How Banks Can Preserve Value Amid Corporate Default Surge

This article was written for Law360.

April began with one of the busiest weeks for corporate bankruptcies since the end of the Great Recession.

Commercial insolvencies are up 43% compared to this time last year, and they're projected to keep climbing. Corporate debt defaults are also growing at the fastest rate around the world since the global financial crisis.

In this evolving and uncertain market, the need for vigilance and preparedness for swift and strategic action by lenders in order to protect and preserve loan and collateral security value has reached a critical high.

In the dynamic realm of banking and finance, institutions often find themselves engaged in loan workouts, enforcement actions and thrown into circumstances requiring navigation of the complexities of corporate bankruptcy proceedings.

In the current economic climate, the risks for lenders are high and ever-increasing. Banks must weigh their legal, financial and risk management priorities to find the best path forward.

This article explores the critical factors banks should consider when addressing loan workouts, debt enforcement and collection, and corporate bankruptcy.

Loan Workouts: Collaboration Amid Distress

Loan workouts emerge as a response to financial distress faced by borrowers.

Prior to significant payment defaults, workouts aim to renegotiate certain terms of the loan to give borrowers financial or operational relief and to preserve the loan as a performing asset on the bank's books.

Following a significant payment default, a troubled debt restructuring necessitates a delicate balance between preserving the overall value of the loan and fostering a cooperative relationship with the borrower. Legal considerations loom large in this process, as banks must navigate contractual obligations, regulatory frameworks and litigation risks.

First, banks must assess the feasibility of a loan workout based on the financial circumstances of the borrower. Understanding the causes of distress and the borrower's ability to fulfill revised repayment terms is crucial. Legal counsel should conduct due diligence and evaluate the enforceability of contractual provisions.

Moreover, banks must ensure compliance with requirements governing loan modifications. Where the causes of distress cannot be addressed through additional time or with short-term financial or operational relief, lenders are often better off cutting their losses and moving past workouts and into loan enforcement.

Where the borrower's distress may be addressed with additional time, relief from operational covenants, or restructuring of financial terms, a workout may make sense. In that case, effective communication and negotiation are paramount.

Banks should strike a balance between asserting their rights as creditors and demonstrating flexibility to accommodate the borrower's challenges, taking the opportunity to shore up collateral positions and address documentation-related issues while providing borrowers relief to weather the current storm.

Lenders counsel should assist the process by structuring viable workout proposals, drafting legally binding agreements to address existing deficiencies in the loan file and mitigating potential disputes.

Collaboration between lenders, borrowers and legal counsel can foster common ground and preserve value for all parties.

Loan Enforcement: Safeguarding Rights and Remedies

In cases where loan workouts prove unattainable or fail to resolve underlying issues, banks may resort to enforcement actions — using legal processes to collect the loan.

Loan enforcement spans a spectrum of remedies, ranging from demand letters and acceleration of indebtedness to foreclosure or repossession of collateral, and filing litigation against borrowers and guarantors. Contractual rights, statutory frameworks and procedural safeguards provide a bevy of tools banks can use to protect their interests.

At the outset, banks should preserve evidence that might be relevant to their legal claims against borrowers and guarantors.

Evidence would include the loan file, collateral file, internal and external communications concerning the loan, and written communications with obligors. It is wise to identify who will act as the corporate representative for the bank in court and designate a bank employee to coordinate with outside counsel on the lawsuit.

Banks must meticulously review loan documentation to determine the rights and remedies available upon default. Loan agreements typically outline conditions precedent to enforcement, such as notice requirements and cure periods. Adherence to these contractual provisions is essential to mitigate the risk of legal challenges from borrowers.

Legal counsel should identify the goals of legal action and craft enforcement strategies tailored to the specific circumstances of each case and the nature of collateral and jurisdictional nuances.

In executing enforcement actions, banks must untangle a complex web of statutory frameworks governing debt collection, foreclosure and repossession to avoid potential liability and reputational risks.

Banks should also stay on top of regulatory changes in consumer protections and fair lending practices and to ensure all available protections against the growing risk of customer data breaches.

Bankruptcy Proceedings: Navigating Complexities and Prioritizing Claims

Bankruptcy represents a last resort for borrowers grappling with insurmountable debt, providing a structured framework for the resolution of financial distress.

For banks, involvement in bankruptcy proceedings entails navigating intricate legal processes, safeguarding their rights and interests in the loan and all collateral security, and maximizing recovery efforts amid competing claims.

The decision to initiate bankruptcy proceedings or respond to a borrower's bankruptcy filing demands careful consideration of legal and strategic factors. Bankruptcy law operates within a federal framework under the U.S. Bankruptcy Code.

Banks must assess the implications of bankruptcy on their rights as creditors, including the impact of the automatic stay on any nonbankruptcy collection actions, exposure to preference and fraudulent transfer clawback claims, and classification of the bank's claim as secured or unsecured, oversecured or undersecured, the potential availability of additional claims such as administrative priority claims or claims for rejection damages, and the allowability, extent, and priority of each of those claims.

Legal counsel represents bank interests and rights from the first sign of distress of a corporate borrower, guarantor, or significant collateral security for repayment of corporate indebtedness owed all the way through to the conclusion of a distressed asset sale of the operating business or substantially all of its assets by way of Section 363 of the Bankruptcy Code or through performance of a Chapter 11 plan by an emerging corporate debtor.

In Chapter 11 reorganizations, banks may have the opportunity to influence the formation of a debtor's reorganization plan, balancing the need for debt restructuring with maximizing the value available to the bank.

Banks moreover have substantial opportunities available in connection with potential provision of debtor-in-possession financing to a debtor by an existing lender and the negotiations of those terms in order to ensure the bank is protected and also recognizes the maximum potential upsides.

This includes, for example, all additional claims, higher priorities, and other protections permitted by bankruptcy courts for lenders willing to provide the financial support needed by corporate debtors to continue operations through its filing.

Conclusion

Loan workouts, enforcement and collection actions and representation in bankruptcy and adversary proceedings represent critical and complex junctures that demand meticulous legal scrutiny and strategic foresight, which junctures have and promise to continue to increase in both size and frequency under the weight of the current economic and market climate.

Banks need a nuanced understanding of contractual rights, regulatory frameworks and evolving legal developments to chart a course through these complex issues in order to protect and preserve their rights and interests.

By prioritizing early action, collaboration, compliance and strategic planning, banks can navigate the legal landscape and mitigate risks inherent in corporate lending operations.

Please reach out to Chris Couch, Danielle Mashburn-Myrick, Sarah Beth Wilson or any member of the Phelps Finance and Lending or Bankruptcy and Reorganization teams with questions or for guidance.