The COVID-19 pandemic continues to wreak havoc across the country. Millions of small businesses are struggling, with many having closed and others on the verge of shuttering.

A recent Harvard Business School survey of 5,800 businesses reveals the median business with $10,000 or more in monthly expenses usually lacks sufficient ready cash to cover two weeks of spending.

Not surprisingly, small business defaults are up considerably. From roughly two percent of small business debt last year, they now consist of 2.7 percent of small business debt. The future does not look bright. By 2021, default rates may rise to as high as five to six percent, according to models.  

Economic stimulus programs passed in 2020 had some positive effects, but the pandemic’s impacts continue to ravage the economy. As a result, many small businesses remain in serious straits. Launched in early April 2020, the Paycheck Protection Program (PPP) showed initial promise in providing businesses with eight weeks of payroll funding to stave off business closure. Within two weeks, 1.66 million PPP loans had been disbursed. It turned out that eight weeks was not sufficient, as the pandemic continued to rage.  Despite further stimulus efforts, the outlook for many small businesses remains bleak for many.

Bankruptcy increasingly looks like a viable option for many small businesses. The Small Business Reorganization Act (SBRA), enacted in August 2019, made reorganization under Chapter 11 bankruptcy easier. When businesses short on cash are looking at an unknown but possibly considerable period of lowered demand, managing debt burdens via bankruptcy appears attractive.

Lenders, however, face a dilemma. If too lenient with businesses by way of offering extended forbearances and waivers, lenders may find the borrower impossible to contact with limited or incorrect information. That lack of information could cause lenders to experience more write-offs than anticipated. Borrowers may determine if they default that other creditors should have priority, whether in payments or asset collection.

On the other hand, overly strict lenders rigidly interpreting loan documents and their covenants could end up forcing businesses to shut down. Many of the businesses may have survived if given sufficient time to pay off loans after business conditions normalized. Such lenders could end up ruining potentially profitable future borrower relationships if they fail to cut these businesses some slack.

A solution to this delicate balance involves workouts, which should aid borrowers and lenders alike. Workouts permit borrowers adequate time to recover their pandemic-related losses and start making standard payments.  While workouts are conducted on a case-by-case basis, how the lender works with specific borrowers depends on their overall loan book and their staff numbers. Given these unprecedented times, each case requires manual review. Models for pre-pandemic contexts may not make sense in the current climate.

Loan book reviews must assess industry COVID-19 exposure and document that all material is sound. Such reviews must track the borrower’s financial health, as well as the effect on their collateral. Obviously, the pandemic has hit some industries harder than others. Those industries that involve a great deal of direct personal contact are the ones suffering the most and will likely continue suffering for the longest period. Industry segmentation in one’s existing loan portfolio not only assists in better understanding individual industry exposure, but it can also help guide lenders’ risk mitigation strategies. 

Look at the collateral protection levels available for those high-risk industries. Also crucial is the effectiveness of your system in collateral monitorization. For example, if depending on inventory and receivables or construction in process when protecting collateral, systems for monitoring assets and advancing funds must function properly. When financial difficulties arise, that is when the unacknowledged gaps in such systems appear. When loans are secured by marketable securities, take extra precautions in the evaluation as the market softens.

Review all loan documents within all industries carefully, in order to determine the likelihood of borrowers defaulting on financial covenants or breaching other types of covenants. Pay the greatest attention to secured loans, ensuring the perfection of liens, and secured collateral.  

Test certain financial documents quarterly, including:

• Cash flow cove­nants
• Leverage ratios comparing total debt to cash flow
• Liquidity covenants
• Net worth covenants

Lenders will probably find in conducting such testing during the pandemic that a large percentage of borrowers are at risk of defaulting under these loan documents.

Some borrowers just need to buy some time until the pandemic is over or under control. If a borrower cannot pass covenant testing in a quarter, explore a workout option. With a sliding scale extension period, the lender will not require swift normal payment resumption or complete adherence to the original covenants when the deferral period ends. Instead, the borrower could contribute interest-only payments with a temporary extension. The borrower continues some engagement, but this option also serves as a potential red flag if the borrower begins faltering under these reduced terms.

Loan security or the need for more collateral is another possibility. This form of debt security not only lowers borrower business interruptions but lessens lender risk. It is imperative to ensure the perfection of lien filings and lenders’ lien priority. The former guarantees collateral collection in the event default occurs, and the latter determines lender order collection.

Perfection means just that – no errors or typos. Roughly 25 percent of all UCC filings contain errors resulting in an unperfected lien. Check debtor name spellings, prior name usage, and ensure the debtor name on the filing is correct and compliant.  

Fourteen percent of such filings involve business entity mismatches. These include liens filed against an entity that:

• Ceased operations within a state while continuing operations in its home state
• Merged with another entity
• Changed jurisdiction or entity type

Possible consequences of not perfecting a lien are illustrative. In Q2 2020, the six biggest banks put an additional $36 billion dollars against future loan losses. This amount is approximately $320 billion or 2.4 percent of their credit books. If 10 percent of these losses are commercial and industrial loans with collateral security, the banks have $32 billion in such loans.  

Because about 20 percent of liens are possibly imperfected because of errors, that increases the number of potentially uncollectable loans to $6.4 billion. At a five percent default rate, that opens up as much as $320 million dollars in loans and fees. Wrongful collection liability also looms over the lender.  Since the pandemic has made prognostications surrounding default likelihood much harder, the lender’s lien filings would benefit from undergoing an in-depth review.

During lender and borrower negotiation, it is wise to provide resources for borrowers to apply for government grants and loans in order to stay in operation. A PPP forgiveness application is especially crucial. In August 2020, the SBA introduced a forgiveness portal for lenders seeking PPP loan forgiveness approval. By helping borrowers with such applications, lenders should find themselves in improved conditions when receiving the forgiveness decision per se. The lender then uses their own submission assessment to acknowledge applications with high approval potential, providing the borrower with lower risk approval ahead of time.  

Introduce networking opportunities for small and mid-sized business owners. At such events, they can share concerns, ideas, and best practices about making it through this time. If done in conjunction with local chambers of commerce, such events help lenders reach new borrowers.  

Workouts are optional for many but not all borrowers. The fact remains that while lenders can work on negotiating favorable terms, there are borrowers who will default anyway. During these negotiations, identifying such borrowers is imperative. Also, some borrowers are not interested in negotiations. Letting borrowers realize how serious these matters are is best performed by selective lawsuit filing. Such lawsuits are good tools to encourage the borrower and the lender to come to an agreement.  

Best Practices

Ways to mitigate risks in this era of extraordinary commercial lending volatility involve intense strong rigor regarding workouts. If workouts are conducted properly, lenders can avoid a default wave. Consider offering reduced payments for a specified period or secure a loan. Keep in mind that not every borrower needs a workout. Do so only when needed. For example, limit workouts to situations where future conditions for the borrower look promising, and the borrower is interested in negotiations in the first place. 

Other best practices include:

• Segmenting your loan books via industry and then performing the risk assessments. By working this way, lenders have a tighter grasp on borrower industry performance and a better idea of where to concentrate their efforts.
• Ensuring adequate systems are available for effective collateral and covenant monitorization. This monitoring helps keep borrowers engaged and serves over time as a dependable risk indicator.
• Reviewing lien filings meticulously to make sure they are perfected. While this step is always a recommended practice, it is especially important in uncertain economic times. A misspelled name or another typo could mean a loss for the lender in case of default.

When you build a strong relationship in volatile times with borrowers, that relationship can remain in place once the economy rebounds. Borrowers want to stay afloat and recover, and they depend on their lenders. Offer resources to borrowers, including federal loan help and networking opportunities. You can help them better understand their various options, in good times as well as bad.