Many different types of funding options are available to a borrower, from an increasingly wide variety of finance providers. Here we look at one of the most common types: the bank loan. We assume that the loan is made to a corporate borrower and is secured (we will explore some of the main security issues in a further article).
The negotiation of the loan will usually start with agreeing a term sheet. This contains the principal commercial terms of the loan, such as duration, interest rate, number of advances, payment dates, main financial covenants and arrangement and legal fees. The term sheet does not amount to a legal commitment to lend. Its purpose is to focus the minds of the lender and borrower prior to agreeing the further details of financing through the loan agreement.
The ‘big 5’ banks will all have standard form loan documentation and their lawyers will prepare the first draft. While, for credit or operational reasons, the lender may be reluctant to concede on certain points, this does not mean that all provisions are non-negotiable. In our experience, the clauses that are most commonly negotiated are as follows.
- Financial covenants - These will be prepared by the lender’s credit department after financial due diligence and the application of internal risk models. They are usually in the form of financial ratios (such as loan to value, interest cover or tangible net worth) and are used to provide an early warning signal should the borrower’s financial health deteriorate. A borrower should check whether these ratios are consistent with what it has agreed to in other loan documents and look to secure enough headroom so that a temporary impairment to its asset values, cashflow or EBITDA does not trigger a breach of the financial covenants.
- Non-financial covenants - These customarily include ‘information covenants’ (such as the duty to supply accounts and management information) and ‘general undertakings’ (such as restrictions on acquisitions, disposals of key assets, incurring further indebtedness, and positive obligations to comply with laws and regulations and pay taxes as they fall due). Although many of these covenants would not unduly concern a conscientious and well-organised borrower, they should be reviewed carefully since they subsist over the life of the loan (which may be several years or occasionally decades) and may preclude key strategic decisions being taken without the consent of the lender going forward. Where the borrower is considering an acquisition or disposal at the time the loan is negotiated, it should disclose this to the lender so that it can be specifically excluded from the covenant in question.
- Representations and warranties - These will tend to relate to proper incorporation of the borrower, its ability to enter into the loan and the obligations in the documentation being binding upon it, an absence of material litigation, having good title to key assets and the accuracy of information provided to the lender. Again, while many of these representations will be easy to make, a borrower should think carefully about each of them and ensure that it is not being asked to represent on any matters that are outside of its knowledge or control. The borrower should also aim to ensure that these representations are not repeated during the life of the loan, as extraneous circumstances (such as litigation proceedings being taken against it) could result in the borrower inadvertently breaching a representation if it fails to disclose the fact to the lender.
The reason these clauses receive significant attention is that their breach allows the lender to decide whether to demand repayment of the principal and accrued but unpaid interest. A breach may also create a ‘house of cards’ effect in that it might trigger ‘cross default’ provisions in the borrower’s other financial or commercial contracts.
Practically, we would advise borrowers to have robust operational systems in place to ensure they can quickly and easily provide the documentation that the lender requires both before the loan agreement is signed and during the life of the loan itself. Such systems will also help guard against the inadvertent breach of covenants and any repeated representations.
With all of this in mind, we would advise all borrowers to appoint experienced lawyers to help them negotiate the loan agreement. Aside from providing general legal advice, instructing lawyers will usually have the effect of minimising the legal fees of the lender’s lawyers (which the borrower will have to pay) and would expedite the time it takes to negotiate the loan.
The content of this article is for general information only. For further information regarding corporate borrowing, please contact a member of Birketts’ Banking and Finance Team.