Thomas K. Durr

As deal activity is expected to rise heading into the fourth quarter, companies of all sizes may be gearing up to negotiate transactions with new and existing lenders. From startups seeking a first line of credit to longstanding enterprises aiming to restructure existing debt, understanding the nuances of loan negotiation is crucial for securing favorable terms and ensuring long-term financial stability. Representations and Warranties As in other transactions, the representations and warranties requested by a bank or other lending institution serve as an initial snapshot of a company and offer baseline insights into a company’s function and operations. Representations provide assurances about certain aspects of the business, such as its financial health, legal standing, operational status (e.g., the company is in compliance with all relevant laws and regulations) and the collateral against which the lender is extending the facility (e.g., the company has good title to its real property and valid ownership of its equipment or other inventory). Warranties constitute the company’s guarantee of the truthfulness of the representations, promising recourse to a lender in the event that any representation is found to be untrue or inaccurate. Representations and warranties allocate risk between the parties. In a loan transaction, these terms are part of the consideration for a lender’s agreement to extend credit and stand as a legal touchpoint to the perceived creditworthiness of a company. When negotiating these provisions, a company should consider the following concepts to shift risk away from its own operations and officers. While lenders are hesitant to remove representations from a credit agreement altogether, there may be room to qualify their scope: Knowledge. Knowledge qualifiers limit the scope of the borrower’s assurances to what it actually knows, or should reasonably know, at the time of the transaction. These qualifiers may commonly appear in representations regarding compliance with laws, the accuracy of financial statements and the absence of undisclosed liabilities. The incorporation of knowledge qualifiers not only serves the purpose of shifting risk away from a company, but it may also encourage more thorough diligence on the part of both borrower and lender to ensure that all parties understand the company’s status quo and the potential risks of the transaction. Materiality. Materiality qualifiers limit the scope of the borrower’s assurances to only those issues that are deemed “material,” essentially defining the threshold above which certain facts or conditions become significant enough to warrant disclosure or affect the deal (e.g., the company is in compliance with all relevant laws in all material respects). Negotiating the incorporation of materiality qualifiers may prevent minor or insignificant issues from becoming points of contention. A counterpoint, however, is the inherent ambiguity in what may rise to the level of “material.” As an alternative approach, lenders are typically receptive to materiality qualifiers set using dollar thresholds that strike a balance of providing sufficient protection to the lenders without placing too much burden for disclosure on the company. Lenders may also accept such qualifiers when the materiality is determined by the lenders at their sole discretion. Duration and Survival. Capping the duration of representations is another way to mitigate the company’s future liability in the event that certain items become untrue at a later point in the term of the loan. Covenants Covenants codify a company’s operational commitments during the life of the credit. Their primary function is to establish a framework to ensure that the company continues to operate in a way that allows it to repay the loan on time. These are typically the most fertile ground for negotiation and are almost entirely composed of business, not legal, points. Affirmative covenants require a company to take certain actions or maintain specific standards (e.g., financial reporting, insurance requirements, compliance with laws, payment of taxes). Negative covenants, on the other hand, restrict or prohibit certain actions in order to prevent behaviors that could jeopardize the financial position for which the lender has underwritten the loan (e.g., limitations on additional indebtedness, asset sales, payment of dividends, changes to management structure, mergers and acquisitions). A company often finds success in its positions when it can clearly demonstrate why it needs a particular type of accommodation — from extended delivery periods to increased debt baskets — based on situational or historical data and other projections. Another effective tactic is to propose practical alternatives to covenants as drafted. For instance, a borrower might consider suggesting a tiered approach for debt limits, where limits become more restrictive only upon the basis of eventual financial performance or other milestones. Events of Default Events of default are predefined conditions that, once met, trigger a lender’s right to exercise remedies. These typically include payment defaults, breaches of covenants, insolvency, misrepresentations or cross-defaults with other facilities from the same lender. Lenders generally seek to establish events of default that cover both the borrower as well as any guarantor of the facility. While many lenders refuse to make concessions in this section of a credit agreement, borrowers may find a foothold by negotiating cure periods for certain defaults or pushing to increase the dollar thresholds for others (e.g., related to judgments, claims, litigation and employee pension plans). Note that a “default” is the first component of an “event of default,” which is usually deemed to have occurred at the expiration of any grace or cure period following a company’s initial noncompliance with a provision of the credit agreement. Many lenders view proper events of default (unlike defaults) as incapable of being “cured” once they occur. Securing a Positive Relationship with Lenders The outcome of negotiations varies by the type of lending institution, the relative size of the facility, the value of the collateral and other risk factors unique to the company. By thoroughly researching the lender, understanding the terms of the loan, and effectively communicating business needs and expectations, a company can significantly enhance its bargaining position. In loan transactions, negotiations are not just about striking the best deal possible at closing, but also setting the stage for a positive working dynamic with the lender that can accommodate what may become a long-term relationship.

The market has seen a steady rise in the number of troubled commercial loans over the last few months. Consequently, companies and their financial officers who previously had minimal experience with loan workouts are faced with varying proposals from their lenders on how to restructure credit facilities and operations. Many companies will go through this process and emerge better disciplined and more focused on their core businesses, while others won’t survive. Whether a company survives and thrives may depend entirely on how well its executives understand the options and strategies available to them. Once an event of default occurs under a loan facility and the loan-workout process starts, lenders will often take one of the following remedial approaches: Do Nothing: This may surprise some companies, but lenders often take a patient wait-and-see approach to troubled credits. After an intensive review of the loan documentation and collateral package, the lender may issue a reservation of rights letter, notifying the company of all of the known events of default and informing the company whether the lender intends to exercise any initial remedies, like imposing a default rate of interest or charging other fees and penalties. In certain loan facilities, this step will also trigger increased reporting requirements. Note that even at this stage, institutional lenders will often have handed the loan package off to an internal restructuring department, which means that company representatives should expect to become acquainted with new bank relationship and credit officers (and possibly lender’s counsel engaged specifically for workout transactions).   Restructuring and Forbearance Agreements: Forbearance agreements are often a hybrid between the reservation of rights letter and a standard amendment to the loan facility. Under the forbearance agreement, lenders will agree not to exercise certain remedies for a set period of time in exchange for modifications to the loan or the collection of waiver and other fees. These modifications may entail introducing additional collateral or guarantor support, amending loan covenants to increase reporting, adding new financial covenants or requiring the engagement of outside consulting firms. This stage also allows lenders to correct deficiencies in the original loan documentation; a company’s default may motivate lenders to enhance the substance of the “remedies” provisions (for example, ensuring that the facility is cross-collateralized and cross-defaulted with other facilities or the facilities currently extended to affiliated parties). Lenders may also ask principals to provide a capital infusion large enough to give the company the necessary liquidity to resolve its current issues. The goal of the forbearance agreement is to give a company the time it needs to alter performance enough to convince the lender that there is a path to repayment or, alternatively, the time it needs to find a new lender that will refinance the existing loan.   Alternative Types of Financing: An almost infinite number of loan structures are available to companies. In addition to standard mortgages and revolving lines of credit, companies might consider equipment term loans, cash flow term loans, subordinated loans, mezzanine loans and asset-based lending (ABL) lines of credit, to name a few. Companies with a standard cash flow revolving line of credit may be required to obtain additional or alternative types of financing. One alternative is subordinated debt. This may come from business owners or other non-bank lenders willing to make riskier loans in exchange for higher interest rates and other compensation. Another asset-intensive business option is obtaining a new ABL facility. ABL loans adjust the size of the loan facility periodically to a percentage of the company’s assets, most often accounts receivable and inventory. This provides benefits to both the lender and the company: The lender can control the loan’s balance to what it reasonably thinks it can fully recover in the event of a future bankruptcy or other liquidation while often providing a company with larger availability than a traditional cash-flow deal may offer. ABL loans involve additional reporting requirements, but the benefits of additional liquidity may greatly outweigh the costs of satisfying those requirements. Finally, a lender may be willing to “term out” some existing lines of credit in exchange for a lien on previously excluded collateral (for example, a lien on real property that a revolving loan lender decided to forgo at the original closing). By providing this additional support, the lender may allow the company to repay the outstanding balance over time in exchange for immediately providing additional working capital availability.   Accelerate and Liquidate: At a certain point, not all businesses can be saved, and a lender’s priority is always loan repayment. The lender and the company will often have worked through at least one of the preceding options before reaching this point. If a lender does not see a viable option for repayment, it will be forced to foreclose on the collateral and/or exercise its rights to collect from the company’s guarantors. Because liquidating and collecting on collateral is costly and time-consuming, lenders will often decide to either sell the loan or the business as a going concern.   It is important to remember that lenders are not necessarily the enemy. Lenders often benefit more from helping a company correct its course and overcome the fundamental issues that led to the events of default rather than simply foreclosing on the collateral and shutting down the business. Companies and finance executives who prioritize working with their lenders may see profound benefits in both the short and long term as a result of the workout. Navigating the initial hurdles of increased reporting and tighter financial covenants may be difficult, but a company’s cooperation and compliance with the redesigned covenants will give the lender greater incentive and visibility into a rehabilitative path forward.