It is quite common for parties to lend money to each other in a business as well as a personal context. It is a prudent practice for both sides to properly document this type of transaction for many reasons. The terms of the loan should be accurately and completely spelled out in written form so that there is no miscommunication between the parties.
Specifically, the amount of the loan, the interest rate to be charged and manner of accrual, the payment schedule and any other relevant terms should be set forth. In addition, some loans require a security interest to be granted. This means that the lender takes an interest in certain assets or property of the debtor which is to be used as security in the event that the debtor defaults, or does not pay, its obligation in full. Along the same lines as a security interest, a loan can be personally guaranteed by another individual or business. Such a guaranty is another layer of protection for a lender in the event that there is a default on the repayment of the loan. The promissory note will also typically define what a default under the loan means; usually it is a failure of the borrower to make a payment under the note plus a certain short grace period, a bankruptcy or insolvency of the debtor, possibly the death of the debtor (for an individual), and other definitions that may be relevant for the parties. Other terms that are considered and memorialized in loan documents include whether the loan can be prepaid in full early without penalty, possible restrictions on the debtor such as a requirement that there be no material changes in the business and operations of the borrower and other terms that might be relevant to a particular set of circumstances.
There are several documents and processes involved in order to properly document a loan. First, a “promissory note” is the instrument by which the loan is made and funds are exchanged. The promissory note contains the relevant terms (as discussed above) and is signed by the borrower. There should be one original promissory note signed by the borrower which is to be held by the lender while the note is being repaid. Once the loan is repaid in full, the promissory note should be either returned to the borrower in its original form or destroyed by the creditor and such destruction is confirmed by the creditor. If there are any additional signed original promissory notes, it is advised that these copies be stamped as “copies” or otherwise marked accordingly.
The next document that might be included in a package of loan documents is a security agreement. As mentioned above, if the parties agree that the borrower will put up some asset or property as security for the loan, such an exchange needs to be document by means of a security agreement. The security agreement will contain a proper and full description of the security or “collateral” for the loan and will state various restrictions on the borrower’s use and care of the collateral. In general, the security agreement will provide that the borrower is not permitted to sell or otherwise transfer the collateral or use it as collateral for any other loan. The security agreement will also spell out the exact procedure that the creditor must follow if there is a default on the loan repayment and the creditor chooses to exercise its right to obtain the collateral. In addition, the security agreement will give the creditor the right to file a financing statement with the relevant governmental authority (the financing statement is also sometimes referred to as a UCC-1 or a lien). The significance of such a filing is to put all third parties on notice that certain collateral is being held as a security interest by the named creditor. This notice to third parties by way of the financing statement gives the creditor comfort that if the time comes to collect on the security or collateral, other third parties will not claim a prior right or interest in such property. While a promissory note and a security agreement each contain distinct terms, it is not uncommon for the two documents to be combined into one “promissory note and security agreement.”
In addition to taking a security interest in certain collateral of the borrower, a loan can contemplate a personal guaranty. Typically, a loan made to a business would call for the principals or owners to give a personal guaranty. However, other parties can also provide a personal guaranty for a loan. A personal guaranty might entice a creditor to make a loan as there is an individual or another business, presumably one with financial means, standing behind the loan in the event that the actual debtor is unable to repay the loan. Accordingly, a guaranty is another document that may be included in a set of loan documents along with the promissory note and security agreement. The guaranty basically confirms the guarantor’s (the party guarantying the repayment of the loan) obligation to repay the loan as set forth in the promissory note in event that the debtor defaults. The guaranty spells out the rights of the creditor to pursue the guarantor in the event of a default on the part of the borrower.
In addition to the promissory note, the security agreement, the financing statement and the guaranty, other loans may require additional documents to memorialize any unique requirements or circumstances of the transaction at hand. It is advisable for both a borrower and a lender to seek the advice of a knowledgeable and careful attorney to attend to the details of a loan to ensure that the contemplated transaction is properly documented. Careful attention to details is a must in order to protect both sides and their respective interests. Borrowers should be loath to sign any loan documents without the advice and review of such documents by a qualified attorney. A lender should hesitate to make any loan based on an oral understanding or a handshake and should only proceed with a full set of documents.
Please contact the attorneys as the Law Firm of Beress & Zalkind PLLC to learn more about how to properly structure any time of loan or lending arrangement.