This article has been written by Vibhor Goel, pursuing the Diploma in Business Laws for In-House Counsels from LawSikho.
In business law, one should be familiar with the different ways in which a business acquires financing. The financing may be for short term or long term purposes and they may also require immediate cash assistance to maintain smooth functioning. While one may think that the concept of financing is only important for those running a business, financing involves a lot of aspects that any corporate legal practitioner should be familiar with. This article discusses one such way by which businesses or individuals secure such financing, i.e., “Bridge Loans”. Further, it is important to know how contracts for such loans are drafted and what to look out for in those contracts. These concepts are important for law students, tax lawyers, corporate lawyers, individuals running a business or planning to start one, individuals working in the finance industry, economics students etc. and by the end of this article, the reader will be well versed with these details.
Bridge loans, also known as “Swing Loans”, “Gap Loans/Financing” “Interim Financing” or “Bridging Loans” are essentially short term loans that are acquired by any business or individual to meet short term or immediate liquidity needs. Bridge loans act as a bridge between the gap of short term cash requirement and long term loans. Like almost every other loan, a collateral has to be provided but these loans involve a relatively lesser amount of paperwork and documentation, this of course will also depend on country to country and the prevalent financial conditions and policy at the time.
Bridge loans are generally taken by businesses before their main source of funding goes through and the amount of the loan and interest thereof is decided according to the repayment capacity of the borrower which may be judged by the collateral offered, financial records or the estimated sale price of the borrower’s home.
Distinct features of Bridge Loans
Bridge loans have certain distinct characteristics that one should be familiar with, they are as follows:
- Cross Collateralization: Collaterals are any asset that the borrower has against which the loan is taken. In case the borrower is unable to repay the loan within the agreed upon time the bank or lender may sell the collateral and recover the payment from the sale thereof. Cross collateralization is when the borrower uses an asset as collateral for a loan which has already been used as a collateral for some other loan secured by the borrower. Most bridge loans allow this practice.
- Short Term Loan: Bridge loans are short term loans as mentioned earlier. The period can range from 2 to 3 weeks or even more but is always less than 12 months.
- Low Loan to Asset Ratio: Loan to asset ratio indicates the amount of financial risk. The formula that is followed is total debt divided by the total assets. This is used to determine the ability of a lender, usually a financial institute, to gain back their money.
- High Rate of Interest: Bridge loans are characterized by an exorbitantly high rate of interest. Since these loans are short term loans, the interest is usually charged on a monthly basis and not an yearly basis.
Bridge loans vs Traditional loans
As compared to traditional loans, bridge loans are easier to apply for and have a faster application approval process. Bridge loans have higher rate of interest as compared to traditional loans and may involve a separate fee as well. This also means that bridge loans are more riskier as they might be difficult to pay off in such a small amount of time and therefore a borrower must wisely evaluate his repayment ability before applying or be prepared to forfeit the collateral. So why don’t borrowers select traditional loans? The simple reason for accepting such harsh conditions is that the borrower needs cash fast and knows that they can positively repay it in a short span of time.
In the corporate sector bridge loans are used in corporate finance and venture capital to inject cash flow so that they don’t run out of cash between private equity financing. They may even be used by companies that are not doing well to hold on to their own till they find a large investor or someone who will acquire the company.
- Examples of Bridge Loans offered in India
Bridging loans can be acquired in India as well. For example, HDFC offers bridging loans even if the borrower is not present in India. They would require documents like a Photocopy of a PIO card, or passport indicating the birthplace of India etc. Bank of Baroda has introduced a bridge loan scheme for top-rated corporate clients that can be taken against expected equity flows or issues, and also expected proceeds in certain cases. Such schemes are, again, for a period of 12 months or less.
Drafting a Bridge Loan Agreement
Bridge loan agreements are the negotiated terms and conditions of the bridge loan in a written format. It is a legally binding arrangement between the borrower and the lender which includes all the relevant details of the loan advance and its repayment. Drafting a bridge loan agreement must be done very carefully and it’s important to understand some basics that apply to almost every type of agreement.
a. Purpose of Drafting a Written Agreement
- While a verbal contract is valid, the agreement and contracts should always be made in a written format to ensure security and proof in case anyone party tries to back out of the arrangement.
- In order for contracts to be valid, there has to be valid consent and the parties must agree to the same things in the same manner. A written agreement ensures such a meeting of minds.
- The contracts include remedies for different types of eventualities which can’t always be done verbally. It creates a set of enforceable rights and obligations on both the parties to conduct business in a more trustworthy manner.
b. Common Essentials of Every Contract
- The Indian Contract Act, 1872
A written agreement enforceable by law is known as a contract. A contract requires witnesses, signatures of the parties involved and to be made on stamp paper. The parties can also, if they wish to do so, register their contract to ensure its legal validity and proper enforceability.
In India, both verbal and written contracts are governed by the Indian Contract Act 1872. There are certain rules given in the act like when the contract can become void or voidable, the remedies available in case of breach, types of contracts etc. In the absence of any express clause in the contract the provisions of the contract act will be referred to and therefore one must try to make the contract as comprehensive as possible while keeping it simple.
- Essentials of a Valid Contract
- There has to be an offer and the acceptance to that offer, an offer should not be confused with a mere invitation to offer.
- There has to be a consideration for something done.
- Both parties must have the capacity to contract, i.e., they cannot be minors, cannot be of unsound mind or prohibited by any other law to contract.
- Everything in the contract should be legal, contracts cannot be prepared for illegal activities.
- General Clauses in Every Contract
- The title: the first component of the contract and tells the reader about the nature of the contract.
- Introduction and Recitals: These clauses are a mere introduction as to the purpose of the contract and the parties involved. It includes any definition of any important words used in the agreement and gives a background to the circumstances of the contract.
- Date of execution of the agreement.
- Effective date, i.e., from which date the agreement becomes applicable.
- Body of the Agreement: This section mentions the details of the agreement like the goods and services to be rendered, consideration of such goods and services etc.
- Dispute Resolution Clause: If any sort of dispute occurs between the parties involved, how that dispute will be settled. Alternate dispute resolution methods like mediation and arbitration are mentioned in this clause.
- Any schedules included to lay down any additional information related to the transaction.
- Termination clauses lay down when and under what circumstances a party can terminate a contract. It involves providing a prior notice of at least 30 days first.
- Amendment clauses may also be included in the contract which specifies the procedure for and circumstances under which the parties may make any amendments to the contract. Long-term loan agreements have such clauses relating to the interest rates of the loan which the bank may revise after 2 or 3 years.
c. Relevant Clause for a Bridge Loan Agreement
- Interest Rate: This clause talks about the applicable interest rates and in case of a long-term loan it also contains details regarding any fluctuations in the interest rate.
- Default: Generally non-repayment of loans is known as a default but a particular definition can also be given in the contract itself to include any other act or abstinence.
- Security or Collateral: This clause will mention the collateral that has been kept against the loan taken and when that collateral can be appropriated by the bank.
- Force Majeure: Force majeure means any event that is beyond the normal circumstances and it can contain a wide range of possibilities. It may talk about market fluctuations and how that might affect the interest rates or repayment.
- Repayment: Clause will mention when and how the loan is to be repaid.
There are free samples of bridge loan agreements available online, for seeing a few you can click here, here, or here.
d. Important Final Tips and Tricks
Drafting a contract is a technical task and it requires practice to be able to make a solid contract using the proper terminologies and language. Following are a few tips and tricks that may help inexperienced drafters:
- Keep the contract as simple as possible, don’t unnecessarily complicate things and use plain English wherever possible.
- Deal with trustworthy people, identify the parties in the contract properly and get every detail in writing instead of relying on verbal promises.
- Maintain confidentiality.
- Avoid unnecessary repetitions.
- It is a good idea to have a lawyer look at the contract as well, a lawyer may pick up some mistakes you’ve overlooked and is also familiar with how certain provisions are interpreted by the courts in case of disputes.
- Try to be familiar with the provisions of the Indian Contract Act 1872.
By now, we are well equipped with the knowledge of what constitutes a bridge loan, the legalese involved and the legalities that must be taken care of should they decide to draft a contract. However, it is imperative to note that a contract is a legally binding document and should be carefully examined or prepared by experts in the field, therefore, always seek the guidance of a legal practitioner before entering into such contracts. While law is a dynamic field that is ever evolving, every person is assumed to know the law and so a mistake of law will not be taken as a valid defence, one has to be well versed with the law. Lastly, bridge loans may be a great option for some but may be a poor choice for others; if a person does not have the financial capacity to repay, this loan may cause an extra burden due to its high rate of interest. So, even while selecting if a loan is suited to your needs or not, properly evaluate your financial needs and capabilities or seek guidance from an expert in the field.
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