COMMERCIAL FINANCING – Part 3: Promissory Notes

Today, BPE Law Senior Attorney and Co-Manager, Keith Dunnagan, continues his multi-part series on obtaining and using Commercial Financing. BPE’s Transactional Business practice has been growing rapidly.

As always, if you have any questions about your business, real estate, estate planning, or any other legal issue, please let us know by e-mailing me at

by BPE Law Senior Attorney and Co-Manager, Keith Dunnagan

In the previous posts, we looked at sourcing funds to finance a project most commonly in a loan transaction. Once the lender is determined, the letter of commitment is executed and the lender completes its due diligence (this does take some time – I have personally been involved in transactions where the time between execution of the letter of commitment and execution of loan documents ran up close to one year). Commercial lenders are not necessarily quick to lend. They require an immense amount of due diligence. However, once that is done and the borrower is staring at the finish line, it becomes time to document the loan.

As with every loan, the loan agreement and promissory note are the backbone to the loan. The loan agreement is more or less the contract that provides all the pertinent background and terms. What is the purpose of the project funding; what definitions will be used for the particular loan transaction, what types of guarantees and securities will be required and what are the general events of default. The loan agreement more or less, in my opinion, almost acts as the executive summary of the entire loan package, although it is a perfectly enforceable contract on its own.

The more important document is the promissory note. This document identifies the relevant terms of the agreement, including repayment terms, payment restrictions, and obligations of the borrower.

While some commercial notes (in my experience very few) are fixed rate notes, most are variable rate notes. Almost all notes operate on a 2.5% margin tied to some index. It seems that one of the more prevalent indexes these days is the 2 year Treasury note rate, but other indexes include the LIBOR or the Wall Street Journal Prime Rate. Additionally, most commercial adjustable rate mortgages (“ARMs”) also maintain a rate floor and while I have seen rate floors at 4.5%, typically the floor will be somewhere around the 6% rate. It is important to understand your interest rate and how it adjusts as it directly relates to your payment and your debt service coverage ratios.

Once the rate structure is dealt with the question then becomes are there pre-payment penalties associated with the loan. The vast majority of commercial loans come with some sort of pre-payment penalty. While a lender may want its money back quickly on a residential loan, in the commercial world, the lender does not want its money back until a profit threshold from interest payments has been hit. Pre-payment penalties can take a few forms ranging from a lock-out period that prevents the borrower from repaying the loan for a period of time (California case law allows a borrower to repay the loan in advance even with the lock-out period, however, under that case law, the lender is entitled to collect all of the interest that would have accrued over the lock-out period) to time based pre-payment penalties. The most common is that for a fixed period of time a borrower cannot pre-pay the loan without paying some extra percentage based fee associated with that pre-payment. These types of pre-payments are not limited to just paying off the loan in full, it usually applies to any pre-payment of the principal within a certain period that exceeds 20% of the then outstanding principal. Borrowers have gotten more and more reluctant to accept these types of agreements so over the last couple of years we have seen sliding scale pre-payment penalties become more prevalent. A sliding scale pre-payment penalty starts by having the highest penalty early in the life of the loan and then over time scaling down the penalty until such pre-payment penalty phases out. It gives the lender a larger fee if paid off early in the loan and reduces the fee the longer the borrower carries the obligation. It is important to understand how your pre-payment penalty works as it can dictate how and when you may refinance your commercial loan.

The last important parts of the promissory note to understand are the negative and affirmative covenants. These are important to understand as they determine what a borrower is required to do under the loan and what they cannot do while the loan is outstanding. Some common affirmative covenants, i.e. actions required of the borrower, include providing tax returns and financial statements on an annual basis, providing and maintaining adequate insurance for the project, paying taxes on time, paying all of the bank’s charges and costs involved in the loan and curing any defects a lender may spot. They are generally wide open and whatever a lender can think of that it wants the borrower to do may become an affirmative covenant. Negative covenants are actions the borrower agrees not to take without causing a default and can include prohibitions against junior liens or encumbrances, dilution of business interests, or the filing of a voluntary or involuntary bankruptcy.

The covenants are important to understand as it sets the stage for a borrower must do, beyond simply paying the loan and also dictates what the borrower is prohibited from doing. Violations of these covenants can lead to a loan going into default even though the loan is timely paid each month.

Commercial notes are significantly more complex than your everyday run of the mill residential mortgage note. They place far more requirements and restrictions on a borrower and it is important to understand how these documents work and are enforced. The theme remains the same, the lenders have multiple attorneys working on their loans, you should have at least one competent lawyer working on your behalf.

BPE Law Senior Attorney and Co-Manager, Keith Dunnagan, practices exclusively in the area of commercial transactions and finance. If you have any questions, you can reach him at 916-966-2260 or

For over 20 years, the attorneys of BPE Law Group, P.C. have been advising and representing business and property owners and investors in dealing with their legal needs. Check us out on the Web at: If you would like a consultation with us, please call our office at (916) 966-2260 or e-mail Keith Dunnagan at the above link.

This article is not intended to be legal advice, lending advice, or a specific recommendation of any particular lender or company, and should not be taken as such advice.