How Lenders Should Deal with a Defaulting Borrower

Watch out for any warning signs

Firstly, a lender needs to spot the early warning signs.

These signs include the borrower breaching or being about to breach its financial overdraft limits, or suddenly requesting new facilities or an extended repayment timetable. The borrower may be under increased creditor pressure or subject to litigation, insurance claims or rent reviews.

Other warning signs include the borrower:

1. Losing a key customer or supplier;
2. Suddenly losing or changing its management team, in particular the finance director;
3. Having a sudden change of auditors or trouble signing off its accounts;
4. Late delivery of information;
5. Asking its bankers to send cheques for round amounts or postpone or push forward certain payments; or
6. Deferring any planned or regular capital expenditure.

Other signs might be a spurious or unmeritorious complaint about an interest rate product of the lender that could be an attempt to draw attention away from more fundamental problems.

Gather information

Secondly, lenders need to be aware that information is key.

Lenders should:

1. Meet with borrowers at regular intervals to open dialogue and discuss strategies;
2. Get up-to-date financial information from the borrower including management accounts and cash flow statements;
3. Review security and priority positions;
4. Instruct independent accountants to review the borrower’s business;
5. Carry out regular insolvency and other searches against the borrowers;
6. Obtain valuations of important assets;
7. Perform regular searches of the personal property securities register; and
8. Assess the borrowers’ overseas assets and creditors as this may be relevant to jurisdictional enforcement choices.

Communicate with other lenders

Thirdly, lenders need to communicate to other lenders and investors. However, Lenders need to beware of any confidentiality restrictions and privacy obligations first.

It would be recommended for lenders that, after having identified relevant stakeholders, they be prepared to implement standstill or other forbearance agreements to stop unilateral action which might frustrate an overall strategy for a defaulting borrower.

Lenders should also consider deciding whether to support a defaulting borrower or rather minimise their exposure through enforcement mechanisms. A decision will need to be made whether the lender wishes to sell the debt to another financier.

If a lender is to support the borrower, the strategy might involve the following:

1. Providing new money subject to pricing risk versus reward;
2. Restructuring existing lending agreements, giving time to pay, providing emergency short-term funding;
3. Considering new credit enhancement – for example, taking guarantees from directors or shareholders;
4. Standstill / forbearance agreements in conjunction with other lenders.

On the other hand, an enforcement strategy might include:

1. Identify events of default;
2. Accelerate loans or converting a loan to a demand instrument;
3. Cancel existing commitments; and / or
4. Enforcing security and appointing a receiver.

Lenders should also consider whether a form of restructuring for a defaulting borrower might be useful.

A financial restructuring could include writing off debt, swapping debt for equity or restructuring loans. Operational changes could also include giving the defaulting borrower time to negotiate a management buy-out or facilitate a change in management acceptable to the lender.   This might give time to enable the borrower to change business direction. The borrower may also look to inflate distributable profits or balance sheet insolvency by issuing new share or reclassifying existing share capital.

A further issue is the need to consider cross-default issues and to assess the advantages and disadvantages of various enforcement mechanisms.   The lender will also need to assess whether any enforcement action will give rise to priority of payment issues.

This article is intended only to provide a summary of the subject matter covered. It does not purport to be comprehensive or to render legal advice. No reader should act on the basis of any matter contained in this article without first obtaining specific professional advice.

For any further information concerning this article, please contact JHK Legal.

Author: Michael Tourkakes LLM., LL.B., Grad.Dip.(Leg Prac), Adv.Dip.Bus.(Leg Prac)

Published: June 2015