Finding an upside to your commercial borrower’s bankruptcy
The COVID-19 crisis is causing many lenders—particularly community banks—to be hit with an increasing number of small business bankruptcy filings. Recent statistics from the American Bankruptcy Institute show that, nationwide, small business bankruptcy filings increased approximately 106% from April to August, and these filings may continue to grow in the coming months.
These small business bankruptcy filings are the product of a perfect storm. The Small Business Reorganization Act (SBRA) went into effect in February, making it easier and cheaper for small businesses to seek Chapter 11 bankruptcy protection. Then the economy was slammed by COVID-19, causing many small businesses to stumble despite significant government assistance made available.
Despite the grim outlook, the current situation presents an opportunity for lenders to cooperate with their borrowers to turn weak loans into stronger loans.
Bankruptcy has a bad name, and for that reason, lenders too often treat it as a bad thing. Frequently that leads to greater animosity with the borrower and increased legal fees. But instead, lenders should think about the borrower’s bankruptcy in terms of a political compromise—the lender accepts certain distasteful key items that are critically important to the borrower, and in return, the lender gets several key concessions of immense value.
The big issue to the borrower is being able to file for bankruptcy, quickly shed significant unsecured debt and emerge from bankruptcy as a going concern. Under SBRA, debtors who devote their disposable income—funds in excess of what is needed to pay essential business expenses—for three to five years will have their unsecured debts discharged and they will retain their property even if those debts were not paid in full.
From a lender’s perspective, this can be a really good thing—the borrower/debtor can reaffirm the secured lender’s debt while simultaneously reducing significant general unsecured debt. If the plan is successful, the weak performing loan will transform into a stronger one.
When small-business borrowers begin signaling that bankruptcy may be coming, lenders would be wise to immediately start working with their borrowers to see how the SBRA bankruptcy can be leveraged for the benefit of both sides. The goal for the lender is to maximize their outcome while minimizing legal time and expense. In an ideal world, this is best accomplished by pre-bankruptcy negotiations between just the lender and the borrower where key elements of the bankruptcy are negotiated. The negotiations should include how financing will work while in bankruptcy, priming liens that will be given to the lender, the borrower’s use of cash collateral and key remedies if a default occurs.
Special consideration should be given to how the lender’s secured loan will be handled by the Chapter 11 plan. Emphasis should be placed on giving the lender a blanket secured loan under terms and conditions that will insure the loan will be repaid in the long term. The lender and borrower need to also consider how the proposed plan will impact other major creditors.
Methodical planning and cooperation with the borrower is required prior to the filing. The lender will have to make certain compromises to extract reciprocal compromises by the other party. As a practical matter, a perfectly planned and executed bankruptcy filing by a borrower that is supported by the lender will be much more likely to ultimately succeed.
Some may view this strategy as being unconventional. That is true, but it has also been successfully employed in some major bankruptcy cases involving hundreds of millions of dollars. There is no reason why these legal concepts cannot also be implemented for small business bankruptcy cases. Lenders should pursue better ways to maximize loan recovery while minimizing legal expenditures.
That said, this strategy will not work in all instances. The borrower may be unwilling to compromise or may have unrealistic expectations, or the borrower may be too far financially gone for bankruptcy protections to economically resuscitate it. The borrower may even desire to use the Chapter 11 proceeding against the lender. If the borrower takes this latter approach, the lender should prepare to vigorously enforce its legal rights and remedies.
But these adversarial situations can be the exception rather than the norm. Lenders who signal a willingness to cooperatively work with their borrowers can find that doing so enables the borrower to shed unsecured debt, strengthen its balance sheet and provide greater assurances that the lender’s loan will be paid in full.