Loan Agreement

When a lender makes a term loan or revolving credit commitment, it provides the borrower with available funds for an extended period of time. Much can happen to the financial condition of the borrower during that period. To safeguard itself, the lender requires the borrower to maintain its financial condition and, in particular, its current position at a level at least as favorable as when the commitment was made. The provisions for protection contained in a loan agreement are known as protective covenants.

The loan agreement itself simply gives the lender legal authority to step in should the borrower default under any of the provisions. Otherwise, the lender would be locked into a commitment and would have to wait until maturity before being able to effect corrective measures. The borrower who suffers losses or other adverse developments will default under a well written loan agreement; the lender then will be able to act. The action usually takes the form of working with the company to straighten out its problems. Seldom will a lender demand immediate payment, despite the legal right to do so in cases of default. More typically, the condition under which the borrower defaults is waived or the loan agreement is amended. The point is that the lender has the authority to act, even though negotiation with the borrower may be instituted to resolve the problem.

The formulation of the different restrictive provisions should be tailored to the specific loan situation. The lender fashions these provisions for the overall protection of the loan. No one provision is able by itself to provide the necessary safeguards; but together with the other provisions, it is designed to assure overall liquidity and ability to pay a loan. The important protective covenants of a loan agreement may be classified as follows: (1) general provisions used in most loan agreements, which are variable to fit the situation; (2) routine provisions used in most agreements, which usually are not variable; and (3) specific provisions that are used according to the situation. Although we focus on a bank loan agreement, the protective covenants used and the philosophy underlying their use are the same for a bond indenture.

GENERAL PROVISIONS

The working capital requirement is probably the most commonly used and most comprehensive provision in a loan agreement. Its purpose is to preserve the company's current position and ability to pay the loan. Frequently, a straight dollar amount, such as $6 million, is set as the minimum working capital the company must maintain during the duration of the commitment. When the lender feels that it is desirable for a specific company to build working capital, it may increase the minimum working capital requirement throughout the duration of the loan. The establishment of a working capital minimum normally is based upon the amounts of present working capital and projected working capital, allowing for seasonal fluctuations. The requirement should not restrict the company unduly in the ordinary generation of profit. Should the borrower incur sharp losses or spend too much for fixed assets, purchase of stock, dividends, redemption of long term debt, and so forth, it would probably breach the working capital requirement.

The cash dividend and repurchase of stock restriction is another major restriction in this category. Its purpose is to limit cash going outside the business, thus preserving the liquidity of the company. Most often, cash dividends and repurchase of stock are limited to a percentage of net profits on a cumulative basis after a certain base date, frequently the last fiscal year end prior to the date of the term loan agreement. A less flexible method restricts dividends and repurchase of stock to an absolute dollar amount each year. In most cases, the prospective borrower must be willing to undergo a cash dividend and repurchase of stock restriction. If tied to earnings, this restriction still will allow adequate dividends as long as the company is able to generate satisfactory profits.

The capital expenditures limitation is third in the category of general provisions. Capital expenditures may be limited to a fixed dollar amount yearly or probably more commonly, either to depreciation or to a percentage thereof. The capital expenditures limitation is another tool the lender uses to assure the maintenance of the borrower's current position. By limiting capital expenditures directly, the bank can be surer that it will not have to look to liquidation of fixed assets for payment of its loan. Again, the provision should not be so restrictive that it prevents adequate maintenance and improvement of facilities.

A limitation on other indebtedness is the last general provision. This limitation may take a number of forms, depending upon the circumstances. Frequently, a loan agreement will prohibit a company from incurring any other long term debt. This provision protects the lender, inasmuch as it prevents future lenders from obtaining a prior claim on the borrower's assets. Usually a company is permitted to borrow within reasonable limits for seasonal and other short term purposes arising in the ordinary course of business.

ROUTINE PROVISIONS

The second category of restrictions includes routine, usually invariable provisions found in most loan agreements. Ordinarily, the loan agreement requires the borrower to furnish the bank with financial statements and to maintain adequate insurance. Additionally, the borrower normally must not sell a significant portion of its assets and must pay, when due, all taxes and other liabilities, except those it contests in good faith. A provision forbidding the pledging or mortgaging of any of the borrower's assets is almost always included in a loan agreement; this important provision is known as a negative pledge clause.

Usually, the company is required not to discount or sell its receivables. Moreover, the borrower generally is prohibited from entering into any leasing arrangement of property, except up to a certain dollar amount of annual rental. The purpose of this provision is to prevent the borrower from taking on a substantial lease liability, which might endanger its ability to pay the loan. A lease restriction also prevents the firm from leasing property instead of purchasing it and thereby getting around the limitation of capital expenditures and debt. Usually, too, there is a restriction on other contingent liabilities.

In addition to these restrictions, there typically is a restriction on the acquisition of other companies. This restriction often is a straight prohibition of such mergers unless specifically approved by the lender. It is possible to have other kinds of restrictions on mergers, but a flat prohibition is most prevalent. The provisions in this "routine" category appear as a matter of course in most loan agreements. Although somewhat mechanical, they are necessary because they close many loopholes and provide a tight, comprehensive loan agreement.

SPECIAL PROVISIONS

In specific loan agreements, the bank uses special provisions to achieve a desired total protection of its loan, A loan agreement may contain a definite understanding regarding the use of the loan proceeds, so that there will be no diversion of funds to purposes other than those contemplated when the loan was negotiated. A provision for limiting loans and advances often is found in a bank term loan agreement. Closely allied to this restriction is a limitation on investments, which is used to safeguard liquidity by preventing certain nonliquid investments.

If one or more executives are essential to a firm's effective operation, a bank may insist that the company carry life insurance on them. Proceeds of the insurance may be payable to the company or directly to the bank, to be applied to the loan. An agreement may also contain a management clause under which certain key individuals must remain actively employed in the company during the time the loan is owing. Aggregate executive salaries and bonuses are sometimes limited in the loan agreement, to prevent excessive compensation of executives which might reduce profits. This provision closes another loophole; it prevents large stockholders who are officers of the company from increasing their own salaries in lieu of paying higher dividends, which are limited under the agreement.