Demystifying the Loan Agreement: A Guide for Lenders

As a lender, you have invested significant time and resources in building relationships with potential borrowers, presenting your financial solutions, and negotiating the basic terms of a loan through a nonbinding term sheet. However, without a well-drafted loan agreement, a seemingly promising deal can quickly turn into a financial nightmare. This article explains the critical sections of a typical loan agreement.

Definitions: Setting the Ground Rules

Definitions hold immense importance. They establish clear and consistent meanings for key terms throughout the agreement, preventing misunderstandings and potential disputes. Pay close attention to how crucial financial terms are defined.

Terms of Lending: The Heart of the Agreement

The terms outline the essential elements of the loan:

• Loan Amount: The principal amount of the loan and the type of credit facility offered (e.g., revolving, term, real estate loan).
• Interest Rates: Method of calculating interest (fixed, variable, etc.) and the applicable rate.
• Payment Schedule: Frequency and amount of loan repayments and potential prepayments.

Conditions Precedent: No Disbursement Until Requirements Are Met

Conditions precedent are conditions that must be met before releasing funds, both initially and for future extensions of credit:

• Appraisals and Valuations: Borrower’s financial health aligns with the loan amount and underwriting assessments.
• Third-Party Approvals: Necessary consents, approvals, and documentation from relevant parties are obtained.
• Representations and Warranties: Representation and warranties are true and correct.
• Insurance Coverage: Borrower has adequate insurance to protect its business and collateral.
• Absence of Default: Borrower is not in default.

Security Agreement and Guarantee: Adding Layers of Protection

• Security Agreement: If collateral is involved, a security agreement grants the lender a security interest in specific assets of borrower and outlines the process for perfecting the claim on the collateral, ensuring priority over other potential creditors. Precisely describing the collateral according to UCC categories and guidelines is crucial.
• Guarantee: A guarantee creates a separate obligation from a third party (e.g., parent company, owners, or key executives) who agrees to repay the loan if the borrower defaults.

Sometimes the security agreement and guarantee are separate documents, in which case it is important to ensure that there are no inconsistencies among the documents.

Representations & Warranties: Understanding the Borrower’s Promises

Borrower’s promises regarding its business include:

• Existence and Power: Borrower is a valid legal entity operating in compliance with the law.
• Authority: Borrower is authorized to enter the loan and borrow the money.
• Financial Statements: Borrower’s accurate financial statements have been provided.
• Solvency: Borrower is and will remain solvent both before and after the loan is made.
• Litigation: Borrower does not have any pending or threatened litigation or governmental investigation.

A key point to negotiate in this section is the definition of “knowledge.” Borrower may attempt to limit “knowledge” to specific individuals and their actual awareness. A lender may appropriately require “knowledge” to include what key individuals are aware of or should be aware of, given their titles and positions.

Affirmative & Negative Covenants: Guiding the Borrower’s Actions

• Affirmative Covenants: Affirmative covenants are actions borrower promises to take throughout the loan to protect lender’s interests. Examples include providing periodic financial statements, maintaining corporate existence, maintaining required insurance (to include listing the lender appropriately), and providing timely notices of relevant events (defaults, material adverse effects, litigation, etc.).
• Negative Covenants: Negative covenants restrict borrower from taking actions that could jeopardize its ability to repay the loan. Examples include limitations on additional debt, liens on property, mergers, consolidations, asset sales, dividend payments, and significant changes in business operations.

The purpose of covenants is not to micromanage borrower’s business but to ensure the lender is informed of critical changes and that borrower’s business operates as expected when the loan was underwritten.

Default and Remedies: Addressing Loan Breaches

This section of the loan agreement defines specific circumstances that would trigger a default, potentially allowing the lender to accelerate the loan, demand immediate repayment, or foreclose on collateral. Standard defaults include:

• Nonpayment: Missed or late payments.
• Breach of Representations and Warranties: Inaccuracy found in borrower’s initial statements.
• Covenant Default: Borrower’s failure to perform or observe certain covenants.
• Cross Default: Default under another loan or material agreement.

Boilerplate: Miscellaneous

Routine provisions, normally at the end of the agreement, are often overlooked but are critical in governing the loan. Pay close attention to:

• Notices: How and when communications must be sent.
• Governing Law, Venue, Forum: What jurisdiction’s law applies and the forum and location for potential disputes.
• Amendments: The process for modifying the agreement.
• Expenses and Indemnification: Borrower’s responsibility for lender’s reasonable expenses and protection of lender from borrower’s actions.
• Successors and Assigns: Lender’s ability to assign the loan; borrower’s restriction from assignment without consent.

This is a general overview, not an exhaustive list of potential provisions. Every loan agreement is unique and requires customization. Lenders should ensure maximum protection of their interests in line with applicable laws.