Borrower Beware – Tips for Borrowers

5 June 2017

Shakespeare penned the phrase “Neither a borrower nor a lender be” over 400 years ago as a warning that lending arrangements between friends can be damaging to personal relationships. However, borrowing money in any circumstance can become risky if the terms of a loan are not properly understood and negotiated at the outset.

With this in mind, we have prepared a short summary of key points to consider by a borrower when seeking debt funding:

  1. Pricing

Lenders generally price their loans based on their appetite for risk. The safer the loan seems, the cheaper the rates a lender will be able to offer. When reviewing the cost of a loan, a borrower should not only consider the headline interest rate but the fees and associated costs being charged by the lender as well. As a borrower, it is important to be clear as to whether the interest rate will be a fixed or variable (otherwise known as a floating) rate. It can also be quite common on larger loan transactions to borrow money on a variable rate of interest and then enter into a hedging agreement (otherwise known as a swap) under which the variable rate will be ‘swapped’ for a fixed rate. If the borrower is late in making any payment when due, a higher ‘default rate’ of interest is likely to apply. Interest may be paid periodically (e.g. on a monthly or quarterly basis) or may be ‘rolled up’ throughout the term of the loan and paid to the lender together with other sums due, at the end of the term.

The usual types of fees a borrower may encounter include:

Arrangement Fee:

a fee payable by a borrower on entry into a loan agreement, usually calculated as a percentage of the loan;

Commitment Fee:

a fee paid by a borrower on its undrawn portion of its loan facility to compensate a lender for their commitment to make loans available to a borrower for a period of time – this is common on a revolving facility;

Prepayment Fee:

a fee payable by a borrower in the event it prepays a loan prior to its stated maturity; and

Exit Fee:

commonly seen in development finance, an additional fee payable by a borrower on repayment or “exit” of a loan. 

It is also usual for the borrower to be responsible for any external costs incurred by the lender, such as its legal and valuation fees. The borrower should ensure that such costs are agreed in advance and will want to keep the wording in the loan agreement specific enough such that any additional costs do not come as an unwelcome surprise. 

  1. Repayment and Prepayment 

Clearly, agreeing when the loan will become due for repayment is an important consideration for both the lender and the borrower. In some situations, the loan may be repayable at any time on demand which means the lender can demand repayment whenever it chooses. Any borrower should be cautious before entering into this type of agreement and should make sure that it will be able to repay the full amount due to the lender, at any time, and at short notice. A borrower should always seek to agree with a lender that the loan will be repayable in accordance with an agreed schedule for repayment, often either by way of equal periodic repayments (amortisation); instalment payments, with a larger payment at the end (balloon repayment); or by one “bullet repayment” when the loan expires.

As well as being clear on what the terms are for repayment of the loan, it is also important to know what (if any) provisions there are in relation to prepayment of the loan, that is, early repayment. Some loans may include provisions which require the borrower to prepay the loan in certain situations such as if there is a disposal of property which forms part of the security. There may also be provisions allowing the borrower to voluntarily prepay the loan. This will often include reference to a prepayment fee, which will be payable by the borrower when the loan is prepaid to make up for any future loss of interest suffered by the lender. Such fees will often be a percentage of the amount prepaid, and calculated on a sliding scale depending on how far into the term of the loan the prepayment occurs.

  1. Security and guarantees

If the loan is a ‘secured loan’ the borrower (and sometimes other parties connected to the borrower) will give certain security to the lender to secure its obligations under the loan agreement. The lender will want to be able to ‘enforce its security’ if the borrower defaults on payment of the loan or breaches any other material term of the agreement (see events of default below). If the lender is in a position to enforce its security, it will usually then be able to take control of the asset (either as mortgagee in possession or more commonly by appointing a receiver or administrator) and have free reign to deal with it, including the ability to sell it in order to recover what is owed.

Security documents can take a variety of forms under the guise of different names, creating different types of security. Common security documents entered into alongside loan agreements include a debenture, legal mortgage, legal charge, share charge (the list goes on) but these documents all create security which is generally granted to the lender. Any borrower should be clear as to what is being granted, not least because the security documents will often restrict how the borrower is permitted to deal with the underlying asset(s), and may also have wider implications on how it conducts its business

  1. Representations, Warranties and Covenants

From a lender’s perspective, it will want to ensure that it is exposed to as little risk as possible and as such, it will require the borrower to give certain representations, warranties and covenants under the terms of the loan documents. These are used by a lender to illicit information and alert it to circumstances which may result in the lender not being repaid so that prompt action, can be taken. Representations and warranties will usually be set out as stand-alone statements which, upon entering into the loan agreement, the borrower confirms are true (often, these are also stated to be repeated every day throughout the term of the loan). Usually, if the borrower breaches a representation or a warranty (which have broadly the same meaning in the context of a loan agreement) it will trigger an event of default. The borrower should make sure that the representations and warranties are carefully reviewed and if necessary negotiated with the lender if the statements cannot truthfully be made, or if a breach of the same is likely to occur.

The lender will often also require the borrower to agree to various covenants (a promise to do or not do something) which will give the lender a certain amount of control over how the borrower may operate and deal with its assets. This may include giving the lender certain information rights, an obligation to seek lender consent before disposing of or otherwise dealing with its property, an obligation not to enter into any other security documentation with any other party, and also to agree certain financial covenants such as to ensure that the value of any asset forming part of the security, does not fall below a certain percentage of the loan amount (the ‘loan to value ratio’).  Again, it is important that the borrower reviews the covenants and is comfortable that these ‘promises’ can comfortably be made, because a breach of covenant will also usually trigger an event of default.

  1. Events of Default

The loan agreement will contain certain ‘events of default’ which, if triggered, will mean that the borrower has defaulted on the loan agreement. An event of default gives the lender the option of declaring the loan immediately due and payable and any security given will become enforceable. Events of default will ordinarily include, amongst others: breach of a material term of the loan (including non-payment); the insolvency of the borrower; a change of control of the borrower and cross default (i.e. if the borrower defaults on any other borrowings). The borrower must be clear on what action will trigger an event of default and, if necessary, negotiate the same accordingly to mitigate its exposure.

The above is a very brief roundup of the key provisions which any borrower should fully understand and be comfortable with before entering into a loan agreement and if necessary, negotiate those points which it cannot agree to. A borrower’s bargaining power can be somewhat limited and it is therefore important to seek advice at an early stage to protect its position.

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We welcome views and opinions about the issues raised in this blog. Should you require specific advice in relation to personal circumstances, please use the form on the contact page.

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