By Frank Simon
What is a “troubled loan” and how do you know that a loan is “troubled?” A troubled loan, also known as a “sour loan,” arises and can be identified through one, or a combination of, the following warning signs:
Decline in and/or insufficient income
Liquidity questions and strain on working capital
Shortfall after debt servicing
Low or negative equity
Adverse business and employment conditions
Credit score problems
In recent years, the number of troubled loans grew exponentially. Fortunately, the trend appears to be easing. The FDIC recently reported that the proportion of troubled loans on bank books fell to 9.1 percent of all loans, down from 10.3 percent at the end of 2009. This does not mean that the lending industry is out of the woods – yet.
Handling Troubled Loans
Although most have come to grips with troubled loans, one must continue to ask if your institution is strategically positioned to handle troubled loans. To answer that question, a lender needs to look internally. Does the infrastructure exist to handle troubled loans? Should the lender have a separate, specialized department, like a special assets group, to handle troubled loans?
A separate department brings with it greater objectivity. The separation allows for a minimizing of a natural sympathy, anger or hostility that may arise between borrower and loan officer after a loan goes sour. Having a separate department also sends a very strong message to the borrower that this is a serious matter, and works 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.
Identified – Now What?
The importance of investigation and information gathering cannot be repeated enough. Great effort should be made to gather information on the borrower’s financial situation before the relationship takes a turn for the worst, or the borrower becomes unresponsive. Among other things, a lender should gather sales figures for borrowers with operating facilities, along with updated financial statements, tax returns and credit reports for the borrower and any guarantors.
In addition, all loan related documents should be assembled, and a history of the lending relationship prepared.
A loan document review should be conducted immediately after identification of a troubled loan. Generally, the loan documents will provide the parameters of the initial lending relationship, including repayment terms, affirmative and negative covenants, and events of default. The loan documents may also provide valuable information regarding a borrower’s asset situation, related guarantees and possible indicators for fraud by the borrower in the inducement to contract.
Title searches can also be obtained to assist in deciding on the course of action to be taken. A title search may be invaluable in determining the present status and value of collateralized property, or liens, mortgages and ownership interests in property considered for cross-collateralization as part of a workout scenario.
Once all necessary information and documents are gathered, it should be fully analyzed and evaluated with appropriate personnel, and a strategy developed. The available action(s) are wide ranging and include: do nothing; workout or restructure; seek a receiver; initiate collection or foreclosure proceedings; requesting a Deed in Lieu of Foreclosure; or initiate involuntary bankruptcy proceedings.
The involvement of outside counsel may be essential to the strategy chosen. Although many institutions have existing relationships with counsel, one must be cognizant of possible conflicts in retention. It is not uncommon, especially in smaller communities, to find counsel in a conflict of interest situation for having previously represented a borrower. In addition, counsel may be disqualified from litigation if involved in the negotiation or generation of the loan documents in the first instance. Counsel may be conflicted out by a court for representing both sides in the negotiation, even though retained by the lender, and may be found by a court to be a witness to the lending relationship.
Upon review of the file, counsel should conduct an independent analysis and investigation, as necessary. Counsel may have a different or fresh perspective on the relationship, or discover new information.
Once familiar, outside counsel should work with the lender to either confirm or develop a new strategy. With a strategy in hand, counsel can work towards its successful implementation. These cases are often very fluid, making regular reporting by counsel on case developments, and identification of changes to strategy, important to eventual success.
Saving the Relationship
A multitude of questions arise when a lender decides whether to pursue a workout or its legal remedies. Those questions include, without limitation:
Is the lending relationship still viable?
Will a greater recovery result from the borrower and asset liquidation?
Will a greater recovery result from preservation of the borrower as a going concern?
Is the loan fully or partially secured?
Are any security interests perfected and enforceable?
Are the guarantors a viable source of repayment?
Are there legitimate lender liability issues?
Answering “yes” to one or more of these questions may weigh in favor of a workout. Indeed, the workout option gives the lender the opportunity to remedy any problems identified in this list.
Once deciding to pursue a workout, the lender’s next step is to determine what form the document evidencing the workout should take. If only a waiver or modification of a financial condition is contemplated, then a simple letter agreement may suffice. The letter agreement would set forth, among other things, the waiver or modification, the period of the letter agreement, and consideration given by the borrower for the relief received.
If the workout is more involved, then it will more likely be memorialized by a forbearance agreement. The forbearance agreement should include recitals and terms that give a snap-shot of, and lock in, the status of the lending relationship at the time the agreement is entered into. This snap-shot makes it more difficult for the borrower to later challenge the original loan documents and the workout itself.
The forbearance agreement should include recitals and terms acknowledging the validity of the initial lending relationship and obligations, the validity of the loan documents, and confirmation of related security interests and priority of same. The agreement should also identify the events of default, provide for the borrower’s acknowledgment of those events, identify terms of the forbearance and repayment of the loan, identify any additional events of default that may arise under the agreement, and re-acknowledge all guarantees.
An important protection which should be included in all forbearance agreements is a release of claims from the borrower and any guarantors. The release should cover the original loan transaction and related documents, the entire lending relationship and the workout negotiations.
Frank Simon is a founding member and shareholder of Simon, Galasso & Frantz.