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Understanding Post-Default Scenarios in Corporate Finance Transactions: Navigating Uncertainty in 2024

As we head into summer, there seems to be a lot of economic uncertainty. Some economists are predicting a slowdown, others a possible recession, while still others admit they just don't know where the economy is headed. For lenders, appreciating this uncertainty is critical in developing successful workout strategies for troubled loans, especially in terms of understanding and evaluating available options.

The current climate presents several risk factors for lenders. We are coming off the tail end of COVID, which may have artificially inflated or deflated borrowers' incomes. There are rumblings of a potential upcoming recession. And legally, based on recent California cases, there appears to be a trend of courts taking a harder line against lenders.

While this evolving landscape doesn't necessitate paranoia, it does require heightened preparation and caution on the part of lenders. There needs to be a greater emphasis on maintaining proper paper trails and documentation. Attempting to reach consensual resolutions and settlements should be prioritized over rushing to litigation when possible. And lenders must understand the full scope of their options, from forbearance agreements to loan modifications to creative alternatives like receiverships, in order to maximize outcomes.

Initial Fact-Gathering and Assessment

When a borrower defaults, the lender's first step should be thorough fact-gathering and assessment. Key initial questions include:

- What is the nature and extent of the outstanding defaults? Are they payment defaults, non-payment/covenant defaults, or a mix? Be wary of simply waiving "technical" defaults, as covenants are included for good reason.

- Why didn't the borrower default sooner or to a greater degree? Is this a one-off issue that can be readily cured or indicative of more systemic problems?

- What are the lender's available remedies under the loan documents? Are there any contractual or legal restrictions on remedies, such as restrictions on imposing default interest?

- What are the strengths and weaknesses of the borrower's business? Consider both micro factors like key customers and vendors and macro factors like industry and geographic trends. 

- How did COVID specifically impact the borrower's business, and are those impacts likely to be temporary or permanent? Be alert for artificial, unsustainable boosts to revenue.

- What is the borrower's history and current status with other creditors? Are they remaining current on other obligations?

- Do the organizational documents and public records searches reveal any changes to the borrower's name, structure or status that could impact perfection of security interests?

- What is the value of the collateral and are there any other existing or potential liens on it? For real estate, carefully review title, survey and environmental.

- Is there any imminent risk the borrower may file for bankruptcy protection? If so, how would that impact the lender's position and strategy?

The lender should also use this period to carefully review its own loan files, including all loan documents, correspondence and internal notes or communications regarding the credit. The goals are to identify any mistakes or deficiencies to be corrected, evaluate potential lender liability claims, and consider opportunities to improve the loan structure going forward. Particular attention should be paid to:

- Completeness of loan files

- Correct execution and notarization of documents 

- Proper perfection of security interests 

- Compliance with applicable notice and cure provisions

- Consistency between informal communications and formal loan documents

- Any course of dealing that could be argued to constitute a waiver

- Any statements that could be characterized as promises or commitments to the borrower

Developing a Strategy

Armed with a thorough understanding of the situation, the lender can then develop its strategy. The key decision is whether the lender's primary objective is an amicable resolution (via a forbearance, modification, deed-in-lieu, receivership, cooperative liquidation, etc.) or an adversarial approach (acceleration, foreclosure, litigation, involuntary bankruptcy, etc.). Factors to consider include:

- Strengths and weaknesses of the lender's position, both factually and legally

- Potential claims and defenses the borrower could assert

- Hopes for a continued, long-term relationship with the borrower

- Likely collectability of any deficiency

- Relative costs and benefits of each approach

- Need for speed vs. additional information

- Willingness to put in additional funds

- Value and type of collateral and ease of liquidation

- Extent to which lender is willing to control its own destiny

In most cases, an initial cooperative approach, with a quick pivot to enforcement if the borrower proves unreliable or uncooperative, is advisable. But every situation is unique and the strategy must be tailored to the specific facts, players and dynamics involved.

Initial Borrower Communications

The first substantive communication to the borrower after a default should be a written notice of default. The contents will vary based on the type of default and loan, but key components typically include:

- Statement of the default

- Amounts needed to cure, including default interest and late fees if applicable 

- Reservation of rights and remedies

- Deadlines to cure, if any

- Request for any updated information required

For simple monetary defaults, the notice can be relatively succinct. For more complex defaults, involving multiple, continuing issues, a longer letter may be appropriate to demonstrate the severity of the situation. Avoid any statements that could be construed as a waiver or commitment.

If the lender is open to discussing a workout, this can be communicated verbally or in a separate correspondence. If substantial negotiations are likely, the lender may want the borrower to sign a pre-negotiation agreement, affirming that discussions will not constitute a waiver of the lender's rights or create any binding agreement absent formal, signed documentation. Keep the pre-negotiation agreement simple to avoid protracted negotiations over it and focus on substantive discussions.

Forbearance Agreements

For many troubled credits, the best initial step is entering into a forbearance agreement. In a forbearance agreement, the lender agrees to refrain from exercising remedies for a set period of time in exchange for certain concessions from the borrower. Benefits to the lender include:

- Opportunity to correct deficiencies and strengthen position (e.g. perfecting liens, obtaining additional collateral, shoring up guaranties) 

- Ability to include acknowledgment of default and amounts owing and release of claims, which can be extremely valuable evidence in any later litigation

- Imposition of tighter controls and covenants, enhanced reporting requirements, and other favorable provisions for the duration of the agreement

- Avoids waiver arguments from partial payments

- Buys time to gather additional information, strengthen position, or let the situation play out

From the borrower's perspective, a forbearance provides much-needed breathing room and a chance to right the ship. For this reason, forbearances can be an ideal "bridge" solution when a borrower needs time to refinance, sell assets, or await an influx of cash.

The terms of a forbearance agreement will vary widely depending on the type of loan, nature of collateral, and specific facts involved,

- Recitation of the basic loan terms and current defaults

- Set forbearance period, often 30-90 days but sometimes as long as 6-12 months

- Acknowledgment of default and amounts owing

- Ratification of loan documents

- Release of claims against the lender

- Waiver of defenses to enforcement

- Enhanced financial reporting covenants

- Streamlined enforcement provisions

- Agreement to pay lender's attorneys' fees

- Milestones and performance covenants tailored to the exit strategy (e.g. dates to obtain refinance commitment, list property for sale, or hit curtailed liquidation targets)

- In some cases, additional collateral, guaranties, or equity infusions

Inclusion of a specific acknowledgment of the current default is important and valuable, but can also trigger thorny tax and regulatory issues for the lender, so requires careful consideration. 

For loans secured by real property, it's also critical to review the title report, determine the status of property taxes and insurance, and consider any lease issues before entering into a forbearance.

Overall, forbearance agreements must be carefully crafted to address the unique circumstances at hand. Attempting to rely on a generic "form" is ill-advised. The agreement should clearly reflect the parties' discussions and understandings and be specific and detailed enough to show a clear meeting of the minds.

Loan Modifications

In some cases, a loan modification may be preferable to a forbearance. A modification permanently revises the loan terms, rather than just putting them on hold. Modifications are most commonly used to extend a maturity date, adjust the interest rate or payment schedule, or add/release collateral. They can also be used as part of an overall restructuring, in conjunction with an equity infusion, new subordinated debt, or new inter-creditor agreements.

The pros and cons of a modification vs. forbearance will depend on the individual situation. Relevant factors may include:

- Anticipated duration of the borrower's issues

- Relative bargaining power of the parties

- Extent of other existing defaults

- Need for post-default advances 

- Ability to meet financial covenants

- Regulatory and tax considerations

Loan modifications tend to be more complex and paper-intensive than forbearance agreements and will almost always require updated title work, lien searches, organizational documents and legal opinions.

Receiver and Bankruptcy Considerations

If initial cooperative efforts fail, the lender may need to pursue more aggressive options. Two key tools are receiverships and involuntary bankruptcy filings, which can provide heightened monitoring, controls and protections.

In a receivership, the court appoints a neutral third party to take possession and control of the borrower's assets. The receiver's role is to preserve and maximize the value of the assets for the benefit of creditors. Receiverships can be an attractive alternative to bankruptcy, offering many of the same benefits at a lower cost. Key advantages include:

- Receiver's ability to quickly take control of and liquidate assets

- Judicial oversight and approval of asset sales, providing title comfort to buyers

- Ability to sell assets free and clear of junior liens

- Reduced administrative costs vs. bankruptcy

- Potentially faster resolution than bankruptcy

However, receiverships also involve risks. The lender typically must front the costs and has limited ability to control the receiver's actions. Appointing an experienced, knowledgeable receiver is critical. The order appointing the receiver must also be carefully crafted to set appropriate parameters. 

An involuntary bankruptcy filing by creditors can be another powerful weapon when a borrower is not cooperating. However, there are strict statutory requirements that must be met and filing an improper involuntary can expose the petitioning creditors to significant damages. Accordingly, involuntary filings should be evaluated carefully with bankruptcy counsel before proceeding. 

Other Considerations for Lenders

Beyond the specific options and strategies discussed above, there are several other important considerations lenders should keep in mind when dealing with troubled loans:

- Carefully document all communications with the borrower and retain detailed notes and records. Assume any statements could later be used as evidence.

- Have more than one lender representative on all major borrower calls or meetings. 

- Be cognizant of potential lender liability claims based on discussions or courses of conduct and refrain from exerting excessive control over the borrower's operations.

- In multi-lender situations, open lines of communication early with other creditors to understand their positions and objectives. An inter-creditor agreement may be advisable.

- Understand any unique regulatory or licensing considerations that may impact the borrower's operations or a potential liquidation (e.g. Medicare/Medicaid for healthcare businesses, liquor licenses for restaurants and bars, etc.).

- For loans with multiple borrower/guarantor entities, a streamlined "one action" approach may be worth pursuing.

- Stay attuned to changing market conditions and get regular asset value updates. 

- Don't fixate on what's happened in the past. While understanding the reasons for the default is important, the focus must be on finding the best path forward.

- Be willing to think outside the box and consider creative solutions. Every situation is unique.

Conclusion

Navigating a troubled loan is never easy, especially amid economic upheaval and uncertainty. While there's no one-size-fits-all playbook, taking a proactive, pragmatic approach—with a strong emphasis on gathering and analyzing all the relevant facts and maintaining detailed records—can help lenders maximize recoveries while minimizing costs and risk. By staying focused on core priorities and adapting their strategy as circumstances evolve, lenders can weather even the choppiest of default waters.