In this series of articles called Financing Your Business | Thomas H. Gray – Consultant, CEO, Director, four of the past five articles have been about getting loans. There have been no articles yet on paying loans, because your lender will be sure to tell you how to do that! However, sometimes borrowers do not pay back loans as agreed, for lots of good and sometimes bad reasons. All borrowers need to know what lenders might do in that situation, just in case you have to face it.
Lenders have many remedies available to them. Bobby Guy has organized them into early, middle, and late stage remedies, and much of this article is based on his article in the Journal for Corporate Renewal: Lender Remedies: Reading Between the Lines — Turnaround Management Association, April 2012.
Early Stage Remedies
Early Stage remedies are designed to get the attention of the defaulting borrower so that the situation does not get worse, and to buy time for both parties to work out a solution such as replacement financing.
The lender starts the process by sending a notice letter, reserving its rights to more severe action in the future, and perhaps activating terms of the lending contract. These might include
- certain number of days for the borrower to “cure” the default
- higher default interest rate
- prohibition of payments to equity holders, affiliates, or subordinated lenders unless approved by the lender.
The result of negotiations at this early stage could be an agreement waiving the lender’s rights (“forbearance”) and providing the borrower with an extension, often for a fee or a higher interest rate or a pledge of additional collateral.
Middle Stage Remedies
If the parties do not agree to modified arrangements in the Early Stage, Middle Stage remedies can come into play. These are designed to provoke immediate action by the borrower, but still leave room for a negotiated solution. They may enable the lender to begin recovering some of the debt, while avoiding costly action by the bank to take over the business or the collateral.
After a default, the lender usually has the right to “call” the loan – to sue for the entire amount of the principal and unpaid interest, rather than merely sue for any overdue payments. There may be a default fee as well. This may also apply to leases. This lawsuit will be against anyone who guaranteed the loan, as well as the business itself. Lawsuits have deadlines, which increases the pressure on the borrower.
Other middle stage remedies include canceling a related line of credit, requiring that the borrower hire a turnaround professional as a condition to grant forbearance, and sending in auditors to review the borrower’s books (cost paid by borrower). This audit team’s report also estimates the value of the company and suggests the best ways for the bank to recover its money using Late Stage remedies.
Late Stage Remedies
When the problem reaches the Late Stage, there is little hope for resolution and the remedies are all about recovering the lender’s funds by taking over collateral. The borrower’s response may be to declare bankruptcy (either to liquidate or to reorganize), which has the effect of forestalling (“staying”) the lender’s efforts to collect. If there is no bankruptcy filed, the lender can sell the collateral to the highest bidder. Even in a bankruptcy, the lender can bid for the assets of the company using the amount it is owed as part of the cash amount of its bid (called “credit bid”).
However, the lender may wish to keep the assets functioning and earning cash. If so, there are several ways it can take over control of the company and its operations. The lender may ask the courts to appoint a receiver to run the company for the benefit of the creditors, or even advance funds to the company to enable it to keep operating (Debtor-in-Possession financing, or DIP) , thus protecting the value of its collateral.
In addition, it is becoming more common for the borrower to pledge its stock in the company as collateral for a loan. If that is the case, then in a bankruptcy the lender will become the controlling shareholder as well as the leading creditor, and control the company through its shareholder rights.
Lenders may also decide to simply sell the loan at a discount in order to be rid of the complexity and cost of enforcing their rights. In that event, the buyer of distressed debt will have all the same rights that the lender had, and likely will also have less patience and more expertise in operating distressed businesses or dealing with their managers.
To sum it up, don’t let your loan get into a default position. Keep your promises and pay your debts. If that cannot be done, then react early to the default, and find a solution in the early stage, whether you are a borrower or a lender. Otherwise, the cost goes up, and the result gets worse as the process goes on.
Tom Gray helps owners save and grow their companies. He is a management consultant focused on small business and telecom, a Certified Turnaround Professional (CTP), a Certified Business Development Advisor, and a Certified SCORE Mentor. He can be reached at 630-512-0406 or email@example.com. See www.tom-gray.com