COVID-19 is a major shock to the American economy. Perhaps even more surprising is the speed by which this crisis has occurred. In this unprecedented time there are several things that lenders can do to with withstand the tsunami of distressed loans that will soon be hitting them.
To begin, it is imperative that lenders keep good, open lines of communication with their borrowers to understand what they are facing. Closely watch for leading indicators of financial distress, including aging accounts payable, decreases in accounts receivable and difficulties complying with loan covenants.
If the borrower is non-responsive to the lender or if the borrower’s accounts are suddenly moved to another institution, that should serve as a red flag of economic distress and a possible imminent bankruptcy filing. For borrowers that are expected to need loan modifications, make sure to closely review existing loan documents to see if any defects exist that impair your lien. Loan modifications are golden opportunities to quietly fix past lender mistakes.
In good financial times, lenders had the luxury of slower and more deliberate in considering loan workout options. But the expected increase in loan defaults will necessitate that lenders establish clear procedures to quickly determine how to deal with a troubled credit. Establish bright eligibility lines for payment deferrals and loan modifications.
It is critical to ascertain the point at which a lender will stop working with the borrower to resolve the loan and turn to enforcement of its lien rights. Even though the CARES Act provides temporary relief to lenders on accounting for troubled debt restructurings, lenders will still need to grapple with the macro challenges to their overall cash flow and balance sheet caused by a spike in debtors struggling to stay afloat.
Lenders should encourage borrowers to solve their own problems. Can they refinance elsewhere? Are they eligible for the SBA’s Economic Injury Disaster Loan Program, which provides low-interest loans up to $2 million? The CARES Act also establishes the Paycheck Protection Program, administered through the SBA – lenders should be encouraging eligible businesses to take advantage of that resource to access desperately needed cash.
Beyond loan modifications and government-backed loan programs, lenders will also be forced to do a greater volume of forbearance agreements (FAs). In addition to normal provisions for resolving troubled credits, FAs need to be smartly drafted to best help the lender in both the short term and in the event judicial recourse is needed in the future. Because courts across the country are restricted to emergency-only operations, it will be difficult to get traditional evidentiary hearings. To get around this hurdle, FAs should contain “whereas” clauses that are admissions of loan defaults by the borrower. These admissions make it much easier for courts to grant a lender’s requested relief if a lawsuit is filed.
Other possible FA provisions include the appointment of a chief restructuring officer or a signed consent to the appointment of a receiver or stipulated judgment in the event of a default. FAs should always include a full release of claims against the lender so as to avoid any future lender liability claim. Lenders may also seek bankruptcy-specific provisions in an FA, such as a concession to adequate protection or the borrower’s consent to stay relief to liquidate collateral if a bankruptcy is filed.
In doing loan workouts, lenders need to be careful to not structure the deal in such a way that it can later be undone by a bankruptcy restructuring. For example, a lender could demand that an affiliated or subsidiary entity pledge additional collateral for an existing loan. But if that affiliate or subsidiary receives no benefit from that pledge, the lien that is given or monies paid can later be voided in bankruptcy as a constructively fraudulent conveyance.
Lenders need to also prepare for the wave of commercial bankruptcies that will be happening in the next 12 months. The new Small Business Reorganization Act (SBRA) has made it much easier, cheaper and faster for small businesses to file for bankruptcy. SBRA’s debt limit was originally capped at $2.725 million, but the CARES Act has raised that debt limit to $7.5 million (exclusive of affiliated and insider debt) for the next 12 months. That is a dramatic change to bankruptcy law and will create more of an incentive for small businesses to file bankruptcy and force beneficial loan restructurings. Lenders to small businesses will need to decide how they will approach critical issues, including doing debtor-in-possession financing, seeking adequate protection or stay relief, and credit bidding at bankruptcy sales.
We are living in turbulent times, and the storm will only intensify in the coming months as businesses struggle to stay afloat. Lenders can best protect themselves now by having the foresight to see the coming problems and taking adequate steps to prepare for the approaching wave of distressed loans.