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.