Can We Do It? How to Determine if a Proposed Action is Permitted under a Loan Agreement | Practical Law

Can We Do It? How to Determine if a Proposed Action is Permitted under a Loan Agreement | Practical Law

A discussion of the steps a borrower and its counsel should take to determine whether a proposed transaction is permitted under the borrower's loan agreement.

Can We Do It? How to Determine if a Proposed Action is Permitted under a Loan Agreement

by��PLC Finance
Published on 06 Jun 2013 • USA (National/Federal)
A discussion of the steps a borrower and its counsel should take to determine whether a proposed transaction is permitted under the borrower's loan agreement.
Loan agreements typically include several covenants that the borrower must comply with until it has repaid all amounts outstanding under the agreement. These covenants include actions that the borrower:
These ongoing obligations and restrictions are generally drafted to allow the borrower sufficient flexibility to operate its business, while ensuring:
  • The lender receives sufficient information to monitor the borrower's continuing compliance with all of its loan agreement obligations.
  • The borrower's ability to repay the loans.
  • The lender's understanding of the borrower's business at the time the lending decision was made remains substantially the same.
Failure to comply with these covenants can result in an event of default triggering the lender's rights under the loan agreement, including the right to accelerate the loans (see Standard Clauses, Loan Agreement: Events of Default). Therefore, borrowers should understand the provisions of their loan agreements so they do not take (or fail to take) any actions that would entitle the lender to exercise its remedies.
Complying with these covenants is generally not an issue for borrowers. Loan agreements are drafted with enough flexibility to allow the borrower to take many routine and, in some cases, non-routine actions without worrying unduly they will violate the loan agreement. However, the extent and scope of this flexibility depends on a variety of factors, including:
  • The borrower's creditworthiness.
  • The nature of the borrower's business.
  • The state of the loan market.
However, certain transactions will usually require the borrower to take a closer look at its loan agreement (and all other relevant documents including guaranties and security agreements) to ensure the borrower remains in compliance with the terms of its agreements. These actions include:
  • Acquiring a new company.
  • Selling certain assets.
  • Making a distribution to its stockholders.
  • Establishing a joint venture with a third party.
At the time the loan documents are negotiated and executed, the borrower and its counsel generally have a fair understanding of what the borrower can do and the impact of these provisions on the borrower's operations. However, after closing, if the borrower wants to engage in a transaction, it may need to review more closely its loan agreement and other loan documents to determine whether the proposed transaction is permitted. Borrowers often involve their outside counsel to help them make this determination.
To assess whether the borrower can engage in the transaction without violating the terms of its loan documents, the borrower and its counsel must:
  • Ensure they understand the terms of the proposed transaction. For example, in the case of a proposed acquisition, this may require a review of the term sheet, the letter of intent or a draft of the acquisition agreement.
  • Review the loan agreement, any security documents and all amendments and supplements to those agreements. This requires a review of the specific provision that addresses the issue as well as any other provisions that may apply, either directly or indirectly. For example, in the case of an acquisition, counsel must review the investments negative covenant as well as (among other things):
    • the definition of permitted investments (see Standard Clauses, Loan Agreement: Standard Definitions);
    • the borrower's financial covenants, if any;
    • the limitation on indebtedness covenant, if the acquisition is being financed; and
    • the borrower's representations and warranties, to the extent applicable. This may be required if any of these representations and warranties must be repeated during the term of the loan agreement.
To assist borrowers and their counsel in identifying these and other loan agreement provisions that may be relevant in determining whether a proposed transaction is permitted under the loan agreement, see:
If the proposed transaction is not permitted under the loan agreement, the borrower may need to amend the loan agreement (see Standard Document, Loan Agreement Amendment) or obtain a waiver of a specific provision of the loan agreement (see Standard Document, Loan Agreement Waiver/Consent).