By Nicholas B. Jalowski, CTP,
CMC Managing Director, Cambridge Financial Services, LLC
As a result of the economic downturn, collateral values have fallen and lenders have faced losses in their portfolios. Plenty of opportunities have become available for debtors to negotiate a settlement of indebtedness or to arrange for an investor to purchase the loan at a discount.
It’s useful for troubled companies to be aware of the rules of the road to recognize when those opportunities exist and how to successfully negotiate a discount on indebtedness. These techniques apply whether a company is attempting to restructure outside of bankruptcy or trying to gain acceptance from an impaired creditor within bankruptcy.
In loan workouts, a lender may not collect fully on the loan. If the debtor has a viable core business and wants to pursue a settlement, there are three rules that guide the lender in deciding whether to accept a settlement that is less than the full value of the claim:
- The settlement offer is better for the lender than taking legal action against the debtor.
- The settlement offer is better for the lender than the risk of litigation by the debtor
- The settlement offer is better for the lender than waiting.
Understanding the dynamics of each is the key to negotiating an acceptable deal.
Case 1
Lenders may agree to a settlement if they determine that pursuing an adversarial collection to its conclusion will probably result in a loss on the loan. Commercial banks and other heavily regulated lenders are required to periodically evaluate their loans for collectability and classify them according to credit quality. Loans characterized by defaults in loan agreements, no or slow payment patterns and impaired collateral values are reviewed more frequently.
Once a loan is considered classified the lender is required to set aside reserves to recognize the possibility of an impaired collection. In essence, what the l ender shows on its internal books is less than the total amount of the claim. Debtors that can estimate that amount and present an offer near that amount or above may be able to achieve a discount on indebtedness from the lender.
The success of this negotiation depends on the debtor convincing the lender that after all legal means of collection are pursued, the settlement offer is significantly better than what the lender would recover in a liquidation. Debtors can build their cases with a detailed analysis of the liquidation values of assets and recoveries from any credit enhancements such as personal guarantees or side collateral. In addition to accounting for as many factors as possible that would affect the value of assets in liquidation, the analysis should show all costs associated with the pursuit of the claim.
For example, debtors can project time delays from initial legal proceedings to recover the claim, including extended litigation; subsequent bankruptcy reorganization attempts; estimated discounts on asset sales; cost of professionals (lawyers, accountants, appraisers, and auctioneers) who would be engaged to pursue the claim and the loss in value associated with collecting money in the future versus now. Provide as many third-party opinions as possible to back up the reasonableness of the analysis.
Lenders who review the debtor’s proposal – and auditors who examine the loan file – may reject the analysis outright because it is too outrageous or dispute the analysis assumptions and try to negotiate a higher recovery.
If the debtor can convince the lender that assumptions made in the analysis are reasonable and the settlement offer is significantly greater than the estimated recovery through legal pursuit, the lender may jump at the opportunity to settle. If the valuation assumptions are suspect or if the debtor’s consultant lacks credibility with the lender – or worse, if there is distrust between the parties – a bankruptcy judge may have to decide the outcome.
Case 2
The debtor could have a valid claim against the lender. Lender liability appears less ubiquitous than in the past, but if the debtor’s claim has merit, the lender may decide to forego the risk of losing a lawsuit and being liable for damages in exchange for a compromise of the indebtedness.
However, this course of action is very expensive and time consuming, and will require engaging legal counsel skilled in lender liability. Usually it is necessary to initiate litigation and be pretty far down the road with discovery before the lender acknowledges its litigation risk. But if the claim is valid and the debtor can convince the lender that there is a serious risk of losing a court decision and having to pay damages, a discount opportunity should present itself.
Case 3
In some situations, the lender, for reasons of its own, may have a greater need for liquidity now compared to later. The lender may see a good reason to cash out immediately even if the liquidation analysis indicates that the loan could be recovered in full through legal action.
For example, a bank that has taken a big hit to its capital base because of increasing loan loss reserves may actively look to monetize its loan assets, even at a discount.
If the settlement offer results in a positive recovery on the loan from its carrying value, the bank may jump on the chance to book it, even if a longer-term plan promises a greater recovery. This strategy is especially useful at the end of a fiscal year or a quarter when most banks want to clean up their books. Offering a settlement that can occur before the end of a quarter is sure to get the attention of lenders in this situation.
The underlying assumption in each of the above approaches is that the debtor has a willing financing source to fund the settlement or loan purchase. Lenders very rarely restructure a loan at a discounted amount and accept time payments. That could play out as a double jeopardy for the lender if the newly restructured loan defaults a second time.
Some debtors spend considerable time soliciting other commercial banks to finance a settlement, but this can be problematic. It will cost valuable time, even if the business development officer at a different bank agrees to consider it. Regulated lenders are loath to provide financing to a debtor unable or unwilling to pay off its existing lender in full. Auditors may criticize the creditworthiness of a new debtor that caused problems for another bank. As a result, they rarely, if ever, approve such a loan.
Fortunately, fresh capital is drawn to opportunities where there is a void and financing alternatives exist. Debtors can network within professional restructuring groups or hire consulting intermediaries.
To negotiate a debt compromise, knowledge is key. Debtors need to know asset values, professional costs of recovery or litigation, the timeline to recovery, and most importantly, knowledge of when a lender considers a discount.
Authored by:
Nicholas B. Jalowski
Managing Director, CTP, CMC
Cambridge Financial Services, LLC
Raritan Plaza III
101 Fieldcrest Ave., Suite 3E
Edison, NJ 08837
(732) 512-9200
www.cambridgefinancialcorp.com
[email protected]