Types of Bank Loans - Term Loans

Following on from a previous post on overdrafts, this article focuses on term loans. A term loan essentially provides an agreed lump sum over a set period, usually referred to as the “term”, requiring payment at or by the end of the term. Such loans usually have a term of more than one year and will often be for more than five years.

Common features of term loans

Term loans are usually committed facilities. A “committed” facility is a facility where once the facility agreement has been executed, the lender is under an obligation to advance money when requested by the borrower subject to compliance with certain pre-agreed conditions by the borrower.

With a term loan, a borrower is usually permitted a short period after execution during which it can draw down funds. This is known as the “availability period”. Additional funds may be drawn down in stages or “tranches” as agreed under the loan facility and at the borrower’s discretion. Each tranche has its own pre-agreed conditions which need to be satisfied and its own availability period. If funds are not drawn down during the relevant availability period, such funds cease to be available and the commitment is automatically cancelled. The use of tranches gives the borrower greater flexibility and greater control over the amount of money borrowed and, therefore, the amount of interest paid.

When the borrower decides to exercise its right to draw down during an availability period, it must give notice to the lender (usually two or three days’ notice) so that the lender can get the required funds. The borrower must choose the first interest period. At the end of the interest period, the borrower pays interest on the amount borrowed and chooses the next interest period.

The loan will be repayed according to the repayment schedule in the facility agreement. The most common methods of repayment are:
• Amortisation: repayment, in equal amounts, is spread evenly over the term of the loan;
• Balloon repayment: repayment is made in instalments and the final instalment is the biggest; or
• Bullet repayment: repayment is made in a single instalment at the end of the term of the loan.

In addition, it may be possible for the borrower, on giving sufficient notice, to prepay
all or part of the loan (that is, before the dates specified in the repayment schedule), because, for example, it may no longer need as much money as it first borrowed. It may have to pay a fee to the lender to compensate it for the lost interest the lender would have received had the money still been outstanding; this is known as a “prepayment fee”.

Advantages of a term loan

A term loan provides the borrower with the certainty of a fixed repayment schedule. This contrasts with the on-demand nature of an overdraft.

The use of tranches provides the borrower with some flexibility, which may be further increased if the term loan allows the borrower to draw money in different currencies. Interest on a term loan is likely to be lower than that paid on an overdraft and will either be at a fixed rate or, more commonly, will be set at an amount (known as the “margin”) above the relevant LIBOR (London Interbank Offered Rate).

Disadvantages of a term loan

Commitment fees may be payable on a term loan as they are committed facilities. The commitment fee is calculated as a percentage of the undrawn funds that the lender has to keep committed to the borrower from time to time. The fee covers the costs incurred by the lender in committing funds to this loan which it cannot then lend to anyone else.

One feature of a term loan is that once it has been repaid, it cannot generally be reborrowed, unlike a revolving credit facility (which will be considered next month) or an overdraft.

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Potential Changes to Market Disruption Clause

Doing Business in Oman

Following on from last month’s article on market disruption clauses, we consider here how the market disruption clause could be negotiated from a borrower’s perspective in a new loan agreement or amended in existing loan documentation. We are using the English style Loan Market Association syndicated loan agreement as the starting point for this discussion. However, even if a different starting point is used, many of the points will be equally applicable. From a borrower’s perspective, the main aim will be to tighten the wording of the market disruption clause. Clearly, lenders and the agent will try and resist many of these changes and will emphasis that anything that is different from the standard in this clause will make it harder to syndicate and close the transaction. Issues that could be raised on the market disruption clause by the borrower include:

• consultation: currently there is no requirement for consultation between the lenders and the borrower when the lenders determine their actual cost of funds. The only requirement on a lender is to provide the costs of funds from “whatever source it may reasonably select”. A borrower would want to know that a lender had considered a broad range of funding options and selected the cheapest. In addition, the borrower may want to request a certificate from each lender certifying its source and costs of funds.

• reasonableness: a borrower may seek to impose an obligation of reasonableness on the lenders in triggering this clause, such as a requirement that a lender’s actual cost of funding exceed an agreed amount above the relevant screen rate for LIBOR (London Interbank Offer Rate) – current wording merely refers to it being “in excess of LIBOR”. A further requirement could include an obligation on the lenders to negotiate in good faith in relation to agreeing on a substitute basis of interest and to use reasonable efforts to minimize their actual cost of funds.

• increase the trigger threshold: the threshold for triggering this clause is a set percentage (usually between 25% and 50%) of participations in the loan. The threshold could be increased to make it harder for one or two lenders to trigger it.

• reference banks: a borrower might seek to use the average funding costs of a number of reference banks (including some of the syndicate lenders) as the basis for calculating the interest rate payable as opposed to the relevant screen rate for LIBOR. This would be a move back to the previous market practice before the use of LIBOR was introduced.

• interest periods: a borrower might seek the right to invoke shorter interest periods than the typically one-, three- or six-month periods, such as one week interest periods to assist the affected lenders in minimizing the actual costs of funds. However, this will create additional work for the agent and has potential cash flow implications for the borrower as interest is payable at the end of each interest period.

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Loan Agreement Market Disruption Clauses

Doing Business in Oman

We understand that the market disruption clause has recently been invoked by more than one Omani bank in relation to loans to at least one Omani company following the turmoil in the banking sector at the end of last year. Previously this clause had seldom been relied upon by lenders and therefore had not been highly negotiated by borrowers. Lenders have been reluctant to rely on this clause for reputational and competitive reasons - they are nervous about revealing they have to pay more in the interbank market than the LIBOR (London Interbank Offer Rate) and their actual funding costs. The market disruption clause in the Loan Market Association (“LMA”) style loan agreement can be triggered if the cost of obtaining matching funds in the market to fund a loan for lenders with the required percentage of participation (typically varies between 25% and 50%) is in excess of LIBOR. If this clause is triggered, then the interest rate on each lender’s share of the loan for that interest period will be calculated using the actual cost to that lender of funding its share of the loan from whatever source it may reasonably select. This clause will need to be re-triggered for each interest period. When this clause is triggered, the borrower may request that the agent enter into negotiations for up to 30 days with a view to agreeing a substitute basis for determining the interest rate. In reality, this may not assist the borrower, as any substitute basis for determining the interest rate will require all lenders’ consent. Issues of concern for the borrower where this clause has been triggered include:

• An increase in the borrower’s funding costs - the actual cost of funds will be payable to all of the lenders;
• The potential breach of certain financial covenants – such as the interest cover ratio – in the loan agreement; and
• If there is any interest rate hedging, this hedging is no longer likely to match the interest rate payable - there are typically no market disruption provisions relating to LIBOR in such hedging arrangements.

Actions that a borrower could subsequently take include:

• Requesting that the additional interest costs should be ignored in calculating the financial covenants;
• Prepaying the lenders with the highest funding rates - this is likely to require all lenders’ consent and may encourage lenders to quote higher funding rates;
• Selecting shorter interest periods – there tends to be greater liquidity available in the market for shorter interest periods and it would also shorten the period during which this clause would apply; and
• Agreeing a higher interest rate payable under the loan agreement - this is only likely to require consent of a majority of the lenders but all lenders’ consent would be required to effectively bind the lenders from subsequently triggering this clause.

The wording of the market disruption clause in a loan agreement will need to be reviewed carefully as it is likely to differ from the LMA style loan agreement.

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