The economic boom that started in 2003 and continued through 2007 was an ideal time for corporate borrowers to increase leverage and take advantage of historically low interest rates. Many of the loans entered into during that period are coming due in the next two years. The financial turmoil sparked by the subprime debt crisis in late 2008 has made it difficult for many corporate borrowers to repay loans on the terms originally agreed to. Never has the need been greater for legal advisors to assist their clients in negotiating the restructuring and modification of troubled loans.

Good Communication Is the Key

Effective negotiation does not take place in a vacuum. Good communication between the borrower and lender forms the foundation that makes effective negotiation possible.

Credit finance attorneys often encounter scenarios like the following: A client, Acme, calls with an urgent question. It just received a letter from its largest customer giving 90 days' notice of the customer's intent to terminate its supply agreement with Acme. Unless Acme is able to replace the customer with another customer within the next three months, it will not have the revenue to meet required debt service on its loan from Bank. The CFO of Acme has looked at the Bank loan documents and has concluded that no provision specifically requires Acme to report the notice of termination of the supply agreement to the Bank. The CFO believes that Acme still has time to find a replacement customer and that, even if general material adverse effect language in the loan documents might require Acme to give notice of this event, Acme should wait as long as the loan documents permit before reporting it. The CFO would like counsel to Acme to quickly review the loan documents and confirm his judgment.

What should the attorney counsel the client to do?

The attorney should advise Acme to report the notice of termination of the supply agreement to Bank promptly, whether or not the loan documents clearly require it.

The benefits to the borrower of open and prompt communication are numerous. When the bank perceives that the borrower is striving to be open and candid, the borrower's credibility and the bank's level of trust in the borrower both increase. The bank's perceived risk of loss on the loan is reduced, making it more likely that the bank will grant concessions to the borrower to facilitate restructuring of the loan. The bank will have the flexibility to deal constructively with the loan in a way that might not be possible at a later time. Finally, the bank will be less likely to seek strict enforcement of the loan documents and take immediate action to protect its own interests and possibly cause irreversible damage to the borrower.

Counsel should encourage borrowers to promptly report events that are material to their ability to repay a loan on the terms agreed to, such as (i) a material increase in the cost of raw materials and other inputs, (ii) a material drop in the price of finished products and other outputs, (iii) a material drop in the demand for finished products and other outputs, (iv) threats of material litigation and (v) anticipated breaches of material contracts by the borrower itself or counterparties.

Lawyers should advise their clients to make a special effort at maintaining open and prompt communication where the nature of a loan or the collateral does not require frequent reporting to the bank. For example, if the loan is secured by equipment or intellectual property, the only periodic reporting required under the loan documents may be quarterly financial statements, and an extra effort should be made to keep the bank in the loop. Where frequent reporting of collateral is required, such as a loan secured by accounts and inventory, this is less of an issue.

How Banks View the World

When negotiating with banks, it is helpful to understand how they view the world. Banks typically have three overarching goals when dealing with loans.

First, the bank wants to keep its loan in "performing status." This means that (i) all payments required by the loan documents are being made on time, (ii) there are no outstanding events of default and (iii) there is adequate collateral to allow the bank to obtain repayment.

Second, the bank wants to receive at least a market rate of return on its loan. The market rate of return on a loan is determined in part by the bank's perceived risk of loss. As the loan is perceived as being riskier, the bank's expected rate of return will tend to increase. The market rate is generally determined by bank policy and not the loan officer handling the loan.

Third, the bank wants a realistic exit strategy for full repayment of the loan, based on reasonable assumptions and projections that are supported by data. The exit strategy may include the refinancing of the loan by another lender.

How Banks Analyze Loans

When analyzing a particular loan and when considering a loan modification, most banks want answers to the following four questions: (i) Is the borrower still fundamentally sound as a credit risk in the long run? (ii) Will the loan require a total restructuring or just some tweaking? (iii) Will the bank ultimately see a larger repayment on the loan by calling it now or by granting concessions? and (iv) What concessions will the bank need to make in order to see successful repayment of the loan?

Counsel to a borrower seeking to restructure a loan should carefully consider these questions with the borrower and be prepared to give thoughtful answers to the bank.

Know Before You Go—What the Bank Is Likely to Require

In any negotiation with a bank to restructure a loan, it is helpful for counsel to the borrower to know in advance what the bank may ask its borrower to do in exchange for granting concessions on the loan.

First, banks will almost always require increased access to the borrower's financial information. This will often take the form of more frequent delivery of (i) borrower financial statements, (ii) accounts receivable aging reports, (iii) asset appraisals and valuations, and (iv) financial projections and supporting data.

Second, to the extent the bank believes that repayment of the loan has become riskier, it will explore the option of requiring more credit support for the loan. The bank will want to know if the borrower has any additional collateral to support the loan. The bank may be willing to accept a second position on additional collateral if there would be excess collateral after fully paying off the first position lender. Offering additional collateral will be viewed very positively by the bank.

Borrowers often have no additional collateral lying around. In that event, the bank will want to explore additional ways to enhance the credit support for the loan, such as the following: (i) requiring one or more letters of credit, (ii) requiring that the borrower's parent or subsidiaries provide guarantees, (iii) requesting that the borrower's principals provide personal guarantees, (iv) requiring that investors provide an infusion of new capital for the borrower on terms approved in advance by the bank, and (v) requesting that other stakeholders (e.g., investors, principals, vendors) provide additional subordinated loans to the borrower.

Third, the bank may request that the borrower make additional payments of principal. These payments are often called "mandatory prepayments." They may take the form of specific amounts at specific times (e.g., $1 million in additional principal to be paid on or before December 31 of each year) or may be in the form of a periodic "cash sweep" of a certain amount of excess cash of the borrower, as calculated based on a formula. The bank may also require that the borrower pay over "extraordinary revenue" generated by any activity that is not in the ordinary course of business. This may include revenue generated by (i) the sale of assets that will not be replaced, (ii) the sale of company stock to investors, and (iii) the receipt of insurance payments for property loss to the extent such property will not be replaced.

Knowing that the bank may make such requests can be a scary proposition for any borrower and may discourage the borrower from communicating with the bank in the hope that the bank won't come calling for additional payments. Counsel should advise the borrower that open communication with the bank will ultimately result in the bank asking for fewer concessions. Not communicating with the bank, on the other hand, will only increase its perceived risk of loss on the loan and the likelihood that it will take draconian measures, perhaps even calling the loan and shutting down the borrower entirely.

The Borrower's Story

Counsel to the borrower should help the borrower formulate its "story" prior to approaching its lender to restructure a loan. To be successful in negotiating a favorable restructuring of its loan, the borrower's story will need to address two important elements.

First, the borrower should take ownership of the loan problems. The borrower should identify the specific issues that have caused its financial difficulty and take full responsibility for allowing them to result in a troubled loan situation. Second, the borrower should propose a reasonable and workable solution to deal with the issues identified, allowing it to return to financial health while keeping the loan in performing status.

Following these two steps at the outset of negotiations will earn the borrower instant credibility and respect in the eyes of the lender and pave the way for a successful restructuring of the loan. Simply blaming the loan problems on the "economic downturn" and throwing up one's hands in despair will almost certainly cause the lender to question the viability of the loan and could be disastrous to the borrower.

Counsel should take the time to help the borrower work through these two elements of its story in a thorough manner. Often a borrower will gloss over these issues, hoping that the bank will understand the borrower's difficulty with little explanation. Lenders are seldom so magnanimous, and for good reason. In order to grant concessions, the lender needs some basis upon which to conclude that the borrower will be able to work out the loan problems. Seeing the borrower take ownership of its financial difficulties will give the lender the comfort it needs to continue working toward a successful restructuring of the loan.

After the foundation for negotiations has been laid, the borrower should carefully address each of the questions in the section above titled "How Banks Analyze Loans." The bank will have already done its own analysis of these issues and will be interested to hear the borrower's perspective.

Useful Tools for the Borrower

As the borrower negotiates with the bank, counsel should help it keep in mind a few useful factors that will keep the process moving forward.

  • Riskiness. The borrower needs to understand that the bank is constantly weighing the risk of non-repayment of the loan. Accordingly, the borrower should demonstrate that the concessions it is requesting will not increase this risk.
  • Facts and Figures. To the extent possible, the borrower should use hard data to back up its projections and assertions.
  • Relationship-building. Most importantly, the borrower should avoid the temptation to become hostile to the bank.

Counsel can be particularly helpful on this third point by assisting the borrower to know whether or not the bank is asking for "market" terms. Often a borrower will become hostile to its bank when faced with demands that are standard in the financial industry. This leads the bank to view the borrower as unsophisticated in loan matters—and as a riskier prospect. The borrower is best served when counsel helps it identify which of the bank's demands are just standard market terms and which may be overreaching so that the borrower can push back where it is most productive and strategic to do so.

Analysis of the Loan Documents

It is absolutely critical that counsel to the borrower review all loan documents. Borrowers often urge their counsel to not spend much time reviewing them in an effort to save time and expense. Counsel should explain to the borrower that a review of the loan documents is essential to establish the negotiating position of the borrower.

Loan documents serve as protection for the bank. In reviewing the loan documents, counsel to the borrower is essentially looking for "chinks in the armor" that may work to the borrower's benefit. Here are a few examples of common issues found in loan documents that can increase the bargaining position of the borrower.

First, for secured loans, counsel should review the security agreement to determine whether it has a valid granting clause that actually grants a security interest and indicates the collateral and the obligations secured. Counsel should keep in mind that an "all assets" collateral description, while adequate for a UCC financing statement1, is not adequate for a security agreement2.

Second, counsel for the borrower should review all UCC financing statements to determine whether they state the name of the borrower (or other applicable debtor) correctly, are filed in the correct location and contain a valid collateral description.

Third, counsel to the borrower should carefully review the "course of dealing" followed by the lender in working with the borrower, with a view to identifying any such course of dealing that differs materially from the procedure set forth in the loan documents. Courts have held that a course of dealing can effectively amend a contract under certain limited circumstances.3 For example, a lender that has regularly accepted payments of principal or interest that are weeks or months late without declaring an event of default may find it difficult to immediately declare an event of default for a missed payment, decreasing to some degree the lender's bargaining position.

Loan Restructuring Options

Loans are typically restructured by means of an amendment to the loan agreement. Counsel should confirm that the loan amendment sets forth a list of all loan defaults and contains language waiving them. Failure to include this element in the amendment to the loan agreement may allow the lender to call the loan later based on prior defaults.

Counsel should familiarize the borrower on the most common ways of restructuring loans, including the following, which are listed in order of preference from the bank's perspective.

First, the maturity date of the loan can be extended. Most banks are willing to consider extending the maturity date of the loan so long as it has not already been extended multiple times in the past. This allows the bank to maintain the loan in performing status while giving the borrower some additional breathing room.

Second, banks are often willing to modify some or all of the financial covenants (such as a fixed charge coverage ratio or a minimum net worth covenant) contained in the loan documents. These covenants can be loosened permanently or for some shorter period of time. This approach also allows the bank to maintain the loan in performing status. The bank may insist on collecting a fee in exchange for agreeing to this concession.

Third, the borrower can request that principal payments be waived for some period of time and that it only be required to make interest payments during that period. This is most beneficial for a borrower with a loan that is close to maturity and where the principal component of its payments is relatively larger than the interest component.

Fourth, it is possible to bring in additional lenders to spread the risk of loss on the loan among more parties. The main lender may be willing to tap into its contacts for the purpose of identifying a lender willing to join the loan. Alternatively, the borrower may identify another lender willing to join. The additional lenders can join on an equal (or pari passu) basis, or on a subordinated basis.

Fifth, the borrower may request that no principal or interest payments be required for some period of time. Banks are unlikely to agree to such a proposal unless the period of deferral is short and the loan is adequately secured by collateral that will not lose its value over time. This puts the loan in non-performing status and will likely require the approval of the bank's credit committee.

Sixth, in extreme situations, the borrower may request that the bank forgive some portion of the principal or past-due interest. This is essentially asking the bank to take a loss on the loan and will be vigorously opposed by the bank unless the borrower can demonstrate that this approach will ultimately result in a larger recovery for the bank than simply calling the loan and foreclosing on the collateral. The borrower should keep in mind that this may result in taxable income in an amount equal to the debt that has been forgiven. The borrower should consult with its accountant on these matters.

Finally, the borrower may propose that some portion of the debt be converted to equity. Non-bank lenders are more likely to agree to this than traditional bank lenders. The borrower will need to demonstrate that it has good growth potential. The lender will likely insist on the right to require the borrower to buy the stock back at a pre-determined price, which will include a premium for the additional risk of the arrangement.

Footnotes

1. See Uniform Commercial Code § 9-504(2)

2. See Uniform Commercial Code § 9-108(c)

3. See, e.g., KBQ, Inc. v. E.I. DuPont de Nemours & Co., 6 F. Supp. 2d 94, 99 (D. Mass. 1998).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.