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Negotiating Loan Documents for Borrowers – Part III

Preparation for Entering into a Loan

Access to capital is critical to every business. Entering into loan arrangements with a lender is a complex process, the results of which can be vital to the success or failure of a company. This is the third in a series of articles intended to explain various aspects of the loan process. In our first article, we discussed the importance of the term sheet stage of a loan transaction. In our second article, we reviewed factors for the prospective borrower to consider in choosing a loan and the types of loans that are available.  In this article, we look at steps the borrower can take to help expedite the loan process, which will help in reducing transaction expenses.

Due Diligence

Beginning with the initial conversations that a company has with a potential lender, the lender will need to obtain certain information about the borrower.  Part of this is for regulatory purposes so that the lender can obtain the information it needs to comply with Know Your Customer (KYC) and Anti-Money Laundering (AML) laws and regulations.  The larger part of the lender’s due diligence exercise is to understand the company’s business and the potential risks that could endanger the repayment of its loan.  The results of the lender’s due diligence efforts will help determine whether to lend money to the borrower and at what terms.  Although some due diligence will occur during the term sheet stage of the loan transaction, the lender typically will not incur significant time or expense in its due diligence efforts until after the term sheet has been signed and the borrower has paid or agreed to pay a deposit to cover the lender’s expenses, including legal fees, to investigate all aspects of the borrower’s business.  The scope of the lender’s due diligence will vary depending on the type of loan, the collateral involved and the nature of the borrower’s business.

Borrowers are advised to be forthcoming in their responses to lender inquiries as it is not in a borrower’s interest for the lender to run into surprises as part of its due diligence process.  The drafting process with respect to the loan documents will be more efficient if the lender is aware of any issues, such as pending litigation or regulatory proceedings, at the outset of the drafting process.Delayed disclosure of any issues may result in protracted negotiations, which will likely delay the time before the lender is able to obtain funds and increase transaction expenses.

Perfection Certificate

Following the execution of a term sheet, the first document that a lender will usually present to a borrower for completion in a secured loan transaction is a perfection certificate, which is sometimes referred to as an information certificate.  This document enables the lender to obtain information from the borrower about the assets of the borrower and any guarantors that will be used as collateral to secure the loan. Based on such information, the lender is able to determine what documents it will require in order to perfect its security interests in the collateral.

Completing the perfection certificate can be an arduous task depending on the complexity of the borrower’s business and its corporate structure. It may require obtaining information from many people within the organization.  Once a company has made the determination that it intends to seek secured debt financing, it should start to compile information that is expected to be requested by the lender so as to expedite this process. Completion of the perfection certificate will be a gating item to the preparation and negotiation of other loan documents.

It is important that the borrower carefully and completely answer the questions in the perfection certificate, which may be defined as a loan document under the loan agreement and any misrepresentation in the perfection certificate may result in a default under the loan agreement.  If the lender requires a representation from the borrower in the loan agreement regarding the accuracy of the information contained in the perfection certificate, the borrower should seek to limit such representation such that the representation is only made as of the date the perfection certificate is delivered.

Conditions Precedent

Loan agreements often contain a number of items that the borrower must deliver as a precondition to funding.  Some of the items may require the performance of a third party, the completion of which are beyond the control of the borrower or lender.  Among the more common types of third party deliverables are (i) surveys, environmental reports and title insurance for loans that are secured by an interest in real property, (ii) landlord waivers or other control agreements with warehousemen, consignees or processors for loans that are secured by inventory or equipment located at properties that are not owned by the borrower, (iii) certificates and endorsements from insurance providers evidencing insurance coverage and naming the lender as a loss payee (in the case of property insurance) or as an additional insured (in the case of liability insurance) and (iv) legal opinions, and, in particular, local counsel opinions for multistate transactions.  Obtaining items from third parties can take significant time and borrowers should coordinate acquiring these deliverables as early as possible so as to avoid delays in closing the loan transaction. 

It will be helpful to the lender for the borrower to obtain estimates as to the timing of any third party deliverables in order to have a realistic expectation as to when closing may occur. Depending on the condition precedents and the value of the collateral, the lender may agree to permit the borrower to deliver certain third party deliverables within a certain period of time post-closing.  Borrowers are cautioned not to agree to any requirement to deliver any consent or other agreement from a third party, but, rather, to only agree to use commercially reasonable efforts to obtain such items as it is beyond the borrower’s control to cause a third party to sign any such document.

Conclusion

Debt financing can be vital to the ongoing operations of a business and a powerful expansion tool, but it can be a time consuming and expensive process.  A prior understanding of the information and deliverables that a lender will require can help the borrower expedite the process and control the costs involved in the transaction. Borrowers and prospective borrowers are encouraged to work with their legal and financial advisors starting in the beginning stages of the process as their early involvement can help to ensure a smooth and efficient transaction.

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