This article was published in the New Jersey Banker (Summer 2018), a publication of the New Jersey Bankers Association. It is reprinted here with permission.
Banks are in the business of making loans. Lenders, underwriters and credit committees do their best to weed out the potentially problematic credits. The approval of a strong credit however is only the beginning. The bank then partners with a law firm to document and close the loan. Everything is full speed ahead, with a target closing date looming in the near future. But before the closing team steps on the gas, they should take a moment to remind themselves that sometimes borrowers default. Lenders need to invest time and care upfront in the drafting, negotiating and closing of a loan to best position their banks to recover if there is a default. Based on my nearly 20 years of experience representing banks, this article will identify the top five most costly mistakes made by lenders and their counsel in the closing of commercial loans.
1. Failure to Issue a Closing Checklist
A comprehensive closing checklist and “kickoff” conference call are vital to managing the closing process. Failing to prepare and regularly update a checklist will cause confusion and delay. Bank counsel should always issue a closing checklist and hold an initial conference call with the borrower’s counsel to review the deliverables and delegate responsibility for the various items listed therein, including drafting loan documents, collecting and reviewing organizational documents, preparing entity approvals, and ordering searches and third-party reports. A number of these items may take weeks to prepare. The third-party documentation and other lead time items (e.g., appraisals, title commitments and surveys) should be started right away, especially when real property collateral is involved. Copies or drafts of the closing diligence should be delivered to the bank at the earliest possible time so the items can be reviewed thoroughly and any identified issues addressed quickly and effectively. Conference calls should be held regularly with the working group (including lender, borrower and counsel for both) to review and update the closing checklist. Lenders do not want the untimely delivery of diligence to hold up closing, create unnecessary post-closing items, or result in a sloppy review and analysis. A good closing checklist will help manage the closing schedule and mitigate against missing or incomplete information and documentation.
2. Reliance on 'Canned' Loan Documents
“Canned” documents or fillable loan documentation software should be avoided, even for seemingly simple loans. Poor drafting and using improper documentation are serious errors that can result in an inability to enforce your loan. The loan documents set out the terms of the deal and contractually bind the borrower and the lender. There is almost always some aspect of a commercial loan that requires nuanced drafting. Most of the canned documents are not intended or formatted for negotiation, and the addition and deletion of text can have unintended consequences. In my reviews of loan files documented with these types of forms, I have seen glaring errors, including documents with key fields left blank (e.g., loan amount), instances when the wrong document is included in a package (e.g., use of a security agreement for a specific piece of equipment when an “all assets” security interest is intended), instances when the information is filled in incorrectly (e.g., incorrect signature blocks and authorized signers), and documents that are missing state-specific legally required language (e.g., mandatory disclosures). These types of errors will directly impact the bank’s ability to enforce its documents and realize the benefit of its intended bargain.
3. Over-Negotiating the Loan Documents
When negotiating loan documents, carefully think through the effect of each proposed revision and avoid conflicting terms. I always put myself in the position of the workout specialist or workout attorney who is trying to enforce the documents post-default. What would they want the documents to say? I generally will recommend against a revision if it would unduly restrict the lender’s ability to call a default (e.g., extended cure periods or narrowly defined events of default). A lender may not want to accelerate a loan, but the ability to call a default will bring the borrower to the table to discuss other options, such as waiver, amendment or forbearance, and will create fee-generating opportunities for the bank. Any agreed-to revisions to the initial documents must be incorporated consistently across the document set to avoid internal contradictions. It is helpful to include a conflicts-of-terms clause in the loan agreement (e.g., “if any provisions contained in this Agreement conflict with any provisions in any other Loan Documents, the provisions contained in this Agreement shall govern”). If a default occurs, a strong and consistent set of loan documents will put the bank in the driver’s seat.
4. Erroneous UCC Filings
Improperly drafted and filed financing statements can have devastating effects on a bank’s collection efforts. In a secured financing, the lender relies on a perfected security interest. Perfection means that the lender has rights and remedies against the borrower’s assets if an event of default occurs. It also means that the lender has rights against other creditors if the borrower goes into bankruptcy. A bank’s failure to properly perfect its security interest will jeopardize its rights to the collateral. A security interest in the majority of personal property assets is perfected by filing a UCC-1 financing statement in the jurisdiction where the debtor is located. The determination of where a debtor is located for perfection purposes depends on whether the debtor is a registered business entity, individual or unregistered business entity. Financing statements filed in the wrong jurisdiction are ineffective. Furthermore, including the correct name of a debtor on the financing statement is critical since the filing will be indexed and searched based on the debtor’s name. A financing statement will be ineffective if it contains any “seriously misleading” errors or omissions in the debtor’s name. Whether an error or omission is “seriously misleading” will depend on the search logic used by the applicable filing office and whether a search run in that office would disclose the relevant filing. Errors that result in a loss of perfection may be as simple as adding an extra space before the “Inc.” or “LLC” in a debtor’s name. These errors will have dire consequences for banks seeking to enforce their rights against collateral.
5. Use of Post-Closing Agreements
Lenders should avoid using post-closing agreements and obtain any desired information and documentation from a borrower before a loan closes. Post-closing agreements listing various deliverables that should have been addressed before the closing date will only create headaches down the road for the lender and the bank’s closing department, which will need to monitor the open exceptions. The borrower is likely to be less than responsive to documentation requests once it receives its money and returns to running its business. The bank has the most leverage before the money is out the door. If the information or documentation is important enough to include as a prerequisite to closing, it is usually important enough to wait for.
Making good loans is key to a bank’s success. Lenders and their counsel should focus on gathering the right information and accurately documenting the transaction in a way that best positions the bank to make a strong recovery if there is a default. By avoiding the above costly mistakes, lenders will develop stronger loan portfolios, with renewed confidence in their ability to enforce the rights and remedies intended under their loan documents.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.