What should a lender do when a commercial borrower defaults and a workout begins?

This piece is a primer for lenders on some of the early matters that may crop up in a workout, and for borrowers, on what to watch for in drafting docs so that they can try to prevent later issues. Troubled loans are challenges but also opportunities for whoever is handling them. For a business owner, the best way to be prepared for a workout is to familiarize yourself with what your lender will look at, what it can and can’t do, and what it may want in return. This is not a complete list of what can come up for lenders, nor a detailed how-to on steps in bankruptcy.

The Panicked Call to a Lender

The first time the workout actually begins for a borrower is usually the panicked call to a lender late in the day. Lenders can get nervous too, but it is important to stay engaged. Panic is not the answer. Listen. Sometimes, the borrower is seeking one thing, but that is only a symptom of another problem. Learn what it is. First: figure out if there is actually a default, and what caused it. A broken covenant, a missed payroll or debt service payment, or a pandemic shutdown can all lead to problems for a borrower. Then, think about whether a short-term waiver or amendment will get you past the immediate problem, or whether a full restructuring or even bankruptcy is a better option. Or forbearance, which does not erase a default, but has the lender agree to wait while the borrower fixes it. What about government money? You don’t want to say yes without knowing. But you also don’t want to say no because you don’t know yet. Understanding the problem and how the borrower is asking for help is key.

Any lender who is asked for a workout should know how the loan documents actually work. Different deal structures will sometimes excuse funding based on things like whether the default is mature or unmature, grace and cure periods, or equity cure rights. If your documents have grace or cure periods, make sure a default really exists. With an asset-based deal, it may be worth checking the borrowing base calculation, reserves and reporting requirements. “In default, do not fund” is not always the rule. There may also be situations where it is a good idea to lend money in default to protect the collateral or save the business. Cutting off your commitments may be premature.

As soon as you know there is a default, send a reservation of rights letter in response. You should use the formal letter to name the default, make it clear that you are reserving your rights and may act or choose not to act at your discretion. Then you’ll have kept the door open without cutting yourself off. Workouts often work out, and not many lenders and borrowers are eager to pull the trigger. Don’t make any fast, uninformed decisions. For example, certain laws limit lenders from acting, such as required employee notice of plant closings and mass layoffs. Reckless actions can lead to lender-liability claims.

Reviewing the File

Next, review the file. What kind of financing is it? Is there any obligation to fund additional money? Is it a true and correct copy of the loan agreement? Is the loan agreement actually signed? Have post-closing items been completed? In the last strong credit cycle, many lender protections were eliminated or compromised. So it is a good idea for you as the lender to look into exactly how unrestricted any subsidiaries are. Or, for example, any excluded assets that are carved out of collateral. Or that a net debt provision is distorting the leverage. Or that a default blocker is missing some sort of investment, or asset sale, or some kind of restricted payment. Borrowers may have more room to wiggle in default than you know. These questions are not meant to be a checklist for lenders to use, only a prompt to think about some of the nuances of the documents that can be at play when a workout begins.

Before you do anything, a good step is also to make a quick review of your collateral. After everyone signs the loan documents and walks away from the closing table, the last thing anyone wants to think about is whether the collateral actually secures the loan. Does the grant clause cover the Article 9 categories? Were the UCCs filed in the right places? Are the accounts for cash or securities governed by the right form of control? Do you hold any federal filings? Like for intellectual property. Or FAA and International Registry, for aircraft engines. Or for ships. Was a mortgage or deed of trust recorded? And what about the insurance? Are you an additional insured? Did you get a lender loss payable endorsement? A missing filing, control agreement or loss payable endorsement can leave a hole in the file. It is one thing to find out a bit late, but before heading into a workout, it is better to get it early, so you can find a remedy before signing a new deal.

Know what your rights are and requirements are before you begin. How much notice do you need to give for an event of default? What does lender vote have to be to change a deal? Whether that is a shorter notice period, a high lender vote threshold, or anything else, the documents determine the game plan. In exchange for concessions, you may be able to get a better position by negotiating more collateral or guarantees, or adding to the number of obligations that are secured, or including limits on value reducing actions. However, preference and fraudulent conveyance risks in bankruptcy and other debt deals may limit any fix-ups.

Before you start thinking about that event of default, confirm who owes what. Obligations may include more than principal, interest and fees; for instance, treasury management and derivatives. Guarantees may be capped or trigger only by specific defaults. Intercreditor agreements also can create restrictions. Cross-border loans also have foreign law and tax concerns, and care needs to be taken to comply with the foreign law and understand U.S. tax risks. The bottom line is that a lender should not assume that the event of default gives them the right to enforce on all their obligors and guarantors; first, check the terms.

Borrowers and lenders who piled in on deals after the last recession are finding themselves dealing with each others’ rights and obligations under shared lien, second-lien and cross-over structures. ABL lenders are typically first on receivables and inventory, for example, while term lenders are first on equipment and real estate. In term loans, unitranche deals and FILO (first-in, last-out) loans, different tranches may have different rights to control at different times, and a term B lender with no maintenance covenant default may not be able to cross-default to a revolver loan that does have one. In a workout situation between a borrower with a term B loan and a revolver loan, where the revolver has a covenant default but the term B lenders do not have one, the revolver lender may enforce and keep proceeds without sharing, for a period. Where you are will dictate what you can do, what you need to get the consent of others to do, and whose proceeds come first. Make sure you know what you can do with and without the other group. Juniors in a unitranche may control a restructuring since the seniors get first proceeds.

Know Your Options in a Workout

The meeting of the minds is where the endgame begins, as borrower and lender determine whether their goals align, and if not, what their options may be. Yes, lenders in a workout want to be paid back. Yes, borrowers in a workout want the business to continue. If the goals can work together, a restructuring is possible. If not, a lender may be looking for an exit. Having a clear understanding of the options that may be available to a borrower or a lender in a workout situation is critical to getting the best results. Borrowers could hire a restructuring advisor to evaluate the business and ask about sales of some of the assets to pay the debt, or any lines of business that could be used to repay the debt, or a DIP loan to operate in bankruptcy or sponsor cash to operate and reduce the debt, or any other injection to enable operations and wind down the debt. Lenders could do the same, looking into the sale of the loan (but beware of borrower consents and disqualified buyer lists), or the acquisition of the borrower, which could happen by negotiated transfer or credit bid, or a debtor-in-possession loan. Finally, there may be some government programs, too. No one move works for all workouts. As things evolve, the ultimate goal may shift, and it is important to consider what changes have occurred, whether there is a new goal and how to get there. If you are considering a workout, always revisit your plan often and be ready to be flexible.

Stretching before you workout is key to getting the most from an exercise. If you don’t workout often, how are you supposed to know your options in a workout? Ask around, read up, refresh your skills. Make a plan, find mentors and remember to stay flexible for best performance.