CRC US Body of Knowledge Dimensions 7-37: Problem Loans PDF

DIMENSION 7 - 20 NOTES: In this section, we will review the following elements of gathering information: Documentation review Lien searches and evaluation of collateral Financial analysis Management and operations Industry positioning Financial problems Survivability analysis Risk level/classificati...

DIMENSION 7 - 20 NOTES: In this section, we will review the following elements of gathering information: Documentation review Lien searches and evaluation of collateral Financial analysis Management and operations Industry positioning Financial problems Survivability analysis Risk level/classification Analytical aids Special concerns in the analytical process DOCUMENTATION REVIEW CRC US Body of Knowledge The first thing you should do at the sign of a problem is a complete documentation review. Typically 60% of files reviewed at the time they become problem loans have major documentation deficiencies. Your position is only as strong as the documents you have to support it. You must review the following types of documents: DIMENSION 7 - 21 AUTHORITY DOCUMENTS Authority documents include borrowing certificates or resolutions and incumbency certificates. These documents tell you who is legally qualified to borrow and under what circumstances. You also need to discover whether the documents cover all borrowing or grant limited authority (see Borrowing Entities Authority and Execution in Dimension 6). NOTES: NOTES You need to determine who signed the notes and whether they were authorized to do so. Have the notes matured? Have overadvances been made? Do they include a clearly stated interest rate and repayment schedule? SECURITY AGREEMENTS AND FINANCING STATEMENTS Two kinds of key documents involved are security agreements and financing statements. Security agreements are used to grant security interests in assets. Financing statements are filed to perfect those security interests. Did the proper person(s) sign the security agreements? Have the financing statements been filed in the correct locations? Are the financing statements still valid? Do the security agreements and the financing statements correctly name the debtor using the actual name of the debtor and not a trade name? Do they adequately describe the collateral, either specifically or by type? If the collateral includes accounts, do you have current lists of your borrower’s customers? Module 7 // Identify and Develop Strategies for Problem Loans Is there an upset interest rate? That is, does the rate automatically increase if the borrower is in default? DIMENSION 7 - 22 NOTES: MORTGAGES/TRUST DEEDS If the documents include mortgages or deeds of trust, did the proper person(s) sign them? (see Security Documents, Deeds of Trust, Mortgages in Dimension 6) Were they correctly recorded in the proper office(s)? Is there a title report or policy? Is the legal description clear and consistent among all of the documents? ASSIGNMENTS (LEASES/RENTS), LANDLORD WAIVERS Are the assignments general or specific? Is there a landlord waiver? There should be a landlord waiver in the file if your collateral is equipment affixed to real property or is equipment or inventory located on leased premises. Without a landlord waiver you may not be able to get physical possession of the property. ENTITY VERIFICATION You must confirm the exact form of the borrower’s name with state or local offices in which the borrower was required to register to establish its existence. Is the borrower’s name consistently used in all documents? (see Borrowing Entities, Authority, and Execution in Dimension 6) CRC US Body of Knowledge Are all of your documents dated later than the date of the registration? If not, they may not be enforceable against the borrower. DIMENSION 7 - 23 GUARANTIES What type of guaranty is involved? NOTES: Is it a guaranty of payment or collection? Most banks’ forms of guaranty are guaranties of payment. With a guaranty of payment the guarantor pays the full amount of debt on demand. With a guaranty of collection you may be able to require the guarantor to pay, but you must exercise all remedies against the borrower first. What is the amount of the guaranty? Is it limited or unlimited? If the guarantor is not directly involved in the business, do you have proof that the guarantor has been notified of significant changes in the borrowing relationship? If not, the guaranty could be subject to challenge. LOAN AGREEMENTS What provisions are in the agreement? (see Content of Loan Agreements in Dimension 6) Have you previously waived breaches? If a violation or breach has been ignored, it could be considered a waiver. The waiver could be used to challenge the entire agreement and make it less enforceable. What notice provisions are included in the agreement? You will need to make certain that proper notices are given before you take action. Module 7 // Identify and Develop Strategies for Problem Loans Is there a loan agreement? If not, your ability to act will be severely limited. DIMENSION 7 - 24 NOTES: LIEN SEARCHES AND EVALUATION OF COLLATERAL DETERMINATION OF LIEN PRIORITIES You must order lien searches and obtain copies of all filings to determine whether you have senior liens on collateral. Searches must be ordered from all locations in all states where financing statement filings were required at the time the loan was made. Where possible you should order Department of Motor Vehicle searches to determine all of the borrower’s vehicles licensed in the state. This search may reveal unencumbered assets that can be used as part of a workout plan. Privacy laws in some states make motor vehicle lien information difficult to obtain. STATUS OF TAXES Does the company have delinquent tax obligations? You must investigate federal, state, and local sources. If tax liens exist, they may have priority over your perfected liens. STATUS OF LAWSUITS OR JUDGMENTS Money judgments can trigger a defensive bankruptcy, which means that your borrower may file a petition in bankruptcy to prevent seizure of assets by judgment lien holders. If lawsuits are pending or judgments have been handed down, you must factor the risks into your workout plan. You should ask your legal counsel for an assessment of the risks involved. QUANTITATIVE AND QUALITATIVE ANALYSIS OF COLLATERAL CRC US Body of Knowledge Start a collateral audit as soon as possible. Obtain current accounts receivable agings and equipment lists. Conduct an inventory audit. Obtain current third party valuations and appraisals, where needed, to confirm asset value. Expert opinions are more costly, but add value in the event court action becomes necessary. Do a going concern value analysis to determine the value of assets if sold as part of an ongoing business. Do a liquidation value analysis to determine the value of assets if disposed of in a liquidation sale. DIMENSION 7 - 25 FINANCIAL ANALYSIS Obtain and review the following: NOTES: Updated accrual basis financial statements and projections prepared by an independent accountant. Only an independent accountant has an entire view of the company and no bias toward management. The accountant has a professional duty to be accurate and complete. Inventory valuation analysis. First in first out (FIFO) vs. last in first out (LIFO). The use of LIFO tends to increase the cost of goods sold in a period of inflation. It may mean that the company’s profits are understated and there may be a LIFO reserve. Pro forma cash budget and profit plan for the next 12 months. It must include accrual profit and loss numbers, a month-to-month rolling budget, and an analysis of borrowing needs. The ability to preserve and generate cash is the key to the company’s survival in the short term. The cash budget details the sources and uses of cash and the resulting excess or shortage for each period. Breakdown of obligations owed to you by owners of the business, guarantors, and affiliates of owners and guarantors. Tax returns for the business entity and guarantors. The returns reveal important information including dividend interest income, debts, assets, and partnerships. Updated personal financial statements (compare to previous years). Debtor’s exam. A debtor’s exam is a non-judicial procedure in which the borrower submits to a deposition-like questioning under oath in the presence of a court reporter. When used selectively, it can be valuable in revealing assets that you can encumber as part of a workout. Depreciation schedules. Look for unencumbered assets. Records of debt owed by borrower, owners, guarantors, and affiliates to your financial institution and to other creditors. It is important to cover all areas were money can exit. Inform all administrative and customer contact personnel (including those who answer the phones) of the changed circumstances. Legally they are presumed to know all that you know. You must make certain they do. If not, they may make inaccurate responses to credit inquiries and expose your bank to liability. Module 7 // Identify and Develop Strategies for Problem Loans Capital budget. This schedule of proposed capital expenditures helps identify prospects for cutbacks, deferrals, or elimination. These are opportunities to reduce cash outflow. DIMENSION 7 - 26 NOTES: MANAGEMENT AND OPERATIONS Review management strategy and operations, including: GENERAL MANAGEMENT CAPACITY (SEE MANAGEMENT RISK ANALYSIS IN DIMENSION 2) How well defined is the company’s organizational structure? Is there a clear chain of command? Are job responsibilities clearly defined? What is the forum for policy setting and major decisions? Which managers participate? Can the company define its business and outline its goals and objectives? What is the quality of the company’s forecasting and planning? Can management define key items that must be controlled? Are there systems in place to monitor them? Are management reports of reasonable quality, thoroughness, scope, and frequency? Does the company have adequate accounting systems? The auditor’s management letter should be reviewed. This documents material operational issues found deficient within the company’s financial control systems that could represent considerable risk. You should also obtain a copy of the company’s response. Does the company have an effective inventory management system? What is the quality of the company’s inventory as it relates to regulations and codes, state-of-the-art technology, taste, style, and cost (inclusive of operating expenses)? CRC US Body of Knowledge Does the company have financial standards and goals for such things as financial leverage, profitability, cash flow, and growth? Are monthly cash and credit needs understood and projected with accuracy? Can the company generate reliable cost data? What is the company’s marketing strategy? Is there a detailed plan that includes advertising, pricing, and distribution to support it? How often is a market and competitive assessment made? How does the company determine customer preferences and satisfaction? DIMENSION 7 - 27 CRISIS MANAGEMENT CAPACITY Has the company previously faced crisis situations? If so, was current management in place at that time? How did they handle the crisis? NOTES: If inexperienced, does current management have the capacity to deal with crisis? What is management’s assessment of the situation? Is it realistic, overly optimistic or too pessimistic? Has management developed a plan to deal with the problem? Is it sufficiently specific with outlined objectives, responsibilities, timetables, and costs? Has management sought outside or professional advice? How committed is management to the plan? MANAGEMENT CONTROLS How are credit checks performed on customers and potential customers? What sources are used? How often? Are credit limits and terms established for individual customers? Who sets them? What guidelines are followed? Who has final approval on a sale—the salesman, manager, or credit person? Can the company readily produce an accounts receivable aging? What percentage of receivables is past due? What past-due percentages are considered acceptable? What procedures are followed to collect past dues? Who collects them? When are they turned over to a collection agency? What is the company’s charge-off policy? What has the company’s loss experience been? Module 7 // Identify and Develop Strategies for Problem Loans ACCOUNTS RECEIVABLE DIMENSION 7 - 28 NOTES: INVENTORY/PURCHASING What are the company’s purchasing procedures? How are purchase orders originated and approved? Who has final authority? On what basis are suppliers selected? How are they screened for quality and dependability? Are there major suppliers that provide more than 15–20% of the company’s product? What is known of the suppliers’ financial condition and management? Is the company using perpetual or periodic inventory methods? Is inventory computerized with automatic reorder levels? How often are physical inventory counts taken? How often and on what basis are inventory write-downs made? What has past experience been? INDUSTRY POSITIONING The company’s performance should be measured against competitors and peers in the industry. The industry should be analyzed to determine its basic characteristics and expectations for turnaround (see Industry Risk Analysis in Dimension 1). For example, if the industry has matured, growth will have stagnated, competition will be severe and the strongest and best-managed will survive without major realignments. Factors to review include: COMPETITORS How many competitors does the company have? CRC US Body of Knowledge How easy would it be for other competitors to enter the market, thus increasing competitive pressures? What is most important—price, quality, or other factors—in determining the company’s market share? What is the company’s perceived position within the industry and the community? MARKET SHARE BREAKDOWN What is the company’s market share? Is the trend up or down? DIMENSION 7 - 29 CUSTOMER BASE Is there a sales concentration in a few large customers or is there a broad customer base? NOTES: What is the general financial and business condition of the customers? Is there a trend in the customer base? What are the prospects for obtaining new customers? Are the prospects based on an objective analysis? Management projections can be subjective and not always useful in evaluating a project’s viability. INDUSTRY SALES TRENDS How do the company’s sales trends relate to industry sales trends? Can industry sales problems be solved? FINANCIAL PROBLEMS QUESTIONS TO ANSWER You should consider the following issues in your analysis: What are the amount and timing of withdrawals and salaries paid to owners of the business? Are there LIFO reserves? What is the level of those reserves? Are there excess non-earning assets? What are they worth? Are they salable? What is the cost of retaining existing leases? Are they needed? Can they legally be terminated? Are there long-term contracts? Are they needed? Can they legally be terminated? Are there held checks and book overdrafts? What is the amount of exposure? What do you expect the company’s cash needs to be over the next 90 days? Module 7 // Identify and Develop Strategies for Problem Loans Can the company outperform the industry by taking a bigger market share? DIMENSION 7 - 30 Does the company have the ability to reduce its general and administrative expenses? By how much and for how long? What is the level of the company’s current accounts receivable and accounts payable? Are aging lists up to date? What is the status of current rent rolls? What will the impact be on a break-even analysis if some of the lower margin products or services are eliminated? Will the company lose more money by continuing to operate or by shutting down? If in bankruptcy, will your claims be fully secured? Is there the potential of successful challenges to your claims? (see Bankruptcy Considerations elsewhere in Dimension 7) Is there a surplus or deficiency in the borrowing base? Are there outside sources of risk capital? How much is available? How soon can it be obtained? Is there a debt-service deficiency? Would restructuring enable the borrower to service its debt? If other creditors are involved, would it be possible to enter into an intercreditor agreement with them? CALCULATING A DEBT-SERVICE DEFICIENCY NEEDS SOURCES Existing operational (bank) debt Margined accounts receivable borrowing base Accounts payable Margined inventory borrowing base Accruals Less Equity capital Term debt payments Extended trade creditor terms Overdrafts or held checks Asset sales CRC US Body of Knowledge Asset acquisition needs To complete the calculation, subtract the sum of the items listed under Sources from the sum of the items listed under Needs. If the result is a positive number, a debt service deficiency exists. DIMENSION 7 - 31 Examples: COMPANY A NEEDS Existing operational bank debt Accounts payable Accruals Term loan payments AMOUNT 85,000 SOURCES Margined accounts receivable borrowing base Margined inventory borrowing base 200,000 Equity capital 150,000 0 55,000 Total needs 45,000 0 Asset sales Asset acquisition needs 160,000 230,000 Extended trade creditor terms Overdrafts or held checks AMOUNT 0 80,000 450,000 Total sources 555,000 COMPANY B Accounts payable AMOUNT 185,000 SOURCES Margined accounts receivable borrowing base Margined inventory borrowing base 25,000 Term loan payments 55,000 Total needs 50,000 Extended trade creditor terms 45,000 0 0 80,000 575,000 Total sources Total needs of $575,000 – Total sources of $455,000 = $120,000 Company B has a debt service deficiency. 200,000 Equity capital Asset sales Asset acquisition needs 160,000 230,000 Accruals Overdrafts or held checks AMOUNT 455,000 Module 7 // Identify and Develop Strategies for Problem Loans NEEDS Existing operational bank debt DIMENSION 7 - 32 NOTES: SURVIVABILITY ANALYSIS Key questions to ask about the company include: Can the borrower survive? If not, there’s no need to proceed further with a workout. You should adopt an exit strategy. What resources are necessary to survival? Where will the money come from? – From the owners? – From third parties, such as, investors, guarantors, or governmental agencies? – From you? If so, how much risk capital are you willing to provide? RISK LEVEL/CLASSIFICATION When a warning sign(s) appears you should conduct a complete credit analysis. Use the procedures and tools you would normally use to risk rate credits. This will determine whether the loan should be classified and may indicate that further steps are needed to deal with perceived problems. You should rely upon an independent accountant as the best source of information to verify the accuracy and reasonableness of information about the company provided to you by management. ANALYTICAL AIDS CRC US Body of Knowledge The following are helpful tools for analysis: On-site analysis. Evaluate the facility, management, and quality of inventory. You cannot properly evaluate a project by telephone or from pictures in an appraisal. Industry or peer group analysis. Tools include RMA’s Annual Statement Studies and your credit files. It is important to compare a company’s performance with both a successful and a classified account. Turnaround or management consultants. This can be costly. There are lender liability risks if you select the management consultant for the company. You could, however, hire an examiner to analyze your financial institution’s risk. DIMENSION 7 - 33 Break-even analysis. What is the company’s sustainable growth rate? At what rate can the company increase sales with no change in equity or operating debt? This is a simple and fast method to identify areas in which the company can create cash flow. NOTES: Performance or trend line analysis. The slope and mass of a variable determine the company’s ability to reverse trends. Has there been a large percentage drop in unit sales and sales dollars? Has the change been gradual or occurring over a short period of time? Computer modeling. How reasonable are the company’s projections given actual historical performance? BREAK EVEN ANALYSIS Step 1. Classify costs as fixed or variable. Step 2. Determine variable costs (VC) as a percentage of sales. Step 3. Determine contribution margin ratio (CMR). Step 4. Calculate break-even sales. Fixed costs Break-even = CMR Sales $ Fixed costs (Price per unit) - (Variable costs per unit) = Break-even units Module 7 // Identify and Develop Strategies for Problem Loans CMR = 100% - Variable costs DIMENSION 7 - 34 EXAMPLE: Step 1. Total costs of $3,000,000 classified as $970,000 fixed cost (FC) and $2,030,000 variable cost (VC). Step 2. Sales = $2,900,000. $2,030,000 (VC) divided by $2,900,000 (sales) =.70 Step 3. Contribution margin rate (CMR) 100% - 70% (VC) = 30% Step 4. $970,000 (FC) divided by 30% (CMR) = $3,233,333 (break-even sales $) 12,000 (P/unit) - $8,400 (VC/unit) = $3,600 970,000 (FC) divided by $3,600 = 296 (break-even units) You may also use an alternate approach, i.e. divide the aggregate sales breakeven by the unit sales price, to arrive at the same answer as the first formula. BREAK EVEN MATRIX UNITS DOLLARS Break-even level Fixed costs (P/unit) – (VC/unit) Fixed costs CMR Sales level to make a profit Fixed costs and profit (P/unit) – (VC/unit) Fixed costs and profit CMR EXAMPLE: Break-Even Level. $970,000 (fixed costs) divided by $3,000 ((P/unit) – (VC/unit)) = 323 units. CRC US Body of Knowledge $970,000 (fixed costs) divided by.30 (CMR) = $3,233,333 sales level. Sales Level to Make a Profit. $970,000 (fixed costs) + $50,000 (profit) = $1,020,000 (fixed cost and profit) $1,020,000 (fixed cost and profit) divided by $3,000 ((P/unit) – (VC/unit)) = 340 units. $1,020,000 (fixed cost and profit) divided by.30 (CMR) = 3,400,000 sales level DIMENSION 7 - 35 SPECIAL CONCERNS IN THE ANALYTICAL PROCESS NOTES: The following are special concerns that may arise as you conduct your analysis: DOCUMENTATION FLAWS How serious are they? Can they be cured? At what cost? HISTORICAL RELATIONSHIP What is the customer’s history with your financial institution? In the course of dealing with your customer, is there anything that could expose you to lender liability claims? Have you treated the customer professionally and responsibly? Do you have documentation to show that your actions are not arbitrary, capricious, or arrogant in dealing with the problem credit? OTHER CREDITORS What is the attitude of each? Is there any willingness to share the risk? ABILITY TO IMPROVE YOUR COLLATERAL POSITION Are there unencumbered assets? Can you obtain additional collateral without being unfair to third parties? A bankruptcy court has the ability to subordinate your claim to those of unsecured creditors if the court finds that you have unfairly gained an advantage over them. This is called equitable subordination. Module 7 // Identify and Develop Strategies for Problem Loans METHOD OF DEALING WITH THE CUSTOMER DIMENSION 7 - 36 NOTES: ABILITY TO DOWNSIZE Can the borrower sell off non-earning assets to reduce debt or operating expenses? Can the borrower make staff reductions? SOURCES OF RISK CAPITAL Where can the company obtain money to fund ongoing operations during a turnaround attempt? Are the owners willing to inject new capital? Are there non-recourse transactions, that is, transactions into which the company has entered that can be avoided without recourse? LOSS ANALYSIS Is the risk of loss from continuing in the credit greater or less than the probable loss in liquidation or bankruptcy? Is costly litigation likely? LEGAL ISSUES If collateral includes real estate, are there environmental issues? (see Environmental Risk Analysis later in Dimension 7) Is a bankruptcy filing likely? CRC US Body of Knowledge Are there potential lender liability claims? Explore the ability to obtain a waiver or release as part of a workout agreement. DIMENSION 7 - 37 DEVELOPING PROBLEM LOAN STRATEGIES NOTES: After you have identified a problem, you must develop a strategy. Costs will be involved. They will include: Legal expense. Do not accept poor quality legal advice in order to save money. You should request an initial fee estimate and updated estimates as the case progresses. Administrative expense. Administrative costs make it impossible to achieve an acceptable return on a problem loan. Reputation. The cost of a damaged reputation may be one of the highest costs associated with problem loans. Excessive loan problems can cause damage to a financial institution’s reputation in the eyes of its existing and potential customers, providers of funds, and the investment and financial community. Borrowing expense. When a financial institution is perceived as having an excessive number of problem loans, the marketplace will charge the institution more for funds. Lost opportunity. Opportunities for normal growth and expansion are limited for the organization that finds itself struggling with excessive loan problems. Some financial institutions find the costs so steep that their very existence is threatened. You have two choices. You can either choose a workout solution with a goal to improve the credit, or an exit strategy to move the credit out of your financial institution. Module 7 // Identify and Develop Strategies for Problem Loans Personnel expense. A bank that is encountering extensive loan problems frequently loses its best people. They may see their longterm career prospects jeopardized by association with a problem financial institution.