Top 12 Mistakes Made in Documenting a Commercial Loan
Jonathan Friedland
Experienced attorney who counsels businesses, their boards, and their owners
[My law partner and I wrote the following article that was published by DailyDAC the other day. I am republishing here with permission from the publisher.]
The Top 12 Mistakes to Avoid When Documenting a Commercial Loan
The accuracy and precision of loan documents are of paramount importance in the context of commercial lending. Lenders must ensure that loan agreements are comprehensive, enforceable, and protect their interests. However, even experienced lenders and experienced lending lawyers can make mistakes in negotiating and drafting loan documents, which can lead to significant consequences down the line.
In this brief article, we address some common mistakes that commercial lenders (and their lawyers) make in their loan documents, aiming to provide guidance on how to avoid them and safeguard their lending transactions (and their jobs).
[Editors’ Note:?Read?Business Borrowing Basics – Negotiating A Loan Agreement?for the borrower’s perspective (or if you are new to the industry and could use a primer).]
As you read down the list, you very well may think to yourself that some of our examples are basic stuff.?We agree, and if you are an experienced industry veteran, those examples are not meant for you but, rather, for your younger colleagues who perhaps were in high school the last time the SHTF.
Mistake #1: Inadequate Loan Structure and Terms
One of the critical errors lenders can make is failing to structure the loan properly and define its terms clearly. This includes establishing repayment schedules, interest rates, default provisions, and additional fees or charges. Insufficient attention to these details can lead to misunderstandings and disputes between lenders and borrowers. Lenders should diligently analyze the borrower’s financial situation and risk profile to tailor the loan structure and terms accordingly.
Mistake #2: Incomplete or Inaccurate Loan Collateralization
Commercial lenders typically rely on?collateral?to secure their loans and mitigate risk. However, incomplete or inaccurate descriptions of collateral can weaken the lender’s position.
To avoid this mistake, a lender must conduct thorough due diligence and ensure that collateral descriptions in security agreements and financing statements are comprehensive, specific, and compliant with the applicable version of Article 9. For example, an overly broad description of your collateral in a security agreement may render your security interest unenforceable. At the same time, too specific of a collateral description in your financing statements may cause a lender to fail to perfect its security interest in certain collateral.
[Editors’ Note: For more detail on drafting collateral descriptions, read?6 Common Mistakes in Drafting Collateral Descriptions. Read more about Article 9 in?Dealing With Defaults Under Article 9 of UCC: A Player’s Guide for the 21st Century.]
Mistake #3: Inadequate Loan Covenants and Conditions
Loan covenants and conditions are crucial in managing risk. Lenders should exercise care in drafting these provisions. These include (among others) financial reporting requirements, limitations on additional debt, maintaining certain financial metrics, maintaining insurance to protect your collateral, and restrictions on asset disposal. Failure to establish comprehensive and enforceable covenants may expose lenders to unnecessary risks and weaken their ability to protect their investments.
Mistake #4: Neglecting Comprehensive Representations and Warranties
Accurate representations and warranties from borrowers are essential for lenders to assess the viability of a potential transaction. Lenders should meticulously draft these clauses, requiring borrowers to disclose all necessary information accurately. Inadequate or incomplete representations and warranties may lead to unforeseen risks and potential defaults. Lenders should pay close attention to the borrower’s financial statements, legal compliance, litigation exposure, and any material changes that may affect the borrower’s ability to meet their obligations.
Mistake #5: Failure to Address Events of Default and Remedies
Properly outlining events of default and remedies in loan documents is crucial. Covenant breaches can serve as an early warning sign for a likely payment default Lenders should work closely with legal counsel to include comprehensive and well-defined default provisions, allowing for appropriate actions, such as acceleration of the loan, collateral seizure, or legal remedies.
Relying solely on a broad “material adverse change” (“MAC”) or material adverse event (“MAE”) clause in your loan documents to declare a default, by the way, is risky. The courts are skeptical when a loan is accelerated based solely on a MAC or MAE clause, and the determination by a court whether such adverse change/event was material (or even adverse) enough to justify the declaration of default will often be made after a fact-intensive, contested, and expensive hearing (which the lender may lose).
Some lenders do not think through their remedies enough. We’ve seen some documents, believe it or not, overlook conditioning future draws on the lack of a default (or an event that may rise to the level of default upon a lapse of time or notice).
Another uncommon but not unheard-of mistake: not having proper access and control over your collateral in the event of a default. Control agreements over accounts and landlord lien waiver/access agreements with respect to inventory or equipment can make a world of a difference to a lender enforcing its remedies.
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Mistake #6: Inadequate Loan Document Review and Update Processes
Lenders must prioritize regular reviews and updates of loan documents to ensure their continued effectiveness and compliance with changing laws and regulations. Failure to keep loan agreements up to date may result in unenforceable terms, insufficient protection, and legal complications. Lenders should establish robust internal processes and work closely with legal professionals to periodically review and update loan documents as needed.
Mistake #7: Inadequate Dispute Resolution Mechanisms
Failing to establish a clear mechanism for resolving disputes, such as arbitration or mediation, can lead to costly and time-consuming litigation. By including well-defined?dispute resolution procedures, lenders can expedite the resolution process, minimize legal costs, and maintain better relationships with borrowers.
Mistake #8: Overlooking Regulatory Compliance Requirements
Commercial lending is subject to various regulatory frameworks, and lenders must ensure compliance with applicable laws and regulations. Neglecting compliance requirements, such as anti-money laundering regulations, consumer protection laws, or usury laws can result in severe penalties and reputational damage. Lenders should work closely with legal and compliance professionals to stay abreast of regulatory changes and ensure their loan documents adhere to all relevant guidelines.
Mistake #9: Insufficient Due Diligence on Borrower’s Legal Standing
Before finalizing loan documents, lenders must conduct thorough due diligence on the borrower’s legal status. Failing to verify the borrower’s legal existence, authority to borrow, or compliance with corporate governance requirements can jeopardize the enforceability of loan agreements. Lenders should verify the borrower’s legal status, review corporate documents, and confirm that all necessary authorizations are in place.
Mistake #10: Incomplete Insurance Requirements
Lenders often require borrowers to maintain certain insurance coverage to protect against potential losses. However, overlooking insurance requirements or failing to obtain proof of insurance can expose lenders to significant risks. Lenders should clearly outline insurance obligations in loan documents, specifying coverage types and minimum coverage amounts. And in most (if not all) situations, a lender should confirm that the borrower’s insurance policy includes a lender’s loss payee or lender’s loss payable endorsement in its favor.
Mistake #11: Poor Documentation and Record-Keeping Practices
Accurate and comprehensive documentation is vital for lenders in managing loan portfolios effectively. Inadequate record-keeping practices can result in misplaced documents, incomplete files, or difficulty tracking important information. Lenders should implement robust document management systems, establish standardized procedures for document retention, and ensure proper storage and organization of loan documents to facilitate efficient loan administration and mitigate potential risks.
Mistake #12: Failure to Seek Legal Counsel
Perhaps one of the most significant mistakes lenders can make is neglecting to seek advice from legal professionals during the loan document drafting process. Legal counsel specializing in commercial lending can provide valuable insights, help identify potential pitfalls, and ensure loan documents fit the transaction and adhere to applicable laws and regulations.
Engaging experienced attorneys can significantly reduce the likelihood of errors and strengthen the lender’s position in the lending relationship. We’re not saying this just because we’re those lawyers, honestly.
The reality of the situation is that to save money, many lenders rely on boilerplate documents that lawyers may have originally drafted but which are revised through negotiations. Over the years, we have seen lenders use the wrong form of documents, fail to properly perfect security interests, and even inadvertently fail to obtain a grant of a security interest. The results can be disastrous. Not having a lawyer involved in those negotiations and revisions can be the epitome of the expression ‘penny wise and pound foolish.’
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