Loan Availability
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.
Prepayment Rights
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.
Escrows
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.
Due-on-Sale
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.
Guarantors
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.
Lawyers' Opinions
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.
Conclusion
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.