What are representations and warranties in a loan agreement?

What a representation is, and why lenders insist on them

A lender decides to lend on the basis of what it has been shown: tax returns, financial statements, a debt schedule, a lien search, the owners' personal financial statements, and for an acquisition the purchase agreement and a quality of earnings report. The representations and warranties section turns that picture into a contractual promise. The borrower does not just hand over its financial statements; it states in the agreement that they fairly present the business's financial condition.

Representations differ from affirmative and negative covenants. A covenant is a promise about the future: deliver financial statements, keep insurance, do not take on other debt. A representation is a statement about the facts as they stand. The two work together. The representations describe the business the lender agreed to finance, and the covenants keep it that way.

A representation is not paperwork. It is the lender's legal basis for relying on everything you showed it during underwriting.

The representations almost every business loan contains

The list varies with the size and type of loan, but a term loan or line of credit to a private company will usually contain most of the following. Each one maps to something the lender reviewed, and each has a familiar way of going wrong.

Several of these go directly to the collateral. On an asset-based line, the representations about receivables are repeated each time the business delivers a borrowing base certificate, and some lenders back them with a separate validity guarantee from the owner. A receivable reported as eligible that turns out to have been billed before the goods shipped is a false representation, not a bookkeeping slip.

Why an inaccurate representation is an event of default

Every credit agreement lists the events of default, and one of them is always some version of this: any representation or warranty made by the borrower proves to have been incorrect in any material respect when made or deemed made. Once a default exists, the lender typically may stop funding new draws, charge a default rate, and in the end accelerate the loan. Three features of that clause matter more than owners expect.

• It does not require a missed payment. A business current on every installment can still be in default because a statement it made at closing was wrong.
• It usually does not require intent. Most representations are flat statements of fact. Unless a representation is qualified by the borrower's knowledge, an honest mistake counts the same as a misstatement.
• It often has no cure period. Covenant breaches sometimes come with time to fix them. A representation that was false when made is usually a default immediately, because it cannot be made true after the fact.

A default under one agreement can also trigger defaults under others. If the business has equipment loans, a real estate loan or a seller note, a cross-default clause in any of them may be tripped by a representation default on the main facility. And because most small and mid-sized business loans carry a personal guarantee, the owner's own exposure follows.

In practice, lenders rarely accelerate a performing loan over a minor inaccuracy. What they do is use the default as leverage: to ask for a waiver fee, tighter terms, additional reporting or a higher rate. That is reason enough to get the representations right, and to negotiate the qualifiers that keep a trivial error from becoming a default.

The qualifiers worth negotiating

A borrower cannot negotiate away the core representations, and a lender will not lend without them. What a borrower can often negotiate is how they are qualified. The common qualifiers are:

• Materiality. The representation is breached only if the inaccuracy is material, or only if it could reasonably be expected to have a material adverse effect. This keeps a small unrecorded claim from becoming a default.
• Knowledge. Some representations, typically threatened litigation and environmental matters, are made only to the borrower's knowledge, often defined as the knowledge of named officers after reasonable inquiry.
• Time. Financial statement representations should speak as of the date of those statements, not as a promise that nothing has changed since.
• Scheduled exceptions. Each representation is made except as set out in a numbered schedule, so the borrower can disclose what is not quite true without breaching it.

Lenders to smaller businesses often start from a standard form, and some will not move far from it. Private credit funds and larger banks tend to negotiate more. Either way, the time to raise these points is at the term sheet and commitment letter stage, when the documentation approach is set, not the week before closing.

Disclosure schedules: where the real work is

The disclosure schedules are the attachments that list the exceptions and the specifics: existing debt, existing liens, pending litigation, subsidiaries, owned and leased real estate, bank accounts, insurance, material contracts, intellectual property. A representation that says there is no litigation except as set out in a schedule is only as safe as that schedule is complete.

Owners tend to treat the schedules as something the lawyers fill in. That is a mistake, because the lawyers can only list what they are told. The facts live with the owner and the controller. A careful review goes through each schedule and asks one question: is there anything true about this business that a lender would want to know and that is not written here?

Items that are commonly missed:

• Equipment leases and financing agreements, and the UCC filings that go with them, including filings from lenders paid off years ago that were never terminated with a UCC-3.
• Merchant cash advances and revenue-based financing, which many owners do not think of as debt.
• Loans from shareholders or family members, and any intercompany balances with affiliated businesses.
• Tax payment plans, including a federal tax lien that has been released or is being paid down.
• Threatened claims: a demand letter from a former employee, a customer dispute headed toward litigation, a regulatory inquiry.

Disclosing a problem in the schedules is almost always better than leaving it out. A disclosed issue is a credit question; an undisclosed one is a default.

Representations after closing

Representations are not a one-time event. Most agreements deem them repeated, in whole or in part, each time the borrower draws on a line, delivers a compliance certificate, or signs a borrowing base certificate. That bring-down is one of the conditions precedent to each advance: the lender does not have to fund if the representations are no longer true.

This is where schedules drafted at closing can become stale. If the business signs a new equipment lease, receives a lawsuit or opens a new subsidiary, the next draw may repeat a representation that is no longer accurate. Well-drafted agreements give the borrower a way to update schedules by notice, and the lender will usually accept updates for ordinary-course changes. Keeping a short internal list of what was scheduled at closing, and checking it before each certificate, is a practical habit.

In an acquisition, keep in mind that there are two sets of representations. The seller makes representations to the buyer in the purchase agreement. The buyer, as borrower, makes representations to the lender in the credit agreement, including about the business it has just bought. The buyer's representations to the lender are only as good as the diligence behind them, which is one reason lenders ask for a quality of earnings report, and why many take a collateral assignment of the buyer's rights under the purchase agreement. See the steps from LOI to closing.

How the lender package helps

Most representation problems start in underwriting, when something relevant is not in the file. A complete debt schedule, a lien search checked against it, financial statements that reconcile to the tax returns, and a plain list of open issues mean the representations the borrower signs later simply describe what the lender already knows.

That is the approach Transparent takes. Once a borrower's documents are in, Transparent builds the full lender package, including the financing model, lender presentation, blind teaser and underwriting memo, in a day; built by hand, the same package takes at least a week. Open items such as a tax payment plan or an old lien are named in the package, so they are priced into the credit decision rather than discovered in the schedules. See what goes into the package and how we underwrite.