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No Pain, No Gain

The business cycle contains upturns and downturns. This is hardly news. Unfortunately, how your business weathers the bad times often dictates whether it will survive.

In such times, it may be necessary to enter into negotiations with your lenders to restructure your debt and get your business back on track to financial stability. This process is called a ‘workout.’ Each situation is unique and generalized observations concerning workouts are difficult to make. However, there are some elements that are commonly incorporated in workouts in various combinations. The following is an overview of those elements.

In a workout, both the lender and the borrower give up something to gain something. A lender must be prepared to give up some of its legal and contractual rights and provide some short-term relief for the borrower, with the long-term goal of enhancing the relationship and likelihood of repayment. The concessions made by the borrower in the workout vary on a case-by-case basis, but in broad terms, in order for a workout to be successful, the borrower must minimally reaffirm its obligations to repay the loan.

Before engaging in any workout discussions, a lender should assess the strength of its position under its existing agreements with the borrower. He should also assess the relative strengths and weaknesses of the borrower and its ability to perform its obligations under various workout scenarios.

As a borrower, you can expect the lender’s review of the loan documentation to be the first step in the lender’s assessment. Title reports and financing statement searches should be ordered and reviewed to determine any lien priority problems and to discover any other interests in the collateral of which the lender was unaware.

Problems are often discovered at this stage and include errors or other inadequacies in descriptions of collateral, improperly drafted or unrecorded extension agreements, and defective, aged, or unfiled Uniform Commercial Code financing statements. A savvy lender can use the workout as a means of curing defects discovered at this stage.

The lender should also assess the borrower’s total financial position and require the borrower to inform the lender of the status of its relations with other lenders as well as with keeping it updated on other workout negotiations. In certain instances, a lender may benefit by joining with other lenders to seek a comprehensive workout of the borrower’s financial affairs. The lender’s analysis of the borrower’s honesty and competence is as important as the analysis of the borrower’s financial condition. The lender should attempt to review as objectively as possible the borrower’s dealings with the lender in the past.

The lender’s representative should also take stock of his or her subjective feelings toward the borrower to determine if it will be possible to work together reasonably. Because a workout necessarily requires the borrower and the lender to work with each other after the optimism that accompanied the initial closing of a loan has faded, there may be feelings of mistrust on the lender’s side and feelings of persecution or harassment on the borrower’s side. It is unlikely that a workout can be successfully consummated if either party consistently feels that the other side is attempting to gain an unfair or unreasonable advantage or is untrust The business cycle contains upturns and downturns. This is hardly news. Unfortunately, how your business weathers the bad times often dictates whether it will survive.

In such times, it may be necessary to enter into negotiations with your lenders to restructure your debt and get your business back on track to financial stability. This process is called a ‘workout.’ Each situation is unique and generalized observations concerning workouts are difficult to make. However, there are some elements that are commonly incorporated in workouts in various combinations. The following is an overview of those elements.

In a workout, both the lender and the borrower give up something to gain something. A lender must be prepared to give up some of its legal and contractual rights and provide some short-term relief for the borrower, with the long-term goal of enhancing the relationship and likelihood of repayment. The concessions made by the borrower in the workout vary on a case-by-case basis, but in broad terms, in order for a workout to be successful, the borrower must minimally reaffirm its obligations to repay the loan.

Before engaging in any workout discussions, a lender should assess the strength of its position under its existing agreements with the borrower. He should also assess the relative strengths and weaknesses of the borrower and its ability to perform its obligations under various workout scenarios.

As a borrower, you can expect the lender’s review of the loan documentation to be the first step in the lender’s assessment. Title reports and financing statement searches should be ordered and reviewed to determine any lien priority problems and to discover any other interests in the collateral of which the lender was unaware.

Problems are often discovered at this stage and include errors or other inadequacies in descriptions of collateral, improperly drafted or unrecorded extension agreements, and defective, aged, or unfiled Uniform Commercial Code financing statements. A savvy lender can use the workout as a means of curing defects discovered at this stage.

The lender should also assess the borrower’s total financial position and require the borrower to inform the lender of the status of its relations with other lenders as well as with keeping it updated on other workout negotiations. In certain instances, a lender may benefit by joining with other lenders to seek a comprehensive workout of the borrower’s financial affairs. The lender’s analysis of the borrower’s honesty and competence is as important as the analysis of the borrower’s financial condition. The lender should attempt to review as objectively as possible the borrower’s dealings with the lender in the past.

The lender’s representative should also take stock of his or her subjective feelings toward the borrower to determine if it will be possible to work together reasonably. Because a workout necessarily requires the borrower and the lender to work with each other after the optimism that accompanied the initial closing of a loan has faded, there may be feelings of mistrust on the lender’s side and feelings of persecution or harassment on the borrower’s side. It is unlikely that a workout can be successfully consummated if either party consistently feels that the other side is attempting to gain an unfair or unreasonable advantage or is untrustworthy. One of the most important aspects of this pre-workout analysis is a determination of the value of the collateral securing the loan. This information may be determinative of whether a workout is warranted at all.

The lender may also find it prudent to enter into a ‘pre-workout agreement’ as a condition to any further, substantive negotiations. The pre-workout agreement need not be extensive, but should include the borrower’s acknowledgment of the validity and amount of the loan, the existence of the borrower’s default under the loan documents, the lender’s reservation of all of its rights under the loan documents until a comprehensive settlement agreement is executed and delivered, and that nothing discussed in the course of the negotiations shall be binding upon the lender until it is reduced to a formal written, signed settlement agreement.

The lender will often require the borrower to make a principal reduction as a condition to making other modifications to the loan terms. The borrower may attempt to convince the lender that a source of funds for the pay down should be a sale of a property, in some cases financed by the lender. If a decision is made to provide additional funds for a project, the lender will likely require additional collateral to support the increase, which should be subjected to the same scrutiny and review as are called for by an initial loan funding.

From the borrower’s perspective, this additional funding presents a downside in that if the loan problems continue after the workout, he would find it more difficult to walk away from the project, since more assets would be encumbered. Generally, lenders must be careful during workout negotiations not to say, do, or write anything that may be used against them should negotiations fail and the borrower commences a lender liability action.

While it is often the case that the analysis and investigations described are being conducted as negotiations in progress, in no event should the workout be consummated until the lender has completed this due diligence.

Assuming that the lender has determined in principle that a workout of the loan is feasible and appropriate, decisions must be made as to the particular elements to be included in the workout package. At least some of the following elements typically are incorporated into most workouts:

• Extension of the payment term;
• Modification of the interest rate;
• Partial forgiveness of principal;
• Requirement of a partial payment of principal;
• Increase of the loan amount;
• Tying interest and principal payments to positive cash flow produced by collateral;
• Temporary deferment of some or all interest payments; and
• Requiring the borrower to ‘give back’ some collateral to the lender through deed-in-lieu of foreclosure or requiring the borrower to put up additional collateral, either because the original collateral’s value has declined to a degree that it no longer adequately secures the funds advanced or because additional funds are being advanced.

The workout process invariably occurs at a stressful time for all concerned. However, with some advance planning and cooperation on the part of the borrower and lender, the end result can be a win-win for both parties.

Martin C. Dunn, Esquire is an associate with Bacon & Wilson, P.C. He practice includes commercial finance and transactions, immigration law, real estate, and corporate law; (413) 781-0560;[email protected].

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