At some point, most Winston-Salem businesses will be involved in a loan transaction – be it an initial loan, refinance of existing debt, funding of capital improvements, funding of an acquisition or some other financing arrangement. As part of the transaction, most financial institutions require borrowers to enter into a loan agreement, which outlines mutual rights and obligations between the parties.
It’s critical that businesses understand what they’re agreeing to, their responsibilities under the loan and how that might affect other holdings or entities. Below are a few key provisions that you’ll encounter in many loan agreements, along with financial institutions’ rationale for including such provisions and special considerations for borrowers.
Naming the borrower. For any number of reasons, your business may consist of multiple entities. A loan agreement will spell out which specific entity or entities are obligated to repay the loan. It behooves any financial institution to seek to obligate as many related entities as possible in order to provide credit support for the loan and influence business cash flow. Conversely, the borrower may seek to limit the number of entities obligated on a loan.
Guarantors. Obligating other individuals or entities as guarantors is another way financial institutions increase the credit worthiness of a particular deal. It is common for principal owners of a borrowing business entity to be required to guaranty the credit. Guaranty agreements may be limited in loan amounts guarantied, period of time for guaranty, requirements for collateral to secure the guaranty and conditions for release of the guaranty.
Other transactional details. Besides a listing of those obligated to repay the loan, a loan agreement will also provide other basic information such as loan amount, terms for repayment, interest rate, definitions, prepayment penalties, purpose of the loan and a detailed list of other loan documents that must be executed prior to funding.
Cross-default provisions. A cross-default provision allows financial institutions to tie default under the subject loan to various other obligations of the borrower, guarantor and related parties, including other loans with that or another financial institution. A cross-default provision stipulates that default under a separate loan arrangement constitutes default under the subject loan. It is important for businesses to understand the full scope of these provisions. A common way for borrowers to mitigate exposure is to insist on written notice and cure rights, requiring that a lender may not call the loan in default until the borrower has an opportunity to cure the default.
Cross-collateral provisions. Similar to cross-default provisions, but specific to collateral, these provisions provide that a lender’s security interest or other lien in a borrower asset secures all loans for that borrower and related entities. Cross-collateral provisions can limit a borrower’s ability to refinance individual loans, or obtain additional credit, if all of its assets are encumbered by numerous loans.
Representations and warranties. Any loan agreement is likely to contain a number of representations and warranties from the borrower, which are statements from the borrower that the lender is relying upon when making the loan. Common representations and warranties include:
- That financial documents submitted by the borrower to the financial institution to aid in underwriting the loan accurately and completely reflect the borrower’s financial condition;
- That the borrower is duly organized and in good standing in any state in which it conducts business;
- That execution of the loan documents does not violate any other agreements that are binding on the borrower;
- That, with regard to collateral given to secure the loan, the borrower owns such collateral free and clear of any other liens; and
- That the borrower is duly authorized by any necessary corporate formalities to enter into the loan.
Covenants. Any loan agreement is likely to also contain a number of covenants, which require the borrower to provide certain information and perform (or refrain from performing) certain actions. Covenants include the continued provision of financial information, which may be used or tested periodically by financial institutions during the life of the loan. Common covenants include:
- That the borrower maintains its current legal form and remain in good standing in any state in which they conduct business;
- That the borrower maintains liquid assets in a certain amount;
- That the borrower uses the proceeds of the loan for its intended purpose;
- That the borrower maintains and keeps adequate financial records, and allows the lender access to such financial records;
- That the borrower maintains and preserves the value and nature of the collateral given to secure the loan, and keeps such collateral adequately insured;
- That the borrower periodically provides to the lender financial statements and state and federal tax returns; and
- That the borrower maintains a specific debt-service coverage ratio.
Default. Finally, the loan agreement is also likely to spell out various events of default (payment and non-payment) and the various rights a lender has upon default.
While these are common provisions for inclusion in loan agreements, a well drafted agreement will be specifically tailored to the terms of your business loan. Understanding why certain provisions are included may help in negotiating more favorable terms. Before entering into your next loan, make sure you are fully aware of what the documents require of your business.
About the Author
Adam Duke is a partner at the law firm of Bell, Davis & Pitt. Adam focuses his practice on banking and financial services, creditors’ rights, real estate and construction law. Active in the legal community, Adam volunteers for the Disaster Legal Services and 4ALL programs of the North Carolina Bar Association.