Borrower Negotiation Of Loan Commitments

When approaching a loan commitment the first steps are critical for making the best deal you can. This memo outlines approaches for negotiating a commitment for the most common types of credit agreement used to finance businesses.

Common components of a credit facility include (1) an agreement to borrow and repay loans from time to time for working capital; (2) an agreement for an amortizing term loan, often for capital items; and (3) an agreement where the bank agrees to issue letters of credit to third parties as requested by your company, typically suppliers. These loans will almost invariably be secured by most or all of your operation s property.

Negotiate Critical Terms Before Signing

Loan agreements are always onesided in favor of the bank. The final documents will require many covenants and restrictions on the company and give the bank a wide range of rights. Be realistic about what you can do. Not being realistic right up front means you will waste time and dollars getting nowhere.

Your most important strategy is to negotiate critical loan terms before you sign the commitment letter, not after. What the bank is selling is largely fungible: money. At the commitment stage, you may be negotiating with other banks. Even if you are not negotiating with other banks, this is the point in the deal where you have options; if for no other reason than you do not have a lot of time and money into dealing with this bank. It is also the time when the loan officer will be the most flexible to get the loan in the door. Negotiate for what you want before signing anything. Having a lawyer experienced in commercial lending at this point is critical. Once the commitment letter is signed, the deal is effectively done. Many companies have lived with oppressive deals because the lawyer arrived only in time to review final loan documents.

Who is Committed to What?

A loan commitment is like any other contract. It is binding and enforceable. But, it is only enforecable to the extent of its actual terms.

Companies often rely heavily on the bank s funding commitment. An existing loan might be maturing. You may have signed a contract to do something that depends on the loan and the time to fund the deal is rapidly approaching. You can never have complete assurance the bank will close the loan on time or at all because of many conditions you will have to meet to close. There are some ways to mitigate this risk.

Loans, especially large loans, are often syndicated. This means the bank you are dealing with will act as the lead for a group of banks. Loan commitments often condition the bank s obligation on its ability to assemble the group. This condition should be resisted. You cannot control the process and do not want to discover at the 11th hour that the bank s efforts were unsuccessful. Insist that the bank bear the risk (if it can do so within its lending limits) of its failure to syndicate, perhaps at first funding more than it might like with the right to syndicate the rest later. If need be, the early addition of a second bank might allow the two to fund the facility within regulatory limits.

Get bank preclearance of problems or bad facts. This may include pending litigation, title issues on real estate, environmental conditions, or important clauses in critical contracts. You should frontend these issues to establish its credibility, get preapproval if possible, and to give everyone time to solve them should it be needed.

Seek to delay paying any fee until closing. If this is not possible, negotiate for the right to a refund of the fee if the loan fails to close for any reason other than your willful default. If the loan does not fund because of any of the escape hatches in the loan commitment, you should get a refund. You will need to concede that the bank can deduct reasonable outofpocket expenses to third parties, like lawyers and appraisers. Any fees you deposit should bear interest for your benefit.

Loan commitments normally have a dropdead date after which the bank need not fund for any reason. In addition to negotiating a commitment fee refund, consider asking for extension rights, even if they come at a price.

Most companies view their commitment as an option to borrow if you so choose. Most welldrafted commitments, however, have language like the following: Bank agrees to lend to Borrower, and Borrower agrees to borrow from Bank, the full amount of the Loan. Companies have been successfully sued for failing to close loan transactions. The commitment letter should say forfeiture of the commitment fee is the only remedy of the bank against the borrower for failure to close the loan.

Negotiating at the Commitment Stage

From your perspective, the entire set of loan documents would be negotiated before you signed anything. This is rarely available or even attractive, however, because the parties want to determine whether they can sketch a broad outline of the agreement before going through the additional legal and due diligence expenses involved in closing a loan. The issues that should be negotiated up front will vary from deal to deal. The following are not a definitive list.

Financial Terms

The basic financial terms must always be spelled out. These include:

The amount that may be borrowed.

The interest rate(s). Any fixed rate of interest should be stated. If the rate will vary, spell out the index. For a primebased loan, detail whether it is based on the bank s announced prime rate or a quoted rate from some other major financial institution.

The loan maturity date.

Any right to extend the maturity date and the conditions for doing it. Be sure the notice required is not too burdensome.

A description of 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 like 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 365/6day calendar year, a 360day year of equal 30day months, or some other rule?

Loan Availability

Almost all commercial credit facilities are secured by personal property of the borrower: typically accounts receivable, equipment, and inventory. The bank will want a cushion for each collateral class and will agree to lend only against preagreed percentages of eligible collateral. Additional sublimits are common. A typical lending formula for a $10,000,000 loan might read: 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 Eligible Accounts can be a problem. Banks have legitimate reasons for limiting the kinds of accounts they consider eligible. Accounts due from affiliates or an overconcentration of accounts from one customer are two types of accounts that might be defined as ineligible. There is no substitute for having your CFO get, at the earliest possible stage, the bank s definitions and formulas, then computing how much you will be able to borrow. Companies often realize too late that the actual loan proceeds available at closing will be insufficient.

Prepayment Rights

It is commonly assumed there is no problem if the commitment is silent on prepayment. Unfortunately, prepayment can be a big problem. Courts have held that without a specific right to prepay, a bank is entitled to the benefit of its bargain payment of the interest over the agreedupon 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.

Banks often insist on prepayment restrictions because if you prepay in a declininginterestrate environment, they will be forced to relend the proceeds at a lower rate. These restrictions can range from outright prohibitions ( lockouts ) to requirements that you pay premiums based on yieldmaintenance formulas designed to ensure the bank s profit on the loan. The yieldmaintenance premium is often based on the difference between the interest rate under the loan and the yield the bank would receive on reinvesting the prepaid amounts in a U.S. treasury security of like duration.

You want to shorten any lockout period and minimize the amount payable under a yieldmaintenance provision. One way to do this is to ask that the yieldmaintenance formula use the treasury rate plus XXX basis points as the measuring point rather than just the treasury rate. The bank is often lending at a rate 125 to 150 basis points over treasuries so its yield on reinvested prepayments will likely be higher than the treasury rate. This still allows the bank to get back lost profits, but also presumes the bank will be able to position 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 you are forced to retire debt early because of a catastrophe, you should also have to pay a prepayment penalty.

Escrows

Banks often require you to escrow funds in an account ( impound account ) to assure certain periodic payments are made: typically, real estate taxes and insurance premiums. These accounts are initially funded with a lumpsum deposit at closing and augmented periodically. Withdrawals are made depending on the circumstances. Banks typically resist paying interest on these accounts.

You should ask to eliminate this requirement or permit the bank to require an escrow only if there is an event of default under the loan documents. You also should ask that deposits bear interest.

DueonSale

Practically all mortgages have a dueonsale clause. It allows the bank to declare a default and accelerate the balance of the loan if you sell the real estate to a third party without its written consent. In a pure real estate loan, where the real estate is only collateral, this is difficult to challenge. In a broader loan facility, however, other approaches may be possible unless the property is a critical part of the borrower s operations.

One approach is to require the bank s discretion in consenting to a transfer be reasonably exercised. A preferable approach is a partial release agreement where you are permitted to dispose of the property provided the net proceeds of the sale are used to pay down the loan. It is important to remember, however, that you 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 you are not a publicly traded company, the bank will often forbid transfers of equity interests in the company. The bank s primary concern is a change of control. The bank knows the management expertise and style of the people it has negotiated the loan with. It is not relying only on the collateral to assure repayment; it is relying as well on the skill of your lead player(s).

You will probably need to give in to restrictions on transfers of equity interests but should get permission for some transfers. 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

Banks never want to compete with other creditors. Loan agreements typically forbid other indebtedness (antidebt restrictions) as well as security interests in favor of other banks (antilien restrictions).

You can typically get exceptions to the antidebt restrictions, permitting you to incur: (1) unsecured trade debt incurred in the ordinary course of doing business, (2) debt subordinated to the bank on terms reasonably acceptable to the bank, (3) intercompany indebtedness, (4) purchase money debt (as long as the debt is not more than the initial value of the asset), and (5) capital leases, which may be treated as debt for some purposes. Occasionally, but not often, you also may be able to negotiate a basket entitling you to incur additional unsecured debt up to a preagreed maximum.

Exceptions to antilien restrictions are rarer but might include (1) specified existing liens, (2) nonconsensual liens imposed by operation of law (like 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 a way that does not to jeopardize the bank s collateral position.

Guarantors

You must understand precisely what guarantees will be required and from whom. If there are multiple guarantors, know whether the guarantors will be jointly and severally liable or not. Banks always hold out for broad liability.

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 ( carry guaranty )? Can the guaranty be structured as an earnout guaranty under which the guarantor is excused if, for example, the borrower reaches (and, depending on the agreement, maintains) certain specified financial targets, like net operating income, net worth, or debttoequity ratios?

Lawyer Opinions

A general enforceability opinion will be required by almost every bank in which your 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 bank will require outside counsel to provide the opinion.

Fights over legal opinions are almost always unproductive and expensive. 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 bank has a perfected security interest in the collateral. Most firms will deliver this opinion, although negotiation over the qualifications and assumptions can take time and cost money.

If the bank wants an opinion that its liens have a first priority, serious problems can come up because most prominent law firms refuse to deliver such an opinion.

If your 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. The bank 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 you are plentiful and must be negotiated at once. Never forget that the bank is weakest at the outset, making this the time to order your priorities and ask for what is most important.