Loan Documents are Serious Business!

Reading loan documents? This task, arduous and sometimes boring is often left to the attorneys and bankers to take care of. While respective counsels are primarily responsible for the drafting of documents, their efforts should not preclude business owners from reading them. Loan documents are vital tools that provide guidance to business owners in handling the company’s financing. They need to be clear and concise, but should also provide some flexibility for both the borrower and the bank.

The increasing amount of government regulations/oversight is the leading cause of the voluminous paperwork dedicated to loan documents. However, the primary critical contractual obligations remain the same in the Promissory Note, Loan Agreement and if applicable, Guarantees.

Negotiating the key elements of these documents should be materially completed before attorneys get involved:

• Terms and conditions should be mutually agreed upon between the bank and the borrower.
• They should be easy to understand and find in the aforementioned documents.
• Key loan terms include amount, rate, term, repayment, collateral, guarantees and covenants.
• A review of Definitions in the Loan Agreement should remove any question as to what the terms mean.

Generally speaking, loan documents are intended to protect the bank but that in no way means borrowers should acquiesce to all the bank’s requirements. Some conditions are onerous, and part of a “blanket” document that the bank or its counsel, may have used in the past. The bank may at times say “no” in the negotiations, but at least there is an understanding of what is required. Remember, loan documents are a contract between two parties and that the bank has responsibilities too.

As mentioned, the key elements in loan documents should be negotiated well before arriving at the closing table. Loan documents should:

• Memorialize, not change, the conversations/agreements between the bank and borrower.
• Largely be mundane and easy to understand.

Nevertheless, you should read and comprehend these items because if something goes wrong, the bank will enforce them.

This leads us to covenants. There are many kinds of covenants, but we will focus on the Affirmative and Negative ones here. Affirmative items generally include what financial reporting the borrower agrees to provide. There should be no surprises in this section of the Loan Agreement. If an upgrade in financial reporting is required by the bank, it should have already been agreed upon.

Negative covenants are a little trickier as each bank has its own philosophy as to what financial measurements are important. Standard ratios that have been used over the years include:

• Liquidity
• Leverage
• Debt service

These measurements have been expanded in recent years to calculations such as Fixed Charge Coverage and Funded Debt to EBITDA, to name a few. These ratios should be well defined in the Loan Agreement and be sure you understand the math.

Covenants are important to all parties involved, and banks vary as to which ones are deemed more relevant. They are not a one-size fits-all measurement as industries, companies and business models are not all the same. Provident Bank uses a simplistic approach to determine covenants because simply stated, the most important covenant of all is meeting the agreed-upon payment due date.

The amount of paperwork can seem daunting and while the business owner’s attorney is charged with reviewing documents, the owner should understand them too. Similarly, the bank is obligating itself under the loan documents. Your banker should also explain the loan documents to you.

William. J. Ruckert, III is Senior Vice President of Middle Market Lending at Provident Bank. Based in Provident’s Iselin office, Ruckert oversees commercial financing for companies with sales of $15 million or more. He holds a bachelor’s degree in business administration from Loyola College in Maryland.