Lending Law Report : Corporate Finance Lawyer & Attorney : Reed Smith Law Firm : Lending Transactions, Secured Investments

On Wednesday, I spoke at an international conference on microfinance.   The conference was a veritable United Nations, with representatives from the microfinance community around the world in attendance.   We even had those little earpieces for language translation.  My role at the conference was to discuss how loans and workouts are done in corporate finance, and whether there are differences in lending to microfinance institutions (covering just the institutional loans this time, not the microloans the institution makes to its individual clients).   I was surprised to find many similar issues, despite the sometimes vastly differing circumstances.  

Is there anything that we, in the corporate finance world, can learn from microfinance lending?  

1.  Use intercreditor agreements.   Workouts involving microfinance institutions highlight the  importance of using intercreditor agreements among lenders.   It's very common for a microfinance institution to have received loans from several different creditors, some domestic and some international, but all without any intercreditor arrangements in place.   One person I met was from a microfinance institution in Eastern Europe that is running into some financial issues.  She's trying to address those issues with ten lenders who each have differing views and approaches.  The lack of a common understanding among the lenders as to what to do in this situation creates problems for the lenders themselves, as well as for the borrower institution. 

2.  Use similar loan documents whenever possible.   When several lenders make loans to a single borrower, it becomes all the more vital that the terms of the loans match up.  Borrowers and senior secured lenders sometimes insist on this approach in corporate lending, but this hasn't happened much (yet) in microfinance.  Microfinance institutions often find themselves with loan documents that contain a wide variety of covenants and terms - each one different from the last.   Several institutional borrowers at the conference mentioned that keeping track of (and complying with) eight or ten different sets of reporting requirements takes up time and resources that would be better spent serving the institution's clients.  Trends toward standardization of loan documents and the increased use of syndicated loan structures may help with this issue over time.

3.  Defined legal structures make a big difference.  Microfinance loan workouts can be significantly complicated by absence of the legal structures that we take for granted in the US and Western Europe.  Several countries don't have Chapter 11-like procedures for bankruptcy -- or if they do, the process isn't always available to microfinance institutions, especially nonprofits.  In many places, it isn't legally possible to obtain a perfected security interest in accounts, which are the primary assets a microfinance institution is likely to have.  Even if you do have a security interest, your priority over other creditors isn't assured.   Also, the entire process can be affected in unexpected ways by local political events and regulatory changes.  Though we are occasionally surprised by bankruptcy court decisions in the US, we benefit from relative certainty as to who has priority and how the legal process will treat our claims.

Borrowers and creditors all over the world, in microfinance and in corporate finance, share many of the same concerns.   We have much to learn from each other.

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This week I am delighted to be in New York attending the WWB Microfinance and Capital Markets Conference. 

For those of us who normally spend our time on corporate lending and workouts, microfinance offers a rare opportunity to use our skills to improve the lives of people who are truly in need.  Micro loans have helped thousands of families around the world to build up small enterprises, move out of poverty, and be able to afford food, education and healthcare for their children.  Because these loans have a remarkably low default rate (often less than 2%), the funds provided to a microfinance institution are returned to be loaned out again and again -- to help even more people. 

Many institutions that make loans to the poor are backed by loans or other types of investments from other entities -- from commercial banks and financial institutions, microfinance investors, donors, and others.  Tomorrow I will be speaking on a panel of commercial lenders and microfinance institutions, discussing the issues that arise when a microfinance institution defaults on a loan.   As you can imagine, workouts in this context are quite different from those we usually see in corporate America.   There are some interesting lessons we can learn from this; I'll have more to say on this topic in my next post.

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In my last post, I gave some suggestions for reducing the risk of lender liability in a workout situation.  This time, let's talk some more about what to do when you're working through a workout, and focus on what happens when you're getting ready to seek remedies.  

As a general rule, it is a good idea to act "reasonably" in a default situation.  

There is usually an implied requirement of "good faith and fair dealing" in a contract-based relationship, whether under general state contract law or under the UCC.  Good faith and fair dealing essentially requires that you follow commercially reasonable standards of behavior and be fair to the borrower.  In some states it means that you have to act "honestly" (the definition varies).   This concept is applied to your agreement regardless of what the contract otherwise appears to say.   And this is true all the time, of course, not just after a default. 

Here's an example of how this plays out in a loan agreement.  Secured loan agreements usually say that any kind of default gives the lender the right to terminate the loan and foreclose on all the assets.  In practice, however, even though the agreement would appear to permit a lender to foreclose on assets if (for example) the borrower is just five days late in delivering its financial statements, it would be unusual for a lender to do so.  Indeed, many courts would find that type of action to violate the implied covenant of good faith and fair dealing, as the remedy would appear to the court to be out of proportion to the harm suffered by the lender.  That said, the law does respect your right to negotiate your own terms, and a judge won't normally rewrite the terms you agreed to.  You shouldn't be asked to do more than what you agreed to, but you will be required to do what you agreed to do fairly and in good faith. 

What else can you do to reduce the risk of lender liability when seeking remedies after a default?

• Give notice.  Even though notice may not be required under your loan agreement, in some situations it may be wise to give the borrower some notice before taking any action.  This is especially true if you are contemplating actions like foreclosure, that have harsh results.  Depending on the situation (and this does differ from case to case), giving notice may be fairly easy and may not do any harm to the lender's position -- and it may help demonstrate to a court later that the lender acted reasonably, giving the borrower a chance to explore alternatives.
   
•  Follow a consistent procedure.  It helps if you have established policies and procedures for seeking remedies and for the decision process to get there.  This seems like a good business practice generally, as it not only establishes consistency in dealing with borrowers, but it also helps to ensure that the options you want to have considered are actually considered -- and that a measured and appropriate response is given.  Also, be aware that if your normal practice is to ignore defaults of the type at issue and then you suddenly deviate from that practice and terminate the loan, some courts have found this behavior objectionable.
   
• Figure out what the assets are worth, and what you're likely to be paid.  If you have sufficient security and you are unlikely to lose anything if you forbear or take lesser steps against he borrower, you might want to consider these other options.  Some courts may find your exercise of remedies inappropriate if it can be shown that you would've had full recovery by forbearing on the default; similarly, your exercise of remedies can be called into question if you recover more than the loan agreement would've given you otherewise.   In these situations, you might do some clever thinking to see if you can get an appropriate result with less harm to the borrower.  For example, maybe forbearance makes sense, or maybe you can do things over a longer period of time, foreclose on only certain types of assets, or seek other types of remedies, while otherwise allowing the business (or portions of it) to continue.  Lots of options here.

There's no way to completely eliminate the risk of liability, but taking careful action can help mitigate this risk.  Applying principles of "good faith and fair dealing" will help.

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Tough times bring all sorts of things out of the woodwork.  Some of you will remember that back in the 80's and early 90's there was a flurry of "lender liability" lawsuits, with lenders being sued when they exercised remedies after a default on a loan.  There were a lot of these cases filed across the country during that time.  But by the mid 90's, these lawsuits appeared to have gone the way of the dinosaur.  Times were good and defaults were few.  Well, guess what . . . they're back.   We shouldn't be surprised, given the increase in the number of loan defaults.  In fact, we probably should expect to see more of these cases in the coming months.

How can you protect yourself against lender liability claims?  

One common basis for a lender liability lawsuit is what the lender did after the borrower defaulted on the loan.   If the lender behaves in a manner that later appears to have been unfair or inappropriate (perhaps "not in good faith", coercive, or in breach of a promise - more on this in future posts), a claim can result.   So, what types of things should you do after a default or in a workout situation?

• Engage in discussions.   When a borrower goes into default on a loan, what is your typical response?   With many lenders, the first thing that happens is a conversation with the borrower.  Sometimes this turns into a long series of discussions, followed by forbearances or partial waivers, as the lender and borrower attempt to sort things out and avoid a negative outcome.   And repeated defaults add pressure to subsequent discussions.   Regardless of how things go, it is often a good idea to engage in at least some discussion with the borrower.   For one thing, a discussion might actually result in the situation being "worked out" to a solution that's reasonably satisfactory to both parties.  Of course, this is usually the goal!   But even if the situation can't be worked out, engaging in negotiation and talking through the options can help you demonstrate later that your response to the default was reasonable and appropriate under the circumstances.
   
• Consider a prenegotiation agreement.   Not all defaults will require prenegotiation agreements, but in some cases you'll find it helpful to document what your understanding is before entering into workout discussions.   As discussions proceed, sometimes misunderstandings can result -- the borrower might think that the lender has promised something when that isn't the case, or may think the lender has agreed to waive the default when the lender thinks it hasn't.  Among other things, prenegotiation agreements help establish the scope of the discussions and what (if anything) can be agreed to orally vs. in a formal waiver document.   A prenegotiation agreement can also clarify who is authorized to make promises on behalf of the lender.   
   
• Speak carefully.  Sometimes lender liability cases arise from things the lender's representative said in the course of workout negotiations.  It can come down to just being careful not to speak in broad terms, avoiding over-promising or over-stating what you are actually willing to do.  In this regard, it is often helpful to establish (perhaps in a prenegotiation agreement) that nothing is considered agreed to or binding until it is in writing.   
   
• Write it down.  If you decide to forbear from exercising remedies for a period of time while trying to work things out, it's a good idea to put the forbearance in writing and include an express reservation of your rights in connection with the default.  Sometimes the argument is made that the lender gave tacit consent to ongoing defaults -- by ignoring them repeatedly, or by doing nothing about new defaults -- and that this action (or inaction) was effectively a waiver.  You can help avoid this by recognizing in writing the ongoing existence of defaults and stating that you're reserving all your rights under the loan documents.

These are just a few suggestions -- hardly an exhaustive list.  And, as we know, not every default can be worked out.  Next up, we'll explain more about lender liability cases and get into how to mitigate the risk when you've decided to accelerate the loan, foreclose or seek other remedies. 

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