Best Practices for Fund Document Diligence in Fund Financing Transactions

By Anastasia N. Kaup and Melissa A. Sharp

It is critically important, for both lenders and borrowers, to confirm that the borrower is actually authorized to enter into a financing transaction, borrow money, and pledge assets as security for those obligations (if the financing is secured).  If a borrower (entity) acts without express legal authority or beyond the stated scope of authority in its charter, operating agreement, or offering documents (collectively, the “Fund Documents”), the entity may be sued by its investors, the transaction may be voided by a court, the lender may suffer a loss, and/or other negative consequences may result. 

Recently, we represented a lender to a mature investment fund that sought to enter into a subscription credit facility. In the course of diligence, we found that the borrower’s operating agreement authorized it to enter into a financing transaction, incur debt, and pledge its assets as security, while the borrower’s offering documents expressly prohibited the same.  Given the conflicting Fund Documents, the lender required that the borrower supplement and correct its offering memorandum prior to closing the financing.  This required the borrower to expend significant time, money, and effort, and delayed the financing closing.

We suggest the following as best practices for diligencing Fund Documents in fund financing transactions:

      • Review the borrower’s Fund Documents as early as possible in the transaction.
      • Confirm that each of the Fund Documents permit all aspects of the proposed financing.
      • Once confirmed, take note of any limitations/additional requirements (e.g. limits on debt, repayment requirements, special approval requirements, etc.).
      • Ensure none of the Fund Documents conflict with each other with respect to the proposed financing.
      • If there is a lack of clear authority or conflicting authority, coordinate to amend the Fund Documents or issue a supplement to the fund’s offering materials, as applicable, to clarify or resolve the conflict.

Our situation involved an already established fund borrower, but the same considerations apply to new borrowers.  It is much easier and cheaper to build in the necessary language and flexibility in Fund Documents up front, than to amend or supplement the Fund Documents later (particularly if the consent of numerous investors is required for amendments). Finally, it is better to have explicit authorization for the financing in the Fund Documents than silence or ambiguity on the topic.  Explicit authorization gives notice and comfort to all parties (lenders, funds, and investors) that the fund may enter into the financing, the terms are approved, and the financing will be enforceable.

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