Negotiating the Loan Agreement: The Borrower's Perspective, Part II

One hallmark of an expanding economy is increased lending to businesses. As more capital becomes available, borrowers need to know how best to negotiate the terms and conditions under which they acquire it.

In a prior issue of this magazine, this author proposed strategies a borrower might adopt when negotiating a commercial loan commitment. While reasonable minds will differ on what points should be raised at that early stage, a number of matters inevitably remain for negotiation in the loan agreement itself. This article will examine a typical asset-based loan agreement and outline practical steps the borrower's counsel should take in order to insure that the closing proceeds smoothly and on time.

Satisfying Conditions Precedent

The loan agreement will list a number of items the borrower must deliver as a precondition to funding. Pay close attention to these items from the outset, particularly ones that will require performance by third parties. These parties might include:

Title companies. A lender taking real estate collateral will require an ALTA Standard Loan Policy insuring the validity and priority of its mortgage lien. Engage your title insurer at once and provide it with the list of the lender's required endorsements. Unexpected difficulties often arise during title clearance and the careful borrower's counsel will leave herself the maximum time to get it accomplished.

Surveyors. Most real estate lenders require a new survey. The surveyor must be hired and provided a list of the lender's requirements as well as copies of existing title evidence. Engaging the surveyor quickly is particularly critical in "year-end" transactions where surveyors often have more fieldwork than they can timely perform.

Landlords. Some states afford landlords a statutory security interest in personal property of the tenant located on the leased premises in order to secure rental obligations. A lender advancing against inventory and equipment stored on such sites will frequently ask all (or major) lessors to waive or subordinate their landlords' liens. The borrower should not assume that these negotiations will be painless (or even successful) and must forward the draft letters to the landlords quickly.

Try to obtain the lender's agreement that you need not obtain letters from all lessors but only from some lesser percentage, such as 75 percent. Do not be surprised however, if the lender insists that acceptable waiver letters be delivered for all sites deemed crucial to the borrower's business operations.

Auditors. When a loan closes sometime after the close of a company's most recent fiscal year, lenders may ask for an audit of the "stub period" from the date of the last audited statements to an agreed-upon date prior to closing. If the lender cannot be dissuaded, the auditor must begin work at once.

Local Counsel. Local counsel must frequently be engaged in multistate transactions for any number of reasons. Negotiations over their opinions are often more protracted than anyone would wish, which is why the borrower should put the lender's proposed form of legal opinion into local counsel's hands as early as possible. Far too many transactions find the lender and local counsel still arguing over opinions on the day of closing.

Many provisions are common to loan agreements. The borrower's ability to revise them will depend not only on its financial strength but also on market terms generally. Nonetheless, the borrower's counsel should keep certain ideas in mind.

Loan Administration

Establish whether the borrower's receipts must be paid directly into a lockbox controlled by the lender. If so, determine whether it can be a "soft" lockbox (where the borrower may withdraw funds from the account prior to an event of default without lender approval) or must be a "hard" lockbox (where withdrawals must be consented to, or pre-approved, throughout the life of the loan). In most cases, a soft lockbox is all that will be required although the lender will always be granted the right to debit the account for regular debt service.

Representations and Warranties

All loan agreements require the borrower to recite certain facts as true and to acknowledge that the lender is relying on the truth of those recitations. There are two schools of thought about representations and warranties. Many view the terms interchangeably.

But others distinguish between them based on whether knowledge is implied. In this view, a representation is the borrower's statement that a fact is true but implies knowledge or at minimum an absence of knowledge that the statement is untrue. A warranty would be much broader: a statement that a fact is true without regard to the borrower's knowledge. Warranties can also be extended to future events whereas representations cannot meaningfully be so extended. An automobile manufacturer, for example, does not know whether an engine will run properly six months from the date its car leaves the lot, but warrants nonetheless to take certain actions if that statement proves untrue.

No matter which view an attorney adopts, breaches of representations and warranties always have adverse consequences for borrowers, so wherever possible, statements of fact should be expressly limited as being "to the borrower's knowledge." Lenders will resist, arguing that the representation and warranty section is simply a risk-shifting device and that, should a given fact prove untrue, the borrower should suffer the consequences without the lender needing to prove the borrower knew the statement was untrue.

A borrower may still succeed in inserting a knowledge limitation on at least two fronts. While it must stand ready to remedy any environmental defect, the borrower should not be in default if an environmental condition arises that was unknown to it. If the Phase I report overlooked something, the borrower should not face acceleration so long as it is actively attempting to remedy the problem.

The borrower should also qualify its representation and warranty about compliance with laws. Most borrowers view themselves as law-abiding, and in popular parlance they are. But on deeper reflection most realize they cannot possibly warrant compliance with all building codes, zoning laws and ordinances, ERISA rules, labor standards, and more. No one can. It should seek to represent only that it neither knows of a violation nor has received a notice of such from a governmental entity.

If a borrower does succeed in obtaining a "best of knowledge" limitation, it must then define that term. What does it mean for a corporate entity to "know" something? Does it have knowledge if anyone in the organization knew it? If anyone should have known it? The borrower's ideal provision looks something like this:

For purposes hereof, "the Borrower's best knowledge" shall mean the actual knowledge of [X and Y] as of the date hereof, with no duty of inquiry, which duty has been disclaimed.

In the above clause, X and Y would be two individuals reasonably expected to know of the important facts that are the subject of the representation and warranty section.

Affirmative Covenants

All loan agreements require borrowers to perform a host of acts, such as maintaining its corporate existence, most of which should be unobjectionable. Three covenants in particular warrant close attention.

Maintaining Insurance

Consult an insurance broker or expert as early as possible. Lenders are known for far-reaching and expensive insurance requirements. Quite often the amounts inserted by the lender in the documents are boilerplate without regard to this particular business. The lender might be talked out of some coverage altogether or limit the terms of other requirements such as the length of time one must covered by business interruption insurance.

Even attorneys well-versed in insurance provisions lack the expertise to assess the reasonableness of the amounts of required coverage or permitted deductibles, particularly under liability policies. These determinations require knowledge of insurance market conditions as well as experience with the types, frequencies and amounts of exposures this particular borrower's business is likely to face.

Financial Reporting Requirements

The loan agreement will invariably require quarterly unaudited income statements and balance sheets together with annual audited statements. There are at least two issues to discuss: (1) does the due date for interim statements afford the chief financial officer time enough to prepare them? and (2) what level of audit review will ultimately be required?

There are three levels of financial statement review. The least expensive, a compilation, consists of the accountant simply arranging the borrower's financial information in the format of a financial statement. The accountant states only that the statements are in proper form and free of obviously material errors. No comfort is given that the statements were prepared in accordance with Generally Accepted Accounting Principles (GAAP). Compilations are typically prepared only for the internal use of small companies and lenders virtually never accept them.

Far more common is a review. The accountant performs a certain amount of due diligence on financial information provided by the company, makes limited inquiry of the company, then applies procedures sufficient to form a reasonable basis for giving a limited assurance that no material changes are required for the statements to conform with GAAP. This may be acceptable to some lenders, particularly if the borrower is a small start-up of some sort.

The most expensive, and the one most lenders want, is the audit. The accountant performs all tests required to determine that the statements conform to GAAP. The accountant then issues an opinion that is either "clean" (unqualified), "qualified," or "adverse." Lenders will require a clean opinion--that the financial statements "present fairly the financial position" of the borrower. A qualified opinion might be issued if there were agreed upon limitations in the engagement or other uncertainties surrounding the audit. Adverse opinions state that the financial statements do not accord with GAAP and are always unacceptable to the lender.

Some loan agreements require the auditor to certify annually that it has reviewed the financial covenants in the loan document and that there are no defaults thereunder. If so, the borrower must determine at once whether its auditor gives such an opinion. Auditors routinely resist them because they often form the basis of actions against them by lenders.

Compliance with Laws

At most the borrower should agree that it will be in material compliance with laws or alternatively that it will comply with laws so long as the effect of noncompliance does not materially adversely affect the borrower.

Negative Covenants

Several of the more important negative covenants (such as due-on-sale and due-on-encumbrance clauses) were discussed in the previous article on loan commitments. Some additional issues that arise during loan agreement negotiations include:

Mergers and Consolidations

No lender will permit its borrower to be merged or consolidated out of existence, so the borrower's goal is simply to narrow the scope of the clause by excluding: (a) mergers of subsidiaries into the borrower; (b) mergers of subsidiaries into one another, or (c) mergers where the borrower is the surviving entity. Exceptions (a) and (c) may be difficult to obtain because, although they will typically satisfy the lender's concern about consistent management and control, they nevertheless expose the lender to the risk that the surviving entity could have a lower net worth than the pre-existing borrower (if the acquired company has a weak balance sheet). An approach acceptable to some lenders is to permit mergers or consolidations where the borrower is the surviving entity and its net worth does not decrease as a result of the merger or consolidation. A careful lender will also insist that certain designated individuals remain in day-to-day control of company decisions.

Dividends

Smaller borrowers frequently express surprise at dividend prohibitions but the lender's view is always the same: debt gets paid before equity. The lender will take great interest in salaries being paid out by the company and can be expected to limit them. Nonetheless, certain carve-outs from the dividend proscription are generally available. These include exceptions for: (1) dividends paid solely in shares of common stock; (2) pre-existing contractual obligations to pay dividends on preferred stock; and (3) distributions to equity holders (of pass-through entities) in amounts sufficient to pay their allocated share of company income. Members of a limited liability company for example must pay income taxes on their aliquot share of company taxable income whether or not received. The members will want to receive dividends sufficient for them to meet those tax obligations. As a practical matter, the lender will be asked to assume that each distributee is in the highest marginal tax bracket for purposes of these computations, as will often be the case.

Materiality and Reasonableness

Borrowers often attempt to insert materiality limitations on covenants and representations (e.g., "The borrower will advise the lender of any material threatened litigation."). The author's view however is that time spent negotiating the many places where materiality limitations could be inserted is largely wasted. The common law requires materiality as a precondition to default in performance of any contract and a loan agreement is no exception. Nor do lenders look to seize upon immaterial defaults as a reason to accelerate. Lenders do not want to run the borrower's business nor incur the expense of liquidation absent a compelling reason to do so. Lenders take action only when there is a significant problem, no matter what the documents say.

"Reasonableness" on the other hand is something worth fighting for, such as obtaining the lender's agreement that its consent shall never be "unreasonably withheld, conditioned, or delayed." A lender will be bound by implied or statutory covenants of good faith and fair dealing, but there is no overarching obligation to act "reasonably" in all contracts nor as to any particular decision. This concession can be difficult to obtain however, particularly in tight credit markets. It is never available in any section dealing with loan defaults.

Events of Default

No section is more apt to capture the borrower's attention than the one detailing events of default. But most lenders will not countenance extensive discussion of this topic and will be quick to wonder aloud why the borrower is spending so much time on it if the borrower never intends to default. The most effective approach is to press for one or two simple things then let the rest go. These include:

Notice and Cure for Monetary Defaults

Borrowers routinely request a right to receive notice of, and then cure, a default before a lender accelerates the loan. The ideal borrower clause might read as follows:

Any failure of the borrower to pay principal or interest within five (5) days after notice of same from the Lender.

Lenders grant this concession far less frequently than in the past, arguing that the borrower knows full when payments are due and should be making them on time. The borrower should recognize that the lender has a legitimate interest in not being burdened with sending repeated default notices to chronically delinquent parties and try to address that concern. One way is by agreeing that the lender need send such notices no more than twice a year.

A different approach, little used but effective, is to insist that a notice of default should always precede the momentous step of acceleration, but to offer instead that the borrower pay escalating late payments each time the lender is forced to give such a notice. Increasing payments quickly attract the borrower's attention and will deal with the lender's worry about chronic delinquency. Parties can and do agree to "reset" the late payments if the borrower is in compliance for an agreed period of time.

Notice and Cure for Nonmonetary Defaults

The borrower has a more compelling request here. While the borrower should know its payment schedule, how is it to know if its lender believes the borrower is not maintaining proper insurance unless it receives notice from its lender? A borrower can often obtain up to a 30-day cure period for non-monetary defaults.

For defaults not capable of being cured within 30 days, borrowers will request a "continuing cure" right such as the following:

Provided however that if the nature of the default is such that it is not capable of being cured within 30 days, then so long as the borrower is actively and continuously attempting to cure such default, the borrower shall not be deemed in default for such breach.

Even if the lender accedes to this request, the borrower should be prepared to accept an outside cut-off date by which the breach must be cured no matter the circumstances. Ninety days is a great result; 60 should be acceptable.

Cross-default Provisions

Pay close attention to cross-default provisions. It may well be that the loan facility under negotiation is not the first or only loan the borrower has with this lender. While the borrower may well view the two loans on a stand-alone basis, the lender often sees it differently. Cross-default provisions should be resisted wherever possible but can prove difficult to fend off.

Material Adverse Change

Although Article 1-309 of the Uniform Commercial Code permits "general insecurity clauses" so long as the lender exercises them in good faith, the borrower should vigorously contest any such provision. The borrower argues that such a provision affords the lender far too much control and, further, that the standards for acceptable financial performance have already been spelled out in the financial covenants. Many lenders will delete this clause but, if unwilling, may be persuaded to move to objective tests rather than subjective ones (e.g., an X percent decline in net operating income for two consecutive quarters or a Y percent decrease in the net worth of the borrower as reflected on the audited financial statements).

Remedies

Beyond the suggestions outlined above, most experienced borrowers' attorneys spend little time on the remedies section. By the time a lender has finally decided to accelerate the loan, it is difficult to argue there should be further contractual impediments to its exercise of remedies. Most lenders summarily dismiss such requests arguing that the borrower's best course of action is to repay the loan as agreed.

In loans with substantial personal property as collateral, however, parties will often negotiate the standards for a "commercially reasonable sale"--as contemplated by section 9-603 of the UCC. Borrowers may seek to obtain as long as 21 days prior notice of an Article 9 disposition, but 10 days is a realistic expectancy.

In a syndicated (multi-lender) loan, it is important to resist provisions providing contractual rights of setoff. Generally the law permits setoff only if there is mutuality (i.e., the same two parties owe each other money) and both obligations are fully mature. But in a syndication with participations, only the lead lender is in contractual privity with the borrower. No participants have a right of setoff unless the borrower contractually grants them one. Borrowers often do not know the identity of all (or any) of the loan participants so should not risk discovering that an account has been set off because one if its depositary banks was an unknown participant. Contrast this situation with a "co-lending" agreement in which each of the co-lenders is in direct privity with the borrower. It will be futile to resist setoff rights here.

Conclusion

Even after the major deal points have been finalized in the loan commitment, the loan agreement itself remains to be negotiated. While large portions will always remain off limits, the borrower must still choose its battles wisely and attempt to pare down the most objectionable portions of the document.