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‘Workouts’ may offer advantages when writing down bad debts Back  
Out of court ‘workouts’ can be the best means of protecting secured creditors’ positions and avoiding reduced asset value fire sales while facilitating the borrowers’ survival, writes Neil O’Keefe.
The informal out-of-court ‘workout’ techniques for distressed commercial loans are becoming increasingly desirable due to the significant growth in the ‘global’ nature of debt finance and institutional reluctance to write-down bad debts during these difficult economic times. A workout is simply a private contractual arrangement to assist companies in financial difficulties whereby a creditor negotiates a restructuring of the payment and other terms of the debt obligation of a company. However, before entering into such negotiations a creditor must assess if a work-out is the preferred option and what strategy to adopt.

Assessing options
Creditors to troubled borrowers will face the options of choosing receivership, examinership, liquidation or informal workout. Obviously, if the borrower is not a candidate to survive in whole or in part, then enforcing receivership or liquidation may be the only option despite public relations problems and the significant loss of principle that may be incurred with reduced asset values in fire sales.

Of more difficulty for a creditor, is its dilemma to choose between a formal examinership and an informal workout when borrower survival may be possible. An examinership has many advantages, including (i) the control over the debtor’s management and the apparent transparency of the process; (ii) the statutory protection afforded to secured creditors in the process; (iii) the automatic stay on further collection efforts by other creditors; and (iv) the binding effect of a scheme of arrangement on any dissident minor creditors. However, an examinership can be to the significant disadvantage of the secured creditor because it will (a) lose a significant amount of control over the process of restructuring the borrower’s finances; (b) be prevented from taking action to collect the debt and enforcing its security; (c) be excluded from the borrower’s director’s continued management of the borrower’s assets; (d) be exposed to the examiner’s intensive review of its claims and security over the company, which might reveal critical shortcomings such as non-perfection; and (e) be exposed to all expenses of the examiner having “super-priority” over all claims of secured creditors.

On the other hand, the consensual nature of a workout arrangement ought to give the secured creditor the flexibility and speed to address its exposure without compromising its position. It offers a discreet option that avoids the pressure of formal insolvency regimes. However, the secured creditor should be mindful of the added risk of granting the borrower more time in a workout scenario. Consequently, any workout proposals must be on the basis of a fundamental restructuring of the borrower’s business operation to improve its cash-flow since a mere re-scheduling of debt will simply put-off an impending insolvency.

A borrower’s request for relief will be assessed by the creditor’s distressed debt teams but external advisors may equally play a critical role in evaluating the creditor’s options. Such roles will be of the utmost importance in collating all of the information, understanding the issues and making a decision. For example, a creditor’s solicitor’s review of the existing security package may identify inter-creditor issues or possibly that the creditor does not have security over a critical asset of the company, each of which would have a critical bearing on the assessment of the creditor’s exposure and options. Equally, if the creditor’s accountant’s assessment of the company’s financial condition reveals that it is highly unlikely to successfully restructure its operations, then the creditor may conclude that “its best loss is its first loss” and opt for immediate enforcement of security.

Workout strategy
The financial difficulties of a company suitable for a workout will ordinarily relate to cash-flow problems. In order to alleviate such cash-flow problems, the company may request the creditor for a temporary relief from some of the terms of the credit agreement, such temporary relief being reductions of applicable interest rates, moratoria on principal payments, creditor permission to sell surplus assets, renegotiation of financial ratio covenants, or possibly the release of security or consent to further subordinated indebtedness so as to obtain additional financing from another source.

Putting it in place
If workout negotiations are to be successful between the creditor and its borrower someone will be required to take a leadership role and very often a huge bona fide up-front effort is needed. Of course, a collaborative approach of support and sharing information will be of benefit and sometimes creditors will have to “share some of the borrower’s pain.” If successful, the parties will agree a workout agreement that will ultimately be a compromise on both sides. Such a workout agreement may require the creditor to forbear from taking action to demand accelerated repayment or to enforce security for a certain “forbearance period.” This forbearance period, however, will usually be subject to early termination by the creditor upon default by the borrower of any of its obligations under the workout agreement. Once the forbearance period expires the creditor has the option of (i) extending the financial accommodation to its borrower, (ii) revising the financial accommodation for the duration of the term of the facility; or (iii) demanding accelerated repayment and enforcing security.

Workouts have many advantages, not least the avoidance of writing down bad-debts. However, such motivation should be tempered with the reality that the mere rescheduling of debt without fundamental restructuring of the business simply postpones an inevitable liquidation or receivership. If indeed an analysis does envisage a borrower being able to fulfil its long-term debt obligations, then a workout can be the best means of protecting the secured creditor’s position while facilitating the borrower’s survival.

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