Securities Law Blog

Access to capital is critical to every business. Entering into loan arrangements with a lender is a complex process, the results of which can be vital to the success or failure of a company. This is the fourth in a series of articles intended to explain various aspects of the loan process. In our prior articles, we discussed the importance of the term sheet stage of a loan transaction, factors for the prospective borrower to consider in choosing a loan and the types of loans that are available and steps the borrower can take to help expedite the loan process to reduce transaction expenses.  In this article, we begin looking at the loan agreement itself by reviewing the representations and warranties section of the document.

What are Representations and Warranties?

In connection with entering into a loan agreement, the lender will typically require the borrower to provide detailed information about the borrower and its business. To ensure the validity of this information, the lenders will likely ask the borrower to make representations and warranties, statements that make the borrower legally responsible for the truthfulness and accuracy of the information that it provides.  Unlike other types of agreements, which typically include representations from both parties, a loan agreement will usually only include representations from the borrower.

Although the terms are often used interchangeably, there is a difference.  A representation is an assertion as to a fact, true on the date the representation is made, that is given to induce another party to enter into a contract or take some other action. A warranty is a promise to indemnify if the assertion is false.  While representations and warranties have different meanings and different remedies under law, for purposes of a loan agreement, the difference is irrelevant as the terms are used together and the consequences of an inaccurate representation or a breach of a warranty are provided for contractually between the borrower and the lender in the loan agreement.

Impact of Representations and Warranties on the Borrower

Representations and warranties serve to allocate risk between the parties to an agreement and create a direct claim against the maker if representations are inaccurate or warranties are breached.  In a loan agreement, a borrower’s misrepresentation will generally constitute an event of default, the consequences of which include that the lender can declare the loan immediately due and payable and enforce any security interests.

As the consequences of a misrepresentation are severe, the borrower should read each representation carefully and ensure it is correct.  In a term loan agreement, representations and warranties are made at closing. In a revolving credit facility, representations and warranties are made at each credit extension and can limit access to the credit facility in the future. In addition, some lenders require the borrower to also make representations and warranties on an annual basis in connection with the delivery of annual financial statements.  If representations are to be repeated, they should be drafted to ensure that such representations will continue to be correct throughout the term of the loan.

Drafting Suggestions

From the borrower’s standpoint, representations should be limited as much as possible to reduce the possibility of a misrepresentation. If a representation is not true or is likely that it will not be true at some point in the future, then it should be deleted or amended before the borrower executes the loan agreement.

Representations and warranties are frequently unqualified statements.  One way to limit the scope of a representation is to request a materiality qualifier to enable the borrower to more comfortably make the requested statements, as set forth in the bolded language in the following examples:

Each Loan Party and each Subsidiary of each Loan Party is duly licensed or qualified and in good standing in each jurisdiction listed on Schedule 1 and in all other jurisdictions where the property owned or leased by it or the nature of the business transacted by it or both makes such licensing or qualification necessary, except where failure to be so licensed or qualified would not, individually or in the aggregate, reasonably be expected to result in a Material Adverse Change.

Each Loan Party and each Subsidiary of each Loan Party is in compliance in all material respects with all applicable Laws in all jurisdictions in which any Loan Party or Subsidiary of any Loan Party is presently or will be doing business, except where the failure to do so would not constitute a Material Adverse Change.

To the extent that representations are to be repeated after the closing, the borrower should seek to limit all such representations by a materiality qualifier as circumstances may change since the date on which the representations were previously made.  The lender will want to add an additional exception to this qualification providing that any representation that already contains a materiality modification will need to be true and correct in all respects, which exception is permissible as such representation already contains a materiality qualifier.

Another way to limit the scope of a representation is to add a knowledge qualifier as follows:

There are no actions, suits, proceedings or investigations pending or, to the knowledge of any Loan Party, threatened against such Loan Party or any Subsidiary of such Loan Party at law or in equity before any Official Body which would, individually or in the aggregate, be reasonably expected to result in a Material Adverse Change.

Knowledge qualifiers are particularly appropriate when the borrower is being asked to make a statement about information that is beyond its control such as information regarding related parties or affiliates.

Where a representation would be inaccurate due to existing circumstances, the borrower can except out such information from the representation by disclosing such information on a schedule to the loan agreement as follows:

Except as set forth on Schedule 2, each Loan Party (a) is in compliance with and (b) has procured and is now in possession of, all material licenses or permits required by any applicable federal, state, provincial or local law, rule or regulation for the operation of its business in each jurisdiction wherein it is now conducting or proposes to conduct business and where the failure to procure such licenses or permits could reasonably be expected to have a Material Adverse Effect.

Additional ways to limit the scope of representations are to limit the time period covered by the representation and to limit the entities to which such representations apply.

Finally, it is also important to note that careful attention should be paid to the definitions section of the loan agreement and the impact that such definitions may have on the representations and warranties section.  The borrower may seek to modify certain definitions in order to reduce the scope of the representations, such as is set forth in the following example by adding the language noted in bold:

“Material Adverse Effect” shall mean a material adverse effect on (a) the financial condition, results of operations, assets, business or properties of Borrowers and Guarantors taken as a whole, (b) the ability of Borrowers and Guarantors taken as a whole to duly and punctually pay or perform the Obligations in accordance with the terms thereof, (c) the value of any material portion of the Collateral, taken as a whole, or Agent’s Liens on a material portion of the Collateral, taken as a whole, or the priority of any such Lien, or (d) the practical realization of the benefits of Agent’s and each Lender’s rights and remedies under this Agreement and the Other Documents, taken as a whole.

Conclusion

Debt financing can be vital to the ongoing operations of a business and a powerful expansion tool, but borrowers must remain wary of pitfalls within the loan documents that can interfere with their business.  Careful attention during the drafting stage of the loan agreement can prevent unexpected consequences in the future.  Borrowers and prospective borrowers are encouraged to work with their legal and financial advisors throughout the negotiation and drafting stages of the loan process as their involvement can help to ensure smooth and efficient operations of the borrower’s business during the term of the loan.