United States: Dealing With A Troubled Loan In Today´s Environment: Strategies And Tactics For The Traditional Lender

Jacen Dinoff is Vice President of Buccino & Associates, Inc.

This article was originally published in the September/October 2007 issue of The Secured Lender. © CSI Financial Services.

Lending is increasingly a different business. The presence of hedge funds and other specialized lenders in what was once the exclusive domain of traditional banks has increased competition on the front end and, on the back end, has given the traditional bank an exit strategy from a troubled loan that previously did not exist. The presence of these new players, along with changes in the Bankruptcy Code, has caused workouts and restructurings to become much more complex. It is increasingly common for a "lender" to provide capital into a company with the trappings of an equity infusion. Indeed, the primary motive of the lender may have nothing to do with earning its living as a lender, but rather in employing a "loan-to-own" strategy.

Thoughts shared here are intended for the more traditional lender, who, from time to time will be faced with the difficult situation of having to deal with a troubled loan. When this happens, what do you do? Whom do you call? What do you say? How do you recover the principal loan balance, or at least as much of it as you can?

Strategy must be quickly developed and executed to minimize any ongoing diminution of collateral and to maximize the recovery on the loan. Yet, at the same time, actions taken should not be inappropriately detrimental to the borrower’s other stakeholders. If for no other reason than the lender is often viewed as a "deep pocket" by other creditors, who sometimes will recover little to nothing on the debts owed by the company unless they expand their targets of potential recovery to include the lender. Any business strategy should be approached with an informed understanding of the overall legal landscape from all parties’ perspective to understand their drivers and to plan accordingly.

Problem loans

A loan, sometimes referred to as a "credit" in the loan portfolio, is given a coding referred to as "credit status." The terms may vary at each institution, but many contain terminology equivalent with "good," "watch" and "workout". In some instances, the loan has been in "watch" status shortly after the bank made the loan. This is common with specialty lending areas at banks, typically labeled as "business credit," "bank name capital" or niche focus such as "retail finance" for borrowers that may be shutting down facilities while under Chapter 11 protection. With compe by tition in the marketplace accelerated, many traditional lenders are expanding their portfolios to include such transactions.

Bank lenders generally deal with troubled loans in their portfolio in one of two ways: the loan may be moved into a troubled loan department or the designated party at the bank, who has been the loan portfolio manager, may continue to handle activity with the borrower even after an internal change is noted in the "credit status" with the bank.

In either situation, the steps taken with a troubled loan are fairly similar. In many cases, the loan is not rotated to troubled loan status quickly enough. A loan can stay in watch status for many months, but, unless attention is brought to the ongoing issues, it may not be visible enough to those at the lending institution charged with solutions. For a loan that is not in watch status at inception, a loan covenant default changes its status in the loan portfolio and draws attention and appropriate actions by the lender. A loan covenant is commonly "tripped" due to financial statement results, amounts of borrowings or based on preliminary sales results.

For these types of defaults, the lender may be willing to draft multiple forbearance agreements with the company, allowing for the covenant defaults. It is at this point that outside advisors often first arrive to the scene. Upon default and forbearance, lenders can, and usually do, require that a company retain the services of a financial and management consultant to advise on the viability of the company and/or offer the lender a general perspective on the company. Lenders typically have past experience with a number of such firms and will prefer that one of those firms be retained.

To limit potential lender liability, the lender should recommend several firms for the company to consider retaining. It is worth noting that the financial advisor may take a management role at the company at the owner/board’s request to empower them to cut through internal corporate red tape and identify and implement solutions to troubled situations. It is also at this time that the borrower typically engages legal counsel if it has not already done so.

The forbearance is usually in the form of an amendment to the loan agreement and allows the lender to redefine the loan covenants. However, if default by the borrower is not on loan covenants but due to violation of the agreement, such as failure to audit books and records or inappropriate use of collateralized assets, the lender may choose not to grant forbearance. Absent such wrongdoing, providing the company multiple forbearance opportunities may prove helpful in forestalling possible litigation.

Eventually, based on business performance, a decision needs to be made by the lender as to whether to continue lending to a company. At the same time, the company management may be considering whether to continue operations. In some instances, the proper business strategy may be to try to save the company. Broken balance sheets can be fixed if there is sufficient consensus among the parties at the various levels of the company’s capital structure. Flawed business models can, in many instances, be improved. To avoid lender liability, the lender should refrain from making comments on the viability of the company or as to whether it should reorganize or liquidate. Those decisions must be left to company management and recommendations left to the financial advisor and should not reflect the influence of the lender.

A troubled company may need cash infusions to continue operating for a period of time until the decision of reorganization versus wind-down is made. Although as the current lender, you may prefer that the company obtain a new lender, it is possible that no other lender is willing to step into the situation. The current lender may find that it will need to maintain its funding in order to preserve the collateral and maximize recoveries to itself and other creditors. Actions that are contrary may even lead to litigation risk.

The lender’s alternative

Selling the loan: Typically, lender agreements allow for the transfer of a loan from one institution to another. It is not uncommon for lenders to trade blocks of loan agreements, bundling portfolio transactions at various stages. While doing so does not mitigate potential litigation exposure, it does allow for "cashing out" of a loan. Force a quick sale or work with the debtor on a longer sale process: Using consistent covenant defaults as a basis, a lender may request that the financial consultants prepare a report recommending a next course of action. If there is a question about viability of the business, the lender may choose to accelerate the loan as payable in full by a certain date. If the company is unable to find a new lender by the deadline, the company may find itself liquidating the lender’s collateral (company assets) to pay the loan. Loan agreements typically grant the lender empowerment in the decision process of liquidation. However, the company can table such demands through the automatic stay provisions in a Chapter 11 filing, though the company is not limited to using Chapter 11 as a vehicle of protection. The lender should be aware of the multitude of solutions available to the company. Included below are several such solutions including state law dissolution, assignment for the benefit of creditors, receiverships and bankruptcy protection under Chapter 7 and Chapter 11.

In many cases, a straight dissolution is a simple, quick and inexpensive method for an insolvent company to pay its creditors as much as possible. However, it is not the preferred method where a going-concern sale is feasible or where there may be significant bankruptcy causes of action to pursue for the benefit of the operating stakeholders. Also, this out-of-court option runs the constant risk that the company’s creditors may file an involuntary bankruptcy petition against it, which can be quite damaging. If the court determines that the company belongs in bankruptcy, there is a presumption that the proceedings will be held in the court where the involuntary petition was filed. This deprives the company of the various legal and practical advantages that it might otherwise have obtained if it had the opportunity to choose its own venue for filing.

With respect to the distribution of assets, state law usually provides that, upon the winding down of the company, the assets shall be distributed as follows:

• To the subsidiary’s creditors in satisfaction of the subsidiary’s liabilities (secured lenders are paid the collected proceeds for the sale of said assets);
• To the establishment of a reserve which the liquidating trustee may deem necessary for contingent or unforeseen liabilities; and
• Thereafter, to the shareholders.

In cases where there are insufficient assets to pay all creditors’ claims in full, claims will be paid according to their priority and ratability to the extent assets are available (much like in bankruptcy). A composition agreement, whereby creditors agree to accept a certain distribution in full satisfaction of their outstanding claims, may be employed in conjunction with a dissolution or standalone. A composition agreement can also contain a provision prohibiting individuals from commencing an involuntary bankruptcy proceeding against the company. Viewed most simply, a composition agreement is simply a contract between the debtor and a single creditor. Debtors will sometimes send composition agreements to each of their creditors that include, as a precondition to the company’s obligation hereunder, that a certain preset percentage of the debtor’s creditors and claims accept the composition in order for such agreement to be binding (in a manner similar to an exchange offer). The lender may find itself in a position where it is in their best interest to fund the composition settlement to avoid potential litigation exposure.

Another popular dissolution alternative is an assignment for the benefit of creditors. A vast majority of states provide for this alternative to a federal bankruptcy filing, either by statute, common law or both. An assignment for the benefit of creditors is a voluntary insolvency process in which the insolvent company (aka, the "debtor" or "assignor") assigns all its property to a designated assignee for liquidation. The assignee then liquidates the property and distributes the assets to the company’s creditors in accordance with certain procedures and priorities.

The process varies from state to state. Less favorable schemes treat the process much like a probate estate. Other states offer a more streamlined process. In addition, certain states do not require that the assignee be local or domiciled within the state. Upon liquidation, claims are paid substantially the same priority as such would be paid pursuant to the applicable provisions of the U.S. Bankruptcy Code. Instead of the Bankruptcy Code however, the priority scheme is usually enumerated by state law and/or in a composition agreement formulated by the assignor and assignee, subject to certain specific statutory mandates with respect to the priority of claims. Similar to a trustee in bankruptcy, an assignee has standing to prosecute and defend claims on behalf of and against the debtor/assignor. Included among these claims are state law versions of preference and fraudulent transfer avoidance actions. One additional advantage of an assignment over a straight dissolution is that, although creditors may still file an involuntary bankruptcy petition against the debtor, a bankruptcy court is more likely to abstain from exercising jurisdiction where there is a pre-existing assignment for the benefit of creditors in process.

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.