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Introduction to debt finance

Apart from raising equity investment (or issuing convertible securities), obtaining debt or loans) is the other alternative to raising finance. For businesses which generate sufficient cash flows, loans and debt may be preferred as the business owners can retain control (and their stake) in the business. Cash flows generated from the business can be used to repay interest and principal amounts to lenders as per agreed schedules.

In this module we will discuss commercial and regulatory issues linked to raising debt from banks and financial institutions.

Accountants, lawyers, business advisors, consultants and company secretaries can add great value to businessmen if they can help them with tasks such as devising financial strategy for the business, preparation of necessary documents required by financial institutions for approving the loan, negotiation of loan and security documents. 

In this module provides an introduction to discusses different participants in the financial sector to familiarize readers with how their activities are regulated.

The discussion below introduces the types of credit facilities granted by banks in more detail.

Most common types of credit facilities granted by banks

Businesses take various kinds of loans or credit facilities from banks, some of which are described below:
  • Letter of credit – A letter of credit (LOC) is a facility extended by a bank to a resident in respect of an import transaction. The LOC guarantees payment to the non-resident exporter (by the importer). A sample letter of credit can be accessed on this link.
  • Cash credit/ overdraft facilities – A cash credit or overdraft facility is a short-term credit facility. It is usually extended by banks to current account holders.
  • Loans - Loans can be extended for various purposes, such as:
  1. For working capital – Working capital loans are given for meeting any deficit in the day-to-day operations of the business. There may be periods of time when the business does not have immediate liquid cash, e.g. when the business is required to make immediate payments but the amounts which are already due to it will be received later. A working capital loan is provided so that it can meet this shortfall in liquidity.
  2. For purchase of specific business equipment (e.g. a tractor, a machine, etc.). Loans can also be provided by for importing the equipment from another country.
  3. For a specific project, e.g. for building infrastructure such as a road, a port or a highway. Loans for specific projects fall within the ambit of ‘Project Finance’ (a major practice area for law firms) and are typically arranged once a project is awarded by the relevant governmental or other statutory body to a private entity for constructing the relevant project.
  4. For a specific business transaction – e.g. for an acquisition. In India, taking loans from banks for acquisition of shares of a company is not permitted. However, loans can be taken from NBFCs or group companies for the purpose of acquisition, subject to compliance with applicable legal provisions in each case. On certain occasions, a company may intend to raise finance from public capital markets (e.g. by issuing shares or debentures), but since the process is time-consuming, it may obtain a loan of similar amount from banks or financial institutions, which can be repaid once the company has completed the public issue. Such a loan is called a ‘bridge loan’.
  5. Syndicate loans - When the loan amount is large, businesses often opt for syndicate loans. In a syndicate loan, multiple banks assume the position of lenders through the same loan agreement. For example, a loan of INR 200 crores by the following banks (lending together), which is for the same purpose and governed under the legal document would be considered a syndicate loan:
Bank Loan Amount (in INR crores)
SBI 20
HDFC Bank 60
Punjab National Bank 30
Standard Chartered 50
Total 200
The portion contributed by each bank in the loan is known as its ‘participation’. Since the outlay by individual banks can be quite substantial, syndicate loan documents have elaborate procedures for banks to exit by selling their ‘participation’ in the loan to another loan. Failure by a bank to provide a credit facility as per the agreement amounts to a ‘default by the lender’, which entitles the borrower to obtain a similar facility for another bank (unless the existing banks wish to increase their participation) in the loan.

Syndicate loan agreements are often drafted on the basis of a standardised format –Asia Pacific Loan Market Association (APLMA) format is one example.[1] Such formats are prepared in light of the interest and experiences of lenders (and borrowers as well) and are therefore useful in protecting lenders against obvious risks. They are frequently updated in light of changing developments and market experiences.

For example, in 2009 an English court held that in case of a breach of a loan agreement, if a bank did not terminate the agreement (and continued performance) without any communication in respect of the breach to the borrower, it had actually elected to affirm or condone the breach and could not subsequently terminate the contract.[2] As a result, the APLMA amended the relevant clause in the standardized agreement (titled Remedies and Waivers), stating that an affirmation or condonation of a breach would only be effective if it is made in writing.

[1] The APLMA was founded in 1998 by seven founding member banks, which included leading banks such as Bank of Tokyo-Mitsubishi, ABN Amro, Citigroup, BNP Paribas, Barclays Capital and Societe Generale.
[2] Tele2 International Card Company SA and others vs. Post Office Ltd.  [2009] All ER (D) 144 (Jan)

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