Finance 101: Initial Loan Documentation

If we conduct a poll on the purpose of money, at least 7 out of 10 people will say it is a means of exchange. This is correct. However, in the world of finance, money is not just a means of exchange, money makes the world go round.

Welcome to Finance 101, a series of articles that will address various aspects of the world of the law of finance. The series aims to give readers (not necessarily lawyers) insights into the world of commercial loan facilities. In this part, we will explore the initial documentation typical in a loan transaction and the purpose it serves. So, let's get to it.

Important Note: Bank is used loosely and may refer to any type of bank - commercial banks, investment banks etc. Lender, when used includes banks, development finance institutions (World Bank etc.), multilateral financial institutions, alternative lending agencies etc.

Initial Loan Documentation

The Commitment Letter

Also referred to as the mandate letter, the commitment letter is the document sent by a bank to a borrower setting out the terms on which the arranger (bank) is willing to lend to the borrower.[i] The commitment letter sets out whether the arranger's obligation to arrange the facility is "best efforts" or whether it will be "underwritten." Best efforts mean that the bank would employ the greatest effort and will not be obligated to provide up to the available amount. However, where a bank underwrites a loan, it is obligated to provide the outstanding sum should the facility amount not be raised. The Commitment Letter usually has the term sheet as an appendix and must be read in conjunction with the term sheet.

The Term Sheet

The term sheet is the document that outlines the principal terms of a loan transaction. While the term sheet is executed by parties to the transaction, it is not intended to be binding. Usually, the introduction to term sheets states that the terms are for discussion purposes and are not to be construed as the bank’s obligation to provide the facility to the borrower. The term sheet contains a date wherein all the terms must be accepted by the borrower.[ii] Note that the term sheet simply gives a broad overview of the transaction and is not always detailed.

Purpose

The term sheet: (i) documents the key terms of the transaction and ensures that the understanding between parties is mutual; (ii) serves as a reference for parties during the loan negotiations and reduces the likelihood of misunderstandings and disputes; and (iii) serves as the foundation for more detailed and legally binding documents.

Importantly, lawyers can identify the key information to a transaction by looking at the term sheet. So, whenever you are faced with a loan transaction and you have no idea of what is going on, ask for the term sheet. Trust me, you would be able to make some sense out of the transaction.

Contents of the Term Sheet

Parties and their roles

The borrower and the lender – these are self-explanatory, right?

Facility

The term sheet states the type and amount of facility being granted by the bank and whether such facility will be drawn in tranches. Types of facilities include:

• An overdraft, also known as a working capital facility. This provides the borrower with money that can be easily accessed to meet the borrower's shortfalls. Okay, imagine a business pays salaries on a particular week, such business may have made little or no sales that same week. To ensure that the payment of salaries will not affect the smooth running of the business, a borrower can request for overdraft facilities.
• Term Loan. The lender provides a specified amount for a set period, with clearly stipulated repayment schedules; and
• Revolving Credit Facility ("RCF"). Similar to a term loan, the RCF provides a borrower with a certain amount of capital for a period. However, the borrower may draw down and repay the tranches of available capital whenever it chooses during the term of the loan.

Purpose

You can easily spot the purpose of the loan. Lenders would typically not grant a loan that has no purpose.

Availability Period

Also known as the Commitment Period, this is the period during which a borrower may draw down a loan. For term loans (where the facility will be repaid over a period), the availability date is usually short after signing the facility agreement and documentation.

Security Package

When a lender decides to lend money to the borrower, it usually wants something in return as security for repayment in case the borrower defaults. Most times, lenders have it in mind that the borrower would default. So, to prevent a case where both the facility is gone, and principal and interest are not repaid, the lender usually (not in all cases) takes security over any of the assets of the borrower.

More on security and security documents

The Lender may take:

• A charge over the shares of a borrower, so you would have the Deed of Share Charge;
• A charge over the current and future assets of the borrower, so you have the All Assets Debenture;
• A charge over the borrower's accounts, you have the Account Charge;
• Security over the proceeds of insurances, you would have the Deed of Assignment of Insurances; and
• Security over the proceeds of contracts, then you would have a Deed of Assignment of Contracts and Receivables.

Note that the list above is by no means exhaustive. These documents stricto sensu provide a lender with effective security over various classes of present and future assets of the borrower.

Conditions Precedents

As the name suggests, these are terms that the bank would require a borrower to fulfil before such borrower can request for a drawdown of the loan.

Representations and Warranties

These are statements of facts (legal or commercial) that the bank requires the borrower to make about various matters and are meant to induce the lender to grant a loan. The bank will only want to lend if the borrower can show that certain facts are true. Where representations are false, the bank may call a default or pursue other remedies.

Covenants and Undertakings

While representations and warranties are about information, undertakings are about control.[ii] Covenants (also called undertakings) are promises given by the borrower to do (or not to do) something.

Amortisation

This is the manner in which the principal and interest will be repaid. Amortisation ordinarily means to deaden – think of it as how the principal and interest gets repaid by a borrower over a period.

Other terms in the term sheet include prepayment, events of default, costs, governing law, interest, etc.

Conclusion

We have learned about the commitment letter and the term sheet in this article and this brings us to the end of the first part of the Finance 101 series. I hope you enjoyed it (as much as I enjoyed writing it) and more importantly, learned a thing or two about commercial loan documentation. Thank you for reading. I’ll see you soon!

References:

[i] Practical Law, Commitment Letter: Arranging Mandate

[ii] Investopedia, "Term Sheets: Definition, What's Included, Examples, and Key Terms"

[iii] David Adams, Banking and Capital Markets, pg 75.