their hands at closing will be insufficient.
Borrowers commonly assume that there is no problem if the commitment (and the loan documents) is silent on prepayment. Unfortunately, prepayment may be a big problem. Various courts have held that, absent a specific right to prepay, a commercial lender is entitled to the benefit of its bargain—payment of the agreed-upon rate of interest over the agreed-upon period of time. The solution is obvious: insist on an express right to prepay at any time, in whole or in part, and without penalty or premium.
Lenders often resist this request, however, and insist on prepayment restrictions because if a borrower prepays in a declining-interest-rate environment, they will be forced to relend their repayment proceeds at a lower rate. These restrictions can range from outright prohibitions (termed "lock-outs") to requirements that the borrower pay premiums based on yield-maintenance formulas designed to ensure the lender's profit on the loan. The yield-maintenance premium is often based on the difference between the interest rate under the loan and the yield the lender would receive on reinvesting the prepaid amounts in a U.S. treasury security of comparable duration.
A borrower wants to shorten any lockout period and/or seek to minimize the amount payable under a yield-maintenance provision. One way to do the latter is to ask that the yield-maintenance formula use the treasury rate "plus 50 basis points" (or some other number) as the measuring point rather than simply the treasury rate. The lender is often lending at a rate 125 to 150 basis points above treasuries so its yield on the reinvested prepayments will likely be higher than the treasury rate. This compromise still permits the lender to recoup lost profits, but it also presumes that the lender will be able to deploy its funds at something above the flat treasury rate.
Most mortgages permit, and some require, that condemnation or casualty proceeds be applied to pay down the debt. If the borrower is forced to retire debt early because of a catastrophe such as a condemnation or casualty, it should not suffer the further indignity of a prepayment penalty. Most lenders will grant this exception.
Lenders often require a borrower to escrow funds in an account (often called an "impound account") to assure that certain periodic payments are made: typically, real estate taxes and insurance premiums. These accounts are initially funded with a lump-sum deposit at closing, either from the borrower's existing funds or from loan proceeds, then augmented periodically. Withdrawals are made annually or semiannually depending on the circumstances. Lenders typically resist paying interest on these accounts.
The borrower should seek to eliminate this requirement or, in the alternative, to permit the lender to require an escrow only if there is an event of default under the loan documents. The borrower also should ask that deposits bear interest.
Examine almost any mortgage and one will find a due-on-sale clause. This clause permits the lender to declare a default and accelerate the balance of the loan if the borrower sells the real estate to a third party without the lender's written consent. In a pure real estate loan, where real estate is the sole collateral, this is a difficult clause to challenge. In the context of a broader loan facility, however, other approaches may be possible unless the property in question is a critical part of the borrower's operations--such as its main manufacturing plant.
One approach is to require that the lender's discretion in consenting to a transfer be reasonably exercised. A second, and probably preferable, approach is a partial release agreement in which the borrower is permitted to dispose of the mortgaged property provided that the net proceeds of the sale are used to pay down the loan. It is important for the borrower to remember, however, that it might not be able to reborrow these funds if the remaining collateral package does not generate enough availability under the lending formula.
Change of Control
If the borrower is not a publicly traded company, the lender will often forbid transfers of equity interests in the borrower. One need not probe deeply, however, to learn that the lender's primary concern is a change of control. The lender knows, and is presumably comfortable with, the management expertise and style of the persons with whom it has negotiated the loan. It is not relying solely on its collateral to assure repayment; it is relying as well on the skill of the borrower's lead player(s).
The borrower will probably need to accede to restrictions on transfers of equity interests but should seek permission for transfers that do no violence to the lender's primary concern. Permitted transfers might include (1) transfers of limited partnership or membership interests; (2) transfers of equity interests that do not result in a change of control; (3) transfers into inter vivos or testamentary trusts for estate planning purposes (so long as the persons responsible for voting or managing the interests transferred into the trust remain the same); (4) transfers among existing equity holders (so long as there is no change in control); and (5) transfers to affiliates.
Other Debt or Encumbrances
Lenders never want to compete with other creditors. Accordingly, loan agreements typically forbid other indebtedness (anti-debt restrictions) as well as security interests in favor of other lenders (anti-lien restrictions).
A borrower can typically obtain exceptions to the anti-debt restrictions, permitting the borrower to incur the following types of debt: (1) unsecured trade debt incurred in the ordinary course of doing business, (2) debt subordinated to the lender on terms reasonably acceptable to the lender, (3) intercompany indebtedness, (4) purchase money debt (so long as the debt is not in an amount greater than the initial value of the asset), and (5) capital leases, which may be treated as debt for some purposes. Occasionally, but not often, the borrower also may be able to negotiate a basket entitling the borrower to incur additional unsecured debt up to a pre-agreed maximum.
Exceptions to anti-lien restrictions are even narrower but might include (1) specified existing liens, (2) nonconsensual liens imposed by operation of law (such as inchoate mechanics' liens), (3) liens securing permitted purchase money debt, and (4) tax liens or judgment liens that are being contested in good faith and in such a manner as not to jeopardize the lender's collateral position.
The nature, content, and scope of guarantees can only be touched on in this article. The borrower must understand, however, precisely what guarantees will be required and from whom. If there are multiple guarantors, resolve at once whether the guarantors will be jointly and severally liable. Lenders always hold out for broad liability, but guarantors just as vigorously resist it.
Even if the loan must be guaranteed, the guarantors should consider ways to reduce or even eliminate their exposure. Can the guaranty be limited to a specific maximum? Can the guaranty exclude principal and be limited to interest and other carrying charges (a carry guaranty)? Can the guaranty be structured as an earn-out guaranty pursuant to which the guarantor is excused if, for example, the borrower reaches (and, depending on the agreement, maintains) certain specified financial targets, such as net operating income, net worth, or debt-to-equity ratios?
Lawyers for a borrower should strongly consider advising guarantors to obtain separate counsel. The interests of a guarantor will frequently be directly adverse to those of the borrower.
A general enforceability opinion will be required by almost every lender in which the borrower's counsel recites, among other things, that the loan documents have been validly authorized, executed, and delivered and that they are enforceable in accordance with their terms (subject to applicable bankruptcy laws and laws affecting creditors' rights generally). In many instances, the lender will require outside counsel to provide the opinion, so a corporate borrower is well advised to understand early whether it can rely solely on in-house counsel.
Disputes over legal opinions are almost always unproductive and expensive. Whether or not it is possible to get a draft of the form opinion at the commitment stage, the commitment should list the items on which the lawyer must opine. Pay particularly close attention to whether the lawyer will be asked to opine that the lender has a perfected security interest in the collateral. Most firms will deliver this opinion, although negotiation over the qualifications and assumptions can take time.
If the lender wants an opinion that its liens have a first priority, serious problems can arise because most prominent law firms refuse to deliver such an opinion. Lenders are far less prone to request this opinion now than in years past, but the careful borrower will make sure the lender does not require it.
If the borrower's real estate collateral is located in multiple states, local counsel will probably need to be retained to deliver enforceability opinions for various security documents granting liens in those states. The cost of local counsel should be anticipated and budgeted from the outset.
Negotiating a loan commitment and agreement can be a struggle for the borrower. The lender has all the money and with that comes most of the leverage. Large portions of the loan agreement will always remain off limits. Nonetheless, issues critical to the borrower abound and must be negotiated at once. Never forget that the lender is weakest at the outset, making this the time to order your priorities and ask for what is most important.