What is a “troubled loan,” and how does a financial lender distinguish that a company’s loan is upside-down and needs help? A troubled loan can be identified through one, or a combination of, the following warning signs:
• Violation of Covenant Agreement
• Insufficient income
• Liquidity questions/strains on working capital
• Shortfall after debt servicing
• Low or negative equity
• Adverse business/employment conditions
• Guarantor weakness
• Insufficient collateral
Since 2006, the number of troubled loans in the United States and Michigan has grown exponentially. Fortunately, the trend appears to be easing. The FDIC recently reported that the proportion of troubled bank loans fell to 9.1 percent of all loans in 2010, down from 10.3 percent at the end of 2009.
However, this does not mean the need for loan workouts have subsided.
Although most financial institutions have come to grips with troubled loans, one must continually ask: “Is my institution strategically positioned to handle a loan workout?” To answer that question, a lender needs to look internally. Does the infrastructure exist to handle troubled loans? If not, a lender should consider staffing a separate, specialized department to handle such problems.
An independent department brings with it greater objectivity. The separation allows for a minimizing of a natural sympathy, anger, or hostility that may arise between the borrower and loan officer if things go sour. A separate department also sends a very strong message to the borrower that “this is a serious matter,” which serves to avoid or minimize lender liability issues.
The separate department should be given authority to implement important procedures and policies. It should report, and have access to, senior management for important policy development, decisions, and resource allocation.
The importance of an investigation and information-gathering cannot be repeated enough. Great effort should be made to gather information on a borrower’s financial situation before the relationship takes a turn for the worse, or the borrower becomes unresponsive. Among other things, a lender should gather sales figures along with updated financial statements, tax returns, and credit reports for the borrower and any guarantors. All loan-related documents should be assembled, and a history of the lending relationship should be prepared.
In addition, a loan document review should be conducted. The loan documents can provide the parameters of the initial lending relationship, including repayment terms, affirmative and negative covenants, and events of default. The loan documents also may provide valuable information regarding a borrower’s asset situation, related guarantees, and possible indicators for fraud by the borrower in the inducement to contract.
What’s more, title searches should be obtained to assist in the decision-making review. A title search may be invaluable in determining the present status and value of collateralized property as well as liens, mortgages, and ownership interests in property considered for cross-collateralization as part of a workout scenario.
Once all the necessary information and documents are gathered, they should be fully analyzed and evaluated with appropriate personnel. The available actions are wide-ranging and include: (1) Do nothing; (2) Workout or restructure; (3) Seek a receiver; (4) Initiate collection or foreclosure proceedings or (5) Start involuntary bankruptcy proceedings.
The involvement of outside counsel or an accredited turnaround management firm may be essential to the strategy that’s chosen. Although many financial institutions have existing relationships with counsel and turnaround managers, one must be cognizant of possible conflicts in retention. It is quite common, especially in smaller communities, for conflicts of interest to develop if a business expert or professional previously represented a borrower.
In addition, counsel may be disqualified from litigation if they were involved in the negotiation or generation of the original loan documents. Counsel also may be conflicted out by a court for “representing both sides” in the negotiation even though they were retained by the lender, and may be found by a court to be a witness to the lending relationship.
Upon review of the file, a turnaround manager or lawyer should conduct an independent analysis and investigation, as necessary. The parties often have a different or fresh perspective on the relationship, and may discover new information.
Once familiar with the case at hand, outside counsel should work with the lender to either confirm or develop a new strategy. With a plan in hand, counsel can work toward successful implementation. These cases are often very fluid, making regular reporting by turnaround managers or counsel on case developments — and identification of changes to strategy — important to the eventual success of getting a business or organization back in the black.
Frank Simon is the founding member and shareholder of Troy-based Simon PLC, a law firm that represents financial institutions. Marjan Neceski is a senior attorney at Simon who specializes in commercial litigation, workouts, and collections.