In our previous blog (HERE), we considered the structure of commercial loan documentation and important objectives of certain agreements. We also discussed common loan concepts that are of particular importance to commercial lenders. Today, we cover some of the important provisions of the loan documents and explain some of the important considerations when definitive loan agreements are negotiated. Effective lenders must strike the right balance between protecting the bank and creating a workable document for the customer.
Important Loan Provisions: Definitions
Loan agreements will contain definitions either at the beginning or end of the document. Lenders should review some of the important definitions such as cash flow, funded debt, interest coverage, material adverse change, and debt service.
Conditions Precedent: Most loan agreements will include conditions that make the loan effective. These conditions precedent must be satisfied before the loan agreement creates a legally binding obligation on the lender to advance funds. Conditions precedent may include any of the following requirements from the borrower:
- Confirm representations and warranties;
- Confirm no default (or conditions that would lead to default);
- Provide the resolutions and approvals; and
- Provide the legal opinions of its counsel.
Representations and Warranties: Representations and warranties assure lenders that the legal, financial and regulatory requirements of the borrower are met each time the loan is disbursed. Representations and warranties are designed to assure the lender that its factual and legal knowledge for its decision to lend at the time the loan agreement is signed is correct. Representations and warranties are a balance of shifting risk from lender to borrower.
If any representation or warranty cannot be made by the borrower, the lender may withhold disbursement and any inaccuracy that is discovered after disbursement will allow the lender to declare the loan in default.
Representations and warranties typically include the following:
- Organization - Borrower has been formed as a legal entity in accordance with applicable laws, and that it has authority to own its assets, conduct its business;
- Authorization - Borrower has done everything required and has corporate authority to enter into the loan;
- Legal, Valid, and Binding - Borrower agrees that the loan agreement is legal, binding and enforceable;
- Government Authorizations - Borrower has done everything necessary to obtain government authorizations;
- No Default - Borrower states that there are no current defaults on any of its debts;
- Consent - Borrower states that it is not obligated to gain the consent of any of its creditors to enter into the loan agreement;
- No Actions - Borrower states that there are no current or pending court actions against it;
- Financial Statements - Borrower affirms the accuracy of its financial statements;
- Environmental – Borrower attests that there are no known or patently obvious environmental risks affecting business or collateral;
- Material Adverse Change - Borrower states that its financial condition has not materially declined since the lender reviewed financial statements; and
- Taxes - Borrower states that the execution of the agreement will not be subject to certain taxes.
Covenants: Covenants are promises the borrower makes to the lender about its behavior and financial situation after the loan is disbursed. Covenants can be either affirmative (promises to do) or negative (promises to refrain from doing). Examples of affirmative covenants are to furnish financial statements, pay taxes, and maintain the borrower’s legal existence. Examples of negative covenants are prohibition on additional indebtedness, not to pledge assets, not to declare dividends or not to make distributions.
Many borrowers will try to negotiate materiality qualifiers. The goal of the lender is to avoid what is called “material material” language. In the following example the lender will have a difficult time enforcing a covenant: The Borrower shall comply in all material respects with the material terms and conditions of all material contracts. In this example, the lender will have a difficult time proving such a high standard of materiality. When considering negative covenants, lenders should pay attention to when the covenant is tested – each incurrence or just quarter or year end. Lenders will attempt to impose an “each incurrence test” because this will require the borrower to declare their breach even between reporting periods.
Events of Default: These provisions specify when the lender may pursue its remedies for default. Remedies may include acceleration (requirement for immediate repayment of the loan), set-off (a lender obtains the money owed to it from another source, such as the borrower’s deposit account), or litigation.
The primary objective for a lender to include events of default is to compel the borrower to renegotiate the loan in an attempt to alter collateral, credit support or the borrower’s cash flow.
Common events of default include the following:
- Payment default,
- Breach of covenant,
- Breach of representation or warranty,
- Dissolution or bankruptcy,
- Specified judgment against borrower,
- Government action,
- Change of Control,
- Material adverse change in the borrower’s financial condition,
- Insufficiency of collateral, and
- Non-filling of financial statements.
Lenders will typically provide a grace period to allow borrowers an opportunity to cure an event of default. Only after the expiration of that grace period is the borrower in default of the loan agreement. Most borrowers will insist on requirement that the lender provide notice of an event of default to allow the borrower to respond or cure the default.
Cross-default versus cross-acceleration: A cross-default gives the lender the ability to trigger a default under one loan agreement if the borrower is in default under another agreement. This provision has serious consequences for the borrower as it can result in the borrower facing repayment of several loans at the same time. Lenders prefer this arrangement because it gives them the ability to escalate their position against the borrower versus other creditors. A cross-acceleration provision is more borrower-friendly and gives the lender the ability to declare an event of default only after another creditor accelerates its loan.
Some borrowers will attempt to include a de minimis provision that specifies if small amounts of debt in other loan agreements are in default or are being accelerated, that the cross-provision does not apply. What constitutes other debt is typically defined as “indebtedness.” A broad definition of indebtedness helps the lender, and, therefore, banks will attempt to broaden this definition to include any obligation of the borrower (including accounts payable or lease obligations).
Material adverse change clauses: A material adverse change clause provides that an event of default will arise if the lender believes that the condition of the borrower makes it unable to perform its obligations under the credit agreement. Borrowers will resist the inclusion of material adverse clauses because of the broad rights that this provision affords the lender. Where lenders insist on this provision, borrowers typically will seek to limit its scope by including a reasonableness clause. Many courts have insisted on high standard of materiality for any lender that invokes a material adverse change clause. We have witnessed much heated negotiation around this clause and have yet to see its practical applicability in middle market commercial loans.
Entire agreement clause: This is also known as the merger clause and states that the signed agreements are definitive and supersede any earlier agreements or understandings whether in writing, email or conversation. To the extent any previous term sheets, emails or proposals are in conflict with the loan agreement, the loan agreement will be binding on the parties.
Eligible Contract Participant: New rules under the Dodd-Frank Act require that only qualified entities sign hedge contracts. Therefore, each borrower that is party to a hedge contract must be an Eligible Contract Participant. To the extent a guarantor is not an Eligible Contract Participant that guarantor may not support the hedge obligation of the borrower. Where multiple obligors are signing documents and only some are Eligible Contract Participants, a Keepwell Provision allows the Eligible Contract Participant to support the hedge obligations of the non-Eligible Contract Participants.
By understanding the important elements of the definitive loan agreement, lenders can be better equipped to address their customer’s needs and negotiating a fair and reasonable outcome for both the borrower and the bank. By having better knowledge and insight of the documentation provisions, commercial lenders can become trusted advisors to their borrowers and achieve better results for their bank.
Submitted by Chris Nichols on April 27, 2016