In most cases, various warning signs exist in a distressed borrower, such as declining financial performance, sudden changes in top management, reduced borrowing availability and increased activity from activist investors, before an actual event of default occurs. Secured Lenders (for this article referred to as “Lenders”) when confronted with a distressed borrower must consider the available options in order to recover their principal, interest and fees. This article outlines common out-of-court and in-court alternatives that a Lender may pursue, after identifying that a Borrower is in distress.

In confronting a Borrower with an impending default, Lenders should first assess four primary factors:

Collateral type and value:

• Ease of collateral liquidation -- Is the collateral easy to liquidate, such as commodity products (corn, oil, etc.), or is it custom-made parts or livestock/nursery (items needing further processing or additional time to mature) prior to liquidation?
• Location of collateral- Is the collateral where the Lender originally thought it was or has it been moved?
• Security interest in collateral -- Although Lenders routinely run lien searches at the beginning of the credit facility, it is imperative for a Lender to confirm that it has properly perfected its liens on the collateral at issue.
• Value of the collateral -- What is the liquidation value of the collateral versus the obligations of the Borrower?

The Lender’s position:

• How are voting rights in the credit agreement structured among syndicate members? Is the Lender the agent or a small or large participant in the credit facility?
• Who are the other stakeholders in the capital structure? Are hedge funds holding a subordinated position? Is equity family-controlled or private equity-owned?

The Lender’s risk profile and relationship concerns:

• Is the Lender willing to take on more risk based on knowledge of industry or market?
• Does the Borrower or another stakeholder have any special relationship with the Lender that should be considered?
• What is the cost/benefit of losing a Borrower (e.g. obtaining a new customer may be expensive)?

Performance of the Business:

• Critical questions should be addressed -- Can cash burn be stopped? How does management propose to improve the financial performance?
• Upon event of default, and during forbearance negotiation, Lenders can request the appointment of an independent third-party consultant to help them assess the situation.

Lenders may be limited in their actions before an actual event of default; however, this should not preclude Lenders from preparing. Prior to default, Lenders should consider taking certain actions to address some of the factors above:

Schedule a visit/meeting with the Borrower:

Structured as a regular field audit or periodic touch point, Lenders can schedule a personal meeting with the Borrower, during which the Lenders can observe the Borrower’s business through a facility tour or a walk-through (a dusty and disorganized facility with a lot of non-moving inventory shows potential signs of distress).

Evaluate characteristics of the Borrower:

During the meeting, Lenders can directly discuss the prospect of an impending default event with the Borrower by laying out financial metrics about which the Lenders are concerned, including increasing working capital needs, decreasing availability and/or declining sales and profitability. Lenders should assess the Borrower’s response on awareness of the issue, clarity and truthfulness of the explanation, and problem-solving capabilities.

Lenders and Borrowers may first work together on an out-of-court restructuring in lieu of pursuing an in-court restructuring. An out-of-court restructuring is enticing to most parties for the following reasons:

• Allows for the Lender to maintain the relationship with a higher rate of return.
• Unsecured creditors are not organized.
• Bankruptcy has a negative perception among stakeholders: Borrowers will consider bankruptcy a “last-resort” option.
• Bankruptcy proceedings take time to prepare and are more expensive due to involvement of more attorneys and financial advisors.

Out-of-court restructuring alternatives for Lenders include the following:

• A Lender may negotiate an amendment to the credit agreement –- the negotiated extension, known as a forbearance agreement, affords the Borrower time to evaluate and, potentially pursue, a refinancing or sale of assets. In refinancing, there is a growing market for secondary loan transactions. Market conditions, risk profile and regulatory compliance continue to drive potential buyers and pricing. The Borrower can commence a sale effort reaching out to both strategic and financial buyers within the forbearance period. The benefits of having a cooperative sale or refinance process are (i) potential higher sale price due to structured sale process; and (ii) relatively low professional fees.
• A Lender may choose to restructure the debt facility alongside the Borrower's proposed turnaround plan –- this alternative may take the longest amount of time to execute, and it assumes that the Lender wishes to maintain a future working relationship with the Borrower. Accordingly, the Lender needs to “buy into” the turnaround story. Whether a Lender decides to “buy-in” is based on three factors: (i) understanding the prospects of the business model; (ii) having confidence in management’s ability to execute; (iii) and the willingness to commit funding to achieve the turnaround goals. As protection, a Lender may seek remedies, such as additional collateral, guarantees, joint funding with equity and a milestone-based turnaround plan.
• A Lender may exercise its remedies under applicable loan documents –- strategic options include, but are not limited to: declaring a formal notice of default; acceleration of debt; and foreclosure on collateral. By foreclosing on collateral, Lenders may obtain a depressed price in light of distressed sale, and a purchase price that is not subject to a competitive auction.

For a number of reasons, an in-court restructuring may appeal to both Borrowers and Lenders:

• During out-of-court restructuring negotiations, the stakeholders involved may not be able to reach a consensus on a turnaround plan. Filing for Chapter 11 provides protection and the stable platform afforded by the Bankruptcy Code (i.e., the automatic stay, which halts certain creditors’ actions against the Borrowers without approval of the bankruptcy court).
• Certain liabilities make it difficult to execute a turnaround or sale of the business as a whole, such as lease rejection claims for a retailer or environmental/contingency damages. Bankruptcy sale processes under §363 of the Bankruptcy Code (explained further below) allow a sale of assets without associated liabilities of the Company.

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