Negotiating A Commercial Loan? Here Are Some Points To Consider
Negotiating commercial loan documents is often a complex exercise, simply because the relationship between the borrower and lender will govern those documents for a long time. It requires a delicate balance between the lender’s requirements and the borrower’s needs. The lender wants to be paid on time and preserve all of its rights and remedies to mitigate the risks of a loan default, keeping in mind that even the best covenants cannot turn a bad loan into a good loan. The borrower, on the other hand, wants to preserve flexibility, run its business as it sees and obtain returns on its assets that exceed the debt-service of the loan.
Below is an overview of a few basic but material provisions of loan documents that are often heavily negotiated before a loan is closed.
Borrowers and lenders should be aware of what will occur when their loan matures, or, more importantly, if it is paid before it matures. In most states, a borrower does not have the right to prepay a commercial loan unless that right is expressly provided for in the loan documents. If the note is silent regarding prepayment, the borrower has no right to pay early. It is generally understood that the borrower may have to pay some type of prepayment or yield maintenance fee to the lender if the borrower prepays all or a portion of the loan before it matures.
In the majority of prepayment situations, the borrower prepays the loan in connection with the sale of the property securing the loan, or in connection with the refinancing of the loan. These prepayments are voluntary acts on the part of the borrower. Often times, however, the parties do not contemplate whether the prepayment fee is payable when the borrower is forced to prepay the loan due to circumstances that are not of the borrower’s choosing.
Both parties should contemplate and discuss whether the prepayment premium will apply to an acceleration of the loan, the application of insurance proceeds or eminent domain proceeds to the principal balance of the loan, as well as any other "involuntary event" the parties can anticipate. Accordingly, in order to enforce a prepayment premium, the loan documents must clearly and unambiguously provide for the payment of the fee under such voluntary and involuntary circumstances.
Representations and Warranties
Generally, the representations and warranties section of a loan agreement includes statements that the borrower makes to the lender regarding such things as the borrower’s organizational status, financial status, compliance with laws, authority to borrow money, business and contractual restrictions, and other matters. Many of these representations and warranties are absolute, and the borrower’s counsel will request that they be qualified by a standard of materiality, reasonableness or knowledge, the theory being that the borrower should not be in default for a condition it did not know about or could not entirely control. While this may be a reasonable comment, many times the lender will not agree to this since the lender does not want to be in the position of arguing whether or not the borrower should have known about a condition or whether a condition was a “material” condition, especially when these issues generally only arise when there is a default under the loan agreement.
The event of default section is often the most negotiated section in a loan agreement. Events of default typically include a payment default, covenant defaults, breaches of representations and warranties, and bankruptcy default. The borrower will generally request a grace period or notice and cure periods or longer grace periods and notice and cure periods than originally provided. Generally, lenders are hesitant to agree to lengthy notice and cure periods since the borrower will likely have notice of a problem before the lender.
As an additional method of securing loans, lenders often place a "cross-default" provision in loan documents which states that a default under any loan between the borrower and lender triggers a default under all of the loans between the borrower and lender. For example, if the borrower has four separate loans with the lender and defaults on just one of them, the lender can accelerate payment or declare an “event of default” under all four loans.
The borrower will want to minimize the scope of agreements and transactions that apply to this provision to documents and transactions that are material and easily identifiable to the borrower. A lender, on the other hand, will want to expand the scope of documents and transactions to include other loan documents relating to the loan, documents evidencing other loans from the lender to the borrower and documents evidencing other loans and transactions between the borrower and third party lenders. The lender’s primary concern in this regard is that the borrower is complying with the terms and obligations of its creditors; if the borrower cannot meet its debt obligations then it is in distress, and the lender should have the option of exercising its remedies, preferably before any of the borrower’s other creditors have a chance to do the same.
Another default provision that is heavily negotiated is the judgment default. This provision generally states that any judgment against the borrower triggers an event of default under the loan. While the threshold is generally a credit decision for the lender, the key issue for the borrower is the size of the dollar amount and the amount of time that it takes the borrower to have the judgment set aside or dismissed. For some borrowers, the nature of their business (i.e., car dealerships, retail vendors) entails a certain amount of anticipated litigation. Accordingly, the borrower will generally request that the judgment dollar amount is high enough so that it is not forced to settle a small claim that it would otherwise litigate just because the claim could result in a monetary judgment that triggers the event of default under loan agreement.
Concluding Points to Consider
The relationship that will exist between the lender and its borrower over the life of a loan can be tempered by the initial negotiation. Below are a few points and recommendations that may make the loan negotiations and closing process a smooth one:
What one party may consider irrelevant, the other may consider material to the loan transaction. Both parties should directly communicate their expectations and concerns early in the loan process. Examples include the ability of a business owner to transfer stock or membership interests in the company to family members for estate planning purposes or the ability to obtain subordinate financing. These types of concerns should be communicated to each party’s respective attorneys and accountants.
If the borrower has prior loan facilities with the lender, the borrower should ask the lender whether its counsel will work from documents from a previous similar transaction. This can be an effective way to bypass most of the loan negotiations and control the associated costs of closing the loan. The borrower should undertake significant research to completely understand the loan process. If the borrower does not have a high comfort level negotiating the loan, it should seek assistance from accountants, attorneys, and other business advisors.
Michael Smith's practice primarily is focused on the structuring, negotiation, documentation, due diligence and closing of commercial lending transactions. For assistance in negotiating a loan, contact Michael at email@example.com or (301) 657-0166.