Your Loan Is In or Near Default—Here’s What You Should Do
March 10, 2009
Case categories include: Executive Development Finance
By Scott Smith
Hanson Bridgett, LLP
Credit is exceptionally tight. Loans are nearly impossible to get and many borrowers are finding them difficult to keep. When combined with all other troubles that businesses are experiencing today, this can often lead to a snowball effect as far as commercial loans are concerned. If a borrower has a problem with their loan they often freeze in the headlights, concluding that damage control is impossible, allowing a bad situation to get worse. This note provides guidance to business owners on how to prevent loan defaults in the first place and what to do if one occurs.
1. Read Your Loan Documents
Loan documents are written by and for lenders. They are exceedingly lender friendly, spelling out in great detail the various rights and remedies available to lenders. Except for one or two sections of a loan agreement specifying the amount and manner in which loan proceeds are disbursed, loan agreements are almost entirely for the benefit of lenders. Many borrowers accept this reality as a fate accompli, and do not even bother to read their loan documents in any detail, concluding that the documents are full of legalese or boilerplate that they can do nothing about. This is wrong and likely to lead to trouble with your lender.
Even in a market where credit is tighter than ever, and negotiation of terms is likely to be kept to a minimum, the prudent borrower reads loan documents from cover to cover. Perhaps even more important, the prudent borrower periodically re-visits his or her loan documents to ensure continued compliance. How can you know if you have or are approaching a problem with your lender if you don't even know what your loan documents require? All of the advice that follows is prefaced on borrowers reading and understanding the loan documents they have executed. If you don't do this, it is a fate accompli: you are in trouble!
2. Pay Attention to What Constitutes an Event of Default, Even If One Has Not Occurred.
In this market, there is no such thing as a "technical default." Any and all defaults are likely to have grave consequences. Of course monetary defaults are at the top of the list, and you need to remain absolutely aware of your payment obligations and payment terms. If you have not done so already, you should consider direct payment options, which often provide for a reduced interest rate or other benefits and allow you to avoid slip ups as far as late or missed payments. Also pay close attention to your reporting requirements. You should map out for an entire year exactly what information you are required to provide to your lender and when. Your CFO or controller should obviously be included in this process, as well as outside accountants and auditors so everyone is in the know as far as your obligations.
3. Stay In Touch With Your Lender
Whatever you think about this financial crisis and the underlying causes, it is true that most bankers are living fairly hectic lives at the moment. Nearly every day the headlines tell of new businesses running into problems with their debt or declaring bankruptcy. Borrowers should stay informed about both how their bank and personal banking representatives are doing. Consider checking in periodically to learn how things are going with your lender, and to let them know how you and your business are as well. Try to learn what is keeping them up at night, what they see going wrong with some of their clients and how you might be able to avoid the same. If you have good news, share it. Calls such as these will preserve and strengthen good will, lead to better customer relations, and might create an ally that you can depend on in a time of need.
4. Ask For Permission Rather Than Forgiveness
If you see problems on the horizon, consider whether it makes sense to bring them to the attention of your lender early. Related to suggestion number 3 above, lenders are more likely to appreciate learning of issues in advance then after they have occurred. Chances are that your lender representative has a superior, and that any surprises which your representative must report to their superior will not reflect well on them. Once a covenant is blown, the cost is usually high to fix it. Borrowers should realize that penalties and fees exacted for covenant defaults are one of the few revenue sources for lenders today. By consulting with your lender before a covenant is breached, you may avail yourself to advice and input on how to avoid breach in the first place. The longer the lead time you give your lender, the more likely they may be able to provide constructive input or at least set the stage for how to correct the situation. Negotiations over penalties for a covenant that is breached will almost certainly go easier if discussions commence before the breach rather than after. In this market, nothing is fixed by delaying hard conversations; it only makes them harder and raises concerns and suspicions.
5. Propose a Solution
At the same time that you approach your lender in accordance with suggestion number 4, above, you should have two proposals in mind. First, you should be able to tell your lender what you are planning to do to fix the problem you are having. Whatever your plan is, do not over-promise and make sure you can deliver. Second, you should have a proposal for what your lender can do to assist. This may and perhaps should include a discussion regarding the modification of particular loan terms if you see no other way out. Yes credit is tight and lenders are in an unforgiving mood, but realize that they are all dealing with an incredible number of bad loans at the moment. If a slight modification of your terms can prevent your loan being added to the pile of bad debts already on their books, you may find them more than willing to listen. Consider asking your lender about:
- Payment of a penalty and modification of covenant(s) to ensure compliance on a going forward basis
- Modification of your payment terms (e.g., stretching out your loan term in order to lower your monthly payments)
- Forgiving late payments now in exchange for a longer term and/or higher interest
- Providing additional security in exchange for a waiver of default(s)
- Refinancing on agreed upon terms
6. Be Aware of Your Rights
Your ability to avail yourself of this suggestion will depend significantly on whether you follow the first suggestion above. Its nearly impossible to be certain of your rights if you do not know your loan documents. This is true because most of your rights are contractual and built in to your loan agreement, promissory note and security documents. If you run into difficulties with your lender you should make sure that they are following your loan documents to the letter just as they are requiring of you. Did they give you notice as required? Did notice go to the correct address and was it in the required form? Is the lender seeking penalties in excess of what the loan documents provide? Were you allowed the opportunity to cure the default as required under the loan documents? How much time were you given to cure? Is your lender imposing unreasonable demands as far as what cure constitutes? Is your lender demanding remedies that are not available? In addition to making sure you are aware of your rights under the loan documents, you need to make sure that you are aware of your rights under applicable law. California law, for instance, places numerous limits on remedies available to lenders that cannot be modified by contract. If you personally guaranty your company's debt, more restrictions may apply. To make sure your lender is complying with all legal requirements, you should consult with a lawyer.
7. Consider What Remedies Are Available To Your Lender
If you granted a security interest to your lender, you should make sure you are aware of the rights your lender has in connection with such security interest. The rights available will depend in large part upon the type of collateral at issue. If real property serves as collateral, there are a host of laws and regulations that will govern your lender's rights as well as yours. Personal property will in most instances be governed by the uniform commercial code. Typically a security agreement covering personal property will require borrowers to deliver to lenders, or allow lenders to take possession of, collateral on default. Security interests also allow lenders to sell such collateral on whatever terms are available. The security interest granted to your lender will in all likelihood allow your lender to exercise rights over your accounts receivable, even allowing your lender to notify your customers that payments are to be made directly to your lender. In all likelihood, you bank or maintain accounts with your lender. Your loan agreement and the security interest you may have granted to your lender typically provide your lender with instant access to whatever cash may be in your account(s), which your lender may apply towards your obligations on default.
8. Consider the Effect of an Attorney Fees Provision
In all likelihood your loan agreement and promissory note will include an attorney fees provision. This allows your lender to recoup any attorney fees incurred in connection with the enforcement of its rights under your loan documents and perhaps even fees incurred in connection with the negotiation of some sort of alternative arrangement. If your lender agrees to waive its rights in connection with any event of default your lender will probably look to you to pay any legal fees incurred in connection with the preparation of a waiver. Your should request that any such reimbursement is limited to reasonable fees, but this is of course a subjective determination. If the legal work in connection with a waiver or loan modification is performed in-house, consider requesting that you are not charged any legal fees at all.
9. Consider an Assignment for the Benefit of Creditors
If you are unable to reach any solution or compromise with your lender, consider offering to voluntarily give certain property or assets to the lender in satisfaction of certain obligations. This may be done without necessarily filing bankruptcy and is referred to as an "assignment for the benefit of creditors." Generally, such a transaction is completed by entering into an agreement with your lender whereby an assignment of certain agreed upon assets is made to an agreed upon third party who will agree to liquidate such assets on the best terms available. The assignment will also specify how proceeds realized in any such sale will be divided, with the bulk of course going towards your outstanding obligations. If real property is involved, you may be able to accomplish something similar with a "deed in lieu of foreclosure." You deed whatever interest you may have in the property over to the lender who already has a mortgage or deed of trust on the property. Real property involves numerous unique issues, however, and if real property is involved you are well advised to involve legal counsel.
10. Consider bankruptcy
If the advice above and all other efforts fail to provide relief, you should consider filing bankruptcy. Bankruptcy may afford protections that are not otherwise available, and may be the only hope for keeping your business alive. Once bankruptcy is commenced, a "stay" is typically ordered, which seeks to maintain the status quo until a plan can be confirmed that sets forth how creditors will be paid while keeping the business alive. Lenders and other creditors will be prevented from exercising certain remedies otherwise available at law or under contract. While this may be extremely beneficial, bankruptcy also comes at a significant cost. You may lose control over your business if the bankruptcy court decides to appoint a trustee to oversee your assets rather than allowing you to do so. Once you file for bankruptcy, the bankruptcy court will have discretion over when and how you ever get out of bankruptcy. Finally, you should know that bankruptcy is expensive. The proceedings themselves and attorney fees are like to consume a considerable amount of your resources as well as your time and energy.
Scott Smith is a Corporate and Tax Partner with the law firm Hanson Bridgett. Scott works with borrowers and lenders of all types and sizes in connection with a variety of different debt transactions. Scott also has significant experience helping borrowers and lenders negotiate loan restructuring and forbearances. Scott can be reached at firstname.lastname@example.org.