D7.pdf

MODULE DULE 7 ENGAGE. LEAD. Bankruptcy Considerations......................................44 Dimension 7: Identify and Develop Strategies for Problem Loans...........................................................2 Preference Period......................................................44 Purpose o...

MODULE DULE 7 ENGAGE. LEAD. Bankruptcy Considerations......................................44 Dimension 7: Identify and Develop Strategies for Problem Loans...........................................................2 Preference Period......................................................44 Purpose of Dimension 7.............................................2 Automatic Stay.........................................................45 Additional Skill-Building Resources...........................2 Lender Liability........................................................45 Introductory Note......................................................3 Failure to Negotiate in Good Faith...........................46 Warning Signs............................................................3 Interference/Control Risk.........................................47 Financial Causes.........................................................4 Failing or Refusing to Lend......................................48 Non-Financial Causes..............................................11 Improper Acceleration or Foreclosure.......................49 Account Management..............................................16 The Exchange of Credit Information........................50 Gathering Information.............................................19 Breach of Fiduciary Duty.........................................51 Documentation Review............................................20 Lien Searches and Evaluation of Collateral...............24 Financial Analysis.....................................................25 Management and Operations...................................26 Industry Positioning.................................................28 Financial Problems...................................................29 Survivability Analysis................................................32 Risk Level/Classification...........................................32 Analytical Aids.........................................................32 Special Concerns in the Analytical Process................35 Developing Problem Loan Strategies........................37 Workout Resolution - Saving the Credit...................38 Exit Strategy.............................................................41 CRC US Body of Knowledge // Module 7 // Identify and Develop Strategies for Problem Loans JOIN. IDENTIFY Y AND DEVELOP DE STRATEGIES IES FOR PROBLEM LOANS DIMENSION 7 - 2 NOTES: PURPOSE OF DIMENSION 7 The purpose of Dimension 7 is to describe early signals of problem loans and to review appropriate responses to those signals. In Dimension 7 we will cover the following topics: Financial and nonfinancial warning signs. Account management alternatives for problem loans. Gathering information about the problem loan. Developing problem loan strategies. Bankruptcy considerations. Lender liability issues. ADDITIONAL SKILL-BUILDING RESOURCES The material in the Body of Knowledge provides an overview of knowledge related to topics covered by the Credit Risk Certification exam. Mastery of topics reviewed here is essential preparation for the exam, but no amount of reading and study can substitute for lending skills that must be acquired through formal classroom and on-the-job training. In addition to reviewing the Body of Knowledge, consider taking the following RMA courses to support your Dimension 7 skill building: Credit Cycle Management Applied Credit Risk Series Detecting Problem Loans CRC US Body of Knowledge Problem Loan Workouts DIMENSION 7 - 3 INTRODUCTORY NOTE NOTES: Dealing effectively with problem loans requires early detection. Any number of events can alert you and your borrower to a problem. The warning of a problem loan may come as a surprise, or as a result of a slowly deteriorating credit. Either way, when it occurs, you should immediately shift into your institution’s problem loan procedures. Each institution has its own process, and it is not the intent of this section to suggest that one procedure is better than another. In Dimension 7 we present certain steps that are common to most problem loan approaches. WARNING SIGNS Early identification of a problem loan may be documented through your risk-rating system or through the process of putting the company’s name on a watch list. Watch-listed credits are generally not those in imminent danger of bankruptcy. They may be identified as watchlisted because the company has changed management or is in a certain industry experiencing economic difficulty. The earlier you can detect a potential loan problem, the more likely it is that you will successfully deal with the problem. Appearance of a warning sign does not always mean that the loan has or will become a problem. It does indicate, however, that you should ask questions. The causes of the problem could be financial or nonfinancial or some combination of both. Module 7 // Identify and Develop Strategies for Problem Loans Nothing can be more chilling than to have a borrower walk into your office, hand over the keys to the plant, and say that they are unable to continue the operation. If the problem is a surprise, due diligence before funding and the subsequent monitoring of the loan were ineffective. (Due diligence, a term borrowed from the investment community, applies to the efforts of the analyst to identify the key issues of the credit.) The most important tool in detecting a problem loan is ongoing monitoring of the credit. DIMENSION 7 - 4 NOTES: FINANCIAL CAUSES Your first warning of company problems is likely to come from financial factors. Early warning signs of company problems based on financial causes could include any or all of the following: Late statements Frequent overdrafts Covenant violations Late payments Overadvances Deteriorating trends LATE STATEMENTS Is this a new event? – If so, you should find out why the statements are late and look for other warning signs. This may indicate that the company is delaying production of financial information because it has bad news to report. Is the company slow in providing other requested information? – This may signal deterioration in the borrower-lender relationship. CRC US Body of Knowledge Have you responded properly to late statements? When statements or other information are late, you can call the loan, extend the time for compliance or suggest changes in reporting requirements. Never ignore the breach. If you decide to call the loan, consult with your legal counsel first. How you initially respond could set a course of dealing with the company that could limit your options when subsequent violations occur. DIMENSION 7 - 5 FREQUENT OVERDRAFTS Overdrafts are signs of deterioration in the company’s cash position. Overdrafts are unauthorized, undocumented, and often unsecured loans. This is frequently the earliest indicator of a troubled company. Unfortunately, by the time the lender is directly affected, the company may already be in trouble. This may be a warning that the company has poor cash management, a lack of working capital, or a growing heldcheck problem. You should track monthly average collected balances to see if there are cyclical trends or a pattern of overdrafts. It is important to ask questions early to prevent problems and avoid losses. Questions you might ask include the following: NOTES: Is this a new event? Are the overdraft items written to suppliers? If so, this could signal a deterioration of supplier relationships. Are the overdraft items written to the Internal Revenue Service (IRS)? If so, this could signal serious tax problems and lead to potential lender liability for unpaid taxes. COVENANT VIOLATIONS In your view, how serious are the violations? Legal counsel, with your input, drafts loan agreements that are tailored to each transaction and borrower. Loan agreements typically contain affirmative and negative covenants or standards that the borrower must satisfy to continue to borrow. An effective loan agreement requires that timely and frequent financial statements be delivered. It generally includes covenants that permit you to monitor liquidity, leverage, and debt service coverage. They provide trigger points to protect the interests of the lender. Typically, covenants have three functions: 1. To allow you to gain control if the company’s financial condition deteriorates. 2. To ensure that a certain level of cash and other operating assets remains in the business. 3. To maintain management stability in the business. Module 7 // Identify and Develop Strategies for Problem Loans Have you properly responded to overdrafts? Never ignore overdrafts. How you respond could set a course of dealing with the company that could limit your options when subsequent overdrafts occur. DIMENSION 7 - 6 NOTES: Questions to ask include: Have you set up an effective system for monitoring the company’s compliance with covenants? An early warning system is needed. Have you properly responded to covenant violations? When the borrower violates a covenant, you can call the loan, extend the time for compliance or suggest an amendment to the covenant. Never ignore the breach. How you respond could set a course of dealing with the company that could limit your options when subsequent violations occur. LATE PAYMENTS Late payments on debt are among the more obvious warning signs. This is typically the last sign before major problems surface. If late payments occur, you can call the loan, extend the time for payment or suggest an amendment to the payment terms. Never ignore the breach. How you respond could set a course of dealing with the company that could limit your options when future payments are late. Questions you might ask include the following: Did the company warn you in advance that the payments would be late? Did the company give a plausible explanation for the late payments? Was the cause a temporary problem that has no permanent implication? OVERADVANCES CRC US Body of Knowledge Overadvances on a borrowing base are a primary cause of loan loss. Deviations from anticipated line utilization suggest potential problems. When an overadvance occurs, it overrides the lending decision you made in granting the loan. Questions you might ask to determine the reason for the overadvance include: Was it required to finance unanticipated growth of the business? If so, are you willing to finance that growth? Was the overadvance caused by a slowdown in accounts receivable collection or other liquidity shortfalls? If accounts receivable collections are slowing, why? If so, are you willing to continue your financing arrangement? DIMENSION 7 - 7 DETERIORATING TRENDS This warning sign comes in many forms. Trends to consider include: NOTES: SLOWDOWN IN ACCOUNTS RECEIVABLE COLLECTION Is it a function of credit policies and collection practices? What is the size of an average transaction? Can the company make money on a minimum credit transaction? How long does the company wait before beginning collection procedures? Did the company acquire the additional assets to prepare for anticipated future demand or to inflate the balance sheet? An increase in fixed assets accompanied by a corresponding increase in sales would generally be a positive sign for the company. If the company purchases more fixed assets and does not have sales growth, it may not be able to service its debts. What is the basis of the company’s predictions and are they reasonable? How were the fixed asset acquisitions financed? Are there purchase money security interests that would be senior to your collateral position? FIXED ASSETS FINANCED WITH SHORT-TERM DEBT Is the company financing assets with consideration to sources of repayment? Is short-term debt financing the purchase of long-term fixed assets rather than short-term needs? Module 7 // Identify and Develop Strategies for Problem Loans INCREASE IN FIXED ASSETS WITH NO CORRESPONDING INCREASE IN SALES DIMENSION 7 - 8 NOTES: DECLINING SALES Did the loss of a major account cause the decline? If so, does the company have any prospects for replacing that account? Did a change in competition or new regulations cause the decline? Does the company have a workable plan to meet this new challenge? RAPID INCREASE IN SALES Is the company discounting prices to increase sales? Does the company have the capability to finance increased accounts receivable? Has the company lowered its credit standards to spur sales? Is the company’s bad debt expense increasing? INCREASE IN SALES WITH NO INCREASE IN EQUITY Are profit margins being eroded? Rapid sales growth with consistent margins would be expected to result with commensurate increases in equity. When this does not occur, it may indicate that growth has been excessive. SLOWDOWN IN INVENTORY TURNOVER Has the company failed to write off non-salable or obsolete inventory and book the loss? CRC US Body of Knowledge Has the loss occurred, but not yet been realized? OPERATING EXPENSES AS A PERCENTAGE OF SALES ARE INCREASING Have sales fallen? What effort has the company made to reduce operating expenses? Operating expenses tend to be fixed in nature. Therefore, when sales fall, the company must make an effort to reduce operating expenses to keep the percentage constant. DIMENSION 7 - 9 DRAMATIC CHANGES IN THE RELATIVE MIX OF ACCOUNTS RECEIVABLE AND INVENTORY NOTES: Are the changes unusual for this company, that is, not due to seasonality? The balance or relationship between accounts receivables and inventory (and cash, of course) is not static and often changes over time—especially in seasonal companies. Do you have a good understanding of the operating cycles of the company? You will need this understanding to be able to recognize when the balance or relationship changes in ways that were not expected. REVALUATION OF ASSETS Are you over lending based on an unrealistic appraisal? Companies revalue assets to create equity and increase borrowing capacity. MULTIPLE LIENS ON THE SAME BUNDLE OF ASSETS Do the liens indicate that suppliers are worried about getting paid? Are the liens old enough to avoid a bankruptcy preference claim? In a bankruptcy, unsecured suppliers who attempt to improve their positions have a 90-day preference window. The presence of supplier purchase money security interest (PMSI) inventory liens often suggests serious problems exist. A WIDENING GAP BETWEEN GROSS AND NET SALES Are returns, allowances, and discounts causing a deterioration in the company’s gross profit margin? Does the level of returns indicate poor quality or dated goods? Module 7 // Identify and Develop Strategies for Problem Loans Is your collateral actually worth the value claimed? Revaluation may not be allowed under generally accepted accounting principles (GAAP), but sometimes occurs in compiled statements in which the accountant reports management’s assessments without passing judgment. DIMENSION 7 - 10 NOTES: POSITIVE CASH FLOW DERIVED FROM NON-OPERATING SOURCES When positive cash flow is being derived from nonoperating sources, such as sale of fixed assets, it provides evidence that the company’s business plan is not working. The company’s strategy may not be sustainable. HIGH DIVIDEND PAYOUTS To whom are the dividends being paid? Except in the case of Subchapter S corporations, dividends do not make economic sense for owners who also receive a salary from the company. Dividends are paid from after-tax profits, on which the company has paid taxes and the recipient will also pay taxes. Are the dividend payouts hindering the ability of the company to internally finance? LOANS/ADVANCES TO INSIDERS Are the loans or advances vulnerable to Internal Revenue Service (IRS) attack? The IRS can recharacterize loans or advances to insiders as dividends or salaries. You need to look carefully at these transactions, noting the rates, terms, and repayment provisions. Are these loans having a negative impact on liquidity and working capital? CRC US Body of Knowledge CONVERSION OF SHORT-TERM BANK OR TRADE DEBT TO LONG-TERM NOTES Does the converted debt have a viable source of repayment? Conversion of short-term debt to long-term debt changes the source of repayment from conversion of assets to long- term profitability. Ensuring a viable source of repayment is critical in converting short-term debt to longterm. DIMENSION 7 - 11 TAX PROBLEMS Has the company paid its property taxes? Nonpayment of property taxes places a lien on property that is superior to your lien. NOTES: Has the company submitted withholding taxes to the Internal Revenue Service (IRS)? The IRS provides that a lender that advances funds to a borrower for wages knowing that that the borrower does not intend to or will not be able to make timely payment or deposit of taxes can be held liable for payment of those taxes. Your liability is limited to 25% of the amount advanced for wages. When this warning sign appears you may decide to require the borrower to make tax payments to you and supply a stamped receipt and photocopy of the tax payment card. You could also require a copy of the general ledger each month and have statements and canceled checks routed through your office. DEBT SERVICE DEFICIENCY Does the company have assets it could sell? NON-FINANCIAL CAUSES Nonfinancial causes of company problems are not as easy to detect as financial ones but can be equally damaging. Nonfinancial causes may include the following: Deteriorating supplier relationships Management issues Ownership issues Industry problems Economic cycles DETERIORATING SUPPLIER RELATIONSHIPS The following may provide warning signs of deteriorating relationships between the company and its suppliers: Module 7 // Identify and Develop Strategies for Problem Loans Does the company have sufficient cash flow to fund its operations and pay your loan? Are the owners/investors able and willing to provide additional capital equity? DIMENSION 7 - 12 NOTES: DISPROPORTIONATE INCREASES IN TRADE DEBT AND ACCRUALS Is the company making late payments or partial payments to suppliers? Have you received a rising level of inquiries from suppliers? Is there a buildup of accounts payable to suppliers? When this happens, suppliers may impose stricter terms, including the extreme “pay on delivery.” They may also require the company to convert trade debt to notes payable and may file purchase money security interest liens. Your lien position could be affected. CONVERSION OF TRADE DEBT TO NOTES PAYABLE Is there an increase in notes payable and a reduction in accounts payable? Are the changes caused by a conversion of trade debt to notes payable? If so, the supplier or suppliers will likely file purchase money security interest liens. Your lien position could be affected. VIOLATION OF FRANCHISE OR DISTRIBUTORSHIP AGREEMENTS Does the company have a franchise or distributorship arrangement with its supplier(s)? Has the company violated its agreement(s)? Can the violations be cured? CRC US Body of Knowledge What penalties are likely? DIMENSION 7 - 13 MANAGEMENT ISSUES Management skills can be a primary cause of business failure. Inadequate management can cause or prevent resolution of problems (see the Management Risk Analysis discussion elsewhere in Dimension 7). NOTES: LACK OF A SUPPORTABLE BUSINESS PLAN AND FORECAST Does the company have a business plan and forecast? Are the company’s business plan and forecast realistic? Do facts support them? The most common cause of problem loans is a lack of adequate management. Management should be able to articulate a defensible short and long-term strategy. INABILITY TO MEET SCHEDULED COMMITMENTS What is the nature of the commitments it has failed to meet? What has caused the failure? Has management failed to consider the company’s capital requirements? What has been the effect on customer relations? When management cannot meet production, delivery, or other commitments on schedule, orders get canceled, goods get returned, penalties are assessed, and payments are held back. The cause can be due to either overselling or poor planning. RETURN OF SOLVED PROBLEMS In solving problems, does the company attack the causes or only the symptoms? How soon after being solved do the same problems reappear? When previously solved problems reappear within a relatively brief period of time, it is likely that management cannot find an effective solution. What kind of help is available? Is there untapped management talent within the company? Could a financial consultant help? Module 7 // Identify and Develop Strategies for Problem Loans In what phase of development is the company? Is it an emerging, stable, mature or declining company? The greatest risk to the company and your financial institution comes in the emerging and declining phases (see Industry/Product Life Cycles in Dimension 1). DIMENSION 7 - 14 NOTES: CAPITAL WITHDRAWALS/DIVIDEND PAYOUTS Have the owners withdrawn capital or paid themselves dividends? Are the capital withdrawals and dividends depriving the company of needed capital? Growing businesses need capital in the form of owner’s equity and debt. Owners may expect you to finance their strategies while withdrawing excessive amounts of capital from the company. You can add covenants to loan agreements to require capital to be maintained at minimum levels and to require injection of new owner capital to meet shortfalls. POOR FINANCIAL CONTROLS Is the company’s financial information late or inaccurate? Does this indicate that the company has failed to establish effective internal controls and systems? This usually occurs when the owners or managers of the business have not contracted for quality auditing reports or good bookkeeping systems. The best way to avoid this problem is to examine the company’s procedures before making the loan. If you find them unacceptable, you can require changes as a condition to making the loan. POORLY COORDINATED INTEROFFICE/INTRACOMPANY TRANSACTIONS Is the company divided into a number of small departments? Does it have affiliates? CRC US Body of Knowledge Are the transactions between departments and affiliates? Is it possible to clearly track those transactions? If the company has a number of small departments or business entities, it is important to be able to track ownership interests in the business entities and transactions among them. DIMENSION 7 - 15 CHANGES IN PERSONAL HABITS OF OWNERS/ MANAGEMENT NOTES: Has an owner or manager changed his or her lifestyle? Has an owner or manager changed his or her personal investing style? Have you noticed unusual personal behavior by an owner or manager? Has an owner or manager become less willing to share information? You must be able to identify lifestyle changes that could distract owners/managers from running the business or cause them to divert business funds for personal use. SUPPORTING MULTIPLE FAMILY MEMBERS AT THE EXPENSE OF MANAGEMENT EXPERTISE OR PROFITABILITY Are there family members on the company payroll? Do they add value equal to their compensation from the company? You should identify salary and other forms of compensation channeled to individuals who do not work for or provide services to the company. Should the money being spent on family members be redirected to the hiring of management expertise or funding of operations? VENTURING INTO NEW BUSINESS OR INVESTMENT AREAS OUTSIDE OF PROVEN AREAS OF EXPERTISE Has the company diversified into new business areas? How closely do the new business activities relate to the company’s proven expertise? Does the owner or manager have any experience in the new line of business? When a company gets involved in new activities that depart from their existing business, attention gets diverted from the ongoing operation of the entity for which you have provided financing. Has the company diverted funds into unrelated investments? Has this left the company with insufficient operating funds? Module 7 // Identify and Develop Strategies for Problem Loans Do they actually work for or provide services to the company? DIMENSION 7 - 16 NOTES: MANAGING PROFITABILITY Is the company managing profitability for tax reduction or has it mismanaged expenses? Tax minimization is acceptable as long as it is not considered fraud. However, extensive tax minimization strategies that reduce profitability can effectively reduce the company’s debt capacity. Are you able to get a clear view of the company’s financial performance and condition? ASSET MANAGEMENT Is the company maintaining the condition of its operating assets? Is the company properly servicing its equipment, updating its computer hardware, upgrading its software and protecting its business data? Well-maintained assets create the products or services that provide the cash flow to pay your loan as well as providing a secondary source of repayment. OWNERSHIP ISSUES UNPLANNED AND UNANTICIPATED CHANGES Has the company made changes in management or key personnel? (see Management Risk Analysis in Dimension 2) Has part or all of the company been sold to new owners? CRC US Body of Knowledge Do the new owners, managers, or key personnel have the ability to implement the company’s strategy? Changes in management, ownership, or key personnel can be a warning sign that a loan may become a problem. Your original analysis was based on the ability of current management to implement the company’s strategy. You will need to do new analysis to determine the effect of any changes. DIMENSION 7 - 17 SUCCESSION PLANNING Is the company dependent upon the expertise of the owner for success? NOTES: Is someone ready to step in if the owner is absent, becomes sick, or dies? Has the owner been unwilling to share authority or management responsibility? Is the owner stretched too thin to be effective? Is there anyone in the company who can challenge unwise decisions the owner may make? Succession planning requires a focus on both personal and business financial planning needs. INDUSTRY PROBLEMS Industry segments may experience declines, despite the overall health of the economy. Problems common to an industry may include (see Industry Risk Analysis in Dimension 1): Excessive regulation: – What does it cost the company to comply? – Can the company recover the cost by increasing product prices? – Will increased prices cause declining sales? Product/service life cycle – Does the company sell a product or provide a service that will always be in demand? – Will technological or other changes make the product or service obsolete? Module 7 // Identify and Develop Strategies for Problem Loans – Can the company comply? DIMENSION 7 - 18 NOTES: ECONOMIC CYCLES Is the nation’s economy headed for a recessionary period? The economy is cyclical. When serious economic downturns occur, almost all loans become potential problems. You must take steps to determine what effect the downturn will have on your borrower’s business. Is the company’s business well positioned for an economic downturn? In a recessionary economy, consumers generally reduce spending for unnecessary items. Companies selling necessary items would likely survive. For instance, a company that makes spare parts for automobiles would be more likely to survive than a new car dealership. Consumers would put off buying new cars but need parts to keep their old cars running. ACCOUNT MANAGEMENT There are four basic methods for dealing with a problem loan once it has been identified. They are as follows: CRC US Body of Knowledge Workout specialist or special assets group. In this case, the account manager is not included in the process. The advantage of this approach is that the specialist or group has the expertise and time to effectively manage the problem loan. Their view of the credit is not influenced by prior relationships. The disadvantage is that the specialist does not have the account manager’s extensive experience with the account. Shared responsibility. In this case, the account manager works with the workout specialist to manage the relationship. The special assets group serves as consultant, providing assistance. The credit may move to special assets, but the account manager stays involved to provide the benefit of his or her experience and knowledge of the credit and the company. Account manager. In this case, the account manager stays with the account “no matter what” with no special assistance. This is the least desirable approach. It is unlikely that the account manager has either the time or expertise to effectively deal with a problem loan in a workout or exit strategy. DIMENSION 7 - 19 Task force approach. In this case, on any credit over a certain dollar level, a senior level task force is assigned to be the decision-making body. It provides a quick and efficient way to handle situations as they arise. This may be used in combination with any of the other methods. NOTES: Effective use of legal counsel is necessary in any event. The cost of legal counsel can be high. The key is to use counsel judiciously and selectivity. Use counsel for legal advice, and not for structuring the transaction. GATHERING INFORMATION A description of the relationship between the account manager and the borrower. This can provide insight into the ability of the account manager to handle the workout and the likelihood that the borrower will cooperate. Whether the account manager recognized the developing problem and took effective early measures to deal with it. Financial statements or correspondence that may provide clues to the cause and nature of the problem. Correspondence may reveal a basic people or communication problem. Whether there is legal vulnerability or advantage. A review of documents may reveal deficiencies that can be corrected. Whether there are potential debtor defenses. The files can be subpoenaed. Do they include subjective comments that may indicate account manager bias or unfairness? Is there indication that the financial institution was controlling the borrower? Talk to others in the industry; speak with companies of similar size in the same economic environment and with the company’s customers and vendors. Talk to other financial professionals about firms that are in the same industry, that are the same size, or that operate in similar markets. Module 7 // Identify and Develop Strategies for Problem Loans When a problem occurs, it is critical to understand the range and scope of the issue. Gather data about the company, the economy, the company’s position in the marketplace, and management. First, check your own credit files. Much of the information you need should be there, including: 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 Equity capital Accruals Less 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. DIMENSION 7 - 38 NOTES: WORKOUT RESOLUTION: SAVING THE CREDIT A workout resolution is the most probable option. When warning signs are recognized early enough, it may be possible to save the credit and limit your loss. GAINING CONTROL OVER YOUR EXPOSURE Gain control over your exposure by doing the following: Manage the loan to the collateral level. Re-size your line of credit availability to an amount that is appropriate to your earlier financial analysis findings. Apply line limitations and restrictions, such as limiting or eliminating advances against inventory, to help ensure your exposure is covered by the most liquid collateral possible. Shore up all deficiencies including loan documentation, loan structure, and advance rates early in the process. If you do not currently apply advance rates, engage the help of a qualified field examiner to determine eligible collateral and to recommend appropriate advance rates. Consider a cash collateral account and lockbox together with a borrowing base certificate requirement to manage the loan-to-value position. If the borrower is undercollateralized, add collateral or design a plan that allows the borrower to phase back into compliance with an acceptable loan-to-value position. CRC US Body of Knowledge Have your legal counsel draft a comprehensive loan workout agreement. DIMENSION 7 - 39 ADDING COLLATERAL If you identified unencumbered assets during your review, you could require the borrower to grant security interests or mortgage interests in those assets to secure the loan. When you take additional collateral you need to be aware of two issues: NOTES: You must be able to prove that you gave value for the new collateral. If no new funds are being advanced you need to be able to prove you waived an event of default, extended the time for payment or otherwise gave up some right. Even if you can prove you gave value, the new collateral can be lost if the borrower either files a petition in bankruptcy or has one filed against it within 90 days after you obtain the new collateral. The 90 days is the bankruptcy preference period and applies to transfers of assets (new collateral) to secure an already existing debt. If the lender is deemed an insider, the period would become one year rather than 90 days. You could obtain guaranties to bolster a troubled credit. You need to determine whether the guaranties add strength to the credit and are enforceable. A guaranty is not enforceable unless it is supported by present or future consideration. In this situation, you would be taking guaranties in connection with a loan that already exists. You would have to prove that you had loaned more money, waived an event of default, extended the time for payment or otherwise given up some right in exchange for and reliance on the guaranties. Even if you could prove you gave present or future consideration, a new guaranty could be lost if the guarantor either filed a petition in bankruptcy or had one filed against it within 90 days after you obtained the new guaranty. The 90 days is the bankruptcy preference period and applies to transfers of assets (new collateral) to secure an already existing debt. If the lender is deemed an insider, the period would become one year rather than 90 days. If you have a Small Business Administration (SBA) guaranty, you must notify the SBA of the problem loan and obtain their consent to workout and/or liquidate as required in SBA rules and regulations. Module 7 // Identify and Develop Strategies for Problem Loans GUARANTIES DIMENSION 7 - 40 NOTES: OTHER SUPPORT Third party security interests and subordinations are additional types of support that could be obtained to bolster a troubled credit: A third party security interest is a collateral interest obtained from a party other than the borrower or a guarantor (see Third Party Support, Collateral Agreements, and Collecting from a Third Party Security Interest Grantor in Event of Default in Dimension 6). A subordination agreement could cover either debt or a collateral position. The subordinating creditor agrees to take a junior position to your institution as to repayment of debt or distribution of proceeds from collateral sales. Bankruptcy courts generally honor subordination agreements. However, the subordination can be lost if the subordinating creditor either files a petition in bankruptcy or has one filed against it within 90 days after you obtain the subordination. The 90 days is the bankruptcy preference period and applies to transfers of assets (subordinations) in connection with an existing debt. If the lender is deemed an insider, the period would become one year rather than 90 days. BUSINESS PLAN If you want to save the relationship rather than exit, you should require the company to establish a realistic business plan. This is the most likely strategy to assist the company in returning to profitability. CRC US Body of Knowledge FINANCIAL CONSULTANT If the borrower cannot establish a realistic business plan to improve performance, an outside consultant or turnaround specialist may be able to help management revive the company. This can be especially effective if your analysis has shown that many of the company’s problems are related to management and operational issues. You cannot require that the company hire a consultant named by you, because this would expose you to a lender liability risk. DIMENSION 7 - 41 EXIT STRATEGY We will now discuss various options and procedures for exiting the credit. NOTES: OUTPLACEMENT AS AN OPTION Once you decide on outplacement, there’s usually no going back. Irreparable damage can be done to the relationship. Changing your mind could involve course-of-dealing and waiver issues that could be raised in lender liability actions. KEY QUESTIONS TO ASK Do you want this borrower? Has the borrower done something that has reduced your confidence in them? For instance, did the borrower sell collateral without telling you and not use proceeds to pay down the loan? What are the consequences of outplacement for you? The risk of loss from continuing in the credit may be less than the risk of loss in bankruptcy or litigation. What will be the cost to your financial institution if the loan becomes a non-performing asset? What will be the cost of managing the credit? What will be the costs in litigation? What is the cost of lost opportunity? ISSUES TO CONSIDER Can the borrower refinance with another financial institution? The ability to transfer marginal credits varies from market to market, depending on how aggressively lenders are seeking new business. What is your history with the borrower? Is the borrower’s current condition worse than it has been in the past? Have you routinely waived defaults in the past? If so, why are you changing your attitude toward borrower’s defaults? Module 7 // Identify and Develop Strategies for Problem Loans Will your financial institution’s reputation suffer from outplacement? Do you want to be known as the lender that moves customers out? DIMENSION 7 - 42 NOTES: What is management’s ability to adapt in a crisis? You should grant extensions if the borrower 1) is making substantial progress toward obtaining takeout financing, 2) has a firm purchase commitment for sale of an asset that will result in reduction of your debt, or 3) is providing other forms of consideration sufficient to warrant a reasonable extension period. Are economic factors part of the company’s problem? Are they likely to get worse or are they likely to improve? Is the industry (service/product) in which the company is engaged viable? (see Industry Risk Analysis in Dimension 1) EFFECTIVELY COMMUNICATING THE DECISION You should communicate your decision to the borrower in a face-toface meeting and confirm the decision in writing. Provide the letter to the borrower at or immediately after the meeting. PROVIDE ADEQUATE NOTICE Loan agreements typically require notice periods of 10–15 days for normal defaults. Adequate notice of a decision to exit a credit is usually 90–120 days, unless the project is very complex or your past course of dealing with the borrower has included longer notice periods. Obtain and keep evidence of delivery of notice. CONTENT OF NOTICE Be simple and direct. Avoid citing specific reasons; otherwise, the borrower may attempt to invalidate them. Address the following: CRC US Body of Knowledge – You will not honor overdrafts. – You will make no payment of checks against uncollected funds. – Outline the conditions under which you may be willing to make advances. – Provide a copy of the letter to all guarantors. Have the borrower and each guarantor sign a copy and return it to you. DIMENSION 7 - 43 ANOTHER LENDER There are lenders that have a higher tolerance for credit risk who may be willing to assume the debt. You may be able to sell your loan at a discount. If you have done an effective review of the problem loan, the discount you give today will most likely be less than the loss you could suffer in foreclosure, litigation, or bankruptcy. If you decide to sell the loan, you must fully disclose to the buyer all that you know about the relationship. For instance, if you have a customer that has rapid growth but limited capital, causing over-advances on its line of credit, the best strategy could be to move the loan to an asset-based lender. NOTES: LIQUIDATION This option is only suggested when there is a high probability that this is your only source of repayment. You can expect a charge-off and the business and its entrepreneurs will lose their entire investment. Most guarantors never expect to be called upon to pay. In many cases guarantors look for ways to avoid having to pay. Many states provide guarantors with legal defenses that make collection difficult. Your position will be strengthened if you have obtained and kept evidence that the guarantor understood the terms of the loan that was guaranteed. This is easy if the guarantor is someone directly involved in the business, more difficult if the guarantor is not involved. If you have obtained written consent from guarantors to subsequent changes in the loan, you will have a better chance of enforcing your guaranties. Module 7 // Identify and Develop Strategies for Problem Loans CALL ON GUARANTOR DIMENSION 7 - 44 NOTES: BANKRUPTCY CONSIDERATIONS When financial burdens become too difficult, many borrowers and guarantors seek protection in bankruptcy court. When this happens you should immediately inform your legal counsel and turn the matter over to an attorney. Two bankruptcy considerations will immediately affect you and your relationship with the filer: You will need to determine whether you have benefited from a preference. You will also have to know and follow the automatic stay rules. PREFERENCE PERIOD The trustee in bankruptcy has the power to void some transfers of a debtor’s property made within certain time frames prior to the bankruptcy petition filing. Both voluntary and involuntary transfers are included. Payments made by the debtor to the lender could be reversed. The trustee could also recover property seized by you prior to the filing. A avoidable preference is a transfer of an insolvent debtor’s money or other property to a creditor as payment on a debt, which gave that creditor a greater percentage of repayment. Besides payment of money and seizure of property, voidable transfers include grants of security interests, perfection of unperfected liens, and attachments of involuntary liens. The preference periods are: CRC US Body of Knowledge 90 days for non-insiders. The trustee would have the ability to reverse only those transfers that occurred within the 90 days prior to the petition filing. You would be allowed to retain regularly scheduled loan payments made during that time. One year for insiders. The trustee would have the ability to reverse only those transfers that occurred within the one year prior to the petition filing. As the term implies, insiders are persons operating the debtor’s business. A creditor could also be categorized as an insider for preference purposes. This would happen if the bankruptcy court found that the creditor had become involved in the day-to-day operations of the debtor’s business. This would be deemed excessive control. DIMENSION 7 - 45 AUTOMATIC STAY An automatic stay comes into place immediately when a petition in bankruptcy is filed. At that point, all actions to collect a loan are prohibited. You must close all accounts of the borrower and open new ones as debtor-in-possession accounts. You may not legally: NOTES: Commence or continue any judicial, administrative, or legal process against the debtor. Enforce a judgment against the debtor or its property obtained prior to the filing. Obtain possession or exercise control over the property of the borrower. Create, perfect, or enforce any lien against the property. Collect, assess, or recover a claim against the debtor that existed before the filing. The automatic stay does not stop any action taken against a guarantor to recover a claim that arose before the filing. LENDER LIABILITY When a financial institution sues to collect a debt, it is often faced with a borrower counterclaim that the institution be found liable for some action it took or failed to take. These counterclaims are called lender liability claims. The following are among the theories put forth in such claims: Failure to negotiate in good faith. Interference/control risk. Failing or refusing to lend. Improper acceleration or foreclosure. Exchange of credit information. Breach of fiduciary duty. Module 7 // Identify and Develop Strategies for Problem Loans Set off any claim against the debtor for debt that existed prior to filing. DIMENSION 7 - 46 NOTES: FAILURE TO NEGOTIATE IN GOOD FAITH Many lenders send letters to customers representing that they would lend certain amounts at a certain rate for a certain period of time (basically a commitment letter) subject to certain factors. These factors could include: Financial statements and other information to be provided by management. Collateral requirements. Appraisals. Proof of corporate existence. Negotiated terms in the loan agreements. The lender feels protected from a final commitment by language that typically states that the loan “will be at the lender’s sole discretion” or the loan will be “contingent upon the lender’s satisfaction with the company’s response and the execution of acceptable documents.” COMMITMENT LETTER RISK The problem with commitment letters is that, in a dispute, a court must judge (frequently in the absence of any further information) whether your decision not to fund a loan was based on evidence that is clear. CRC US Body of Knowledge For example, courts have found that when a borrower refused to execute the lender’s loan documents, it was because they contained clauses that were not included in the commitment letter and that the lender should have known would be unacceptable to the borrower. Even though the commitment letter included such a statement, as “borrower will execute documents in a form acceptable to the lender,” the court could decide that the lender did not negotiate the additional terms in good faith. Unacceptable terms include standard clauses such as waiver of jury trials, confessions of judgment, and exclusive jurisdiction. PROTECTING THE FINANCIAL INSTITUTION You can protect your financial institution in several ways. If you don’t intend to commit, don’t send a commitment letter. If you send a commitment letter, have it drafted or reviewed by your legal counsel and include as many of the loan documents, including clear definitions of terms and conditions, as are available. DIMENSION 7 - 47 COMMENTS Disputes over what was said between the two parties can cause lender liability suits to occur. Whenever you meet with the borrower, have another representative of your financial institution with you and document what transpired for the credit file. NOTES: INTERFERENCE/CONTROL RISK This risk arises when you interfere with or control a borrower’s business to the extent that you dominate the borrower and misuse that control for your own purpose, i.e., repayment of your loan. A court may hold you liable for any damages that result to the borrower or any third parties. PROTECTING THE FINANCIAL INSTITUTION To avoid interference/control risk, do not: Serve or have another employee of your financial institution serve on the borrower’s board. Exert or appear to exert pressure on the borrower’s board. Involve yourself in the selection of the company’s management or a consultant to management. Involve yourself in the direction or development of the firm’s strategic or tactical plans. Make suggestions to management as to which of the firm’s checks should be honored or returned. Module 7 // Identify and Develop Strategies for Problem Loans Attend or solicit others to attend the borrower’s board meeting on your behalf. DIMENSION 7 - 48 NOTES: FAILING OR REFUSING TO LEND Many lenders provide discretionary lines of credit to borrowers with a demand note evidencing an obligation to repay advances. Under these credit facilities, the lender reserves the right, at its sole discretion, to refuse to make any advances. The lender is not required to have a reason for the refusal to lend. When it refuses to lend, however, the borrower may claim that the lender did not act in good faith. FAILING-OR-REFUSING-TO-LEND RISK Typically, problems with discretionary line of credit agreements are few if everyone understands the contract. Lenders get into trouble when they make statements to the borrower that go beyond the written documents. For example, indicating, “Although the documents state that the line is available at the lender’s discretion, all things being equal, we would expect to honor your request for advances,” exposes the lender to possible future litigation. PROTECTING THE FINANCIAL INSTITUTION To avoid failing-or-refusing-to-lend risk: Have all agreements and amendments relating to the loan and security in writing and signed by all parties. Keep a written record of all the borrower’s defaults and related conversations. Limit credit file comments to factual matters. In litigation, all written materials are subject to discovery. Provide the borrower with written notification of an event of default. Include any actions you plan to take. CRC US Body of Knowledge If you are waiving this event, indicate that you are waiving this event only, and that any other default, whether the same or some other, will be dealt with as it occurs. Consult with senior management and/or your legal counsel, before refusing to fund or calling a loan. Notify the borrower, in writing, if you are contemplating calling a loan or intend to make a substantive change in the way you deal with the borrower. Your prior course of dealing with the borrower may limit your ability to make changes. Allow time for the borrower to seek alternative arrangements. Failure to do so will enhance the possibility of legal action. Have the letter relating to this action reviewed by your legal counsel. DIMENSION 7 - 49 IMPROPER ACCELERATION OR FORECLOSURE NOTES: When a lender takes action against a borrower, either by accelerating a loan or taking possession of collateral, it is an extremely serious event. Even if the loan is in default, this event may result in legal actions against the lender. A court might find that the lender had acted in bad faith. IMPROPER ACCELERATION OR FORECLOSURE RISK If you continually accept delayed payments from a borrower, you may be deemed to have, by your course of dealing, modified the terms of the loan agreement. You will lose the right to accelerate in the future based on delayed payments with that borrower. You must give adequate notice to a borrower before you can call a loan in default. You can then take possession of collateral if the problem is not resolved. This rule may apply even if you have a loan agreement in place that says that notice is not required. Always consult with your legal counsel before you demand payment on a loan. Module 7 // Identify and Develop Strategies for Problem Loans PROTECTING THE LENDER DIMENSION 7 - 50 NOTES: THE EXCHANGE OF CREDIT INFORMATION Financial Institutions exchange credit information on a regular basis with their borrowers’ customers or other third parties. To facilitate the exchange of information, The Risk Management Association, the national association of credit professionals, was founded. One of its original purposes was to standardize the exchange of credit information. Despite this standardization, many lenders are giving credit information about their customers that could expose their lenders to potential liability. EXCHANGE OF CREDIT INFORMATION RISK Your financial institution may incur liability if an individual responding to a credit information request makes representations or omissions of material facts that are false at the time. The institution may also have liability if the person does not exercise reasonable care and diligence to see that the information is accurate. The plaintiff would have to prove the following: Misrepresentation or omission of fact that is material or significant. Failure to exercise that degree of diligence and expertise the public expects of reasonably competent financial institution representatives. Reasonable reliance by the plaintiff on the institution’s misrepresentation or omission. Damages incurred as a direct and proximate result of such reasonable reliance. PROTECTING THE FINANCIAL INSTITUTION CRC US Body of Knowledge To limit the possibility for litigation in this area: Consult a Lender’s Guide to Commercial Credit Information Exchange (available in the Credit and Lending Studies Pack Credit Information Exchange). Refer all credit inquiries to a central group or single individual that can assure consistency and standardization. Make a record of who called or wrote requesting information, when the contact occurred, what was asked, and finally, how the financial institution responded. Be sensitive to the implied agreement that exists between you and your borrowers regarding confidentiality. Get an agreement from your borrower that you can release information to those who appear to have a legitimate business reason for inquiring. DIMENSION 7 - 51 BREACH OF FIDUCIARY DUTY Borrowers have not often raised this claim successfully. They are generally required to prove that the individual handling their account was perceived to have knowledge superior to that of the borrower and used that knowledge to pressure the borrower to make decisions that benefited the lender to the detriment of the borrower. NOTES: Module 7 // Identify and Develop Strategies for Problem Loans Example: The president of a small financial institution in an agricultural community was asked to approve a loan to a local cattleman. The president said he was sure the cattleman’s ranching activities would improve if he would purchase a registered bull owned by the president. The bull was purchased and the loan was made. If the bank had to sue to collect the loan, the cattleman could counter with a claim that the president had breached his fiduciary duty.