By: Devin Lawton Palmer, Esq.
As one might expect, our firm has recently witnessed more and more beleaguered businesses waiting in the lobby for consultation on their mounting debt and cash flow shortage. Unfortunately, only the lucky few have been offered the ear of Congress for multi-million dollar bailouts. For the rest, the current financial climate is not a pleasant one. Many of the small companies in our community are quickly finding it increasingly difficult to survive in their under-capitalized, illiquid state.
The client’s inquiry normally begins with the possibility of a Chapter 11 bankruptcy reorganization. Chapter 11 certainly offers a variety of benefits to a distressed business, including time to assess and restructure, a stay on any outstanding litigation and enforcement, elimination of unsecured creditors at a reduced rate, and termination of unprofitable leases. Because of these debt shedding resources, a company’s secured lender may actually promote a bankruptcy filing.
In some cases, however, the client’s most pressing issue is the secured lender itself, due to a pending or current default. For all of a Chapter 11’s benefits, dealing with a secured creditor is not necessarily one of them. In all likelihood, a bankruptcy would just serve as an expensive arena in which to undertake the same negotiations that could be had outside of the federal courthouse. Instead, a more advantageous and cost-effective solution might be a voluntary workout with the lender.
In a workout the borrower requests that the bank offer both time for the business to address its financial condition and assistance through some type of loan modification. A secured lender may lower interest rates, extend loan terms, offer a period of interest only payments, increase lines of credit, or forbear from any pending foreclosure.
Again, as one might expect, recent reports suggest that requests for workouts have nearly tripled under the weight of the current downturn – recession – depression –economic Armageddon. But why would a lender be willing to agree to this?
Numerous factors are in play in a lender’s decision to entertain a workout, including whether the borrower has a sustainable core business, the value of its collateral, current cash flow, strength of management, status of the industry, and effects of a possible Chapter 11.
All of these factors, however, can just as easily be streamlined under the guiding principal of all lending institutions – maximize recovery and minimize loss. A bank is not interested in losing money any more than you are. While a lender has a right to foreclose on its security interest, it faces the obvious question of whether the sale of that collateral will actually result in a better recovery than working with the borrower to reinstate payments on the loan. Moreover, in today’s declining market the value of collateralized equipment, inventory, and real estate at a foreclosure sale often renders a reasonable workout a more palpable alternative to immediate liquidation.
Under this backdrop, borrowers seeking a workout need to persuade the lender of three things: (1) the financial problem is temporary; (2) it has the ability to implement a solution; and (3) allowing for the restructuring is in the bank’s best interest to minimize its own loss.
Before making this pitch, it is imperative that the borrower first prepare itself by honestly assessing the validity of its business. Not only is it necessary to understand whether the business is worth restructuring, but the bank will require a clear and accurate picture of the borrower’s financial status going forward. In addition to in-house number crunching and the possible engagement of a financial consultant, going-concern and liquidation appraisals are an effective means of illustrating to the lender the risk if the business simply shuts its doors and forces a foreclosure sale.
Even if this review proves the business’ cash flow problems are uncorrectable, it may still be in the company’s best interest to work with the lender to ensure that the bank maximizes its return on assets – thus reducing the liability on any existing guarantees. Active cooperation will also alleviate the lender’s (or any other creditor’s) fear of possible fraudulent conveyances or hidden assets.
Second on the agenda – seek legal advice. While this may sound like a shameless plug, experienced legal counsel can, among other things, better position the borrower in negotiating an acceptable workout. A sophisticated attorney brings knowledge and experience to the negotiating table. Legal representation also sends a message to the lender that the client has thoroughly explored its legal options and is prepared to litigate or file for bankruptcy relief if necessary. Banks are fully aware that these alternatives will be more time-consuming and costly, and only further depreciate the value of its collateral.
In addition, an attorney’s review of lending documents and guarantees might expose defects that open the lender to legitimate defenses or counterclaims in future litigation. A similar review of the bank’s UCC filings may reveal that the collateral was not properly secured, or its perfection was delayed to a point that it can be avoided as a preference in bankruptcy. Obviously, if the loan is not properly documented or adequately secured a lender will be more apt to work with the borrower than rush to the courthouse.
Finally, before initiating these negotiations, borrowers must be aware that workouts do not come without a cost. Lenders have the right to review the company’s books and records, undertake appraisals, hire legal counsel, accountants, and financial consultants – all of which are expenses passed along to the borrower through the terms of its loan agreement. Distressed businesses may also be asked to pledge any remaining unencumbered assets and additional guarantees. Despite its necessity, by entering into a forbearance agreement the borrower often releases the lender of potential liability, acknowledges its default and the enforceability of the loan documents, and waives various legal rights.
Regardless of these costs, the benefits associated with a workout may prove it to be option “A” for many distressed businesses seeking to survive during today’s economic climate.
Devin Palmer is a Senior Associate in the Creditor’s Rights Group at Boylan Code, LLP, concentrating his practice on bankruptcy and commercial collections. For more information, please call (585) 232-5300 or visit www.boylancode.com
This article was republished with the permission of the Rochester Business Journal.