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Learn to draft a loan agreement like a pro

DeekshaSinghLoan agreements, like most commercial agreements, have a standard structure that must be moulded and adapted to suit specific transactions. In corporate lending, that is, where a bank is lending to a company, the amounts involved tend to be substantial and both the bank and the borrower will typically have legal representation. The bank’s lawyers usually draft the first version of the loan documents and the borrower’s lawyers review and negotiate the terms of the agreement on behalf of the borrower.

Remember, a loan agreement goes through many rounds of discussions and negotiation. A drafting lawyer must be prepared to rework the draft several times.

Term sheet

Before the lawyers begin drafting, the bank and the borrower enter into a term sheet that lays down the key commercial points that they have agreed upon in relation to the loan. Referred to as a financing term sheet, it is the basis for the legally binding documents that the lawyers have to draft. Generally, it covers only the more important aspects of a deal, without going into every detail covered in a binding contract. Typically, the authority or committee within a bank that reviews and approves loan proposals also considers financing term sheets.

Facility agreement

Often, a corporate loan is also called a ‘facility’ provided by the bank to the borrowing company and so, a corporate loan agreement is also known as a facility agreement.

A facility agreement between the bank and the borrower sets out the terms laid out in the term sheet in the form of a binding legal agreement. It contains the details of the loan, the manner in which the loan will operate, and the terms and conditions that have to be fulfilled by the parties to the agreement.

Each facility agreement is different and is drafted bearing in mind the nature of the facility. While there are several ways of drafting facility agreements, all of them can be divided into the following key sections—introductory, interpretation, operational, terms and conditions, and boilerplate clauses.

The introductory section

APCCLP_CompanyLaw-BannerAt the beginning of a facility agreement, the introductory section contains all the vital information that sets up the contract. This is typically the part where the drafter tells the reader what is being communicated, and what will be contained within the body of the contract.

The title, the exordium, the recitals, and the table of contents, which are items that are found at the beginning of most commercial agreements, are placed at the beginning of a facility agreement also.

The interpretation section

Every facility agreement also needs a separate section defining the special terms used in the agreement, or terms that are used in a particular way in the agreement. Typically, in facility agreements in India, definitions are provided at the beginning.

This section should be accurately drafted as it will significantly impact the way in which key clauses in the agreement operate. Many definitions are common to all facility agreements, but they can have minor variations depending on the specific transaction. It is, therefore, important for the drafter to tailor the definitions to suit the term sheet.

Most facility agreements will define terms like “Borrower”, “Obligor”, “Material Adverse Effect”, and “Event of Default”. A drafter must examine the terms of the particular loan transaction and determine how they should be defined.

In addition to a definitions section, a facility agreement can also contain a section that sets out specific rules for interpreting the agreement. These rules apply through the document.

The operational section

DraftingCreditFacilityAgreementsThis is the section of the facility agreement that deals with the operational details of the loan, that is, the amount of the loan, the term and purpose of the loan, how the loan will be drawn by the borrower, the repayment schedule, the details of payment of interest, conditions relating to prepayment of the loan, and so on. Obviously, these details are transaction-specific and the drafter will need to rely on the commercial understanding contained in the term sheet to draft the clauses in this section.

Terms and conditions

The terms and conditions section of a facility agreement is transaction-specific and contains the terms and conditions based on which the lender agrees to give a loan to the borrower. These terms and conditions differ among agreements and include both generic conditions that any lender would ask of a borrower—such as the borrower’s capacity to take the loan—as well as conditions that specifically relate to the facts and circumstances of that particular facility. An example of a specific condition is one where the borrower has to obtain the necessary environmental approvals, if the loan is for setting up a power plant.

Broadly, the provisions in this section can be categorised as representations and warranties, undertakings, events of default, and consequences of events of default. This section also includes provisions protecting the bank from changes in circumstances that could affect the loan.

Representations and warranties

The representations and warranties in a facility agreement typically focus on issues such as:

– Whether the borrower is a legally incorporated entity, carrying on business legally, and is duly authorised to take the loan and enter into the agreement;

– Whether the loan agreement and other finance documents for the transaction will be valid, admissible as evidence, duly stamped or registered, and binding on the borrower;

– Whether the borrower has committed any default in relation to the loan or has committed any default that could impact the loan;

– Whether all the information, including financial statements, that the borrower provided to the lender, are true, accurate, and in the form that the lender requires;

– Whether the rights of the lender under the loan agreement or the security documents are in any way subordinated to any other creditor of the borrower;

– Whether the borrower has any legal proceedings pending against it that could affect the borrower’s business or its ability to repay the lender; and

– Whether the assets offered to the lender as security are legally owned by the borrower, and whether they are free of any existing encumbrances.

Covenants

Covenants or undertakings are provisions in the loan agreement that relate to actions that the borrower company is required to carry out (known as affirmative covenants), or prohibited from carrying out without obtaining prior consent from the bank (known as negative covenants). These can also be financial covenants, which  set out parameters for the borrower to follow during the tenure of the loan. Typically, this section contains some specific financial definitions provided by the bank, based on which the bank intends to judge the financial performance of the borrower. The breach of these covenants can be an immediate event of default.

Events of default and consequences

InfrastructureLawThe section on events of default tends to be extensive, in order to protect the interests of the bank in the best way possible. Broadly, events of default focus on the following key points:

– Events relating to the loan agreement: Naturally, any non-payment of any amount due to the bank, any breach of, or any misrepresentation under the loan agreement will be considered an event of default by the lender. Similarly, any breach, or misrepresentation in relation to the security documents will also be included as an event of default.

– Events relating to the borrower: There will also be some other events, which affect the borrower’s ability to repay the loan that will be included as events of default. These include cross-default provisions that consider non-payment by the borrower in other loans as a default, any events in relation to the insolvency of the borrower, the cessation of business by the borrower, any illegal activity by the borrower, and so on.

Since loan agreements tend to be fairly one-sided documents, where the obligations remain primarily on the borrower, events of default are usually linked only to breaches by the borrower and not by the lender.

Deeksha Singh is part of the faculty on myLaw.net.

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151 years of federal banking regulation in the United States

DeekshaSingh151 years ago, on February 25, 1863, the United States enacted the National Banking Act of 1863 (“National Banking Act”), the first federal banking law, with the goal of creating a single national currency.

Single currency, national banks

At that time, notes were issued by several state banks and linked to their gold and silver holdings. Even though these notes were exchangeable and denominated as U.S. dollars, they were being issued by different banks with different paying abilities. This is because the gold and silver holdings of these banks were not uniform and they were not linked to any single unified entity or standard. The established national banks could issue notes that were printed by the government and backed by the U.S. Treasury. After the Act, each bank’s ability to issue notes was linked to the level of capital it deposited with the Comptroller of Currency at the Treasury, a position created under the Act. It also facilitated the phasing out of notes issued by the state banks by providing for a system of taxing those notes.

The banking system

Within one year however, the 1863 law was replaced by the National Bank Act of 1864 (“NBA”), which created the banking system of the United States. It established federally issued bank charters, which enabled the setting up of new national banks, and the conversion of state banks into national banks.

This is not to say that state banks became redundant. Since state banks could no longer issue notes, the capital requirements they had to fulfil became less onerous. This allowed the state banks to carry out rapid branch expansion while they continued to compete with the national banks in relation to regular banking services.

This dual system of banking created by the NBA now defines the U.S. banking system. The Comptroller of Currency (like the Reserve Bank of India in India) is responsible for the administration and supervision of national banks (and some of the activities of their subsidiaries).

ComptrollerOfTheCurrency_JohnDHawke.jpg
John D Hawke (right) was the controversial Comptroller of the Currency who used the 1863 law to bar the Attorneys General from investigating and prosecuting predatory lending practices by banks and mortgage companies. Image on the left is published under a CC BY-SA 3.0 license.

As recently as 2004, the provisions of the NBA were used by the then Comptroller to bar the Attorneys General of states from investigating and prosecuting national banks for predatory lending practices in relation to the real estate sector. The Comptroller’s move is believed to have hastened the sub-prime mortgage crisis.

Banking regulation

The NBA created a unique, but fragmented, system of banking regulation in the U.S. with both federal and state-level regulation. Banking regulation is also separated from the regulation of other financial services, each of which is regulated by a separate agency.

Apart from the Comptroller, depending on the charter and the organisational structure of the bank, a national bank’s primary federal regulator could also be the Federal Deposit Insurance Corporation or the Federal Reserve Board.

The varying priorities of banking regulation

The NBA was the first step in defining banking regulation in the U.S. Since then, several laws have addressed different regulatory concerns.

– Following the 1929 depression, the Glass-Steagall Act was enacted to establish the Federal Deposit Insurance Corporation and provide deposit insurance to protect depositors from losing their deposits if a bank became insolvent.

– In 1999, a part of the Glass-Steagall Act was repealed, with the enactment of the Gramm–Leach–Bliley Act also known as the Financial Services Modernization Act of 1999. This allowed commercial banks, investment banks, and securities firms to consolidate. The aim of the Act was to increase competition in and provide equal access to the financial services industry. One of the criticisms of this Act however, was that it would result in banks that would become ‘too big to fail’.

INTRO-Banking-And-Finance-PL– When the recession hit in 2007, the necessity of overhauling financial regulation in the U.S. became the primary concern of the U.S. government. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) was enacted in response to this need. It impacted not just banking regulation, but every sphere of financial services regulation. It streamlined the regulatory framework for the financial services industry in the U.S. by creating new agencies like the Financial Stability Oversight Council and the Bureau of Consumer Financial Protection. It also substantially changed the powers of existing agencies including the Comptroller, the Federal Reserve, the Federal Deposit Insurance Corporation, and the U.S. Securities and Exchange Commission.

From its formative period therefore, federal banking regulation in the U.S. has switched priorities from the protection of depositors to supporting the aggressive practices of banks, and then back again to the protection of depositors. It is still too early to say whether the lessons from the last recession will continue to affect financial policy and regulation in the U.S.

The Indian parallel to the 1863 law is the Reserve Bank of India Act, 1934. Studying the evolution of banking laws in the United States provides an interesting parallel to the evolution of our own laws. The Indian government and Reserve Bank of India have always been conservative, often taking pointers from the mistakes of regulators in the West. So far, this has held them in good stead.

(Deeksha Singh is part of the faculty on myLaw.net.)

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The regulatory confusion over banks as insurance brokers

DeepaMookerjee.jpgBy and large, commercial banks operate in the insurance sector either as joint venture partners or as corporate agents. Historically, the Reserve Bank of India (“RBI”) has encouraged banks to enter the business (whether as a joint venture participant or as a corporate agent) provided they followed some guidelines and maintained some standards. However, to ensure that a bank maintains its solvency requirements and continues to function as an effective bank, the RBI insists on banks obtaining its prior approval before entering into the sector as a joint venture participant. The RBI does not perceive a similar risk in a bank acting as a corporate agent because there is no equity participation by the bank and the corporate agency is only a subsidiary business. Prior approval therefore, is not required.

Since foreign investment up to twenty-six per cent is permitted in the insurance sector, banks are highly sought after joint venture partners. Banks offer their huge database and distribution network to foreign partners who bring in specialised expertise. An insurer’s success depends on how deeply it penetrates the market and a bank’s readymade distribution network is very useful. ICICI Prudential Life Insurance Company and ICICI Lombard General Insurance Company are examples of this structure.ADV-Banking-And-Finance-PL

A corporate agent is an insurance intermediary appointed by an insurer to sell its products. Its principal duty is owed to the insurer. Again, an established distribution network and the availability of a large database are advantages and insurance companies that have banks within their group benefit from having them as corporate agents.

Regulations make it difficult for new insurers stitch together a distribution network

According to Regulation 3(2) of the IRDA (Licensing of Corporate Agents) Regulations, 2002(“CA Regulations”) and subsequent circulars issued by the IRDA, a corporate agent (such as a bank) can only sell the products of one life insurer, one general insurer, and one health insurer.

New entrants face a distinct disadvantage. This is because most banks (who are ideal corporate agents) are either already in joint venture partnerships or have corporate agency tie-ups. Without an efficient distribution network, an insurer invariably meets its downfall.

Keeping this in mind, the Insurance Regulatory and Development Authority (“IRDA”) in 2011, notified draft regulations – the (draft) IRDA (Licensing of Bancassurance Agents) Regulations, 2011. Amongst other changes, this regulation divided the country into zones and permitted banks to act as corporate agents for a specified number of insurers within the same zone. In short, it proposed that the prevailing limit for acting on behalf of only one life insurer, one general insurer, and one health insurer in the whole country, apply instead to a zone. This tried to balance the playing field for new insurers who could also now appoint banks as corporate agents.

These regulations however, were never notified and there has been no statement from the IRDA explaining the delay.

There was strong opposition from industry — mainly, a strong lobby of insurers who already have banks as joint venture partners or corporate agents. Other insurers also felt that though this move may help insurers, it would not help consumers who would have to deal with different corporate agents as they moved across zones.

Banks to become insurance brokers

Interestingly, this was not the direction issued by the Finance Minster to the insurance industry on October 1, 2011. He had clearly indicated that if banks wanted to sell the products of more than one insurer, they should opt to become insurance brokers.

UNIONBUDGET201314_banks_insurancebrokers.jpg

An insurance broker is an insurance intermediary who, in return for a consideration, arranges insurance or reinsurance cover for its clients (the prospective insured). For instance, if a person wanted to insure his life, he will approach an insurance broker. The broker will then look at all the life insurance covers available in the market (from different insurers) and advise the client as to the cover that is most suited for him. The broker does not recommend the product of only one insurer. It recommends the product of the insurer who is best suited to the needs of its client. In short, an insurance broker owes a primary duty to its client. While a corporate agent works solely for one insurer and sells the products of only that insurer, an insurance broker works for the customer rather than the insurer.

As brokers, the Finance Minister felt, banks would also become responsible sellers and be able to sell the products of different insurers. Accordingly, the IRDA notified the IRDA (Licensing of Banks as Insurance Brokers) Regulations, 2013 and the Reserve Bank of India notified certain requirements through its circular dated November 29, 2013. In short, banks were permitted to be insurance brokers with the prior approval of the IRDA and the RBI. This seemed to be good for banks, which could now choose between operating as insurance brokers or as corporate agents.

InsuranceBrokervCorporateAgentOn December 20, 2013 however, a letter from the Finance Ministry to the chief executives of public sector banks advised public sector banks to become insurance brokers and leverage their branch network for insurance penetration. They should no longer act as corporate agents.  A circular by the Department of Financial Services asked public sector banks to implement the spirit of the 2013- 2014 Budget speech by January 15, 2014.This took the insurance industry by surprise because now, banks could no longer be corporate agents, a decision that had not been discussed with the industry.

This move has the backing of the IRDA who have proposed that these guidelines will be the same for both state and private sector banks. There cannot be a distinction where state-run banks are selling all products while private banks continue to peddle the products of their own group companies.
It is becoming increasingly clear that the regulator is not going to change its stance. From a preliminary analysis, this will adversely affect banks that have promoted insurance companies. Most of these banks are corporate agents for life and general insurance companies within their group. Asking them to sell products of competing insurers does not make commercial sense. In fact, the executive directors of state run banks have clearly said that their foreign partners are already questioning their decision to enter India when the policy keeps changing arbitrarily. A joint venture is based on the premise that the insurer uses the Indian bank’s branch network for expansion. Taking this away, changes the game. Two foreign insurers — New York Life and ING — have already exited their Indian ventures.

Regulatory confusion

Perhaps, the regulators should analyse the adverse effect of this step on the insurance market, which is flooded with bank-promoted join ventures. An exit by foreign players does not help the market as it loses more sophisticated insurance practices.

This move also seems to have left the insurance industry in confusion, as there is no clarity on how the existing arrangements will be treated. Should they be terminated now or can they run their course? None of the banks have been asked to surrender their corporate agency licences. The CA Regulations have not been amended to exclude any reference to a ‘bank’. The IRDA has issued no circular, clarification, or direction to clarify matters at a time when clarity is much needed.

This position calls for better thought out and more regulated action by the IRDA and the Finance Ministry. There is much that needs to be clarified and one hopes that there will be more concerted thinking in the coming months before such a drastic step is taken.

(Deepa Mookerjee is part of the faculty on myLaw.net.)

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Forcing long-term thinking in the banking industry

 

KidandthebankerLast week, The Hindu published this article on the report of the United Kingdom’s Parliamentary Commission on Banking Standards and what the RBI stands to learn from that report. The article highlights the key findings of the report in relation to raising the standard of accountability within the management of banks.

As the article concludes, the Indian banking sector is changing from largely public to inclusively private. In this context, the RBI should be mindful of the regulatory landmines waiting when the banks it is regulating change from risk-averse public banks to market-hungry private banks.

One of the points that caught my eye deals with incentives for performance within the banking system. One of the key takeaways from the financial crisis is the risk stemming from the issue of executive pay. Managers become prone to taking short-term risks easily, while ignoring the long-term consequences. Immediate positive consequences are heavily rewarded while the negative long-term consequences take their toll on the banks, and eventually the system, as a whole. In this context, the Commission made the following recommendations:

  • Creation of a separate set of accounting statements dealing exclusively with remuneration, both at the company level and at the level of business units.
  • Avoiding the use of narrow measures such as return on equity for determining remuneration.
  • Bank remuneration committees must disclose the measures used to determine remuneration.
  • A significant part of variable remuneration must be deferred, for up to ten years.

Banking-and-Finance-LawTo my mind, these steps could play a significant role in tempering the zeal of executives and making them mindful of the long-term consequences of their actions.

(Deeksha Singh is part of the faculty on myLaw.net.)

 

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India Post: Biting off more than it can chew?

 

India Post applies for Banking Licenses
Photograph by Parul Kumar.

The finance world has been abuzz since the Reserve Bank of India (“RBI”) announced its intention to grant banking licences to a few more private sector entities. The July 1 deadline has passed and there are 26 contenders for these licences.

While no one was surprised to see established private sector groups like Tata, Birla, and Reliance on the list, entities like Muthoot Finance (the gold loan company) and some Non-Banking Finance Companies like Edelweiss Financial are also part of it. But the one that interests me the most is India Post.

India Post brings rural access to the table. At its current infrastructure, about 90% of its branches are in rural India. The RBI, with its focus on financial inclusion, has already made it compulsory for new lenders to have at least 25% of their branches in rural areas. So, you might think, who better than India Post to lead the ‘financial inclusion’ brigade?

The answer appears to be—almost everyone else. This is because:

1. New banks for private sector only: The RBI’s intention is to expand the representation of the private sector in banking, and to thereby fuel competition in the market. The new licensing norms titled ‘Guidelines for Licensing of New Banks in the Private Sector’ make that evident. So where does that leave India Post? To be a serious contender, either the department (a part of the Ministry of Communications and Information Technology) becomes a corporate entity, or the RBI will have to find a place for a government department in its new regulations.

2. Regulation of a government department: Let us assume that the RBI allows the latter option. How will the RBI enforce regulations on or penalise a government department?

3. Ability to run banking operations: Fundamentally, there are two functions that make an entity a bank — accepting deposits and lending funds. In a way, India Post is already running certain schemes that explain why it has any banking ambitions at all. The Post Office Savings Schemes allow people across the country to create savings accounts that offer good rates of interest and, in some cases, tax rebates. It is in the second function however, that it runs into a major roadblock. Our postal department has no experience in lending. There are no rules, guidelines, or paperwork to tell the department how to go about lending the corpus of funds that they collect from the deposits.

This is India Post’s biggest challenge. You see, they have the infrastructure, but they don’t have the people. You cannot convert your local postman into a bank branch manager. It would involve a colossal operational, not to mention a philosophical change, within the department for it to be equipped to handle banking operations. And experience tells us that change does not come to the Indian public sector easily.

Only five or six licences are expected to come out of this round, and it is unlikely that the RBI will announce its decision until 2014. I, for one, am interested to see the final take on India Post.

(Deeksha Singh is a member of the faculty on myLaw.net.)