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Negotiating the Loan Commitment: The Borrower's Perspective

Author(s): John N. Oest


Source: Business Law Today, Vol. 19, No. 3 (January/February 2010), pp. 60-64
Published by: American Bar Association
Stable URL: http://www.jstor.org/stable/23297371
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Law Today

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provisions

preclearance
of bad
facts
financial
terms

prepayment

legal
opinions

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Negotiating the
Loan Commitment
The Borrower's Perspective

By John
John N.
N. Oest
Oest

Negotiate Critical Terms Before Signing A borrower often relies heavily on


nies will increasingly seek financ Loan agreements are always one the lender's funding commitment. An
As credit markets rebound, compa
ing for their businesses. Financing sided in favor of the lender. No matter existing loan might be maturing. The
may take many forms: revolving credit how persistent the borrower, the final borrower may have signed a contract
loans, loans to finance the acquisition documents will impose numerous cov to purchase a company or a piece of
of a target company, or construction enants and restrictions on the borrow land, and the closing date is rapidly
loans, to name a few. Loans may be er and afford the lender a wide range approaching. The borrower can never
short- or long-term, may fully amortize, of rights. It is important for any bor have complete assurance that the lend
or may have a balloon maturity date. rower to be realistic about what it can er will close the loan when needed
This article stresses the critical hope to achieve. because of various conditions prece
importance of the initial steps when The borrower's most important dent that the borrower must meet. But

approaching a loan commitment and strategy, by far, is to negotiate criti there are still several ways to mitigate
outlines effective approaches for a cal loan provisions before it signs the this risk.
borrower negotiating a commitment commitment, not after. Never forget Loans, particularly large loans, are
for the most common type of credit that what the lender is selling is fungi frequently syndicated—meaning that
agreement: a facility that the company ble: money. At the commitment stage, an arranger will act as the lead for a
will use for most of its credit needs. the borrower may actually or purport consortium of lenders. Loan commit
Common components of such a facility edly be negotiating with other lenders. ments often condition the lender's
will include (1) an agreement to bor This is the moment when the loan offi obligation on its ability to assemble
row and repay loans from time to time cer will be the most flexible in order to such a syndicate, but this condition
for use as the borrower's working capi get the loan in the door. It is important should be resisted. The borrower
tal; (2) an agreement for an amortizing that the borrower recognize this and cannot control the syndication pro
term loan, often for capital items such negotiate its wish list early before sign cess and does not want to discover at
d as equipment purchases; and (3) an ing anything or making any kind of the 11th hour that the lead lender's
& syndication efforts were unsuccess
agreement by which the lender agrees deposit. Engaging counsel is also criti
to issue letters of credit to third par cal. Many a borrower has lived with an ful. The borrower should insist that
ties as requested by the borrower, typi oppressive loan agreement because its the lead lender bear the risk (if it can
cally suppliers to the borrower. These lawyer arrived only in time to review legally do so within its lending limits)
loans will almost invariably be secured final loan documents, which by then of its failure to syndicate, perhaps ini
by most, if not all, the property of the memorialized a deal cast in stone. tially funding more than it might like
borrower. but retaining the right to syndicate
Who Is Committed to What? the rest later. If need be, the early
Oest is a lecturer at law at the University of A loan commitment is like any other addition of a second lender might
Chicago School of Law. His e-mail isjost@ contract: a binding agreement enforce enable the two to fund the facility
able in accordance with its terms. within regulatory limits.

JANUARY/FEBRUARY 2010 61 BUSINESS LAW TODAY

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It is critical to obtain lender pre Loan commitments typically have a • Any rights to extend the maturity
clearance of problems or bad facts. drop-dead date after which the lender date and the conditions for doing so.
Such matters may include pending liti need not fund for any reason. In addi Be sure the lead time required is not
gation, title issues on real estate, envi tion to negotiating a commitment fee too onerous.

ronmental conditions, or important refund in such an instance, consider • A description of the fees and their
clauses in critical contracts (such as requesting extension rights, even if due dates. When will fees be deemed
employment or supply contracts). The such extensions come at a price. to have been earned? Can the bank's
borrower should front-end these issues Most borrowers incorrectly view outside legal fees be capped, or at least
for several reasons: first, to establish their commitment as an option to bor estimated?
its credibility with the lender; second, row if the borrower so chooses. Most • Financial covenants such as debt
to obtain preapproval if possible; and, well-drafted commitments, however, service coverage ratios, tangible net
finally, to give everyone time to solve will contain language something like worth requirements, or capital expen
them should that be required. the following: "Lender agrees to lend diture limitations.
to Borrower, and Borrower agrees to bor • Calculation of interest. On what
row from Lender, the full amount of the basis will interest be calculated? For
Loan." Borrowers have been success example, will it be based on a 365/6
The borrower's fully sued by lenders for failure to close day calendar year, a 360-day year of
loan transactions. The commitment let equal 30-day months, or some other

most important ter should recite that forfeiture of the


commitment fee is the sole and exclu
convention?

sive remedy of the lender against the Loan Availability


strategy is to borrower for failure to close the loan. Almost all commercial credit facili
ties are secured by personal property of

negotiate critical Negotiating at the Commitment Stage


From the borrower's perspective, the
the borrower: typically accounts receiv
able, equipment, and inventory. The
entire set of loan documents would be lender will want a cushion for each
loan provisions negotiated before it signed anything. collateral class and will agree to lend
This result is rarely obtainable or even only against pre-agreed percentages of

before it signs desirable, however, because the par


ties want to determine whether they
eligible collateral. Further sublimits are
common. A typical lending formula for
can sketch even a broad outline of their a $10,000,000 loan might read as fol
the commitment, agreement before undertaking the addi lows: "85% of Eligible Accounts (but
tional legal and due diligence expenses in no event more than $6,500,000)
not after. attendant to closing a loan. The issues plus 70% of Eligible Inventory (but
that should be negotiated up front in no event more than $2,500,000)
will vary from transaction to transac plus 70% of the value of Eligible
The borrower also should seek to tion, so the following items should not Equipment (but in no event more than
delay paying the commitment fee until be viewed as the definitive list. All are $1,000,000)."
closing. If this is not achievable, the bor important enough, however, to warrant The definitions of items such as
rower should negotiate for the right to serious early consideration. "Eligible Accounts" can be a trap for the
a refund of the fee if the loan fails to unwary. Lenders have legitimate rea
close for any reason other its own will Financial Terms sons for limiting the kinds of accounts
ful default. This means the borrower will The basic financial terms must they will consider eligible. Accounts
be exposed (and ought to be exposed) always be spelled out. These terms due from affiliates or an overconcentra
to loss of the commitment fee if it sim would include: tion of accounts from one supplier are
ply finds another loan it prefers. On the • The amount that may be but two types of accounts that might be
other hand, if the loan does not fund borrowed. defined as ineligible. There is no sub
because of any of the escape hatches • The applicable interest rates. Any stitute for having the borrower's chief
in the loan commitment, the borrower fixed rate of interest should be stipu financial officer obtain, at the earli
should receive a refund. The borrower lated. If the rate will vary, specify the est possible stage, the lender's defini
will need to concede that the lender can underlying index. For a "prime-based" tions and formulas, then computing
deduct from the refund its reasonable loan, specify whether it is based on the how much the company will be able
out-of-pocket expenses to third parties, lender's "announced" prime rate or a to borrow. Borrowers often realize too
such as lawyers and appraisers. Any fees widely quoted rate from some other late that the actual loan proceeds to be
that are deposited should bear interest major financial institution. delivered into their hands at closing
for the benefit of the borrower. • The maturity date of the loan. will be insufficient.

BUSINESS LAW TODAY 62 JANUARY/FEBRUARY 2010

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Prepayment Rights debt early because of a catastrophe to reborrow these funds if the remain
Borrowers commonly assume that such as a condemnation or casualty, it ing collateral package does not gener
there is no problem if the commitment should not suffer the further indignity ate enough availability under the lend
(and the loan documents) is silent on of a prepayment penalty. Most lenders ing formula.
prepayment. Unfortunately, prepay will grant this exception.
ment may be a big problem. Various Change of Control
courts have held that, absent a specific Escrows If the borrower is not a publicly
right to prepay, a commercial lender is Lenders often require a borrower traded company, the lender will often
entitled to the benefit of its bargain— to escrow funds in an account (often forbid transfers of equity interests in
payment of the agreed-upon rate of called an "impound account") to assure the borrower. One need not probe
interest over the agreed-upon period of that certain periodic payments are deeply, however, to learn that the
time. The solution is obvious: insist on made: typically, real estate taxes and lender's primary concern is a change of
an express right to prepay at any time, insurance premiums. These accounts control. The lender knows, and is pre
in whole or in part, and without pen are initially funded with a lump-sum sumably comfortable with, the man
alty or premium. deposit at closing, either from the bor agement expertise and style of the per
Lenders often resist this request, rower's existing funds or from loan sons with whom it has negotiated the
however, and insist on prepayment proceeds, then augmented periodi loan. It is not relying solely on its col
restrictions because if a borrower pre cally. Withdrawals are made annually lateral to assure repayment; it is relying
pays in a declining-interest-rate envi or semiannually depending on the cir as well on the skill of the borrower's
ronment, they will be forced to relend cumstances. Lenders typically resist lead player(s).
their repayment proceeds at a lower paying interest on these accounts. The borrower will probably need to
rate. These restrictions can range from The borrower should seek to elimi accede to restrictions on transfers of
outright prohibitions (termed "lock nate this requirement or, in the alter equity interests but should seek per
outs") to requirements that the bor native, to permit the lender to require mission for transfers that do no vio
rower pay premiums based on yield an escrow only if there is an event of lence to the lender's primary concern.
maintenance formulas designed to default under the loan documents. The Permitted transfers might include
ensure the lender's profit on the loan. borrower also should ask that deposits (1) transfers of limited partnership or
The yield-maintenance premium is bear interest. membership interests; (2) transfers of
often based on the difference between equity interests that do not result in
the interest rate under the loan and Due-on-Sale a change of control; (3) transfers into
the yield the lender would receive on Examine almost any mortgage and inter vivos or testamentary trusts for
reinvesting the prepaid amounts in a one will find a due-on-sale clause. This estate planning purposes (so long as
U.S. treasury security of comparable clause permits the lender to declare the persons responsible for voting or
duration. a default and accelerate the balance managing the interests transferred into
A borrower wants to shorten any of the loan if the borrower sells the the trust remain the same); (4) trans
lockout period and/or seek to mini real estate to a third party without the fers among existing equity holders (so
mize the amount payable under a lender's written consent. In a pure real long as there is no change in control);
yield-maintenance provision. One way estate loan, where real estate is the sole and (5) transfers to affiliates.
to do the latter is to ask that the yield collateral, this is a difficult clause to
maintenance formula use the treasury challenge. In the context of a broader Other Debt or Encumbrances
rate "plus 50 basis points" (or some loan facility, however, other approach Lenders never want to compete
other number) as the measuring point es may be possible unless the property with other creditors. Accordingly,
rather than simply the treasury rate. in question is a critical part of the bor loan agreements typically forbid other
The lender is often lending at a rate rower's operations—such as its main indebtedness (anti-debt restrictions)
125 to 150 basis points above treasur manufacturing plant. as well as security interests in favor of
ies so its yield on the reinvested pre One approach is to require that other lenders (anti-lien restrictions).
payments will likely be higher than the the lender's discretion in consenting A borrower can typically obtain
treasury rate. This compromise still to a transfer be reasonably exercised. exceptions to the anti-debt restric
permits the lender to recoup lost prof A second, and probably preferable, tions, permitting the borrower to
its, but it also presumes that the lend approach is a partial release agreement incur the following types of debt:
er will be able to deploy its funds at in which the borrower is permitted to (1) unsecured trade debt incurred in
something above the flat treasury rate. dispose of the mortgaged property pro the ordinary course of doing business,
Most mortgages permit, and some vided that the net proceeds of the sale (2) debt subordinated to the lender
require, that condemnation or casualty are used to pay down the loan. It is on terms reasonably acceptable to the
proceeds be applied to pay down the important for the borrower to remem lender, (3) intercompany indebted
debt. If the borrower is forced to retire ber, however, that it might not be able ness, (4) purchase money debt (so

JANUARY/FEBRUARY 2010 63 BUSINESS LAW TODAY

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long as the debt is not in an amount (and, depending on the agreement, Conclusion

greater than the initial value of the maintains) certain specified financial Negotiating a loan commitment and
asset), and (5) capital leases, which may targets, such as net operating income, agreement can be a struggle for the
be treated as debt for some purposes. net worth, or debt-to-equity ratios? borrower. The lender has all the
Occasionally, but not often, the bor Lawyers for a borrower should money and with that comes most of
rower also may be able to negotiate a strongly consider advising guarantors to the leverage. Large portions of the loan
basket entitling the borrower to incur obtain separate counsel. The interests of agreement will always remain off lim
additional unsecured debt up to a pre a guarantor will frequently be directly its. Nonetheless, issues critical to the
agreed maximum. adverse to those of the borrower. borrower abound and must be negoti
Exceptions to anti-lien restrictions ated at once. Never forget that the
are even narrower but might include Lawyers' Opinions lender is weakest at the outset, making
(1) specified existing liens, (2) non A general enforceability opinion will this the time to order your priorities
consensual liens imposed by opera be required by almost every lender in and ask for what is most important. 133
tion of law (such as inchoate mechanics' which the borrower's counsel recites,
liens), (3) liens securing permitted pur among other things, that the loan
chase money debt, and (4) tax liens or documents have been validly autho
judgment liens that are being contested rized, executed, and delivered and that Keeping current

in good faith and in such a manner as they are enforceable in accordance (Continued from page 44)
not to jeopardize the lender's collateral with their terms (subject to applicable
position. bankruptcy laws and laws affecting violation—because it had "cultivated
creditors' rights generally). In many an environment of compliance" and
Guarantors instances, the lender will require out took remedial measures to address the

The nature, content, and scope of side counsel to provide the opinion, so Regulation FD violation.
guarantees can only be touched on in a corporate borrower is well advised The compliance measures highlight
this article. The borrower must under to understand early whether it can rely ed by the SEC included the following:
stand, however, precisely what guaran solely on in-house counsel. • A written investor relations policy
tees will be required and from whom. Disputes over legal opinions are that included a section addressing the
If there are multiple guarantors, resolve almost always unproductive and expen requirements of Regulation FD.
at once whether the guarantors will sive. Whether or not it is possible to get • Periodic Regulation FD compliance
a draft of the form opinion at the com training by counsel.
• ••••• mitment stage, the commitment should • The existence of an earnings guid
list the items on which the lawyer must ance policy.
Never forget opine. Pay particularly close attention • Review by counsel of proposed
to whether the lawyer will be asked to written communications to analysts.
that the lender opine that the lender has a perfected • Prompt corrective disclosure upon
security interest in the collateral. Most learning of the Regulation FD violation

is weakest at firms will deliver this opinion, although


negotiation over the qualifications and
and self-reporting of the violation to
the SEC.
assumptions can take time. • Adoption of remedial measures to
the outset. If the lender wants an opinion that address the violation and to prevent it
its liens have a first priority, seri from recurring.
ous problems can arise because most Public companies of course need to
be jointly and severally liable. Lenders prominent law firms refuse to deliver tailor their Regulation FD compliance
always hold out for broad liability, but such an opinion. Lenders are far less procedures to their own particular cir
guarantors just as vigorously resist it. prone to request this opinion now than cumstances. However, all public com
Even if the loan must be guaran in years past, but the careful borrow panies should use this most recent
teed, the guarantors should consider er will make sure the lender does not action as a catalyst for evaluating the
ways to reduce or even eliminate their require it. sufficiency of their Regulation FD com
exposure. Can the guaranty be limited If the borrower's real estate collateral pliance procedures and whether those
to a specific maximum? Can the guar is located in multiple states, local coun procedures are followed in day-to-day
anty exclude principal and be limited sel will probably need to be retained to practice. This action also underscores
to interest and other carrying charges deliver enforceability opinions for vari the importance of having in place, in
(a carry guaranty)? Can the guaranty be ous security documents granting liens advance, a crisis management plan that
structured as an earn-out guaranty pur in those states. The cost of local coun enables the company to quickly address
suant to which the guarantor is excused sel should be anticipated and budgeted both intentional and nonintentional
if, for example, the borrower reaches from the outset. Regulation FD violations. ED

BUSINESS LAW TODAY 64 JANUARY/FEBRUARY 2010

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