Legal Framework of Loans

In summary:
• A loan is a contract.
• The law helps assure that both lender and borrower comply with legal standards.
• The most relevant elements of loan transactions are the domicile and location of the parties and the collateral.
• There are several key considerations for loan documentation.
• Guarding against fraud is limited by "act of God" and other legal doctrines.

In general, the legal framework of a loan agreement is only relevant once one of the parties fails to perform as agreed. The framework also dictates how the loan is to be repaid. This perspective is fundamental to the earliest negotiations of any financing arrangement, and should drive the lender at all stages of the loan agreement, through the monitoring of the loan repayment. The Iridium case is a spectacular example of default, but not uncommon.

The parties to the loan agreement need to provide for all reasonable contingencies and agree on a forum that might be used to resolve any resulting dispute.

Loan = Contract

The meeting of the minds on the formation of any contract, including an agreement to loan funds, involves the basic contractual elements of offer (by the lender) and acceptance (by the borrower). Standard loan terms are easily obtained from most lenders, that is, the limitation on the amount to be loaned, the applicable interest rate, and the terms of repayment. Thus, there is little negotiation 'per se' involved in determining basic information on the loan and its terms. However, the final agreement between lender and borrower will typically reflect the specific situation of the borrower.

Parties

The legal domicile and specific location of the parties is relevant, as the individual jurisdiction of each party may have controlling laws that apply to a loan transaction. In any case, it is likely that the respective laws of each jurisdiction pose at least some conflict in their application. This should be addressed in the loan agreement itself, with a provision that addresses choice of law.

As a practical matter, in the event that litigation does arise out of a loan agreement, it is a given that the court which asserts jurisdiction over the case will more likely favor the party whose legal domicile or operations are in the same jurisdiction as the court.

Collateral Security

Pledged collateral is an asset that is incorporated into a loan agreement in addition to the personal promise on the part of the borrower to assure repayment of the loan. The collateral may include real property, shares of stock or other financial instruments, which will be subject to seizure upon default in the proposed repayment. The location of the collateral may be as critical a factor as the location of the parties to the loan. Furthermore, where it is subject to removal or transportation (e.g., shares of stock or equipment), it may cause additional problems.

It is no wonder that financial institutions are paying more attention to the legal risk associated with taking securities held through multiple tiers of intermediaries as collateral. The exposures involved are extremely large. Each day hundreds of billions of dollars of securities are provided as collateral under arrangements involving a cross-border element, and the market is growing. Collateral providers are able to reduce their borrowing costs if collateral takers are willing to accept their securities as collateral. Collateral takers, however, need to be certain that they have valid and enforceable legal rights to the securities posted as collateral, not only as against collateral providers, but also against third parties. In cross border situations, a key question a collateral taker must ask is: “Which laws do I need to satisfy to have a valid legal entitlement to the collateral that is good against third parties?"

The two proposed solutions are:

The 'place of the underlying securities' approach. However, this may involve application of multiple jurisdictions.

The 'place of relevant intermediary' approach (PRIMA). Essentially requiring the law where the collateral is accounted for on the company books, this provides for application of the law of a single jurisdiction. The US has chosen to operate under PRIMA.

Documentation

The documentation relevant to a loan agreement includes the loan application (with all its attachments), the loan agreement itself, and any public filings related to the loan (indicating indebtedness and the release of indebtedness). Certain documents can be expected to become public filings or publicly available, depending on the parties and the pertinent laws or regulations. This should be an issue closely considered by both parties. The language(s) of the documents should ensure that there is no miscommunication between the parties that might result in the finding of a void contract or that magnify any problems related to the loan agreement.
The language of the documents needs to be subject to agreement between the parties. If the documents are prepared in more than one language, there should be clarity about which instrument is the controlling document.

Overriding Legal Doctrines

Most loan agreements can be expected to provide for the application of such well-known and well-recognized legal doctrines as force majeure or Act of God. A typical provision may provide that the suspension of a contract is allowed, but it can never judge the full force of any Act of God, i.e., it cannot be fully outlined or provided for in the loan agreement.

It may be even more difficult to provide for fraud by either party. Such a provision would undermine the element of trust that is the foundation of any loan agreement. It is even less likely that the loan agreement will provide for the consequences of fraud. This is probably the most unwieldy of any legal calamity, since it will be difficult to assess where the fraud exists and where it ends. Any provision for the likely consequences of the unknowable, the typical lawyerly, "If [this is true], then [this should occur] . . ." cannot be calculated or hypothesized within the loan agreement.
In the case of fraud, the loan agreement is void and remedies will be available outside of the loan agreement itself, based on general principles of law and equity. Case laws have demonstrated fraud on the sides of both the lender and the borrower. The remedy lies in arbitration or litigation proceedings.

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