Negotiating the Loan Workout



Practice Areas

Robinson Bradshaw Publication
January 2009

A loan default is a serious event for a borrower, especially when it is caused by financial distress in the borrower's business. Under most loan agreements, a default gives the lender the right to accelerate the loan obligations, take enforcement action against collateral, and charge default interest. In addition, if the default is under a revolving credit facility, a borrower's right to further credit will be cut off unless the lender agrees otherwise. When a defaulting borrower has suffered a downturn in its business, it likely will need to approach its lender to request a workout plan. Such plans typically involve waiver of the existing defaults and restructuring of the loan terms and covenants. But dealing with lenders on a loan workout can be daunting, especially for borrowers who have not faced this situation before. This article provides an overview of items to consider when approaching lenders and negotiating a workout, as well as an explanation of the legal documents that a borrower is likely to encounter.

1. Approach lender early, be honest and ensure financial statements are in order. Many borrowers are reluctant to notify their lenders of potential problems before a default occurs. They wait until their financial statements reveal a default under their financial covenants or some other default has occurred. Those borrowers may be embarrassed by their financial distress or may be hoping that their problems will be rectified before an actual default. What those borrowers fail to understand is that this is precisely the time when the lender needs to be reassured that the borrower's management is forthright, honest and competent. Advance notice to the lender and an honest assessment of the situation by the borrower's management are the keys to developing the trust necessary for a workout plan to succeed from the borrower's perspective. In addition, the lender must have complete confidence in the borrower's financial reporting - if there have been any reporting issues in the past, the borrower must quickly resolve them. Unless the lender trusts the borrower's management and its financial statements, it may pursue remedies far less appealing than a loan workout.

2. Read your loan documents - all of them - and comply. Reading the operative documents is always good advice for working through any legal issue. But it is especially important to read loan documents after a default. Borrowers with many different financing arrangements, such as real estate developers, should determine whether a default under one loan agreement triggers a default under its other loan documents. In addition, even for a borrower with only one financing in place, many things that the borrower routinely did before the default - such as disposing of assets outside the ordinary course of business, making certain investments, or making distributions- may be prohibited by the loan documents while a default exists. Taking any action that is restricted by the loan documents after a default could undermine the lender's confidence in the borrower and its management. The lender wants to know that its borrower takes seriously the gravity of the situation and is mindful of honoring the agreed-upon covenants and not causing new defaults. The borrower should realize that the decision maker for the lender may no longer be the same credit personnel with whom it has been dealing for the last several years. Instead, someone in the lender's special assets area may be the decision maker and may view the borrower's position and the lender's agenda differently.

3. Terms of workout plans vary widely. The terms of a loan workout will differ greatly depending on the circumstances of the particular situation. Unlike loan documents that are negotiated at the start of a lending relationship, there are few "market standards" for workout terms. Remember, a lender has no obligation to waive existing defaults and restructure the borrower's loan documents. On the contrary, the lender is free to exercise the rights and remedies that it negotiated for in the loan documents. However, a lender's motivation is maximizing its recovery, and the best way to do that is often for the borrower's business to continue in one way or another. In some situations, all that may be required is a loosening of the financial covenants and an increase in interest rates. Other times, the lender may request that additional capital (equity or junior debt) be invested in the borrower or that the borrower dispose of a particular subsidiary or division, with the proceeds used to reduce debt. All of these items (as well as many other possibilities) will be the subject of negotiation. From the borrower's perspective, the critical elements of the loan workout are that all existing defaults are waived, that it has sufficient working capital (or access to sufficient revolving credit) to meet its required expenditures (including future debt service), and that the financial covenants have been restructured to levels that it can live with for the foreseeable future.

4. Consider tax issues. Borrowers should carefully consider the tax implications of any modification to the loan terms in a workout. As a general rule, if there is a reduction or cancellation of all or a portion of the loan, then the borrower will incur taxable income in the amount of the reduction. In addition, for borrowers with debt that is regularly traded or for which price quotations are regularly available (which is the case for many borrowers with syndicated term loans), the tax consequences can be worse. For that type of loan, certain modifications to the deal terms can result in taxable income to the borrower even if the principal amount of the loan is not reduced. Under the tax code, if there is a significant modification of a loan (which could include an increase in interest rate, a payment of fees in connection with a waiver of default or an extension of the debt's term beyond certain safe harbors), the modification is treated as an exchange of the "existing loan" for a "new loan." When the loan is regularly traded or has price quotations that are regularly available, the tax code deems the price at which the new loan is issued (and the price at which the existing loan is repaid) to be the price at which the loan is trading or quoted at the time of the amendment. Thus, if a syndicated term loan trades at a price less than the face amount of the outstanding principal, the borrower recognizes taxable income at the time of the modification based on the difference between the face amount of the loan and its trading value. For example, if the borrower's term debt is trading at 62% of its actual principal amount - which, according to Standard & Poor's Leveraged Data and Commentary, was the average bid price for all regularly traded syndicated term debt as of December 31, 2008 - the tax code would treat the amendment as having resulted in (1) an issuance of a new loan at an issue price equal to 62% of the principal amount of the existing loan, (2) a repayment of the existing loan with the proceeds of the new loan (again, at 62% of the principal amount), and (3) taxable income to the borrower equal to 38% of the existing loan's principal amount. This treatment of the deemed exchange of loans could also result in tax issues under the tax code's high-yield OID rules.

5. Legal documents used in workouts. From the identification of the loan default to the implementation of the workout plan, a borrower can expect to encounter some or all of the following legal documents:

Finally, note that with any document executed by both borrower and lender in which the lender is making a concession to the borrower with respect to the loan terms (such as agreeing to forbear, waiving a default, agreeing to an amendment in favor of the borrower), the lender is likely to require that the document include a release by the borrower of all claims against the lender for any actions occurring prior to the document's execution.

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