How Lenders Should Deal with a Defaulting Borrower

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

The Perils of Mediation in Commercial and Civil Litigation

Mediation is becoming an increasingly popular form of commercial dispute resolution. It is often preferred to litigation upon the basis that it is faster and cheaper.   Mediation will also allow underlying commercial relationships to be preserved.

However, there are potential problems for lawyers arising out of a mediation. There is the potential for negligence actions against solicitors and barristers involved in mediations and claims for wasted legal costs where lawyers breach duties owed to parties.

An example is the recent 2013 English Court of Appeal decision in Frost v. Wake Smith & Tofields Solicitors is a good example where claims can be made against lawyers involved in mediations.   In the Frost case, Mr. Frost made a claim against his solicitors arising out of a mediation which took place in 2003.   The mediation related to a long-running, wide-ranging and acrimonious dispute between two brothers, David and Ronald Frost, who had been in business together for twenty years.

After a difficult mediation, an agreement was reached. The two brothers went out to dinner to celebrate. They left David Frost’s solicitor to draw up the settlement agreement.   This is always a foolish action. Experienced lawyers will never allow the parties to leave the mediation room until the mediation agreement has been finally drawn up, agreed and signed by all parties involved in the mediation.   However, this did not occur in this English decision. The two Frost brothers returned to the mediation room after dinner.   They signed the agreement. Brother Ron subsequently raised various objections to the agreement.   The two brothers ended up requiring a second mediation. Ultimately, the dispute was resolved except for the tax consequences of the agreement.

David Frost alleged that his lawyers had been under an obligation to achieve finality at the first mediation.   He claimed damages representing the difference in value to him between the first and second mediation agreements. At first instance, the English Court rejected Mr. Frost’s claim upon the basis that the first mediation agreement was impossible to perform.   At the first mediation, matters had not developed to a point at which the parties had reached, or could ever reach, a final agreement. It was not within a solicitor’s power to fill in the gaps.   The English Court of Appeal agreed and dismissed David Frost’s appeal.

David Frost did not, however, allege that his solicitor had not advised him properly about enforceability. The Court of Appeal, however, commented in the Frost case that a solicitor in such a situation would be under a duty to warn their client that the outcome of a mediation is not a final and binding agreement from which the other party could not reconcile. However, the Court of Appeal commented that the damages which would flow from the breach of this duty would at best lead only to the recovery of any expenditure wasted in attempting to explore the enforceability of the agreement.

It is also important to remember that under the Civil Procedure Act in Victoria, a party which refuses to mediate without good reason for doing so is likely to be penalized in costs either before formal litigation is commenced or during such litigation.   If that party’s solicitor fails to advise them of this risk, a claim against the solicitor could follow.   An interesting issue might arise where the defendant argues that it is entitled to refuse to mediate because of the strength of its defence. A court might still argue that the defendant should mediate because this strength should be made apparent during the mediation process.

Another duty on lawyers engaged in mediation is the duty to advise a party properly on the merits of the claim or defence. A solicitor could be sued for his or her failure to advise a client properly about the merits of the claim or defence both in the lead up to a mediation and at the mediation itself. Under-settlement may be a particular risk for a claimant where they are ill-advised about the strength and quantum of their claim or of their defence. Both solicitors and counsel could theoretically be liable for a breach of this duty.   Preparation before a mediation involves foreseeing any legal points which may arise and, where appropriate, arranging for colleagues or counsel to be available by phone or email should a need for specialist advice arise during the mediation. An example might be to seek advice about complex taxation issues.

Confusion about the status of offers of settlement can arise during a mediation.   One way of avoiding such an issue is to have the mediation agreement entered into between all mediating parties and the mediator to provide that any agreement reached between the parties and the mediation cannot be complete until it is reduced to writing and signed by or on behalf of each of the parties. In this way, arguments about whether or not offers have been made and, if so, whether or not they have been accepted, will be avoided. This places a duty onto solicitors for all parties to check carefully about the status of offers that have been made, offers that have been rejected, or offers that have been accepted so that a client’s expectations can be managed appropriately.

Frost v. Wake Smith & Tofields Solicitors raised the duty to advise about the nature of any agreement reached at a mediation.   Many details require attention before a final agreement can be reached at a mediation.   These will include checking that the representatives of the parties are in fact authorised to settle the dispute and to sign a settlement agreement. If the authority of those attending the mediation is limited either to sign or to settle the dispute, the solicitors for other parties will need to insist that additional authority is obtained before the mediation can commence.

It is always useful for solicitors attending a mediation to come equipped with a draft settlement agreement either on paper or, preferably, in electronic format on a laptop.   This makes for easy amendment. Many points will need to be checked before the mediation is completed such as the primary claims, secondary claims by and against third parties, payment terms, breach provisions, payment of legal costs and others.   If the mediation occurs within the context of a court case, what is going to happen to that case? Is to be withdrawn, dismissed, discontinued, stayed or is a default judgment being given now or in the future if the mediation agreement is breached or if payments are not made under it? Should the mediation agreement provide that it can be enforced as a court judgment without the breaching party having the right to prevent that enforcement?

David Frost’s solicitor was fortunate having regard to the Court of Appeal’s decision.

Drafting a complex settlement agreement is the last thing barristers and solicitors want to face after a hard day of negotiation. However, it is an unavoidable duty. However, care must be taken to have already provided clear advice to parties as to what is an acceptable agreement.

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 L.L.M, LL.B., Grad.Dip.(Leg Prac), Adv.Dip.Bus.(Leg Prac)

Published: June 2015