How to detect and solve a company's financial distress.

The business community, like the rest of Los Angeles, has felt the effects of the country's economic problems. Many businesses will face tremendous financial difficulties. The following is an effort to assist both creditors and distressed companies in understanding the signs of financial distress and potential solutions to these problems.

Recognizing Signs of Distress

The ability to recognize signs of impending financial distress is an art requiring common sense and experience. Here are some common signs of financial distress:

* Lack of financial awareness. This may be seen by an inability to answer basic financial questions, by financial information not being reliable or by signs that financial information is not being used to manage the company.

* Inability to pay debts as agreed. Was the creditor realistic on this score at the outset?

* New borrowings being requested which will simply be used to pay down the trade. Analyzing seasonal lines of credit can be particularly tricky, and misjudgments may result in seasonal debt becoming long-term debt.

* Trade creditors insisting on purchase money security or consignment terms.

* Working capital deficit problems. Suggests likely future cash flow problems.

* Trade payables being stretched, evidenced by increased trade inquiries to the creditor, demands for payment or lawsuits.

* Continuing inability to meet operating projections. Suggests either poor financial forecasting or poor operations, or perhaps both.

* Delay in delivering financial statements or having qualifications to the financial statements.

* Reduction in sales volume not attributable to historical business cycles. Suggests operating problems and loss of market share.

* Catastrophic loss from business operations, or otherwise, which cannot be recouped from insurance in a timely manner (e.g., a fire or embezzlement).

* Key personnel departures. Suggests a "sinking ship."

* Industrywide downturns, regulatory problems or third-party decisions that might have a negative impact (e.g., a new generation of computers is introduced).

* Secured debt payment defaults and lien foreclosures.

* Tax liens.

As a general rule, the best results are obtained when the problem is spotted early and positive action is taken. There is no substitute for a continuing review and audit process to identify potential problems.

A word of warning to the creditor at the outset: In most problem loan situations, two people--the debtor and the creditor--have made a mistake. Creditor arrogance simply reduces the likelihood of a successful workout and is often misplaced.

The tax consequences of debt forgiveness also should be carefully considered. A debtor may be deemed to have income for the debt that is forgiven.

Do's and Don'ts

while each fact situation is unique and rules are often not as useful as common sense, here are some "do's" and "don'ts" for workouts.

Do's

* Understand your entire credit risk exposure both as a debtor and a creditor.

* Insist on adequate audit procedures.

* Make every effort to see that employees are paid.

* Make sure withholding taxes are being paid.

* Make management changes and changes in business direction.

* Don't rely on verbal understandings; reduce these to writings that are consistent with the loan documents.

* Deal with experienced workout personnel instead of the loan officer. The officer who made the loan may be angry or scared and, consequently, too hard or too soft.

* Review loan documents for completeness and perfection of liens and security interests.

* Review collateral dispositions with persons familiar with the practicalities, such as auctioneers.

* Review bankruptcy risks with the bankruptcy adviser (e.g., stay, use of collateral), while at the same time considering the positive use of Chapter 11. Repeat this process from time to time.

* Look at potential material concessions on loans, including loan maturity extensions in return for debtor concessions, such as being given collateral or being released from claims.

* Understand your true state of financial affairs (to the extent possible).

* Be wary of personal guarantees.

* Conduct a lender liability review, which should include investigating whether the documents fit the deal, the course of dealing (possible oral side agreements) and the rights of third parties.

* Take adequate notes and communicate in writing with the lender.

* Deal honestly with trade creditors by giving accurate and consistent answers to trade inquiries or by declining to answer.

* Evidence all waivers, moratoria or extensions in writing.

* Consider the need to find alternative financing.

* Get reasonable notice if the amounts to be advanced will be reduced, late payments will no longer be accepted, a default or acceleration will be declared or any remedies will be exercised by the lender.

Don'ts

* Use documents that are inconsistent with each other or the business purpose.

* Rely on technical language.

* Threaten a default where you do not intend to act or say things intended to otherwise mislead.

* Use threatening or abusive language.

* Mislead trade creditors who make credit inquiries.

* Make notes or write letters that cannot be explained to a jury.

* Try to hide a preference, which may simply turn the payment into a fraudulent transfer.

* Routinely attend board meetings if you're a creditor.

* Offer opinions concerning the future, except concerning what you will or won't do.

* Engage in schemes to promote any creditor's interests at the expense of third parties.

In any financial distress situation, fair play and attention to appearances will be important. These concerns should not, however, drive matters to the point where the creditor fails to take action and permits further deterioration of an already bad situation. Where a liquidation of the debtor appears inevitable, a Chapter 11 case may be the wisest course.

If any of the above situations occur, consult your adviser. Do not wait until it is too late to take appropriate action.

Michael S. Kogan is a partner at the Beverly Hills law firm of Ervin, Cohen & Jessup LLP, where he serves as Head of the Bankruptcy and Reorganization Department.