One of the most common questions we are asked as counsel to commercial lenders is “Does the bank really need a legal opinion, or can we waive it?” This month’s WDWC post reviews the purpose of a legal opinion given to the lender by borrower’s counsel, why we think legal opinions are important, and the limited situations in which a lender may agree to forego the requirement of a legal opinion as part of a loan closing. For clarity, this post focuses on due authority and enforceability opinions for a borrower and/or guarantor that is a legal entity (as opposed to a natural person), and not on zoning or land use opinions.
The purpose of a legal opinion in a loan transaction is to provide an additional layer of assurance and comfort to the lender. The borrower’s counsel opinion will typically include statements that (i) the borrower or guarantor is a validly formed, existing legal entity and is duly authorized to enter into the loan transaction by the borrower’s managers, trustees, governing board or equity holders (due authorization); (ii) the execution of the applicable loan documents by the borrower or guarantor will not violate other agreements or contracts to which it is a party, or any law or internal governance document of the borrower, and the signatory for the borrower has been properly authorized to execute the loan documents (execution); and (iii) the loan documents are the legally binding and enforceable obligations of the borrower and/or guarantor (enforceability). While the borrower typically makes similar representations and warranties in the loan documents, the legal opinion provides corroboration from a professional source (i.e., the borrower’s counsel) usually tasked with preparing and/or reviewing the organizational documents, and necessary votes of the borrower and/or guarantor in connection with closing the loan.
First, in examining due authorization, the legal opinion should indicate that the borrower’s counsel has reviewed the relevant authority, formation, and organizational documents of the borrower and that, based upon such review, the borrower is a duly organized, validly existing (and/or in good standing, if applicable in the jurisdiction), legal entity. Frequently, an entity may be formed just days before, or even on the day of, the closing itself. Therefore, the opinion provides assurance that the borrower is properly formed and authorized to transact business in all places where they are required to do so. The legal opinion should also certify to the lender that the borrower’s counsel has reviewed all relevant certificates of legal existence and good standing issued by the applicable Secretaries of State for each state where the borrower is registered to transact business, and that the borrower is in “good standing” in both its “home” jurisdiction (the jurisdiction where it was initially incorporated or organized), as well every other jurisdiction where it is required to be registered to transact business. Finally, borrower’s counsel should also opine that they reviewed authorizing resolutions for the transaction from the borrower, and as a result they can (i) confirm that the borrower has the authority to enter into the transaction, and (ii) specify who are the authorized individuals that can execute the loan documents.
Second, with respect to proper execution, an opinion that provides confirmation that the loan documents were duly executed gives additional comfort to the lender that the loan documents were indeed properly executed by the appropriate individual. The opinion also states that borrower’s execution and delivery of the loan documents will not create a breach under any provision of the borrower’s organizational documents or any law applicable to the borrower’s business or any other agreements with other third parties provides comfort to the lender that the lender will not end up embroiled in a lawsuit by another party alleging the lender intended for the borrower to violate its contracts or agreements with another party, including with other lenders.
Third, the reason we care about inclusion of enforceability of the loan documents in the opinion is that we want to make sure that the lender can enforce the covenants and remedies in the loan documents against the borrower. The opinion should be given by an attorney licensed in the state for the governing law in the loan documents. The opinion should also indicate that the loan documents are enforceable because the borrower is not a party to any actions or legal proceedings that would adversely affect the validity or enforceability of the loan documents or the ability of the borrower to perform its obligations thereunder. Some opinions will also disclose any known ongoing litigation affecting the borrower. The opinion will also indicate whether any third-party consents, such as from a governmental authority or parent entity, need to be obtained by the borrower in order to execute the loan documents. Finally, the opinion should state that the execution and delivery of the loan documents does not violate any law, statute, rule, regulation, ordinance, constitution, or any other kind of order, writ, judgment, or decree of any court or government authority applicable to the borrower.
The risk to a lender in not requiring a legal opinion is that it could be determined after a loan closing that the appropriate votes/consents were not obtained from the legal decision-makers of a borrower to empower the borrower to enter into the transaction. If the person signing the loan documents on behalf of the borrower is not empowered by the directors, members or beneficiaries of the Borrower, then the loan documents may not be enforceable against the borrower since the signer and therefore the borrower acted outside its authority. This is the legal doctrine of “ultra vires”. Obviously the least risky situation where a bank may agree to waive the legal opinion is when the borrower is a single member limited liability company or single shareholder corporation. There is more risk in situations where there are many layers of ownership. With multiple owners, there is always the risk that some of the owners do not want the borrowing entity to take on additional debt. This can occur due to varying opinions amongst the owners about how to run the company or because an owner is seeking to be bought out and uses the situation as leverage in this regard. Lack of authority is also a weapon a bankruptcy trustee could use to try to invalidate the loan and/or security documents executed in favor of the lender.
While a borrower may object to providing a legal opinion due to cost considerations, it is important to determine whether borrower’s counsel is actually willing or able to give a “clean” opinion. By way of example, we recently worked on a deal where the borrowing company was owned by a father and two sons. The borrower was supposed to deliver a legal opinion from borrower’s counsel at closing (it had always been on the closing agenda) and then, right before the closing, borrower’s counsel informed us that the borrower refused to pay for the legal opinion. This seemed very strange since it was such a last-minute objection over a routine diligence requirement, so we asked if cost was the only reason for not giving the lender an opinion. After some hemming and hawing by borrower’s counsel, he finally admitted that one of the sons had refused to agree to the financing since he wanted to be bought out of the business while the other two owners (the father and other son) wanted to go ahead with the financing over his objection. Borrower’s counsel was “uncomfortable” issuing an opinion in this situation since he did not think the two owners were permitted to override the third owner based on the shareholder agreement. Borrower’s counsel was worried that a lawsuit would occur between the owners which could lead to a default under the loan and then a possible claim under the legal opinion by the bank against borrower’s counsel. By requiring a legal opinion in this transaction, the lender was able to flush out these potential authority issues affecting the borrower’s ability to enter into the loan which were otherwise unknowable, and ultimately this loan did not close.
Cost is usually the major reason given by borrowers when requesting that the lender waive the legal opinion. It seems however that cost of a legal opinion is entirely dependent upon the size of the firm being used by borrower’s counsel, whether it is necessary to negotiate an inadequate opinion, and the number of entities involved in the transaction for which an opinion is being provided and whether the applicable law on which counsel will be opining is the law of one state or multiple states. We have recently had larger law firms tell us that they won’t provide opinions on deals smaller than $10MM and that it is not “market” for a lender to require one. We generally disagree with this assertion and feel that it is important to understand in what “market” the lender and the borrower are operating. A loan under $10MM may still be a significant loan for many of our commercial lenders and it is still important to conduct proper diligence, and thus the value of a legal opinion to the lender should not be gauged by the size of the loan transaction. We are confident that there are many smaller law firms and practitioners willing and eager to provide legal opinions for borrowers at cost levels which are commensurate with the loan size.
Lenders should care about legal opinions for the main reason that they provide an additional layer of security and assurance from the borrower’s own counsel regarding the proper due authorization, execution, and enforceability of the loan documents. It causes the borrower’s counsel to put their professional liability insurance behind such statements, even taking into account all of the assumptions and exclusions typically found in such opinions. If the legal opinion of the borrower’s counsel is incorrect in a statement that it makes, or fails to disclose a material item (such as pending litigation) to which it had a proper base of knowledge to opine upon, the lender’s reliance on those misstatements, misrepresentations, or lack of disclosures in making the loan to the borrower can form the basis for a possible lawsuit against the borrower’s counsel asserting an inaccurate or inadequate legal opinion. For this reason, we recommend that lenders require legal opinions, in form and substance satisfactory to lender’s counsel, be provided prior to closing, and contain the proper representations indicating that the loan documents are duly authorized, properly executed, and ultimately enforceable against the borrower, and disclose any material matters affecting any of those three prongs.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.