One difference between a great commercial lender and an average commercial lender is the understanding of loan documents and insightful knowledge of key terms found in loan documents. In this first part, of two, we will consider the structure of common commercial loan documentation and some finer points about working with these agreements and terms.
Borrower’s and Lender’s Objectives
When negotiating loan documents, the following are borrower’s typical key objectives:
- Ensure funds will be available when needed;
- Obtain funds at the lowest interest rate possible;
Eliminate or dilute covenants, conditions precedents, reps and warranties;
Provide for the repayment of the loan over a period as long as possible;
Prepay the loan with the highest flexibility and lowest cost;
- Extend any cure or grace periods;
- Provide as little documentation and financial reporting to the lender as possible.
The lender has a diametrically opposed agenda and negotiates the opposite of the objectives listed above. Additionally, lenders want to strictly define conditions under which it is obligated to disburse funds. Lenders should attempt to require the borrower to provide as much information as possible, in the shortest amount of latency in order to better monitor the borrower’s financial situation and to take remedial action if the borrower experiences financial difficulties.
More and more middle-market credit facilities are being papered with automated documentation programs such as Laser Pro or EasyLender. The more complex transactions are still documented with attorney-prepared agreements. Typically, but not always, attorney-prepared agreements rely on the credit agreement for the majority of the definitive negotiated documentation. With automated software programs, documentation is parceled into various agreements. While our discussion centers on automated software programs, these comments also generally apply to attorney-prepared agreements.
The Promissory Note
In middle market commercial bank lending, promissory notes typically are short documents that refer and incorporate information in a business loan agreement. A promissory note differs from a loan agreement in that the borrower, but not the lender, signs a promissory note. A promissory note heavily favors the lender instead of the issuer of the note (the borrower). The borrower undertakes all obligations under the promissory note: such as promise to pay a monthly amount or the entire loan on-demand or at certain times. Because the lender is not a party to the promissory note, it does not have any obligations it would otherwise have in a loan agreement (such as obligations to mitigate damages, act reasonably, or provide certain notices).
Another important distinction between a promissory note and a loan agreement is that the promissory note is a liquid asset and can be negotiated by the lender (transferred or sold). Also, under many jurisdictions, the rights and obligations provided under a promissory note are easier to enforce than those provided under a loan agreement.
However, a promissory note cannot stand alone without reference to the other loan agreement terms.
The loan agreement will contain the majority of the obligor/creditor language. This is where most lenders will include the following:
Representations and Warranties;
Negative Covenants; and
Events of Default;
Beside the promissory note and loan agreement lenders may include any of the following documents, depending on the nature of the financing and the credit arrangements:
- Corporate Resolution;
- Subordination Agreement;
- Intercreditor Agreement;
- Assignment Agreement;
- Pledge Agreement;
- Security Agreement;
- Deposit Account Control Agreement;
- Mortgage or Deed-of-Trust;
- Error and Omission Agreement;
- Disclosure and Authorization forms;
A discussion of each of the above document is beyond the scope of this blog, however, commercial lenders need to have a basic understanding of the intent of each document.
General Loan Concepts
Secured or Unsecured Loan: An unsecured loan is supported by the borrower’s cash flow and assets, but does not include a specific lien any particular asset. A secured loan is supported by the borrower’s cash flow and assets and also grants the lender a priority claim to a specific asset or cash flow stream as security for the loan. Letters of credit and third-party guaranties are other types of credit enhancements and both of these may also be secured or unsecured.
Negative Pledge: Negative pledge clause is typically used on unsecured loans and prevents the borrower from pledging certain types or amounts of assets to other lenders. The intent is to prohibit another creditor from having a superior security interest in the assets of the borrower for future loans.
Reserve Requirements: Bankers that have experienced a couple of downturns know that a reserve fund can make a world of difference with certain types of short or intermediate-term credit shocks. Banks will often require that borrowers build up a reserve fund, to be kept on deposit at the bank, once cash flow exceeds certain requirements such as 1.3x debt service coverage. Borrowers are allowed to use these funds, with the bank's approval, to make certain payments to include mortgage servicing, insurance, tax and repair in times of credit stress. The presence of a reserve fund is often an offset to help the bank reduce risk in cases where the borrower needs to obtain certain pricing levels. A bank may grant lower than market pricing but in exchange, require a reserve fund be built up to handle a specific level of payments, often structured as 90 days to 120 days of cash flow payments. Alternatively, banks may always require reserve funds for certain types of lending such as hospitality or specialty commercial real estate that comes with higher risk.
Reserve funds can be critical to help a bank and borrower maintain the current payment of debt service before insurance kicks in for Acts of God (hurricanes, earthquakes, floods, etc.) or should long-tail events occur such as civil unrest, temporary road closures, or other such short-term shocks that may or may not be claimed by insurance.
Letter of credit: A letter of credit is a promise by the issuer of the letter of credit, typically a bank (the issuer), to pay a specified amount to the recipient of the letter of credit (the beneficiary) when the beneficiary presents the letter of credit to the issuing bank stating the conditions specified have been met (default or non-performance). Typically, a letter of credit is issued at the request the borrower (the applicant) who in turn must secure the letter of credit at the issuing bank. A letter of credit substitutes the creditworthiness of the issuer of the letter of credit (another bank) for that of the borrower (the applicant). If a bank relies on a letter of credit to enhance an obligation of the borrower, the underwriting of that specific obligor will be much easier.
Term, Demand and Revolving Loans: A term loan is repaid on a specified maturity and usually allows for early repayment (with or without prepayment penalties). A demand loan is due at any time the lender requests payment. While demand facilities abound, they are not common in commercial funding transactions. Some lenders will attempt to include provisions in term loans that modify the facility to behave like a demand loan. Lenders prefer the ability to demand funds back for any reason, such as the loss of confidence, material change in the borrower’s financial conditions, deterioration in the economy, or change in the lender’s financial health. Lenders must be careful to avoid including covenants and defaults in demand notes as this may negate the purpose of the demand nature of the facility.
Under a revolving line of credit, funds can be disbursed and repaid during the life of the loan agreement. The amount of outstanding will not exceed the lender’s commitment under the facility.
Bullet Versus Amortizing: Loans, where the principal is payable at maturity in a single lump sum, are called bullet loans. Loans, where the principal is payable according to a schedule, are called amortizing loans. Commercial lenders should have the knowledge and tools to be able to compute average duration of a loan based on any amortization and repayment term. It may be surprising to some lenders that a 15-year, fully amortizing loan may have a shorter duration than a 25-year amortizing, 10-year term loan (depending on the interest rate used to amortize the facility). This knowledge may be useful to lenders in marketing, pricing, and structuring loans.
Successful commercial lenders do not require a law degree or specific drafting skills; however, understanding the various loan documents and the important provisions allows lenders to be better negotiators and trusted advisors to their customers. In our second part of this discussion we will consider certain loan provisions typically contested between borrowers and lenders and discuss how lenders should approach such negotiations.
Submitted by Chris Nichols on April 20, 2016