Lenders are nervous. Despite long-term institutional relationships with customers, many banks are seeking to reduce financial exposure to borrowers because of uncertainty in the current economic environment. This has been especially so with vendors to the retail, hospitality, and travel industries, many of which have suffered tremendous losses in 2020.
Borrowers should not be surprised when their lender requests a “checkup,” financial review, or audit. It should be anticipated that the lender may become stricter in its interpretation of covenants: there may be less forgiveness or flexibility than in the past for reduced profitability or losses that management firmly believes are temporary. Long-term relationships mean less.
Borrowers should anticipate the questions likely to be asked by their lenders and prepare appropriate responses in advance that will give the lender comfort that it should be patient and not become more restrictive.
Creating an “Action Plan”
If the borrower has experienced declining sales or losses, it must demonstrate that it has a well-developed turnaround plan which is already being implemented. This includes reducing unnecessary expenses, cutting payroll, bringing books and records up to date, remediating accounting deficiencies, aggressively collecting accounts receivable, replacing lost customers with new customers, and taking the steps to assure that the business is competitive in the changing marketplace.
This “action plan” can be a key indication of the borrower’s determination to conserve assets and mitigate any further losses. Thus, the lender has the justification for continued support of the borrower.
Lenders will scrutinize accounts receivable closely because they are a principal form of collateral. Lenders view aging accounts receivable as a devaluation of their borrowing base and may respond by reducing the advance rate or modifying the definition of eligible receivables.
If receivables have aged out, a borrower should be prepared to explain efforts to bring them current — commencement of litigation, retention of a collection agency, suspension of shipments, or reduction of the credit line. The bank will be critical of customers that are slow payers which continue to receive trade credit. If necessary, the borrower should be prepared to justify its leniency towards late receivables.
A lender is likely to request financial projections that demonstrate that the lender will be adequately collateralized despite the borrower’s temporary difficulties. It is often requested by the lender that a third party, such as a turnaround or financial advisory firm, assist management in the preparation of the projections. This provides reassurance to the lender that the projections were prepared by someone who is able to see the forest for the trees and who is not jaded by closeness to the situation. A fresh face often is able to cut additional expenses where management has not been able to do so. Lenders have greater confidence in third-party prepared projections than in the projections prepared internally by management.
Implications of Bankruptcy
A goal of a successful restructuring is to avoid bankruptcy. The best way to avoid bankruptcy is to understand the impact that it will have on all parties in interest — including the lender.
Bankruptcy is expensive. It causes a devaluation of collateral. Selling a business as a going concern in chapter 11 will bring forth scavengers and bargain hunters. Selling the business at a multiple of earnings as opposed to liquidation value is impossible in most instances. Going-concern value is difficult to achieve in bankruptcy.
It is important to validate to the lender that forbearance enables the borrower to generate greater recovery for the lender — which may include a replacement lender — than if the lender takes action that may precipitate the Chapter 11 filing. It is also important to prove the potential downside to the lender of excessively tightening the reigns on the borrower – an inability to find a replacement lender or forcing a chapter 11.
In liquidation, raw materials and work-in-process typically have nominal, if any, value. Depending upon the kind of finished goods produced, they also may have minimal liquidation value. Products sold to retailers may be more saleable than products sold to other manufacturers as components. But, most retailers are cutting back on purchases because of the uncertainty about having to close their stores again due to another potential wave of the pandemic. Vendors who supply to end-manufacturers also are anticipating declining purchases due to a recession.
Certain assets of the borrower that do not have material value on its balance sheet may nevertheless have much value as collateral. A prime example is intellectual property, including customer lists, patents, and registered trademarks. Those assets may have dramatically increased in value since the inception of the loan. This incremental value should be acknowledged in establishing the “price” of the bank’s forbearance. The retention of a valuation consultant may be worthwhile to support a greater worth of assets.
Lenders represented by sophisticated insolvency counsel are aware that in bankruptcy there is likely to be much delay in the bank’s ability to obtain possession of its collateral. Further, the bank may be forced to fund losses for a period of time because bankruptcy judges are loath to shut down a debtor’s business too early and typically rule in favor of preserving jobs. Further, in most Chapter 11s, a committee of unsecured creditors will be appointed whose mission is to extract money from the bank.
Utilizing Collateral in Exchange for Forbearance
Lenders are more likely to be cooperative if additional collateral is being offered to it in exchange for forbearance. Alternatively, the guarantee by the principal of a debtor/borrower can be offered (if not already in place). However, the length of the forbearance period should be sufficient to achieve the borrower’s goals. Too short a forbearance period will enable the lender to repeatedly ask for more collateral every time that the forbearance period expires.
The savvy borrower will negotiate at the onset the price of additional forbearance time periods which may be required provided that the lender’s collateral position has not materially eroded during the interim. If additional security is being provided in the form of collateral provided by a third party — such as a shareholder — the safest means of doing so is for the third party to acquire a “last out” position in the lender’s existing loan facility rather than the third party making a new, subordinate loan to the borrower. This reduces the likelihood of a creditors’ committee attack in the event of bankruptcy.
Prior to embarking upon negotiations with the secured creditor or bank, it is imperative to review all of the loan documentation and to analyze whether the lender has a valid and perfected security interest in all of the assets described in the security agreement. In the event of an error or omission, forbearance may be the price that the lender must “pay” for a cure.
Kenneth A. Rosen is chair of the bankruptcy department at Lowenstein Sandler LLP.