Posted on January 11, 2011 by Susan Alker

Is the Borrower in Default? Sometimes It's Hard to Tell

This post was written by guest blogger Svetlana Attestatova, one of my colleagues in the financial industry group here at Reed Smith.  She answers a question that often comes up at this time of year, when year-end financial statements are being prepared.   

Let’s talk about borrowing money under revolving lines of credit.  Sometimes it's not entirely clear whether the borrower is in default, and there's a question as to whether they can borrow money.  Here are our facts: 

  1. The company needs to draw on its revolving line of credit, and it’s three weeks before the end of the fiscal quarter.
  2. Based on the numbers in hand, the CFO thinks the company may go into default on its financial covenants at the end of the quarter.
  3. The required “notice of borrowing” under the credit agreement requires the company to certify that there is no default at the time of the borrowing.

Can the company borrow the money?

The answer is an all too frequent “it depends.”   It would be helpful to know more.  What if the CFO learns that the company is expecting additional sales that will result in more revenue, and that revenue is expected to come in before the end of the quarter?  Once the revenue is in, the financial covenants would be met and there would be no default.  In that case, the answer is that it’s probably OK for the CFO to certify that there is no default.  If the quarter has not yet ended (assuming the financial covenants are tested only as of the last day of the fiscal quarter, as is typical for many corporate loan agreements), there is still time for the company's performance to improve, and the CFO's belief that there is no default would appear to be reasonable and in good faith.  

Now, let’s change our facts.  What if it’s three weeks after the quarter end.  The CFO has financial data for the quarter that indicates a default occurred at the quarter end, but the financial statements have not yet been completely finalized or delivered to the lenders.  The answer here is that the CFO probably can’t certify that there is no default, and the company probably can't borrow the funds.

A word of caution:  One court found the company to be in breach of its credit agreement when it certified to the lenders that there was no default even before the financial covenant test period ended (similar to our first set of facts).  This was in the "Motorola" case (The Chase Manhattan Bank v. Motorola, Inc., 184 F. Supp. 2d 384 (S.D.N.Y. 2002) (PDF)).  But, in that case the outlook for meeting the covenants was very bleak.  We'll talk about the rather unique Motorola facts in our next post.

And, of course, not every case is as clear as these sample fact patterns -- often, there are many factors that should be considered and weighed (i.e., call your lawyer).   Also, note that most financial covenants need to be tested monthly or quarterly (at the month-end or quarter-end date), rather than being tested on an ongoing basis.  A continuous requirement to comply with financial covenants would change the analysis.  

More on this next time.

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Posted on February 17, 2010 by Susan Alker

How to Avoid Lender Liability - Part 1

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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