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Doing the Deal 101: Credit Agreement Structures

With this post, we will be taking a look at some of the more important structural features unique to credit agreements. Credit agreements, like corporate transaction agreements generally, contain representations and warranties, covenants, closing conditions and the like. However, credit agreements have structural features special to themselves. The features discussed below include credit agreements with multiple lenders, revolving loans and term loans, PIK and cash pay interest, events of default and financial covenants.

Multiple Lenders: Credit agreements, by their very nature, involve the making of loans by a lender to a borrower. Some credit agreements provide, however, for more than one lender party. These multi-lender credit agreements (often called “syndicated loan credit agreements”) introduce a number of special provisions. Let’s discuss two of them.

Multiple Lenders/Decision-Making Issues: The multiple lender credit agreement must provide for how decisions should be made by the lenders. Typically, credit agreements draw a distinction between, on the hand, lender group decisions that can be decided by the affirmative vote of lenders holding a majority (or sometimes a supermajority) of the principal amount of loans outstanding and, on the other hand, lender group decisions that can be decided only by the affirmative vote of each and every lender. Falling into the first group of “majority vote” lender decisions are, for example, those decisions relating to whether to enforce certain provisions (such as loan payment acceleration upon a borrower default) or whether certain credit agreement provisions can be amended.

The second group of “unanimous vote” lender decisions includes those that involve amending the credit agreement to commit lenders to providing financial accommodations to the borrower beyond those currently called for by the credit agreement (such as providing for an increase in the amount to be lent to the borrower). Another example where a unanimous vote of lenders is often required is a decision by the lenders that would diminish lender rights (such as by extending the maturity date of the loans made under the credit agreement).

Multiple Lenders/Loan Trading Issues: Unlike most other types of corporate transactions, a very active secondary market (the “loan trading market”) exists in which lender parties to multi-lender credit agreements can sell their rights and obligations under the credit agreement to third-parties who are not already parties to the credit agreement. Confronted with this loan trading possibility, lenders who are already “in” the credit agreement (and borrower itself) will want some control over just who can join the lender group upon a purchase of an exiting lender’s rights and obligations. Not surprisingly, credit agreements contain provisions that, while authorizing the transfer of lender rights and obligations, also limit these transfers in significant ways. Examples of these limiting provisions include requiring that a prospective new lender exceed a certain financial size (in order to increase the likelihood that the new lender will be able to satisfy future loan funding obligations) or prohibiting a competitor of the borrower from becoming a lender.

Loan Types: Credit agreements can provide for different types of loans to be made under these agreements. Some credit agreements contemplate that a loan can be made to the borrower on a revolving basis. Revolving loans, or “revolvers,” are like credit cards, because, although they are subject to an overall borrowing amount limit and to a specified repayment date, the outstanding loan balance can fluctuate as the borrower draws down and pays back the revolving loan multiple times during the life of the agreement. Another type of loan provided for under a credit agreement is the term loan. Term loans are more like a home mortgage loans because they generally call for the borrower to receive loan proceeds in one lump sum that the borrower is then required to repay over the term of the credit agreement. The borrower can repay the term loan either by way of fixed-amount periodic installment payments made according a payment schedule specified in the credit agreement or by way of a single, one-time payment — a so-called “bullet” term loan — that becomes due in full on a stated “maturity” date.

Interest Payment Types: Credit agreements can also provide the borrower with different ways to satisfy its interest payment obligation. For example, a credit agreement might straightforwardly require that the borrower periodically pay interest in cash on outstanding loan balances. Alternatively, a credit agreement may provide that, so long as the borrower is not in default on any of its obligations, the borrower may forgo making an interest payment in cash and instead have the amount of interest that has accrued at the end of a stated period be added to the principal amount of the loans outstanding. In this latter case, the interest is described as having been “paid in kind” (i.e., paid in the form of an accretion of additional loan principal amount) — with these types of interest payments bearing the “PIK” acronym in credit agreement terminology.

Loan Acceleration/Default: Another set of provisions that are unique to credit agreements are those governing loan acceleration rights of the lenders. Loan acceleration is the requirement that the principal and interest of the loan be immediately repaid in full and in cash. The lenders’ power to exercise their right to accelerate repayment can arise automatically when the borrower breaches certain covenants (promises) or representations. The kind of events (usually called “Events of Default”) that can automatically trigger loan acceleration right powers are standard in some cases (e.g., events involving non-payment of monies due) and are heavily negotiated by the borrower and the lenders in other cases. For example, counsel for the borrower and the lenders will often wrangle over whether a covenant, such as one requiring that the borrower maintain insurance on its tangible properties, can be cured in a timely way if breached and, therefore, should not be deemed an “Event of Default,” unless the borrower does not fix the problem (or “cure the default”) within a certain number of days after the lender provides notice.

It’s also common for credit agreements to provide that certain kind of events (which consist of borrower breaches that are less seriously adverse to the lenders’ interests than a payment failure) could “ripen” into “Events of Default” after a specified period of time has elapsed or after a lender notice has been given to the borrower following the events’ occurrence. These “Default” events (so-called to distinguish them from “Events of Default”), therefore, typically give the borrower some breathing space to cure the Default within a window time specified in the credit agreement.

Nonetheless, Default events can have an immediate impact under the credit agreement short of accelerating loan re-payment. For example, during the occurrence of a “Default” and prior to its cure, the borrower may be prohibited from drawing down advances under a revolving loan. Another example of the immediate impact a “Default” event’s occurrence can have is the imposition of a higher rate of interest for as long as the “Default” remains uncured (with the imposition becoming permanent if the “Default” ripens into an “Event of Default”).

Financial Covenants: Finally, while most corporate transaction agreements contain covenants that bind the parties, credit agreements typically contain covenants that impose financial tests that the borrower must satisfy. These “financial covenants” set forth various measures of the borrower’s financial well-being overall and, more particularly, of the borrower’s ability to meet its payment obligations under the credit agreement as they come due.

Often these covenants are designed to signal to the lenders that, although the borrower may be meeting its payment obligations at present, the likelihood is increasing that the borrower will soon be in financial trouble. One type of financial covenant, called a “maintenance test,” specifies levels of financial performance that the borrower must meet at stated intervals or over stated periods of time (such as the borrower’s maintaining a certain amount of tangible net worth or a certain ratio of earnings to interest payments). Another type of financial covenant, called an “incurrence test,” prohibits the borrower from engaging in certain types of activities, such as incurring additional indebtedness in excess of a debt to earnings ratio.

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