A Refresher on Term Sheets and Commitment Letters
Term sheets and commitment letters are documents frequently used by lenders to outline the terms of a potential financing. However, these two documents differ with respect to what is required of, and whether the terms are binding on, the parties.
What is a term sheet?
A term sheet is a summary of the main business terms and possible options for a prospective financing. Term sheets are provided by lenders to prospective borrowers prior to a full underwriting of and credit approval by the lender. The terms are intended to be a starting point under which the lender will consider providing financing to a prospective borrower. Generally, parties are under no financial or legal obligation to each other based on the provisions of the term sheet.
What is a commitment letter?
A commitment letter is a document that intends to establish specific deal terms regarding an extension of credit from the lender to the borrower. Commitment letters are provided by lenders after a full underwriting of and credit approval by the lender and frequently contain identical business terms to the final agreed to version of a term sheet. To form a commitment letter, the letter must meet the following requirements:
- It must provide a credit accommodation and be in writing. While some courts will allow an oral commitment to be enforceable, many courts require that the commitment to lend to be in writing. N.C. Gen. Stat. § 22-5 requires that a commitment to provide credit in excess of $50,000 be in “writing and signed by the party to be bound,” however, both the 4th and 9th Circuits (Mid-Atlantic states and West Coast states, respectively) have enforced financial commitments that were made by means of an oral communication only.
- The document should include the basic terms. Even if there is not an agreement on all of the terms, a commitment letter will still be enforceable by a court if there is an agreement on the basic terms of the loan.
- Both parties must “manifest an intent to be bound.” Unless a document contemplates a more definitive forthcoming document or an express statement that a party does not intend to commit itself via the document, a court may find that the parties manifested an intent to be bound through the formation of a commitment letter or oral contract.
A commitment letter differs from a term sheet in that it creates a binding agreement on the part of a lender to make a loan on the stated terms. In addition, a commitment letter generally requires that a borrower reimburse a lender for out-of-pocket expenses and possibly pay a break-up fee if the loan transaction does not close, whereas there is generally no obligation for the borrower to pay these costs and fees in a term sheet. Because of this, it is recommended that lenders obtain a commitment letter and a good faith deposit prior to engaging counsel or ordering any third party reports.
In drafting commitment letters and term sheets, lenders should be aware that:
- If the lender does not initially address an important issue in a commitment letter, the lender may not be able to insist upon it in the loan documents.
- Even if a term sheet or commitment gives the lender “discretion” in deciding an issue later on, the lender must still use “good faith” and act in a “commercially reasonable” manner in resolving any remaining issues. Thus, “discretion” does not mean that the lender has unfettered or absolute discretion in deciding an issue.
- A lender should not oversell assurances of credit approval to a borrower or agree to issue a commitment upon the satisfaction of conditions in the term sheet phase, or else it may be liable for negligent misrepresentation to the borrower.
- A term sheet should, in addition to stating the business terms, include:
- A statement that it is non-binding, is for discussion purposes only and does not constitute a commitment on the part of the lender;
- A general description of the conditions precedent to closing, such as receipt and approval of third-party appraisals and other customary due diligence deliverables; and
- A statement that the terms are subject to formal underwriting and credit risk approval.
- A commitment letter should, in addition to stating the business terms, include:
- A general description of the conditions precedent to closing, such as receipt and approval of third-party appraisals and other customary due diligence deliverables;
- A condition that there has been no material adverse change in the borrower’s financial condition between the date of the commitment and the closing of the loan;
- A condition that the borrower may not shop competing financing or disclose the terms of the commitment letters to other lenders while the commitment is outstanding; and
- An accept by and close by date after which the commitment expires.
Understanding the differences between a commitment letter and a term sheet is critical and should be a point of emphasis to all lenders.
We would like to acknowledge the help of our 2015 summer associate, Preetha Suresh, in the preparation of this article.