Shakespeare’s quote in the famous play, Hamlet “To be, or not to be: that is the question: Whether ’tis nobler in the mind to suffer The slings and arrows of outrageous fortune, Or to take arms against a sea of troubles, And by opposing end them?” weighs the pain and unfairness of life against the alternative, which might be worse. Right now, a less existential debate is going on in certain ABL circles regarding the use of Demand Notes, which per the name is a promissory note structure that gives the lender the right to demand payment at any time. The Demand Note structure is pervasive in middle market bank deals, but less so in the ABL world where it is starting to be utilized by firms in the lower end of the market. The simplicity of the product is that it enables the debtor to have a no-covenant loan with the trade-off being the lender has the ultimate control over calling the loan that they hope to never exercise.
Much Ado About Liquidity: Committed vs. Demand Facilities
A no-covenant loan is great in theory, but not always in practice although to be fair it always comes down to the client’s choice. Shakespeare aside, the better way to frame this debate is from the client perspective as some clients prefer the flexibility of no covenants compared to a fully-committed line that often times does come with covenants. Demand/uncommitted lines offer greater flexibility to borrowers via fewer or lighter covenants and reporting requirements; these lenders legally have the discretion to demand full repayment of the loan at any time for any reason whatsoever. The seminal point for many businesses typically comes down to whether they trust the lender given the remedies available. It’s a dream product for entrepreneurs who worry about today and not about tomorrow although the repercussions of that can be dramatic both literally and metaphorically. The counterpoint is that sponsors usually prefer the certainty of committed facilities. There are several reasons a demand note could be called and historically not all pertain to liquidity – i.e. the lender needs the funds back.
Fully committed lines, by contrast, typically have a tighter structure (i.e. preset covenants, reporting, cash dominion) but offer greater certainty to the availability of funds over a pre-defined time commitment, usually 2-4 years. In a worst case scenario (borrower bankruptcy), a court of law will hold a fully committed lender to a high standard for acting commercially reasonable/in good faith to support the business (as outlined in loan docs) even if they are in default/BK. Whereas a demand lender can call their loan at any time, even if it forces their borrower into bankruptcy, and consequently when borrower sues demand lender, courts usually rule in favor of the lender. That said, if a Demand Note lender calls its loan for no reason a judge could find for debtor under the guise they were not being commercially reasonable. Whereas covenant defaults are more black and white and are less open to being challenged. It should also be said that the majority of lenders regardless of structure are all operating within a certain set of ethical standards. Meaning it’s rare that a lender would take this step without making it known and creating a document trail that calling the note was a strong possibility.
Parting is Such Sweet Sorrow: When Loans are Called
While the risk is there the ability to compare and contrast loan products is often helpful to the client. More products to choose from creates a healthy market and ultimately provides more options to the client. The Demand Note structure is clearly here to stay and has a real place in the market. However, what’s not always discussed is when the Demand Note lender is left with no choice as well as very little warning and is forced to call the loan. This is as opposed to a committed lender who typically would have a covenant breach to set off a warning before a client runs out of liquidity, although not always. It should also be said that when calling a covenant default the committed facility lender should make sure to do a materiality test or give aggressive borrowers something to sink their teeth into. These are not always apples to apples situations as smaller companies tend to favor the demand note instead of a committed line as they need the extra liquidity rather and prefer no covenants. That’s ultimately a business decision but runs a higher risk of ending in liquidation or distressed sale when these companies don’t then listen to their lenders’ warning when they run low or out of liquidity. By the time the lender can do anything about the situation the company has run out of cash and the only real remedy is to call the loan.
The real story here is that the ABL market continues to evolve and clients ultimately benefit from new products even though the actual product has been around for centuries. Borrowers really need to trust their lenders and lenders need to really communicate to borrowers the ramifications if liquidity evaporates. The primary selling point of a committed facility is that it doesn’t require trust and does give both the lender and debtor time to find a solution when a liquidity situation arises. At the end of the day, irrespective of the loan structure, it’s better to be than to be in good standing with your lender or find yourself in Shakespearian ending.
This article first appeared on ABF Journal: https://www.abfjournal.com/articles/to-demand-note-or-not-to-demand-note-that-is-the-question/
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