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Out-Law Guide | 30 Aug 2011 | 4:29 pm | 12 min. read
A loan agreement is the document in which a lender – usually a bank or other financial institution – sets out the terms and conditions under which it is prepared to make a loan available to a borrower. Loan agreements are often referred to by their more technical name, "facilities agreements" - a loan is a banking "facility" offered by the lender to its customer. This guide concentrates on the most common terms of a facilities agreement.
What does a facilities agreement consist of?
A facilities agreement can be divided into four sections:
The interpretation/definitions section
Defines the key terms used in all the finance documents.
There are many definitions in every facilities agreement, but most these are either standard - and usually uncontroversial - or particular to the individual transaction. They should be reviewed carefully and, where necessary, checked closely against the lender's offer letter/term sheet.
A few of the key definitions which occur in every facilities agreement are:-
Borrowers: It is essential that the definition of 'Borrowers' includes all group companies which may need access to the loan, including any revolving credit (flexible credit, as opposed to a fixed amount paid back in instalments) or working capital element. These will also need to include any target companies being acquired with the funds provided. There may need to be provision for future subsidiary companies to join the borrower group. If there is some reason why the target companies cannot be parties to the agreement when it is executed – for example, on a public company takeover – prior consent from the bank should be sought for them to be added to the agreement later. If there are foreign group companies, consideration needs to be given as to whether or how they will have access to any credit facilities. Alternatively, the facilities agreement can name a single borrower and allow that borrower to on-lend to other members of its corporate group.
LIBOR: The London Interbank Offered Rate (LIBOR) is a daily reference rate based on the interest rates at which banks can borrow unsecured funds from other banks. It is usually defined for the purposes of a facilities agreement by reference to a screen rate (usually the British Bankers' Association Interest Settlement Rate for the relevant currency and period), or the Base Reference Bank Rate, which is the average rate at which the bank can borrow funds in the London Interbank Market.
Mandatory Costs: This formula, related to the costs that banks incur in complying with their regulatory commitments, is rarely negotiated. It is provided as a schedule to the facilities agreement. The rate should however only apply to LIBOR-based facilities and not base rate facilities, as a bank's base rate already includes a sum to reflect mandatory costs.
Material Adverse Effect: This definition is used in a number of places to define the seriousness of an event or circumstance, usually determining when the lender may take action on a default or request a borrower to remedy a breach of the agreement. It is an important definition and is often negotiated.
There are usually "standard" negotiating points raised by borrowers, for example, a standard material adverse change/effect definition will usually refer to the effect something may have on the obligor's ability to perform its obligations under the relevant facilities agreement. The borrower may seek to restrict this to its own (not other obligors') obligations, to the borrower's payment obligations and, (sometimes), its financial undertakings.
Default/Potential Default: A facilities agreement will contain a standard provision to cover events, although they are not yet events of default, are likely to become so. These are known as Defaults or, sometimes, Potential Defaults. They are often negotiated by borrowers who are keen not to be subject to "hair triggers" under which they could lose access to their banking facilities.
The mechanical section
This will include provisions relating to the facilities, their purpose and their availability. It will also include details of repayment schedules and the interest payable.
The facilities and their purpose: The amount of the facilities should be checked carefully, as should the purpose for which they may be available.
Availability: The borrower should check that the facilities will be available when the borrower requires them (for example, to fund an acquisition). Lenders will often start from the position that they require two or three days' notice before the facilities can be used or drawn from. This can often be reduced to one day's notice or even, in some cases, notice given by a certain time on the date of use. The lender will need to have sufficient time to process the request for a loan and where there are multiple lenders this will usually take at least 24 hours.
Lenders will always need certain confirmations before funds can be used or when notice is given, including confirmations that there are no events of default and no breaches of representation or warranty.
Interest: The interest rate margin should reflect that set out in the lender's offer letter/term sheet. LIBOR and the bank's mandatory costs will also be payable. Any provisions relating to a increase or reduction in the interest rate margin (known as a "margin ratchet") should also correctly reflect the lender's offer letter/term sheet.
Interest will be payable at the end of each interest period, interest periods may be fixed periods (usually one, three or six months) or the borrower may be able to select the interest period for each loan (the options will usually be one, three or six month periods).
There will also be a default interest clause which increases the interest rate payable on amounts which are not paid when due. This default rate should be an accurate reflection of the cost to the lender of the amount not being paid when due. If the rate is excessive there is a risk that it will not be enforceable.
Prepayments: A borrower should ensure that it has some flexibility to make prepayments (repay the loan early) without incurring extra fees if possible. Prepayments will, however, only be permitted at the end of interest periods - this avoids the payment of breakage costs and is in the borrower's best interests on most occasions. Particular attention should be paid to any mandatory prepayments (for example, on a sale or, for private companies, on a float) and any prepayment fees that are payable.
There may also be provisions relating to prepayments out of insurance or disposal proceeds. These will often allow the borrower to first use those funds to replace the assets sold or damaged money has been received in relation to. These provisions allow costs and taxes have been deducted so that only net proceeds are required to be used to replace assets.
The transaction-specific section
This section will include the representations and warranties, undertakings and events of default applicable to the particular facility. It will also include provisions protecting the bank from changes in circumstances which may affect its lending.
Representations and warranties: these should be considered carefully on all transactions. However, it is worth pointing out that the purpose of representations and warranties in a facilities agreement is different to their purpose in sale and purchase agreements. The lender will not be looking to sue the borrower for breach of a representation and warranty – it will instead use a breach as a mechanism for calling an event of default and/or demanding repayment of the loan. A disclosure letter is therefore unnecessary in relation to representations and warranties in facilities agreements.
The representations and warranties are similar in all facilities agreements. They concentrate on whether the borrower is legally capable of entering into finance agreements and the nature of the borrower's business. They will often be widely drafted and the borrower may seek to restrict them to matters which, if not correct, would trigger a Material Adverse Effect. This qualification can be applied to many of the representations and warranties about the borrower's business (for example litigation, environmental and accounts) but will probably not be acceptable to the lender to limit the borrower's capacity to enter into the finance agreements, or in relation to key financial information.
Particular attention should be paid to the accounts warranty where, for example, management accounts should not be warranted to the same level as audited accounts because they will not have been prepared to the same accounting standards.
The representations and warranties should only apply for as long as monies are owing to the lender or the lender is committed to lend, and any representations and warranties applicable to original information (for example, the business plan or the accountants' report) should not be repeated throughout the term of the facility.
Undertakings: these will usually be split into positive, negative and financial duties. The positive undertakings will include a duty to supply financial information to the lender (for example, audited and management accounts). These provisions should be discussed closely with the finance director or other officer who will be providing this information to the lender. Appropriate timescales and provisions as to content of such accounts should be included - particularly important if there are foreign group companies.
Any positive undertaking that the lender's facility will always take priority over the borrower's other debts may be resisted as this is not always within the borrower's control. A negative covenant that the borrower will not take any action to affect the ranking of the facility may be an acceptable alternative.
As the name suggests, the negative undertakings list various activities that the borrower may not engage in without the lender's consent. These should be checked carefully to ensure that the borrower has enough flexibility to carry on its business without breaching the undertakings. Any restriction on the disposal of assets should not prevent inter-group disposals, although the lender may only allow these between group companies which have granted security. The disposal of assets which are to be replaced should also not be prevented.
A key negative undertaking is one preventing dividend and other shareholder payments, which lenders will require to ensure that there is no "cash leakage" from the borrower group
Financial undertakings, or covenants, govern the financial position and health of the borrower. They set out certain parameters within which the borrower must operate. Input should be sought from the borrower's advising accountants as early as possible as to their content. Dates when these undertakings are tested should be checked closely, as should the separate financial definitions which will be applicable. The financial covenants are a key element of any facilities agreement and probably the most likely to trigger an event of default if breached. Stronger borrowers may be able to negotiate a right to remedy breaches of financial covenants, for example by putting more cash into the business. This is known as an "equity cure".
Events of default: these will be extensive. However there is good reason for them and, if properly negotiated, they should not allow the loan to be called in unless there is a serious breach of the facilities agreement.
Particular attention should be paid to any "cross-default" clauses, affecting when default under one agreement triggers a default under another. These should not apply to any on demand facilities provided by the lender, and should contain appropriately defined threshold amounts of default.
There will also be event of default provisions relating to breaches of the facilities agreement itself. These may allow time for remedy by a borrower, and may in any case only apply to material breaches or breaches of the main agreement provisions. The non-payment default provision will usually include a grace period to cover administrative or technical difficulties. Insolvency defaults should also contain appropriate grace periods, and should include appropriate waivers for solvent reorganisations with the lender's consent.
The lender should only have the right to demand repayment of the loan if an event of default has occurred and is continuing. If the event of default has been remedied or waived, then the lender's right to accelerate should stop.
Protecting a lender from changes in circumstances: some of the principal provisions which could do this are set out below:
For some transactions it may be necessary to obtain a warranty from the lender that it is a Qualifying Bank (for example, if the borrower is dealing with a foreign bank).
A borrower should also always seek to include a 'tax credit' provision, so that if the lender receives a tax credit in respect of any grossed-up payments it should be obliged to repay the amount of the credit to the borrower.
Finally, a syndicated facilities agreement will contain numerous provisions relating to an agent bank and its role. These will often not be of direct relevance to the borrower, but it should check that the agent bank can only be replaced with its consent and that the agent bank has sufficient powers to act on its own to allow the borrower the flexibility it requires. A borrower will not wish to obtain consents or waivers from a large syndicate of lenders.
The existence of a syndicate will not affect certain other provisions in a facilities agreement. For example, there will also be a definition of 'Majority Lenders' whose consent will be required for certain actions. It is normal for this definition to be two thirds of the syndicate banks by reference to the amount of their stake in the loan. The borrower should ensure that all syndicate banks are 'Qualifying Banks' for the reasons mentioned above, and once again a warranty to that effect may be appropriate.
Diversity and Inclusion - best laid plans
Fintech meet up