Documenting Loans: Key Principles
By Benjamin T. Beasley, Idaho Business Attorney
Loans are a key facet of the financial system in Idaho and throughout the United States. Nearly anyone can be a lender: individuals, small businesses, midsize and large companies, banks, credit unions, and governmental entities, to name a few.
At the outset of a loan transaction, lenders are nearly always highly confident in their borrowers – if not, the lender usually just doesn’t make the loan. But this confidence should be tempered with care to properly document and secure the loan in case things don’t work out as expected.
The attorneys at the Idaho law firm of Racine Olson have been helping clients document and secure their lending matters for over seventy years. We have advised lenders, borrowers, and ancillary parties in these types of transactions, so bring a broad perspective to the discussion. Our team of experienced attorneys will work with you to ensure that we understand your needs and situation, and create effective solutions that meet your needs.
One of the most critical things that a lender can do to protect itself is to properly document the loan. Depending on how simple or complicated the loan transaction is, the documentation may also be simple or complex, but its purpose is to ensure that the details of the transaction are clear and to secure the lender. Many disputes can be avoided in advance simply by making sure that all parties to a deal are clear on what the agreed-upon terms are, and that these are reflected in written documentation. It’s harder to fight about a specific issue if everyone agreed in advance on how that issue would work and signed their names to a document laying it out.
To try to cover the various terms and issues that may arise with a loan, the lender and borrower should think through problems that might come up (or that have occurred in similar deals) and come to an agreement as to what happens if those things occur. The specifics needed in a particular transaction will, of course, depend on the details of the transaction, but some typical issues are discussed below,.
The promissory note is the most basic loan document evidencing a loan that has been made. Often just called a “note,” a promissory note is a written promise by the borrower to pay an amount of money. Though notes can be formatted in different ways and have many different provisions, a note should clearly identify the parties, the amount owed, the maturity date of the loan, timing and amount of payments, the addresses of the parties, and the interest rate. It may also need to include provisions regarding prepayment rights or costs, late charges, negative covenants (especially relative to actions or collateral), assignment, waiver, and other similar items.
Care should especially be given to a provision regarding default. Without clarity as to what constitutes a default under the note, potential cure rights, and rights of a holder in the event of default, it can be much more expensive and time consuming for a lender to enforce its rights to payment. Normally, a lender will require that it is not only a default if the borrower fails to make payments when due, but also if the borrower fails to comply with other obligations in the note or other loan documents; fails in collateral requirements (such as selling collateral when the loan is not paid off); fails to maintain clean title to collateral; files bankruptcy; or takes other actions that may harm the lender’s security for the loan.
In the default section, a lender may include a default interest rate, default fees, costs, and other requirements that will help the lender protect itself financially in the event of default. These, like the other provisions of the document, must comply with usury laws.
Some or all of these default provisions may also be set forth in other loan documents, such as the loan agreement or security instrument.
A loan agreement is often part of a loan transaction, and usually acts as the overarching, governing document that explains the details of the loan, how the loan transaction is meant to work, what the parties’ intents and understandings are, and other key details about the deal. Accordingly, a loan agreement is usually longer than a promissory note and contains more background details about the loan.
The loan agreement may include:
• More detail about interest rate calculations and payment requirements.
• Calculations for principal amounts, interest rates, disbursements, fees, default costs, and other amounts.
• Provisions regarding title to collateral, lender title insurance requirements, surveys, and appraisals.
• Provisions regarding insurance for collateral.
• Specifics about administration of the loan, how disbursements will occur, and where loan payments can be made.
• Construction loan provisions, if the loan is a construction loan.
• Requirements about use of loan funds if the loan is meant to be for a specific purpose.
• Documentation requirements to back up borrower obligations and promises.
• Borrower representations and warranties about the loan and the borrower’s ability to borrow.
• Borrower covenants regarding net worth and debt service ratios.
• Default provisions, which may be similar to or more specific than those in the promissory note.
• Provisions regarding waiver, integration, notices, governing law, and similar items intended to clarify requirements in different situations that may arise.
Loans are often secured by property, whether real estate or personal property. This property is often called “collateral.” The purpose of collateral is to help the lender avoid a total loss if the borrower defaults and has no assets to pay back the loan (for example, in bankruptcy). If a lender is properly secured, it may be able to seize the collateral, sell it, and use the proceeds to pay for the outstanding debt.
If a lender desires to secure a loan, it should first ask several questions. Does the collateral have enough value to be able to pay the debt if it were sold? Will it continue to maintain that value in the future? What will the costs and time requirements be for the lender to foreclose on the property and sell it? In a foreclosure sale, will there be a discount to the expected fair market value? Are there any other lenders or parties that have a priority interest in the property, that might take all of the value before this lender can be paid back?
If the lender is comfortable with the collateral situation, then it will need a security instrument to secure the loan with the collateral. Some examples of security instruments are mortgages (for real property), deeds of trust (for real property), and a personal property security instrument (for personal property), though many others may be used, depending on the type of collateral that is securing the loan. The security instrument generally specifies that the borrower is pledging the collateral to secure the loan; includes representations and warranties from the borrower about its situation and the collateral; lists default and foreclosure provisions; and specifies other obligations of the borrower with respect to the collateral.
Different types of collateral often require additional action or documentation. Personal property, for example, usually requires a filing of a UCC-1 financing statement. For real estate, a mortgage or deed of trust is typically recorded with the appropriate governmental recording office. If the collateral has a title (for example, a vehicle), the lender will usually be listed on the title as kept by the appropriate governmental agency. If the collateral is a public security, then the holder or agent may need to sign an agreement about trading. If the collateral is a security in a private company, such as equity in a closely held business, then the company and other equity holders may need to sign agreements about the company, its equity, and what will happen in the event of foreclosure. Pledges of collateral owned by someone who is not the borrower are called “third party pledges,” and special care must be taken with these to ensure that the pledges are in fact binding under applicable law.
Depending on the loan structure, additional documents may be required to accomplish the objectives of the lender and borrower. Some typical documents include an action by the borrower (if an entity), a certificate of borrower, an assignment of contracts and agreements (if relevant to the property), a co-lender agreement and agent agreement (if the loan will be syndicated), a guaranty (if there is a guarantor), and an environmental indemnity (for real property).
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