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 lending and financing 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. This article provides an overview of the key strategies for secured creditors in a workout process.

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 may be in the form of reductions of applicable interest rates, moratoria on principal payments, creditor permission to sell surplus assets, renegotiation of financial ratio covenants, and possibly the release of security or consent to subordination so as to obtain additional financing from another source.

Creditors to troubled borrowers will face the options of choosing receivership, examinership, liquidation or workout. Obviously, if the borrower is not a candidate to survive in whole or in part by means of restructuring or otherwise after an examinership or workout, then enforcing receivership or liquidation over the borrower's assets may be the only option despite PR problems and the significant loss of principle due to 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.

The principal reasons for a secured creditor's preference for examinership are likely to include:

1. the control over the debtor's management and the apparent transparency of the process;
   
   
2. the statutory protection afforded to secured creditors in the process;
   
   
3. the automatic stay on further collection efforts by other creditors; and
   
   
4. the binding effect of a scheme of arrangement on any dissident creditors.

Conversely, once a corporate borrower becomes the subject of an examinership, the secured creditor will:

1. lose a significant amount of control over the process of restructuring the borrower's finances;
   
   
2. be prevented from taking action to collect the borrow debt and enforcing its security;
   
   
3. be excluded from the borrower's director's continued management of the borrower's assets;
   
   
4. 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
   
   
5. 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. 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 have an impact on its cash-flow since a mere re-scheduling of debt will simply put-off an impending insolvency.

Such requests 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 and selecting one. Such roles will be of the utmost importance for the credit file review and security file review. A creditor's solicitor's review of the existing security package may reveal that the creditor does not have security over a critical asset of the company, the creditor may then seek to negotiate a final workout agreement that involves the creditor taking the additional security required over the relevant assets. The solicitor may also identify inter-creditor subordination issues amongst other pitfalls. 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.

In the event that the creditor does enter into workout negotiations with the company, it will have the following principal goals -

• to maintain and increase value of the security package for the debt;
• to retain customers for future sales in financial services;
• to correct deficiencies in documentation; and
• to avoid the likely larger expenses incurred in an examinership or liquidation.

In addition, there will be a number of specific items that it may seek in order to protect and enhance its position, including:

• postponement of the claims of unsecured and subordinated creditors against the borrower until after the forbearance period;
  
  
• acquisition of additional security to secure the debt, either from the borrower itself or from related entities;
  
  
• delivery of additional guarantees in respect of the debt from entities related to the borrower, such as controlling shareholders, officers and associated companies;
  
  
• increase the interest rate on the debt;
  
  
• waiver and release of claims against the creditor by the borrower and guarantors;
  
  
• imposition of tighter financial ratios and more restrictive financial covenants governing the borrower and the operation of its business;
  
  
• disposition through sale by the borrower or enforcement of security by the creditor of non-essential assets, with the proceeds of the disposition being turned over to the creditor;
  
  
• increased and more detailed financial reporting requirements;
  
  
• replacement of the borrower's management by a qualified 'turnaround' consultant; and
  
  
• the extension of take-out financing by another lender customer within a prescribed period of time.

If the workout negotiations are successful between the creditor and its borrower, 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." During this period, the borrower will be required to resolve its cash-flow problems, to reorganise its business to prevent re-occurrence and to possibly obtain additional third party credit facilities to pay off its existing creditor debt. 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

1. extending the financial accommodation to its borrower,
2. revising the financial accommodation for the duration of the term of the facility; or
3. demanding accelerated repayment and enforcing security.

Workouts have many advantages, not least the avoidance of writing down 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 fulfill its long-term debt obligations, then a workout can be the best means of protecting the secured creditor's secured position while facilitating the borrower's survival. Ultimately, a successful workout will augment the going concern value of the borrower's business so as to have the loan repaid in full over time.

March 2008.

For further information please contact Neil O'Keeffe.