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If your company needs a loan from a bank, it must pass the initial due diligence stage. Depending on the outcome of your due diligence, the bank can present a preliminary offer for the loan. One of the ways banks present you with an offer is with a commitment letter. Essentially, commitment letters are an agreement by a bank to lend your company money unless it later uncovers something unusual about your company. Since debt financing can be crucial for any company, it is important that you are familiar with the terms of a commitment letter. This article outlines the purpose of loan commitment letters and its implications for your business.
What are Commitment Letters?
Before a bank lends your company money, it must be satisfied that your company can repay the loan and any interest owed. Consequently, the bank must investigate your company’s performance. In other words, the bank must undertake a due diligence process.
The bank will likely present you with a commitment letter if your business passes the preliminary due diligence process. This letter signifies the bank is satisfied with the initial due diligence outcome and prepared to lend your money. However, it also signifies that the bank needs to complete its due diligence and does not want you shopping around for another loan in the meantime.
By presenting you with a commitment letter, the bank essentially says that unless they uncover something unusual about your company, they are committed to lending you money. In other words, a commitment letter is an agreement to try and formally agree to the loan terms.
Do Commitment Letters Have Legal Effect?
A commitment letter creates certain legal obligations for both the lender and the borrower. As a legal contract, a commitment letter contains certain terms that specify each party’s rights and obligations during the loan negotiation process.
In general, commitment letters operate on the basis that certain ongoing or future conditions will later be met. In other words, the terms are conditional. Provided the specified conditions are met, both parties remain obligated to observe the terms of the commitment letter. If the conditions are not met, the contract ceases to have an effect, and both parties are released from their obligations.
The Bank’s Obligations
A bank’s main commitment when issuing a commitment letter is to lend your company the agreed sum of money. This is on the basis that all other conditions are met. Generally, a bank expresses this commitment by stating the bank will ‘underwrite’ the loan.
Your Company’s Obligations
The two main obligations your company undertakes when accepting a commitment letter are:
- a promise to not seek out other lenders for the same loan (a ‘clear market’ clause); and
- the requirement that your company pays the bank any money they lose due to your company’s improper conduct throughout the remaining negotiations.
Conditions in Commitment Letters
The other terms in the letter will set the conditions that allow either party to terminate the negotiations. Either party may terminate the negotiations if:
- they exceed the agreed timeframe;
- your company does not pass the final due diligence process;
- market conditions change; or
- your company’s business materially changes.
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What Happens if I Breach the Commitment Letter?
As is the case for most contracts, if you breach the terms of the commitment letter, the bank can initiate legal action against you. In practice, the bank will draft the letter in such a way that limits your company’s ability to claim against the bank outside of egregious breaches. For this reason, it is important to seek legal advice if you are unsure about the terms of your commitment letter.
Key Takeaways
A commitment letter is a legally binding document that sets out how your company and a bank will conduct future loan negotiations. In this sense, a commitment letter is an agreement by a bank to lend your company money unless it later uncovers something unusual about your company. In exchange, you cannot go to other lenders looking for better rates.
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Frequently Asked Questions
A commitment letter is a legally enforceable document that sets out how you and your bank will negotiate a loan in the future.
A commitment letter creates legal obligations. Consequently, you could face legal action if you breach one of your obligations.
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