The following is a transcript of a simulated presentation to an audience of lawyers at the monthly meeting of a Lending Association. The participants are Professor Arnold B. Cohen, who serves as the moderator, and Thayer Dolan, Jr., a bank loan officer specializing in commercial loans.

Professor Cohen: Good morning. I would like to welcome everyone to the monthly meeting of our Lending Association. Our guest this morning is Thayer Dolan, a bank vice president who specializes in commercial loan transactions and who will talk about bank commitment letters.

Thayer. What exactly is meant by a loan commitment?

Mr. Dolan: A loan commitment is a binding promise to lend. When issued by banks, loan commitments may pertain to almost any type of extension of credit to a borrower, including the establishment of a line of credit, revolving credits, term loans, commercial mortgages, construction loans, and so on.

Professor Cohen: Are there instances when a loan commitment will be verbal rather than written?

Mr. Dolan: Yes. In my bank, only verbal commitments are given in connection with consumer loans or in connection with business loans for less than $50,000. The main reason for this is to enable loan officers to process more loans by eliminating the time required to produce a written document. If a loan officer does not have to spend time preparing documents, the loan officer can service more loan applications in a given amount of time. That means that the bank could employ fewer loan officers, with a corresponding reduction of its overall costs.

Commitments for business loans in excess of $50,000, however, are supposed to be written. Clearly, written loan commitments are superior (and safer) to verbally communicated ones because all critical terms and conditions can be clearly set out on paper, and the likelihood of a misunderstanding is reduced.

Note, however, that the discussions that go on between a loan officer and the potential borrower's officers may lead to the borrower drawing the inference that it has a verbal commitment from the bank. This is even more likely to be the case when the borrower has a long credit relationship and history with the bank. The borrower may view conversational discussions with the bank's loan officer as reflecting a binding commitment, whereas the loan officer may have only intended to gather information and an understanding of the borrower's needs and desires. Unfortunately for banks, it is impossible to eliminate the risk of having disappointed potential borrowers contend that the bank reneged on an alleged oral promise to make a loan.

Professor Cohen: Written loan commitments are usually called "commitment letters." In practice, how would a lender define "commitment letter?"

Mr. Dolan: A commitment letter is a written document that sets forth the lender's obligation to extend credit upon the satisfaction of certain conditions. Essentially, the commitment provides the loan applicant with an option under which it may borrow funds in accordance with certain repayment terms.

Professor Cohen: Are there any non-refundable fees that the loan applicant is required to pay in connection with commitment letters?

Mr. Dolan: Yes. Many banks require the commercial loan applicant to pay a fee before the bank begins the underwriting process. The fee is intended to cover part of the bank's costs in accumulating and analyzing information about the applicant's creditworthiness and ability to repay the requested loan. The amount of the fee will vary, but it is not unusual for it to be many thousands of dollars.

In the event that no commitment is issued and the loan is denied, some of the fee may be returned. The non-returned portion covers all or part of the bank's costs in analyzing financial and other information about the applicant in light of the requested loan.

In the event that a commitment is made, the bank may require an additional fee that is tied to the period during which the commitment may be exercised.

Professor Cohen: Can you give us a sense of the amount of fees that might be assessed for loan requests of $1 million, $10 million, or $100 million?

Mr. Dolan: Fees, the payment of which are a condition to either the issuance or acceptance of a commitment, are computed as a percentage of the loan. Our standard commitment fee is 1% of the amount requested. Thus, a $1 million loan request would carry a $10,000 commitment fee; a $100 million loan would require payment of $1 million for the commitment.

At times, however, the commitment fee will be more or less than 1% of the requested loan amount. This will be the case when the perceived risk is greater or less than a so-called normal risk, or when the duration of the loan is for a very short or an unusually long period.

Commitment fees may be expressed in the documentation either as a percentage of the loan or as a fixed amount.

As one might expect, these fees can be a "hotly" negotiated component of the proposed transaction. The applicant frequently considers the interest rate as a charge covering all aspects of the loan process, including risk, duration, and the bank's underwriting and future monitoring costs. On the other hand, banks view these fees as reducing return risk and improving loan yields. Depending on the relative strength of the applicant's financial position, the fee could even end up being waived entirely by the bank.

Professor Cohen: I'm not certain that I fully understand. I gather that your reference to a commitment fee reducing return risk means that the fee serves as a hedge against the borrower defaulting under the loan agreement.

Mr. Dolan: Yes, that is part of its function.

Professor Cohen: But your reference to fees serving to improving loan yields seems to be a substitute for increasing the interest rate. Is that true?

Mr. Dolan: Let me respond this way. Any customer worth having as a customer is one that would be attractive to other banks. Accordingly, we compete with other banks in offering services, one type of which is to offer loans. The most visible part of every bank's marketing effort is the interest rate. Thus, banks seek to keep the rate as low as possible -- and, in a sense, to keep the rate artificially low. But banks are in the business of making money, and they have to correct for these artificially low rates somehow. One way is to require compensating balances. That is, the corporate borrower must maintain non-interest-bearing checking account deposits. Another way is to require commitment fees.

Professor Cohen: That's well put. But a commitment fee presupposes the issuance of a commitment letter. So, why does a potential borrower want a commitment letter -- especially when there will be a significant fee for its issuance?

Mr. Dolan: Let me initially focus on an implication in your question. If a borrower seeks to avoid commitment fees by going directly from the application to the closing of the loan, we might seek to charge the 1% as a so-called closing fee at the time the documents are signed.

Professor Cohen: Why all this emphasis on commitment fees or substitute closing fees?

Mr. Dolan: Some banks, I'm not saying my bank, compensate their loan officers on overall profitability and not merely loan volume. Accordingly, the interest rate is merely one component of a loan's profitability -- essentially, the difference between the interest rate charged by the bank to the borrower and the interest rate that the bank has to pay in order to obtain the funds that it provides to its customer.

But there are other ways for banks to increase profits. One way is to charge fees. After all, the cost to the bank of making and servicing a loan -- i.e., underwriting and monitoring costs, and costs of funds -- are a constant. Any fees obtained on top of the interest paid is pure additional profit. Loan officers at some banks may be bonused or commissioned based on the profitability of the loans that they handle. So, a $1 million commitment fee or closing fee on a $100 million loan may cover the cost of the Porsche that the loan officer has been dreaming about.

At my bank, let me hasten to say, we don't engage in these unseemly activities.

Professor Cohen: In any event, the extent to which the borrower will end up paying a commitment fee or a closing fee is going to be negotiated between the borrower and the bank, and may be as low as zero, or as much as several percentage points of the loan amount.

Mr. Dolan: Right.

Professor Cohen: Returning our attention to the overall concept of a commitment letter, what advantages are there from the borrower's perspective?

Mr. Dolan: There are several reasons why borrowers want commitments. First, the issuance of the commitment will enable the borrower to avoid spending additional time and effort in finding alternative funding sources. Second, the borrower will be able to make contingency plans in the likely event that the loan is finalized -- although it is possible that the loan will not close because of the borrower's inability or failure to meet a condition that is set forth in the commitment.

Professor Cohen: What is an example of a condition that might prevent the loan from closing?

Mr. Dolan: The commitment letter might contain conditions requiring the receipt of approvals from certain governmental regulatory bodies or that actual audits and appraisals of the borrower's inventory establish certain minimal values, or that any in-process tax audits be satisfactorily concluded by a certain date. If one or more of these conditions are not satisfied, the commitment will terminate and the bank will not be obligated to make the loan.

Professor Cohen: Are there any reasons why banks would find it advantageous to issue commitment letters?

Mr. Dolan: As we discussed, most commercial commitment letters require the applicant to pay some fee, and this will provide the bank with an additional source of income.

In addition, the commitment letter, even if used as a vehicle to require the payment of a significant commitment fee, may discourage the prospective borrower from shopping around for better terms and may increase the likelihood that it will sign the loan agreements.

Professor Cohen: Does the applicant know the amount of the commitment fee before it commits itself to pay it?

Mr. Dolan: Sure. Generally, the prospect will have up to a week to sign the commitment and pay the fee.

Professor Cohen: Therefore, the larger the amount of the fee, the more the applicant may be induced to find some other bank that would be interested in making the loan. Isn't that true?

Mr. Dolan: Yes. That is one more reason why these fees are generally rigorously negotiated and why some banks compensate their loan officers handsomely when they are able to obtain high fees.

Professor Cohen: Assuming that a commitment letter is signed, what other benefits does it provide to the bank?

Mr. Dolan: A commitment letter generally includes a list of the conditions for the loan closing. Accordingly, it serves as a checklist for the borrower and reduces the likelihood that the borrower will fail to obtain any necessary approvals or forget to take required action prior to the time when the loan is scheduled to be closed.

Finally, the commitment letter serves as an additional sales tool for the lender. A commitment letter is often phrased in positive terms indicating enthusiasm on the part of the lender for being able to serve the borrower, thanking the borrower for past business when applicable, and indicating that the lender looks forward to future business.

Professor Cohen: Why isn't the commitment letter only issued after all conditions have been satisfied?

Mr. Dolan: If this were literally done, there would be no need for a commitment letter since one of the usual conditions is that the borrower sign loan documents that are satisfactory in form and substance to lender's counsel. But other conditions required to be met before the loan can close may include approval by regulatory agencies or the completion of physical audits or appraisals of the borrower's assets. Rather than force the applicant to wait, banks will issue conditional commitments so that the applicant can weigh the likelihood that the conditions will be met and the loan close and make appropriate plans for use of the anticipated loan proceeds.

Professor Cohen: Who generally drafts the commitment letter? The lending officer or the bank's attorney?

Mr. Dolan: In most instances, the lending officer is responsible for writing commitment letters. The lending officer will take care to ensure all terms of the commitment letter accurately reflect those of the approval. Just as with the final loan approval, a final commitment letter often requires review and approval by a bank officer, credit committee, or credit department with the appropriate lending authority.

At times, however, the loan structure may be so complex or detailed that an attorney will draft the commitment letter on behalf of the lender. Often the commitment letter will outline many terms and conditions of the loan that may or may not be repeated in the loan agreement and other closing documents. If an attorney is going to be drafting the final loan documents, it may make sense for the attorney to also draft the commitment letter.

Professor Cohen: What are some of the provisions that should be included in a commitment letter?

Mr. Dolan: Although the contents may vary considerably, depending on on the type and complexity of the loan, most commitment letters should include the following:

1. Full, exact name of the borrower.

2. The dollar amount of the commitment.

3. Credit qualifications of the borrower (i.e. financial statement requirements, collateral, guarantors, provisions for periodic audits of the borrower's accounts receivable, inventories, or the like).
4. The interest rate and any applicable fees.

5. The purpose of the loan (e.g. short term working capital, fixed asset acquisition, purchase of real estate, etc.).

6. Terms pertaining to the repayment of the loan.

7. An expiration date of the commitment. Often lenders have a short "open" period to "encourage" a borrower to act quickly and reduce the "shopping" possibility. Of course, the time before the commitment expires is also affected by the number of conditions which must be met before the loan can close and the time that performance thereof might take.

8. A clause stating that the commitment letter supercedes all prior agreements, written or oral, and can only be modified in a writing that is accepted by both parties.

9. As I noted before, a clause spelling out that one of the conditions to the loan is the preparation and signing of formal loan documents that are satisfactory in both form and content to lender's counsel.

10. A clear statement about how any legal expenses will be allocated and paid.

11. Appropriate space for the borrower to execute the commitment letter and to indicate the acceptance date.

Professor Cohen: One frequently hears about bank letters of intent as well as about bank commitment letters. Are these terms interchangeable?

Mr. Dolan: Letters of intent in a lending context are different from commitment letters. Letters of intent are primarily marketing letters and are sometimes called "Proposal Letters" or "Letters of Interest." Commitment letters, on the other hand, are viewed as outlines of a proposed financing arrangement that is about to close.

Professor Cohen: Is this a distinction without substance?

Mr. Dolan: Let me explain it in a different way. Letters of intent set forth the terms which a lender will consider in analyzing and establishing a lending relationship. This emphasizes the marketing function of the document. In other words, the letter of intent is issued prior to any approval of the proposed loan, whether final or interim, and is intended to solidify the prospective borrower's interest in working with the lender by giving the borrower assurances that the lender is actively engaged in the underwriting process.

Professor Cohen: If letters of intent are issued at a pre-approval stage, it would seem that the bank must be extraordinarily careful of the wording used by the lending officer to ensure that it is not viewed by courts as a commitment to lend.

Mr. Dolan: You are absolutely correct. Great care must be taken to ensure that the letter of intent makes it clear that there is no obligation on the part of the lender to make the loan.

Professor Cohen: Earlier, you told us that commitment letters could not be issued by a lending officer unless he or she had the approval of any other officers, committees, or departments of the bank that would be necessary to approve the loan itself. Does the same requirement exist with respect to letters of intent or may they be issued by the loan officer even when committee approval, for example, would be required for issuance of a commitment letter?

Mr. Dolan: Since the letter of intent is primarily a marketing document, it may be issued by the loan officer in the absence of any other approvals.

Professor Cohen: And do I correctly recall your indicating that commitment letters could contain conditions other than the condition that it sign and be bound by formal loan documents that are satisfactory to the lender's attorney?

Mr. Dolan: Yes.

Professor Cohen: Then why not dispense with letters of intent and simply add more conditions to the commitment letter? That way, there will be one document only and the bank won't be running the risk that a letter of intent will be treated by a court as a commitment letter.

Mr. Dolan: Letters of intent are issued purely for business reasons. Commitment letters generally require the bank to know the conditions that must be met in order for the loan to occur. In large and complex financing transactions, it may take a relatively long period of time before the bank can acquire the information it needs to identify the conditions to a loan closing. The borrower may simply insist on some indication of the bank's seriousness -- possibly in order to satisfy its board of directors, or other companies with which it may be seeking to do business or seeking to engage in some joint venture. The letter of intent, even when all parties fully understand that it has no binding effect, meets this purpose.

However, most competent loan officers are aware of the caution flag you are raising. Accordingly, the practice in my bank is to include a boldface disclaimer on each page of the letter of intent and all attachments thereto to the effect that the letter is not to be considered as a commitment and that the underwriting process has not been completed. Note that the letter of intent should not contain any wording that would (1) lead the borrower to believe that the lender will provide the requested financing, and (2) cause the borrower to discontinue pursuing other alternatives because it was under the expectation that the loan was a sure thing.

Professor Cohen: For purposes of clarity, how might you summarize the differences between the commitment letter and a letter of intent?

Mr. Dolan: I have put together the following simple chart which, I believe, highlights the major differences.

Letter of Intent Commitment Letter

Primary Purpose Marketing Legal Obligation

Conditional Yes Yes (to protect lender)

Legal Review Desirable Yes (complex deals)

Legally Binding No (yes, if flawed) Yes

Fee Paid No Yes, preferably

Expiration Not Applicable Yes

Full Terms No (strictly proposed) Most

Borrower's Concurrence No Yes

Acceptance No Yes

As one would expect, letters of intent and commitment letters may be either simple or extremely complex. For example, a letter of intent may merely state that the lender is considering a loan application from the prospective borrower. Or, at the other end of the spectrum, a commitment letter may establish each of the terms and conditions which will be incorporated in the loan documents.

Regardless of the provisions contained in either a commitment letter or letter of intent, all terms should be clear and unambiguous.

Professor Cohen: Thayer, I'd like to thank you for addressing our Association and hope that you'll return and talk to us about other commercial lending matters.