When first submitted for publication in February, this article predicted a recession of unknown origin. COVID-19 answered the question in March.  While we don’t know how long the current health and economic crises will last, we know they are here, and that a meaningful number of lawyers and businesspeople have not encountered a widespread economic downturn.  As a dear mentor has frequently reminded me, “It’s easy to make a loan.  The trick is figuring out how it gets repaid, especially during tough times.”  Troubled credits present unique and interesting challenges and opportunities for businesspeople charged with handling them, along with their legal advisors.  The following is not an exhaustive list of every possible consideration which may arise during a workout, but rather acts as a refresher for those who have not been involved in a workout in some time, and as a primer for those less familiar with restructurings. It considers certain issues or concerns present at the onset of a workout or restructuring, and suggests certain solutions or actions one may take during the workout process (understanding that a detailed review of actions taken in bankruptcy are beyond the scope of this article). The related benefit is this article also serves as a guide for addressing certain items when preparing financing documents in order to avoid future problems.  

Many workouts start with a late-day call from a borrower to a lender indicating that it has a problem. For some, the initial reaction understandably may be one of frustration, panic or anger.  Instead, look to understand the issue and what immediate steps may be taken to limit negative consequences resulting from it.  Remain engaged with the borrower. What is the problem? Is there a mature or unmature default under the loan documents? For example, did the borrower breach a financial covenant? Does it have liquidity issues such that it cannot meet payroll obligations or service debt payments when due? Has the pandemic forced it to cease operations? Once you diagnose the ailment, start considering a remedy. Is the borrower seeking a short-term solution, like a waiver or amendment to address a discrete issue, or a longer-term plan of action, which may result in a complete restructuring of the credit or a bankruptcy proceeding?  Will the lenders counter with a forbearance arrangement that keeps the applicable default outstanding, but provides the borrower time to resolve the problem it faces?  Might government funds be available to support the borrower? Understanding the issue, and requests being made in connection with it, are critical to a workout proceeding down the right path.  

While determining a course of action, ensure that financing documents work as intended, and that the parties understand their ongoing obligations. Will lenders be required to extend credit during the workout process? Check the funding conditions to see whether mature or unmature defaults stop funding requirements.  Consider whether grace or cure periods are available to the borrower, including equity cure rights, and what impact those have on whether a default, whether mature or unmature, exists.  In an asset-based lending transaction, will the borrowing base provide sufficient availability to extend a requested loan? What reserves might be implemented during the restructuring? Will additional reporting be required from the borrower? Lenders may elect to make loans during a default in order to preserve collateral value or help save the borrower’s business.  As a result, it may be premature to terminate funding commitments upon the occurrence of a default.  

In many cases, when a mature default is outstanding, lenders should deliver a reservation of rights letter to a borrower, noting the existence of the applicable default and indicating that the lenders may, in their discretion, act or refrain from acting in respect of such default. The letter states the lenders’ position that issues exist, and they retain maximum flexibility as to how to address them. Be cautious about exercising remedies too quickly.  A borrower and its lenders often will be able to collaboratively and constructively work through a troubled situation. Legal limitations, such as providing a borrower’s employees with notice of the closure of a plant or mass layoffs, also may limit immediate actions taken by lenders.  Lenders taking the wrong actions without fully understanding a situation may form the basis for lender-liability claims. 

A file review should occur at the beginning of most workouts. The review should consist of answering a series of questions about the applicable financing.  The following is not exhaustive, but rather a sample of the types of questions one might need answered.  Confirm the type of financing that was provided and whether future funding obligations exist.  Audit the financing documents evidencing the transaction.  Do you have all of them? Are they complete, including schedules and exhibits? Were they signed and dated, with all blanks having been completed?  If your agreements contemplated post-closing deliveries or obligations, were those addressed, or do they remain outstanding?  Understand the covenants that bind the borrower and its subsidiaries.  During the most recent robust credit cycle, many standard protections were removed from loan documentation or otherwise meaningfully limited.  Unrestricted subsidiaries may operate outside of the parameters of the financing’s restrictions.  Certain assets may have been contractually excluded from the lenders’ collateral package. Net debt provisions may have colored the borrower’s actual leverage profile. Certain investments, restricted payments and asset sales may not be subject to default blockers. A borrower may be able to do more than expected during a default.

In a secured financing, consider the types of collateral supporting the credit.  Does your security interest grant clause appropriately set forth the categories of Article 9 collateral in which you believe you should have a security interest? If you have an all-personal-property collateral package, check your grant clause against the definition of general intangibles set forth in Article 9, as that definition lists the various categories of personal property against which a lender may take an interest. What was missed, if anything?  If the financing is secured by personal property, were appropriate UCC-1 financing statements recorded in the appropriate jurisdictions?  If deposit or securities accounts constitute collateral, were appropriate control agreements put into place? Were security interests taken against types of personal property that require additional filings (for example, Federal filings against certain intellectual property, FAA and/or International Registry filings against aircraft and their engines, or ship mortgages against vessels)? If real estate secures the financing, were mortgages or deeds of trust recorded in the proper jurisdictions? Interests in insurance policies should be evidenced by the appropriate additional insured and lender loss-payable endorsements. Were those obtained? 

After lenders have answered the foregoing types of questions, then they should consider the rights and remedies available to them while a default is outstanding, including any limitations on how and when they may be exercised. What notices must be delivered, and what lender votes are required?  Understanding the terms and conditions of the loan documents helps shape the form of the restructuring plan.  Subject to voidable preference and fraudulent conveyance concerns in a bankruptcy, and contractual limitations imposed by other debt transactions, lenders may have time to address issues surfaced during a file review in exchange for concessions requested by a borrower. Perhaps additional collateral is available or additional guarantees may be provided. Perhaps additional obligations may be secured by the borrower’s and the guarantors’ assets. New restrictions on activities that reduce the value of the borrower’s collateral or its enterprise value may be introduced. 

One should confirm which parties are required to repay obligations under the financing documents, as well as the types of obligations supported by guarantees or collateral.  Obligors often agree to repay more than principal, interest, fees, and expenses. They may be liable for the payment of treasury management and derivatives obligations.  What is the extent of those obligations, do the parties know the identity of the creditors that provided them, are there limits on the amounts which may receive the benefit of credit support, and where are they satisfied in a payment waterfall? Guarantees may be limited in amount, or available only upon the occurrence of certain defaults.  Intercreditor arrangements may introduce limitations beyond those restrictions found in the principal loan documents.  Cross-border financings present their own tax, legal and operational challenges.  Ensure that actions taken during a restructuring comport with all applicable foreign laws and regulations, and consider whether U.S. tax liabilities will result from such actions. 

Many transactions completed since the last recession involve shared liens, second-priority liens, or crossing liens where certain creditor groups have first-priority liens on one pool of assets, and second-priority liens on another pool of assets. For example, asset-based lenders may have first-priority liens on current assets like accounts receivable and inventory, and second-priority liens on fixed assets like equipment and real estate.  Term loan lenders likely have the first on the fixed, and the second on the current.  These creditor groups are governed by intercreditor arrangements that include guidelines for how a creditor group may exercise remedies against collateral.  Lenders must know what steps they may take with, or without, the consent of other creditor groups.  With the growth of the institutional term loan market, the emergence of unitranche financings, and the increased use of FILO (first-in, last-out) financing tranches, different creditor groups will have different rights at different times. Their respective abilities to exercise remedies against collateral or receive collateral proceeds will be impacted by where they sit within a transaction.  For example, term B loan lenders without the benefit of a financial maintenance covenant (like a leverage covenant) will not have an immediate cross-default to a revolving credit facility with such a covenant.  The revolving lenders may be able to exercise certain remedies against an obligor group or its assets without the term lenders having a corresponding right to do so, at least for some period of time, and the revolving lenders may be able to apply proceeds resulting from such exercise without sharing them with the term lenders. Depending on the nature of the default, the junior lenders in a unitranche financing may be able to control a restructuring process because the senior lenders will receive the initial proceeds resulting from any exercise of remedies.

Once triage is completed with respect to the initial default or other event, the lenders confirm how their financing documents work, and they understand the nature of future interactions with other creditor groups, then they will be able to move to the next phase of the process.  What does the borrower want, and do the lenders want the same thing? The financing may be relationship-driven, such that the parties work together to see the borrower through its troubled situation. This may include the borrower’s retention of a restructuring advisor, the approval of asset sales with proceeds repaying debt, or venturing into new lines of business.  This also may include lenders providing a debtor-in-possession financing during a bankruptcy. Alternatively, a borrower owned by a private-equity sponsor may receive cash injections to keep its business afloat through the troubled situation, as well as reduce the borrower’s outstanding indebtedness.  There may be other instances where the lenders must exit the credit quickly, in which case they will pursue a loan sale.  However, they must understand what rights the borrower may have to consent to such a sale, and if the financing papers provided for a disqualified list of parties to whom sales are prohibited.  Some lenders may be prepared to live through a restructuring or bankruptcy in order to ultimately acquire the borrower’s business, whether through a negotiated transfer or a successful credit bid in bankruptcy.  The current economic crisis has resulted in a variety of government-sponsored financing programs that may benefit troubled businesses.  The endgame may change over time, so lenders need to be prepared to pivot if circumstances change.

Just as stretching before exercise maximizes a workout’s benefits and ensures peak performance, refreshing one’s restructuring skills (or newly acquiring them) will ensure peak performance when handling a troubled credit. Be prepared to understand a borrower’s troubles. Be cautious about jumping to remedies. Be ready to formulate a game plan, whether short- or long-term. Seek out guidance from those who have lived through tougher times, and understand why flexibility matters in a restructuring.  Understand the nuances of various relief programs that may be available to help solve issues.  Stretch in these ways, and you’ll be ready for your next workout.   

This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content therein does not reflect the views of the firm.