The text of commitment letters is extremely important and must contain the exact terms and conditions of a loan commitment. It will contain all essential specifics. In order for one to generate an effective commitment letter, one must have a clear understanding of all the terms. To get there, it is often desirable to start with a term sheet.
The term sheet will outline the basic business terms that a lender intends to propose. It will typically include a paragraph of section that specifically declares that the document is not an offer, and its acceptance by a prospective borrower does not create a commitment by the lender to make the requested loan. It may further note that the term sheet is subject to modification by the lenders at its sole discretion, prior to the execution of the commitment letter.
The preliminary term sheet is a document-in-progress. The lender puts out its offer on a term sheet and the borrower often provides a counter offer. Then the bankers make a counter offer to borrower's counter-proposal, and so on. In most cases, lawyers are not involved in the preparation of the term sheet and the negotiation of it. It is, after all, a discussion of terms between two people negotiating a business arrangement. It is important, therefore, that one bears in mind the following three elements to be included in a term sheet.
The term sheet must include the basic business terms that the bank wants to propose (amount of the credit facility, interest rate or method of calculating it, term of the facility and collateral).
Since the document is evolving, the term sheet should include a paragraph or section that specifically states that this document is not an offer and its acceptance by the prospect (one must try not to use the word “borrower”) does not create a commitment by the lender to make the loan or that the lender will be obligated to make the loan based on the terms contained in the term sheet. The following is a sample of such language:
“This letter is not a commitment to lend on the part of the bank. A commitment shall be issued by the bank after the bank obtains certain necessary internal approvals and a commitment letter is issued by the bank which sets forth the terms and conditions of the commitment. The terms and conditions of the commitment letter, when and if it is issued, may be different from those proposed herein. Upon receipt of an executed copy of this letter, the bank will begin the process of seeking the necessary approvals and performing its review of the proposed transaction.”
The above exculpatory language would prevent a potential borrower from claiming that the initial term sheet or loan application resulted in a commitment to lend. The term sheet should also include a statement to the effect that the terms set forth in the term sheet are subject to modification by the lender in its sole discretion. The lender wants the flexibility to modify the term sheet before issuing the commitment letter.
The commitment letter is an important step of the loan process. It formalizes the terms that were outlined in the term sheet, if there was one, and it becomes binding both to the borrower and the lender. For that reason, substantial care has to be taken in preparing the commitment letter. The following are some of the issues one must consider in drafting the commitment letter.
1. Secured v. Unsecured Loan
The commitment letter must spell out clearly whether the loan is secured or unsecured. Often lenders will issue a commitment letter that refers to an unsecured loan, Then, when the loan documents are drafted, they include language to the effect that the lender will have a security interest and right of offset in the accounts of the borrower that are in the control of the lender (i.e., borrower's deposit accounts at the lender). It is not unusual for the lender to ask for such right. Without it, the lender may have encounter problems in trying to take control of the accounts that the borrower has with the lender at the time of default. However, such language means that the loan is not unsecured. There is a security interest in those accounts borrower. The commitment letter should make that clear. Otherwise, borrower's counsel can raise it as an issue at the time the loan documents are prepared. One way is not to refer to the loan as “unsecured.” If the lender wants to clarify this issue, while making a statement that the loan is unsecured in all other respects, the following sentence should cover the point: “The loan will be unsecured except for the security interest in borrower's accounts with the lender.”
2. Identifying the Collateral
Another deal point that needs to be addressed in the commitment letter is the clear identification of the collateral that will be used to secure the loan. It is difficult for the lender to ask for collateral that was not identified in the commitment, once the borrower has signed the commitment letter. The only time a lender may be able to justify asking for additional collateral is if during due diligence the lender determines that the value of the collateral outlined in the commitment letter is inadequate.
3. Financial and Reporting Covenants
The commitment letter should spell out in detail the financial covenants (such as debt service coverage ratio). It should also spell out the reporting covenants. It is advisable that all the details of the reporting covenants be included in the commitment letter so they do not become the subject of negotiation at the time of loan document drafting.
4. What else to include in the commitment?
One can debate for a long time the issue of the amount of detail that the commitment letter should contain. One view is that the commitment letter should be generic and all the details will be spelled out in the documents. This is not the prevailing view of bankers today. The other view is that the commitment letter should include in detail as many terms as possible. Of course, if we took this view to the extreme, then the commitment letter would be the full set of loan documents. The middle of the road view is the most reasonable one. A commitment letter should go into sufficient detail as to the economic terms and in addition as to the principal representations, covenants and default provisions. There are many cases where the attempt to introduce a term at the drafting stage of the documents (e.g., imposition of default rate) is countered by a claim by borrower's counsel that such term was not in the commitment letter.
So what are the important terms that must be included in a commitment letter? The list below sets forth most of the important terms that a commitment letter should address. However, one must bear in mind, first, that the list is not exhaustive, and second, that each deal being different, one should be mindful of what other provisions should be added each time that a commitment letter is prepared.
Finally, commitment letters for special types of credit facilities may require additional terms. For instance, in the case of a construction loan, the commitment letter must include a series of covenants and conditions relevant to that type of financing.
In summary, the commitment letter process is critical to the success of the loan. If all the terms of the deal are clearly outlined at that time, then the documentation phase of the loan will be smooth and uneventful. The caveat to that statement is that even though you think you have worked out all the terms of a deal, during due diligence you are bound to find new issues that may end up making you modify the terms that you spent all this time negotiating. The commitment letter should be drafted in a way that it gives you the flexibility to do that.
Tassos Efstratiades is a partner in the Philadelphia and Cherry Hill, N.J., offices of Obermayer Rebmann Maxwell & Hippel LLP.
