Credit Agreement Contracts: Key Components and Best Practices

What Is a Credit Agreement Contract?

Credit Agreement Contracts, also referred to as debt contracts, are used by creditors to ensure that they will be paid back for any cash loaned. In order to make this legally binding, a Credit Agreement Contract must be signed and returned to the creditor after being reviewed and agreed upon. These credit agreement contracts must have a clear payer (person taking out the loan), clearly defined payment amounts and terms, and must often be notarized to be enforceable.
From a business perspective, Credit Agreement Contracts are a very important marketing tool in getting a loan to a future customer. They require debtors to sign a legally binding document that states that the creditor is owed money, which in turn keeps the person whose signature is on the document honest about their intent to pay back the creditor. Debt contracts should also list the loan amount , due dates, and interest rate to be charged in a clear manner to avoid confusion.
Although Credit Agreements are often written with the creditor having all of the power, it does begin a legal relationship between debtor and creditor. Because of this, fraud protection should be placed onto all credit agreements or debt contracts to keep the debtor in check and to avoid collectability issues later on down the line. Fraud protection requires that the debtor actually read the contract and that there are no "unconscionable actions" or otherwise illegal activities occurring. There is, of course, some level of trust required for each party, but that does not mean that there cannot be a legal "backdoor" in place just in case.

Components of Credit Agreements

Credit agreement contracts are often lengthy and complex, but they all contain the same essential components. The essential components of those contracts include the amount of the loan, the interest rate, repayment terms, any collateral on the loan, lender’s right to demand payment, lender’s right to take the collateral, and what happens if the borrower defaults on the agreement.
Loan amount – Both personal and business loans are made by creditor lenders to debtor borrowers. However, the size of the loans will vary for a myriad of reasons including the risks that the lender is willing to accept from the particular borrower. Determining the size of the loan is the very first step in the credit agreement process. Once that is accomplished, the creditor must determine how much interest to charge on the loan for the use of that borrowed money, and other terms of the loan.
Interest rates – Given the fact that it is more expensive than ever to borrow money from a lender, both personal and business borrowers can expect to be faced with interest rates on the money borrowed. Those rates will vary among creditors and depend on whether the borrower has good credit ratings, which type of loan is taken out, whether it is secured or unsecured, and other factors as well.
Repayment terms – It seems obvious, but it is crucial to put into writing when, how and where the borrower must repay the money lent. Any lender wants to be assured that it will be repaid the money that was borrowed, these terms make it clear to both parties involved in the contract.
Collateral – As the author Stephen R. Williams of "Understanding Credit Arrangements" notes, "A loan or credit arrangement may be ‘collateralized’ by pledging some property of the borrower to insure repayment of the money borrowed. That means that if the borrower defaults on repayment, the lender can seize the property pledged as collateral." Of course, not all loans are collateralized by property, but if they are, it is crucial to spell out the exact property and how the creditor can seize it if need be.
Demand for payment – A creditor’s demand for payment is the last line in the credit agreement. It essentially tells the borrower that, due to some default on its part, your loan is now due immediately and you must pay us in full.
Default – The last clause that essentially ends the credit contracts is the consequence for which will befall on the borrower for defaulting on its end of the contract. Otherwise the contract would never work, and would indeed be named a generally unsecured promissory note, as is explained below. Defaults usually include late payments, failure to pay, foregoing security agreements and late notice of default.

Types of Credit Agreements

A credit agreement can be classified into two different types, a secured versus an unsecured credit agreement. The difference is that for a secured credit agreement, the lender is entitled to have some of the borrower’s assets set aside as collateral, in the event the borrower defaults in repayment. In the US, pursuant to Article 9 of the Uniform Commercial Code, a security interest can be created in most personal property by a security agreement. A document evidencing the intention of parties to create a security interest, is called a security agreement. Such a security interest would ordinarily be perfected by filing a financing statement. If a security interest is not perfected, in the event the borrower defaults and there is other indebtedness in the capital structure, the secured lender will ordinarily be behind the unsecured loans in a privity disbursement waterfall.
Pursuant to a revolver agreement, a borrower obtains a certain line of credit from the lender, and is allowed to borrow under the line from time to time, within certain limits, and to repay borrowings on a revolving basis, provided that certain conditions precedent are met.
A term loan is a loan that is made to a borrower for a certain number of years at a fixed or floating interest rate. The principal amount plus accrued interest of such facility shall be payable in installments over a specified period.
A line of credit may be established for a borrower and may be composed of either revolving credit or term credit. In a revolving credit line, a borrower can obtain funds up to, and not exceeding, a certain maximum borrowing limit. The borrower may borrow, pay back, and re-borrow funds under this facility, subject to compliance with certain terms and conditions. Term credit on the other hand, is a line of credit extended to a borrower for a specific period of time, with a specified repayment schedule (such as monthly principal payments).

Legal Issues in Credit Agreements

Credit agreements are legal contracts and, as with any contract, careful attention must be paid to the applicable laws and compliance issues that may arise during the credit process. Contract enforceability is key, especially considering the credit industry has changed dramatically since the introduction of the Consumer Financial Protection Bureau. Every agreement must also comply with federal, state and local regulations. The value of legal counsel cannot be over-emphasized when dealing with credit agreements. Attorneys with broad experience in consumer and commercial credit can assist in ensuring that all credit agreements comply with various statutes and regulations, including Truth in Lending Act (TILA), Fair Credit Reporting Act (FCRA), Equal Credit Opportunity Act (ECOA), Fair Debt Collection Practices Act (FDCPA), and Fair and Accurate Credit Transactions Act (FACTA).

Common Mistakes and Avoidances

Crucial pitfalls are often overlooked when it comes to common contract provisions and credit agreements in general. Sometimes ambiguities are hard to spot, and when the lender’s loan package has been reviewed by many different lawyers on its way to closing all kinds of things could be missed. However, you cannot afford to hit and run when it comes to reviewing credit agreements and intercreditor agreements. Lenders who think they have carefully reviewed their credit agreements before loan closing may be in for a surprise later when the legal tangle finds its way into a courtroom. A few pointers to avoid these legal tigers are discussed below.
One common pitfall to be avoided in a credit agreement is a clause that looks fine on its face but turns out to not be how the bank does business. For example, a clause may require a bank to give an opportunity to a borrower to find financing elsewhere if the bank wants to call the loan. This is a good clause for the borrower, but maybe not so much for the bank. The bank would not want to force a borrower to find replacement financing that would only make it harder for the borrower to repay the existing loan. If the clause had read "the borrower shall have an opportunity to find other financing to pay off the loan," then everyone would know that the borrower had to find its own money to refinance the loan.
Another clause to avoid is a clause which may be ambiguous as to whether one language is modifying another and the second language modifies the first . If the language is subject to interpretation this means that it is unclear whether the first clause or the second clause is the modifying clause. Let’s say the clause reads, "Section 2 shall apply to the financing terms at liability of the corporation." The clause should not read this way if the intention is to modify the ‘terms’ and not the ‘liability’. Even a well-thought-out hedge clause will mean nothing if it does not clearly conscript the modifying language.
Another common pitfall with credit agreements in general is a repayment mechanism that does not clearly identify the currency and amount of the payments. If the loan is denominated in Japanese Yen but the payment is in US dollars, make sure that everyone understands what currency the loan will need to be repaid in. Imagine trying to make these payments when the payment mechanism mistakenly uses the wrong currency and then gets adjudicated under the wrong country’s law. Either solution here is not going to be optimal for the bank. Make sure that the credit agreement identifies the currency of repayment and more importantly, that the parties get it right!
Finally, a common pitfall is not thinking the credit agreements through and using them as standardized templates. Each credit agreement should be drafted uniquely to fit the situation at hand. Not every loan is made the same way, using the same methodology. Keep that in mind because sometimes a unique situation might warrant a different credit agreement to fit the facts.

Common Best Practices

Best Practices for Drafting and Negotiating Credit Agreement Contracts
While it is important that a credit agreement contract is clear and unambiguous, there are various best practices for drafting a contract to ensure that all parties involved in the arrangement are treated fairly and that all the terms are legally compliant. For the loan officer or bank representative, honesty and clarity goes a long way in developing a strong, trusting relationship with your client.
Eliminate surprises As a lender or bank officer, one of the best practices for creating a credit agreement is to over-explain the details of the contract to the borrower prior to signing. Too often, an unexpected detail reveals itself after a borrower has already signed, leading to a sense of distrust on the part of the borrower. Taking extra care to "overshare" the facts tends to lead to stronger communication and trust, both of which will pay off long term.
Document, document, document The more accurate your documentation is during the credit agreement contracting period, the less chance there is of any issues after the fact. While we understand that it can be difficult to strike a balance between inserting too much legalese and not enough terminology, try to find an adequate balance. Also, as the process continues to unfold, keep all paperwork in a single location to avoid any disorganization or missed documents. Keeping your document administration tight will only help you in the long run.
Provide general outlines and scenarios One of the greatest sources of stress can be confusing terms. One of the most common examples is a variable interest rate and how it can fluctuate over time. In most loan contracts, variable interest rates may change by more than two to three percentage points over the life of the loan – that is significant when you’re dealing with sums approaching a million dollars or more. The best way to avoid confusion is to provide a general outline of different scenarios that are possible as it relates to the variable interest rate.
The job of a bank officer or loan officer is to make sure that their client understands the terms of a credit agreement contract, to ensure that both companies and individuals fully understand their obligations under the agreement. By keeping contact regular and open, you’ll develop a positive relationship with borrowers, and you’ll likely see their business again.

Role of Credit Agreements in Business Financing

Businesses are always looking for ways to finance their operations. To this end, many businesses enter into credit agreements. Credit agreements are contracts under which a financial institution or governmental entity provides financing for the purchase or redevelopment of properties. Because these agreements typically allow for larger amounts of financing with longer repayment periods, they are sometimes the best option for financing real estate projects . The approach is used by businesses, municipalities, and non-profit entities to fund redevelopment projects that require large amounts of capital, and may have long time horizons for realizing revenue. But as with any contractual relationship, credit agreements require a negotiation of terms and conditions — particularly when value is not being provided on both sides of the contract. Without the right guidance, both parties involved in the credit agreement can experience unintended consequences.