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You owe your company a good workout.

Both debtor and lender have a common interest in resolving a loan problem. if you need to negotiate a workout, here is how to recognize your strengths and weaknesses and how to analyze your options.

Is your company faced with financial difficulty because of a downturn in your industry, the general recession, or debt left over from an acquisition or an LBO in the 1980s?

If you're in difficulty, a financial restructuring may be in your future. You certainly don't want the lender foreclosing on your company and selling part of its assets to recover the original loan.

Fortunately, lenders are more open to workouts today than in the past. One reason is the shortage of capital to fund acquisitions, which makes it difficult for a bank taking over a company to dispose of its assets by selling them to a third party. Given this problem, banks are more willing to restructure the original loan transaction. However, structuring and implementing a workout is an art rather than a science. You need to satisfy your company's short-term and long-term needs in a way acceptable to the lender.

When do you need a workout?

There is no convenient list of early warning signs to indicate when you should initiate a workout. Companies these days frequently experience an increase in their payables, an aging of receivables, or simply a decrease in sales volume. To continue doing business as usual, some "stretch the trade" by finding better credit terms, while others find they have to pay suppliers COD. But when the situation deteriorates to the point of a loan default, a workout must be considered.

Perhaps a leveraged buyout of a few years ago is not performing as you anticipated. You accepted terms or conditions back then that you considered a necessary evil to get the deal done. Those conditions might be a net worth covenant, an inventory/cost-of-goods-sold ratio, or a capital expenditures test. If you're now violating some of those covenants, you need to restructure your debt. And if the defaults are more than technical, if you need to start deferring some of your principal and interest payments, you should also consider the relief a bankruptcy court may offer.

The initial steps

If your lender is knocking at the door, here are the steps to follow in a workout.

* First, analyze the cause of your financial problems. You may be surprised at the number of opinions you will get. But this step is essential for a successful workout.

* Second, be realistic when you talk to your lender. Major financial institutions have people who deal daily with troubled loans, and who retain lawyers as workout and bankruptcy specialists. These bankers will be better equipped than you to deal with a workout. So, before you approach them, prepare a thoughtful game plan that addresses your problems realistically.

* Third, don't try a "quick fix. " For example, the easiest solution probably is to sell a division, and so generate cash to pay down the debt. But will selling that division be in the company's long-term interest? Moreover, there is nothing worse than agreeing to provide a quick pay-down, only to default on that new promise. While it is difficult to negotiate the first workout, it is even more difficult to deal with the workout of a workout.

* Fourth, understand the consequences of failure. If you can't reach an agreement with your lender, the result may be bankruptcy. Learn the effects of a bankruptcy petition, whether it is filed by your company or against it. The risks can be catastrophic for both you and the lender.

Is Chapter 11 in your best interest? Under Chapter 11, you submit your company's assets and operations to the jurisdiction of a bankruptcy court. Your company receives many benefits, but you also suffer certain limitations to your operations.

A major benefit in such a reorganization is that an automatic injunction prohibits creditors from enforcing almost any claim they have against your company. Thus, if a lawsuit was pending at the time of bankruptcy, it must immediately cease. And if a lender has a lien, it must stop all action leading to foreclosure or to collecting the debt.

The Bankruptcy Code allows a company to resume its ordinary course of business and to continue to use assets that it has pledged as collateral for a loan. What you must do is demonstrate to the court either that the collateral is more than sufficient to secure the loan or that there will be no further deterioration in the value of company assets. For if you should fail to convince the court, the lender will be allowed to foreclose. And you will be out of business.

The bankruptcy court judge must balance the right of a debtor to attempt reorganization and the right of the lender to enforce his lien rights and collect his debt. During the process, you must be aware that if workout negotiations fail, you may be forced out of business. Likewise, the lender must be aware that if it loses in the first set of hearings, it may not be able to enforce its lien or collect its debt for months, or even years. This gives both parties a strong incentive to develop a successful workout.

You should also be aware that a secured lender faces another serious risk. If the court invokes the fraudulent conveyance provision, it could invalidate the liens the lender holds, thus making it an unsecured creditor.

For example, suppose that Company A (a holding company with insignificant assets) would like to buy all the stock of Company B (a successful manufacturer). However, all the stock of Company B is owned by Company C. If Company A seeks a loan to buy the stock of Company B it could led e the stock it was about to acquire and secure the loan. However, the lender might refuse the stock as collateral, and ask that the loan be secured by hard assets.

Thus, if the purchase price is $5 million, it is acceptable for the bank to loan Company B $5 million and take back a lien to secure repayment. Company A then buys the stock of Company B from Company C. Company B loans the $5 million to its new shareholder, Company A. And Company A uses the same $5 million to pay for the stock, thus transferring the $5 million to Company C. At the end of the transaction, Company A owns all the stock of Company B, Company C gets its $5 million sales price, and the bank has a loan to Company B secured b its assets.

Should Company B suffer serious financial difficulties, however, because it is servicing a $5 million loan from which it received no economic benefit (since the money ultimately went to Company C), the transaction may be attacked as a fraudulent conveyance under state or federal bankruptcy law. If the transaction is set aside, the lender may not be able to enforce its loan or its lien against Company B. For a company forced into bankruptcy, this can be a formidable weapon against its lender.

Filing a Chapter 11 petition also helps your company deal with trade creditors. For example, unsecured creditors cannot receive any monies for their prior claims. So funds your company has been using to pay the trade can be used for other purposes. Of course, many of those trade creditors will now demand COD terms from you, so you will still have strong demands for cash after you file a Chapter 11, even though you are temporarily relieved from making any payments for pre-chapter indebtedness.

Of course, the main reason you file for Chapter 11 is to get the bankruptcy court to approve a reorganization plan that you have negotiated with your unsecured and secured creditors.

If you and your creditors cannot agree, however, a provision of the Bankruptcy Code does allow you to "cram down" a reorganization plan over the objections of these creditors, even a secured creditor.

So, if you are in default under your secured loan but your reorganization plan pays to the secured creditor the present value of his claim in a reasonable time period, the Bankruptcy Code allows you to cure the default and continue to use your pledged assets. So you are allowed to force the lender to keep the loan on his books and to pay over time, even if the amortization schedule and interest payments are different from the original loan. Of course, if you fail to convince the court that you can repay the loan in this time period, you may be forced to turn over company assets to the lender.

To sum up, before you begin negotiations with the lender, you must analyze the cause of your financial problems, and you must understand the strengths of your workout plan and the strengths of a Chapter 11 case should the lender not accept your proposal. You must also understand the weaknesses of your workout plan and the possibilities of failure in Chapter 11. Let the negotiations begin ! The more complete your business plan is and the more realistic its performance assumptions, the more likely will you get a good audience with your lender. What you ask for in the workout is limited only by your imagination. Of course, to request forgiveness of a certain debt will probably be met with great resistance. But if you need to defer principal and interest payments for a given period, and your projections show such a deferral will put your company back on track, your lender may well accept your proposal.

Here is what to consider in structuring a loan workout:

* Reduction in the interest rate. Seek either a temporary reduction, with the rate increasing over time to a rate higher than in the original contract, or payment of a portion of the interest and accrual of the balance.

* Stretch-out of the principal payments. Negotiate for either temporary "cash flow" payments, with any missed payments on the back end of the note, or for a long term amortization schedule, with a later "bullet" payment.

* Controlled sale of assets. Seek either a mandatory sale of a portion of company assets, with all or a portion of the proceeds applied to the secured debt, or seek a sale of certain assets, with a built-in incentive that calls for every $1.00 turned over to the lender to be matched by $1.20 of credit on your indebtedness.

* Conversion of trade debt to equity. Seek to convert a portion of secured debt, giving your creditor warrants to your company in lieu of a higher interest rate, or seek deferral of principal payments.

* Secure unsecured loans. Negotiate to pledge certain assets to secure your loans. Provide guaranties from related or affiliated companies, and secure these guaranties with assets of the related company.

* A turnover option. Negotiate either a turnover of certain assets to the lender to satisfy a portion of the debt or the ability to sell an asset in a specific time frame, with a turnover to the lender if you do not succeed.

* A Pre-packaged " Chapter 11. By cramming down the restructure on unsecured creditors, you may be able to give the trade or subordinated debt certain equity in the company to clean up the balance sheet. Seek a new amortization schedule to go with the secured debt.

Any combination of the above strategies is negotiable in a workout. But however well you negotiate, you should enter into a workout only if you believe you can meet its terms. if you don't believe that sales will improve as your projections state, if you don't believe you can sell certain assets at the price stated, or if you don't believe your company will be back on solid footing in the time stated, then the workout will fail.

Negotiating the first workout is trying enough, without entering into a second if your workout fails. if you believe your company will not survive bankruptcy, and if your lender is offering a realistic opportunity to work out your loan problems, you would be well advised to accept the lender's restructuring demands.

The key is realism

The aggressive acquisitions of the 1980s created an enormous number of defaulted loans. in your case, perhaps the projections you prepared and that your lender relied on were unrealistic. Whatever the reason, the workout scenario you now face can be physically and emotionally trying for both of you. But failure to implement a successful workout can force you to file for Chapter 11, an even more demanding process.

Your defaulted loan is probably one of 100 non-performing loans in your lender's portfolio. To expect to find a new lender under today's conditions is unrealistic. Thus, borrower and lender must work together to restructure the original loan.

What you need for this to happen is a realistic view of your company, its achievable goals, and its future performance. You can then negotiate a workout that has a high degree of certainty-and is likely to provide full payment to your lender. Ill

Katten Muchin Zavis & Weitzman is a Los Angeles law firm.
COPYRIGHT 1991 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Finance
Author:Pelliccioni, Daniel M.
Publication:Financial Executive
Date:Nov 1, 1991
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