While significant energy here at the Bankruptcy Cave is devoted to substantive bankruptcy matters, not all aspects of a general insolvency practice are always fun and litigation. Oftentimes insolvency lawyers add the most value by helping clients avoid a bankruptcy filing, or by successfully resolving a case through a consensual transactional restructuring. Below are a few key issues diligent counsel for creditors and debtors should think through in connection with a transactional restructuring.
1. Notice and Demand After Default. As anyone reading this knows, a lender often sends a notice of default and maybe even a demand for payment after its borrower defaults. However, simply sending a notice of default and demand for payment may not always be sufficient or have the intended effect. Most loan documents provide a cure period before a breach becomes an actionable default. Some loan documents will only permit a lender to accrue default interest after specific notice is given to the borrower. And sometimes no notice or demand is required at all. While it is generally considered best practice for a lender to notify a borrower of a breach, demand repayment, and affirmatively elect to accrue default interest after a breach, a careful reading of the loan documents is an absolute necessity. Also, remember that a lender doesn’t always have to react to a breach by attempting to exercise every possible remedy. Sometimes a simple reservation of rights letter that notifies the borrower of the breach and reserves the lender’s rights and remedies may be sufficient to protect the lender and yet not scare the borrower into precipitously considering extreme countermeasures like bankruptcy. After all – all you can control is your actions; you cannot control (or sometimes even predict) how others may react or overreact to your actions.
2. Pre-negotiation Agreements. Post-default discussions between a lender and a borrower can be tense, with both sides guarded so as not to say or do something that they may later regret. A critical tool to cut through some of the tension is a pre-negotiation agreement between the parties, which in general is a contractual agreement regarding the parameters of negotiations between the parties regarding the defaulted debt, an acknowledgment that things said in those discussions will not be used in future litigation, and an acknowledgement that the discussions will result in an agreement regarding the defaulted debt only if put into writing. Often these agreements will include additional features, such as acknowledgments of defaults and debts or a tolling of the statute of limitations, but the primary function is to allow the parties to negotiate without fear that statements made during negotiations may be used against them in the future. All it takes is a single offhand comment by a lender or its counsel in an email, such as “we think that sounds like a good proposal” for an unscrupulous debtor to argue that the loan was modified, or a concession was granted by the lender. The pre-negotiation agreement will prevent these sorts of arguments; we highly recommend them in all workout discussions.
3. Document Review and Cleanup. A lender will have no better opportunity to scrub its documents and fix any documentation gaps than after a default. We consider it best practice when in-taking any distressed matter for a lender client to thoroughly scrub all loan documents and identify any potential issues that the lender should address. We consider it best practice to do the same for a borrower representation. Did the lender fail to obtain signatures for all of the loan documents? Do the loan documents contain any significant errors affecting the deal? Did the lender fail to properly perfect its security interest? (Consider especially any sorts of unusual collateral, where the perfection rules can be different.) Did the lender opt at origination not to get a guarantee from the trust holding all of the assets of the borrower’s principals, and now the lender wishes it had? Did the lender receive non-ordinary course payments recently? In a situation where the borrower is in default and is probably asking for more time or other financial accommodations, the lender has unparalleled leverage to clean up errors, grab the additional guarantees or collateral that it didn’t require previously, and otherwise manage things like preference exposure. And where a borrower identifies that some of these issues exist, it too may have significant leverage to obtain the accommodations it seeks. (By the way, for more specific tips on collateral issues you really need to check in advance of any workout, check out this ABI post by our colleagues Leah Fiorenza and Wendy Godfrey.)
4. Forbearance Agreements. Sometimes a workout doesn’t result in a waiver of defaults and new deal terms. Rather, many times a lender may be looking to exit the relationship but may be willing to give a borrower time to get its affairs in order to accomplish a payoff, refinancing, sale, etc. In this situation, the lender may agree to forbear from exercising rights and remedies with respect to a default for a limited period. The lender will often agree to modify covenant compliance requirements or other terms of the loan during the forbearance period, but the existing defaults are not waived. If the borrower doesn’t repay the debt at the end of the forbearance period, the lender then once again has the ability to exercise its rights and remedies due to the default.
5. Modification Agreements. And sometimes a workout does result in a waiver of defaults and new deal terms. That is often accomplished through a modification of loan documents, where the parties agree to waive existing defaults and modify the terms of the loan. While the goal here may still be an early exit (i.e., where the parties agree to shorten maturity), the loan modification will bring the borrower back into compliance and eliminate the threat of default interest and enforcement actions.
6. Acknowledgments and Reaffirmations. Whether through a forbearance agreement, a modification agreement, or any other variation of agreement, acknowledgments and reaffirmations are critical. A lender will expect to receive from the borrower and any guarantor in any such agreement an acknowledgement of the debt owing to the lender, an acknowledgment of the loan defaults, and a reaffirmation of all of the loan documents and of the security interests granted to the lender. These, and the releases discussed below, are often the only consideration, and sometimes the most important consideration, that a lender will receive in a workout.
7. Releases. Perhaps the most critical consideration that a lender will expect to receive, and any borrower or guarantor should expect to be asked to give, in a workout is a general release of claims. While releases come in many varieties, a well-crafted release will provide for an immediate and complete release by all borrowers and guarantors in favor of the lender of any and all claims, known or unknown, that may exist as of the time of the written workout agreement, an agreement by the borrowers and guarantors not to bring suit based on any released claims, and an acknowledgment that the release may be pled as a full and complete defense to any such suit. Of course, state law differs regarding releases. We always recommend a thorough review of applicable state law regarding releases and that practitioners include all relevant statutory release and waiver language where applicable.
8. Authority. Finally, one of the most overlooked aspects of any transaction, and particularly a workout transaction, is ensuring all necessary corporate, trust, or other authority has been granted for the parties to enter into the agreements evidencing the transaction. We often see practitioners either ignore this issue or, perhaps, rely on representations in the written agreement along with the provisions of any applicable corporate or LLC statute to confirm the authority of the parties to enter into the agreement. However, that does not substitute for an actual review of the relevant organizational or trust documents to determine who is actually authorized to sign on behalf of the entity. For instance, you may find that although your signer is a member of the LLC borrower, the LLC’s operating agreement gives the member no power to enter into agreements on behalf of the LLC and rather all power is vested in a manager or board that must approve all transactions. Taking the time to analyze these authority issues and obtain the necessary authorizing resolutions as part of the transaction will eliminate any pesky argument down the road that the person who signed the documents had no authority to bind the entity to the agreement.
The foregoing is, of course, just a brief discussion of some of the many issues insolvency lawyers may need to address in a transactional workout, but each is an important component to consider in any distressed debt representation where a transactional workout is a possibility.