Working Capital Flexibility, Resilience and the Negotiation of Facility Letters

This article covers facility letters with banks. It is important for corporates to have working capital facilities at multiple banks and it is important to be able to increase these facilities quickly when needed. It is also important to have the ability to decrease committed facilities to avoid commitment fees with some assurance that it is quick and painless to increase the facilities when needed. The goal is cost effective working capital flexibility and resilience. 

In my past I have dealt with numerous facility letters for different corporates. I have seen examples of best practice and, to put it mildly, instances that were not so exemplary. I also had occasion to put some deep thought in how to improve the facility letter process and made some solid progress to achieving my end vision at my last employer. I pioneered the concept of a master agreement with an appendix, similar to an ISDA master and trade confirmation. Other banks have been slow to adopt this format and are stuck to their legacy “all in the body” formats. I will explain the benefit of a master agreement and appendix construct. 

First, let’s explain what a facility letter is. A facility letter is an umbrella agreement that contains the following:

• the economics of various facilities, by this I mean the applicable limits (credit limit for an overdraft, daily settlement limit, trading limit known as the Potential Future Exposure (PFE), aggregate corporate credit card limit, guarantee limit, etc) and the pricing (interest rates applicable to those facilities that incur interest and the commitment fees for unused committed facilities). 
• the security that has been committed to the bank. Security can include cash, financial instruments, debtors, inventory, fixed/immovable and moveable property and guarantees, particularly parental guarantees for subsidiaries of global corporates. To be clear, the security agreements (mortgage bond, general notarial bond, special notarial bond, pledge, cession, guarantee, etc) are separate to the facility letter. In the main, the facility letter just lists the security and collateral, hence my description of a facility letter as an umbrella agreement.  
• ?client specific conditions / covenants such as a maximum debt:equity ratio, interest cover, etc. 
• general clauses such as set-off, banks rights on default, anti-money laundering, agree to electronic communication, etc.

As a rule of thumb, a facility letter generally contains items with a maturity of less than a year. There are exceptions as a facility letter can contain guarantees which extend beyond a year, for example. The major exclusion is debt where the maturity is greater than a year. The excluded debt is mostly for non-working capital purposes such as to finance buildings, plant and equipment, vehicles, etc.  

I purposefully ordered the contents of the facility letter in descending order of frequency of changes. The economics change most frequently and the general conditions are fairly static. The old format of a facility letter embedded the entire contents into the body of the agreement. When there was a change, no matter how slight, such as the change in the credit limit of a corporate card for an executive travelling abroad, a new facility letter would have to be issued. The facility letter would be referred to the corporate legal department, they may consult external counsel, and an entire cycle of clause negotiation was initiated. The corporate lawyer wants to change a clause, he/she informs the relationship manager at the bank, who informs the bank lawyer, the bank lawyer may not have authority to agree to the change and so the bank lawyer escalates the requested change for approval, the bank reverts with a compromise clause, the corporate lawyer needs to consult the corporate treasurer who may need to consult the corporate CFO and the cycle continues. With each step there is a delay whilst the facility letter sits in the next person’s inbox. This can carry on for months - in extreme cases this cycle can take longer than a year. It is far more practical to go through this cycle once for the master agreement and have an appendix, particularly for the economics that change frequently. So when the corporate treasurer or CFO needs a change in facility, they e-mail their relationship banker, who then initiates an internal bank process and the bank is able to issue a new appendix and make the requested change on the same day.

The master agreement should be evergreen. Many legacy facility letters need to be renewed on an annual basis. This creates a huge burden of work for both the bank and corporate. It is good practice for a bank to do a credit review at least annually but this does mean that a new facility letter needs to be issued every year. Often the credit risk is still acceptable and there is no need to amend the facility letter. If there is no need to change the facility letter then why commit to generating a new facility letter every year ? If there is a need to make a change, then it is also much easier just to change the appendix rather than the whole facility letter.    

There is debate as to whether the client should sign or e-sign the appendix or whether it should be a notification. Time is often of the essence - for example, the corporate needs the increased overdraft limit for a tax payment that is due tomorrow. Agreed, it is a symptom of poor cash forecasting that the corporate left the request to the last minute but it happens and it happens regularly. When the treasurer requests a ZAR 100m increase in their overdraft, the relationship banker initiates a process whereby the request is sent to credit to approve the increased limit and to the product house to check the pricing (the interest rate and commitment fee), once these processes are complete, another team is notified to change the overdraft limit on the system. If the corporate is required to sign the revised appendix before the overdraft is increased on the system then a delay is introduced. The corporate treasurer may be unavailable to sign or e-sign the revised appendix and the relationship banker may also be otherwise engaged and unable to track down the corporate treasurer. There is thus a risk that the corporate does not get access to the increased overdraft and they have insufficient funds to make the tax payment, vendor payments, or even salary payments. The compromise at my former bank was for the change request to be signed or e-signed by the corporate. The law of contract requires an offer and acceptance for a binding contract. If the corporate asks for ZAR 100m overdraft, the bank grants it and the corporate uses the overdraft then there is tacit acceptance and the contract is binding. However, if the corporate only uses ZAR 40m and the bank charges commitment fees on the unused portion of ZAR 60m then with hindsight and knowledge that the corporate did not need the full ZAR 100m overdraft they could argue that they did not request the full ZAR 100m, only ZAR 40m, and the bank’s proof of the request (offer from the corporate) may be weak in the absence of a signature from the corporate. The corporate could also ask for ZAR 100m and the bank only approves ZAR 80m - technically this is a counter offer which the corporate needs to accept. The most practical solution is for the corporate to submit their request in a binding electronic form such as e-mail, logging into the corporate portal or e-signature of an electronic form instantly generated by the bank. There is some legal risk compared to both parties signing the revised appendix, but in my (non-legal) opinion this is acceptable legal risk. In the retail world, banks change credit card limits at will without any amended agreements so there is a level of bank comfort with unsigned notifications.

I often hear corporates claim that they have banked with a particular bank for 10, 20, 50 or even a 100 years and so they do not want to move banks as they believe their loyalty to this bank will be reciprocated in tough times. It is true the relationship manager will point this out in the credit committee, however banks are set up to ensure the credit they extend is repaid. Most banks will penalise the bonus of a relationship manager if there is a default in their portfolio. So it is not a given that your relationship manager is in favour of the increased credit limit. The primary metric used to evaluate the credit community is the loss ratio ie the extent of loans provisioned or written off relative to those extended. The consideration as to whether the bank is likely to be repaid is far greater than the past relationship with a corporate. The bank also operates within a context. If the bank is over exposed to a particular sector relative to their portfolio or they have just suffered a large loss within the sector, they make a sector credit call that they will not increase their exposure to a particular sector or, even worse for the corporate, they may elect to reduce their exposure to that sector. There are other factors which could also impede an increased facility - there could be an internal bank power play and your relationship manager may be on the losing side. Or there could be a sticky legal or compliance department that finds a minor fault with a document such as an inconsistent date and delays the availability or pay out of funds. There are some pretty hard nosed legal and compliance folk that will fold their arms and wait for an amended board resolution regardless of whether the directors are in the bush, circumnavigating the world in a hot air balloon or giving birth, whilst thousands of employees are denied their salaries.  

That is why it is so important to have facilities available at more than one bank. If there is a hassle with your incumbent bank and you have to start from scratch with another bank then you could be in for a long wait before your new facilities are in place. You need to provide all the KYC / FICA documents, a credit analyst needs to analyse your organisation and draft a credit application, the credit application needs to go through an approval process which may entail credit committees that only meet at a certain frequency, a thorough legal department will want to check the Memorandum of Incorporation to determine the borrowing capacity, they will need a board resolution authorising the borrowing and mandating the signatories and aside from the aforementioned facility letter process all the security documentation needs to be put in place. Bonds need to be registered, busy senior executives need to sign parental guarantees, etc. It is essential that you complete this process before the working capital is required.

A rookie mistake is to promise the crown jewels to the first bank and then have very little left to offer the subsequent banks in terms of security, priority on default and ancillary business. I was very impressed with a global motor manufacturer who standardised their facility letters with every bank they dealt with globally. They were in the fortunate position that their credit was A rated investment grade and banks were comfortable with a parental guarantee as security. As they were in a strong negotiating position there was very little if not zero tolerance for any deviations to the facility letter which they had drafted. As a bank we were happy to accept their facility letter as we knew we were being treated equally (and ranked “pari passu”) with the other banks, despite the absence of some of our standard clauses. With the recent drop in revenue due to Covid19, they now have a range of banks to call on for additional working capital facilities. They achieved flexibility and resilience in the good times which will help them through the tough times.

Let’s dwell on promising the crown jewels to the first bank for a moment. As you know when a bank extends credit, whether utilised or not, they are required to commit capital to the debt or facility. The ambition of South African banks is to earn an 18-20% return on capital / equity. Market pricing does not allow the banks to achieve these capital returns on the debt or the facilities they extend alone. Banks need (near) capital free revenue such as transactional revenue and foreign exchange revenue to boost their return on capital. (I say near capital free revenue as some capital is still required for operational and market risk.) Aggressive banks will insert a clause in the facility letter that in return for the facilities the corporate is obliged to do all their ancillary business with that bank. The corporate can complain about the pricing of the ancillary business but they have contracted to do their ancillary business with that bank at a price of the bank’s choosing. The corporate has backed themselves into a corner and need to pay the price. At my former bank we thought this was inconsistent with treating customers fairly and opted for more lenient versions of this clause. One version of the clause was that the corporate was obliged to allow the bank to bid on all ancillary business and the corporate was at liberty to do their ancillary business with any bank of their choosing even if it was at a higher price. Another version that was more favourable to the bank was the right of first refusal. In this version, the corporate could shop around for the best price on the ancillary business and then would have to give the bank the option to match the pricing, and if they matched the price then the corporate was obliged to give the bank the ancillary business. As you can see there are often many variations in the terms of facility letters. Hopefully this paragraph has highlighted two important principles. Firstly, do not promise the family silver to the first bank and secondly, it is possible to negotiate the clauses in your facility letters with banks.

General practice amongst the top corporate treasurers is not to promise any ancillary business in the facility letters but to allocate their ancillary business to the banks that provide them with debt and facilities on a proportional basis. These treasurers understand the bank economics and want to be as fair as possible to all banks. Clearly the banks need to play ball and they need to provide a decent price for the ancillary business else they will not win their proportionate share of the ancillary business relative to the debt and facilities they have extended. Structurally, however, much of the transactional banking is hard wired to one or two banks. Generally one bank has the main operational bank account. Even if a corporate splits collections/customer deposits and payments the corporate often sweeps their cash into the payment bank. The payment bank thus not only wins the fees for the payments but they also benefit from the operational cash deposits which attract very little interest. Of all the (near) capital free business that a corporate can offer a bank, the operational deposits are the most profitable for a bank (as they can lend these deposits out at a healthy margin). Corporate treasurers should ensure that those banks earning the most ancillary revenue are also coming to the party with the largest debt and facilities.

If your cashflows are strong you can get away with unsecured facilities. If, however, the bank/s require security, be careful not to commit all your security to the first bank. It goes with saying that if you commit your assets to the first bank then the best you can offer the second bank is second place leftovers. This will drive up the second bank’s loss if there was a default (Loss Given Default / LGD) and they will need to increase the interest rates on the facilities they offer you to cover the increased risk and cost of the increased capital.

On the topic of negotiating facility letters, banks will “throw in the kitchen sink” (every clause under the sun) in their standard facility letters and hope that the corporate blindly signs the facility letter. An example of this is the negative pledge clause where you commit not to sell your assets or offer your assets as security to anyone else. It is conceivable that a corporate could be in technical breach of the agreement on day one if they do not read and fully understand the contents before signing the facility letter. As one of my banking lawyer friends said, it is important to “de-kitchen sink” the agreement before signing it. There are certain clauses where the bank will not budge and there are others which are nice to have and the bank is taking a chance that the corporate will just accept them. Through my banking experience I have come across a handful of top banking lawyers. These are lawyers who are practical and in touch with the market. They will quickly knock your agreement into shape and tell you what the bank will roll over on, where there will be some resistance and where the bank will stand firm. Best of all they will give you a fixed price per agreement and you won’t be billed by the hour for an inexperienced lawyer and their juniors to research the topic and expose you with their drafting that lacks practical experience. I am happy to connect you with these top banking lawyers. 

Some corporates fail to see the purpose of a facility letter. Frankly, I agree with them if their only dealings with a bank are products that are dealt with in separate agreements. For example, when a corporate requires a bank guarantee such as the guarantee needed for the rent payable to a landlord, then the bank and the corporate enter into a specific agreement for the guarantee. The corporate agrees to pay the bank a fee (expressed as a percentage of the value of the guarantee) and in return if the corporate defaults on their rent payment then the bank will pay the landlord the outstanding rent. The guarantee is governed by a stand alone agreement. There is thus no need for a facility letter that only covers the guarantee. There are other products, particularly overdraft, where the facility letter is the sole agreement between the bank and the corporate. A facility letter is necessary for these products. Once there is a genuine need for a facility letter I do see merit in listing all the facilities in the appendix of the facility letter, even those covered in stand alone product agreements. If the corporate were to move to another building or close the store that relates to my aforementioned hypothetical guarantee then the facility letter will serve as a reminder to cancel the guarantee. Another scenario may be a change in treasurer where the outgoing treasurer failed to inform the new treasurer of the guarantee which was buried in some filing cabinet or their e-mail inbox. In summary, there are benefits to having a single schedule which lists all the facilities between the corporate and the bank.  

You would have gathered from this discussion that I am in favour of the revised facility letter appendix containing all the facilities and not just the changes since the last appendix. In my mind it is a nightmare if the first schedule says overdraft of ZAR 100m at 5% interest, then a reduction of ZAR 20m, then an increase of 1% and so you have to sum all the changes across the schedules to figure out the current economics ie overdraft of ZAR 80m at 6% interest. You may be wondering why it is even necessary to mention this - why would anyone design an appendix schedule that just contains the delta or changes ? I kid you not...this is how some facility letters operate.

?Thanks for lasting this far on rather a dry topic....Hopefully the need for facilities with multiple banks makes sense in terms of working capital flexibility and resilience. Ensure that you negotiate the most favourable terms and ensure that you contract with your banks on equal or proportionate terms. Finally, structure your facility letters to minimise the turn around time when changes to facilities are required.