Lenders are sometimes confused as to the distinction between a “term sheet” on the one hand and a “commitment letter” on the other.
In this edition of “Why Do We Care” we will compare and contrast the two different types of documents in order to clarify when they are each advisable and to suggest some protective language to use in each version. Term sheets are ordinarily not intended to legally bind or commit a lender to making a loan to a borrower. The purpose of a term sheet is to set forth in general terms the essential business terms of a proposed credit facility being discussed or for which the lender may be willing to proceed to seek senior management approval. Term sheets serve an important function at the inception of a possible lending relationship to be sure the lender and borrower are on the same page as to the proposed loan. In addition to laying out the essential terms, lenders issuing a term sheet should be aware and make clear in the term sheet that:
- Since term sheets contain only broad deal terms, it is important that lender make clear that in addition to terms set forth, other customary terms and conditions will apply to the final loan;
- It is imperative that a lender issuing a term sheet be careful not to use words like “commit,” “offer” and “extend” which could give the impression of a commitment to lend;
- Ordinarily with a term sheet, no fee or payment is associated with return of an accepted term sheet, although it is permissible to state that the prospective borrower will reimburse the costs and expenses incurred by the lender in conducting its due diligence and to collect an upfront deposit for such third-party costs;
- All further communications after issuance of term sheet should be documented in writing with an appropriate disclaimer in each instance to reiterate that the lender is not bound by the terms being discussed (whether verbally, by email or even by text);
- It is important to include broad disclaimer language in the term sheet. At a minimum, the term sheet should state that: “The terms contained herein are proposals and are subject to change” or “Formal approval is required by Lender before a commitment may issue.” More formally, set forth below is a good example of a disclaimer which we recommend be used in a term sheet:
“The financing proposal set forth below has been prepared on the basis of certain information and materials provided by you to the Lender and at a time when the Lender has not had an opportunity to complete its due diligence investigations. The terms and conditions set forth below are the terms and conditions which the undersigned will present for approval to the appropriate approval authorities within the Lender. This proposal is not a commitment by the Lender to make a loan or loans on the terms and conditions set forth herein. In addition, the terms contained in this proposal may be subject to change or to additional terms and conditions required in connection with any final commitment which may be made by the Lender.”
In contrast to a term sheet, a commitment letter is typically issued after the lender has completed some initial due diligence and is intended to be a binding commitment to lend, provided certain conditions precedent are met. As such it is quite different in tone and content and is intended to be a legally enforceable document. In general, lenders issuing commitment letters should be aware and make clear in the commitment letter that:
- Because commitment letters are legally binding agreements, terms should be precise and detailed and include all material terms. Any ambiguity in the terms outlined in the commitment letter will often be construed against the lender. If not included in the commitment letter, a lender may have difficulty trying to include other material terms in the final loan documents;
- Terms described in the commitment letter should include:
- Closing fees;
- Late charges;
- Default rates;
- Prepayment fees;
- Scope of Guarantees;
Requirements for third party agreements, including specifics for the subordination of shareholder, other third-party debt and anticipated seller financing;
- Commitment letters typically require some deposit or commitment fee to be paid by the prospective borrower and, in all cases, should indicate that borrower will be responsible for the payment of all fees and expenses incurred by the lender with respect to the closing, including lender’s legal fees, regardless of whether the borrower actually ends up closing the loan;
- While disclaimer language is customary in a commitment letter, it is usually much more limited than in a term sheet. Set forth below is a good example of such a more limited disclaimer which we recommend be used in a commitment letter:
“This Commitment Letter has been issued to the Borrower on the basis of certain information and materials provided by the Borrower to the Lender and at a time when the Lender has not had an opportunity to complete all of its due diligence investigations. The Lender reserves the right to terminate or amend this commitment based upon information which comes to its attention after the date hereof in the course of its diligence investigations. Any misinformation, misrepresentation, or withholding of material information incident hereto or the occurrence of any material adverse change to the proposed Borrower, Guarantor or collateral shall, at the sole option of the Lender and without limitation to any other right or remedy of the Lender, void all of the Lender’s obligations hereunder.”
A key question is often asked as to whether commitment letters should survive execution of the loan documents. Some lenders prefer that the terms set forth in a commitment letter survive (i.e., are not superseded by the loan documents) as a fall back just in case an essential term is missed in the loan documents. On the other hand, the potential for contradictory operative documents (i.e., the commitment letter terms differ from the final loan documents) is a prescription for a problem, even if the loan documents provide that in the event of a conflict between the loan documents and the commitment letter that the loan documents control. Ordinarily we recommend against the survival of the commitment letter post loan closing. If the lender has hired a competent law firm, it should anticipate that the loan documents will cover all essential terms set forth in the commitment letter and the commitment letter should no longer be operative post-closing.
Below are sample paragraphs setting forth how the commitment letter will be treated post loan closing.
- A. If the commitment letter is not to survive: “This Commitment sets forth the entire agreement of the parties with respect to the subject matter hereunder, and supersedes all prior written (including, but not limited to, any loan application executed in connection with the Loan) or oral understandings with respect hereto. No modification or waiver of any provision of this Commitment shall be effective unless the same shall be in writing and signed by all the parties hereto. It is also hereby intended that this Commitment shall not survive the execution of the Loan Documents and that once executed, the Loan Documents shall set forth the entire agreement of the parties to the Loan.”
- B. If the commitment letter is to survive: “This Commitment Letter shall survive and shall not merge into the Loan documents upon their execution and delivery and shall constitute an independent obligation of the Borrower and each Guarantor enforceable by the Lender after the closing date of this transaction. In the event of any material inconsistency or conflict between this Commitment Letter and the Loan documents, the Loan documents shall prevail.”
As in all matters related to lending, it is important for the lender to proceed with care and clarity in its communications with a prospective borrower. This overview of the differences between term sheets and commitment letters is not intended to be exhaustive but is intended to at least “flag” some of the issues and potential pitfalls faced by a lender if communication of the lender’s intent with respect to its loan proposal is left ambiguous and/or vague.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.