1 Overview 1.01 INTRODUCTION 1.01(a) Scope Of This Work This treatise is a practical guide for secured creditors, i.e. creditors with collateral securing their claims against debtors, in the restructuring, or workout of those claims, and in the realization of those claims through foreclosure of collateral. Consensual workouts are essentially contractual arrangements involving the secured creditor and the primary obligor. In many of these situations, secondary obligors and other creditors, secured and unsecured, will become parties to the workout arrangements. At other times, however, a secured creditor may, for one or more reasons, decide to foreclose on its liens and security interests in collateral without first attempting to restructure the debt or upon the failure of a prior restructuring attempt. 1 A secured creditor s foreclosure of its liens and security interests in real and personal property collateral is primarily governed by statutes and not the common law of contracts although, as will be discussed below, some of these statutory procedures may be modified by agreement of the foreclosing creditor and the debtor. Because this work is a practical guide for secured creditors and their counsel, the authors will not attempt to describe every state s law concerning workouts and foreclosures. Nevertheless, the reader should bear in mind that the laws of various jurisdictions contain similar provisions and concepts. Indeed, because of the Uniform Commercial Code, the law governing foreclosures of security interests in personal property is to a significant extent uniform throughout the nation. 1 After foreclosing on and disposing of its collateral, a creditor may be left with an unsecured deficiency claim against the debtor and, perhaps, other obligors, such as guarantors of the debt. The procedures for collection of these unsecured deficiency claims are in the realm of collection law and beyond the scope of this treatise. 1
2 Strategies For Secured Creditors 1.02 1.02 Brief Description of the Workout Process A workout has been defined by one author as a process rather than an event or technique. 2 A workout results when a creditor, often a secured creditor, negotiates a restructuring of the payment and other terms of the debt obligations of a borrower or other entity that has received financial benefits from the creditor. A common example of a workout involves a business debtor, such as a manufacturer of goods, that is suffering from cash flow problems which render the company unable to pay its debts on a timely basis. The working capital needs of the manufacturing company will normally be satisfied by a commercial bank which, in return for financing, will be granted first priority liens and security interests in all of the company s real and personal property. To alleviate the company s cash flow problems, the company may request from the bank temporary relief from some of the terms and conditions of its credit agreements. This relief may include some or all of the following: a reduction of interest rates charged by the bank on its loans; the payment of interest only with a moratorium on principal payments for a specified period of time; partial payments of interest and principal or the consent of the bank to sell surplus manufacturing assets or real estate; an increase in the borrowing base for the bank s revolving line of credit; a waiver or renegotiation of restrictive covenants in the bank s credit agreements, such as the maintenance of financial ratios; and the release of security interests and liens in collateral or their subordination to obtain additional financing from another source. These requests for relief will be evaluated by the bank, which will then decide whether to negotiate a debt restructuring agreement with its customer or to accelerate the maturity of the secured debt, demand its payment and begin foreclosure and other collection activities. To assist the bank in deciding whether to negotiate or foreclose, the bank may transfer the responsibility of administering the credit agreements from the commercial loan officer assigned to the account to an employee in the bank s workout or special assets department. Unlike the commercial loan officer who first negotiated the terms of the loan with the borrower and maintained that relationship while the loan was performing, this officer will be specially trained in handling financially distressed bank customers and their credits. In addition, the bank may retain the services of workout professionals such as lawyers, accountants, appraisers, environmental engineers and turnaround consultants to assist the workout officer in evaluating the bank s options and in selecting a course of action. For example, if the bank attorney s review of his client s credit files discloses that the bank does not hold a lien or security interest in certain of the customer s key assets, the bank may then seek to negotiate a workout agreement granting the bank a lien in these assets. Alternatively, if the bank s accountants and turnaround consultants conclude that the customer s prospects for successfully restructuring its operations are entirely speculative or nil, then the bank may conclude that its best loss is its first loss and opt for immediate liquidation. 2 Donald L. Rome, Business Workouts Manual 1.01 (2d ed. 1992).
1.02 Overview 3 If the bank concludes, as a result of its initial assessment of its position vis a vis its customer, that its borrower has the ability to reorganize successfully, the bank may then develop its wish list of provisions to be negotiated into the resulting workout agreement. These provisions may include one or more of the following: acquisition of additional collateral to secure repayment of the bank debt, either the borrower and/or related entities; delivery of one or more guaranties of payment or collection of the bank debt from entities related to the borrower, such as controlling shareholders, officers and affiliates; increase in interest rates on the bank debt; waiver and release of claims against the bank by the borrower and guarantors; imposition of tighter financial ratios and more restrictive covenants governing the borrower and the operation of its business; disposition through sale by the borrower or foreclosure by the bank of nonessential assets, with the proceeds of the disposition being turned over to the bank; increased and more detailed financial reporting requirements; replacement of the borrower s management by a qualified turnaround consultant; and the extension of take-out financing by a replacement lender within a prescribed period of time. If the workout negotiations between the bank and its borrower are successful, the parties will draft and execute a workout agreement that is normally the result of compromise on both sides. This agreement may require the bank to forbear from taking any action to collect the debt owed by its borrower for a certain period of time, normally referred to as the forbearance period. During this period, the borrower will attempt to solve its cash flow problems or recruit a new financial institution to pay off the existing bank debt through the extension of new loans and other credit facilities. This forbearance period, however, will often be subject to early termination by the bank if the borrower defaults on its obligations under the workout agreement. These events of default may include any one or more of the following: failure to pay installments due to the bank under the workout agreement and/or the original credit agreements; failure to comply with reporting requirements; failure to meet stated financial milestones described in the workout agreement, such as maintenance of collateral values and financial ratios; the attachment, garnishment, levy or execution by any third party on the borrower s assets; and the commencement of a bankruptcy case by or against the borrower. Once the forbearance period expires, the bank may elect not to extend any further financial accommodations to the debtor and proceed to collect, repossess, and foreclose upon its collateral. Once the bank makes this decision and communicates it to the borrower, the entire dynamics of the relationship between the bank and the borrower will undergo a sea change involving new professionals and different objectives for all of the parties involved.
4 Strategies For Secured Creditors 1.03 1.03 Brief Description of the Foreclosure Process 1.03(a) The Liquidation Analysis Secured creditors will foreclose upon their liens and security interests in collateral when they conclude either that (i) the workout process has failed and that their borrower cannot be successfully rehabilitated; or (ii) because of the nature of the borrower and the extent of its financial problems, any workout attempts would be futile. A critical element of a secured creditor s decision to forego a workout and foreclose on its collateral is that creditor s liquidation analysis. The creditor will often retain professionals, such as turnaround consultants and appraisers, at the first sign of the borrower s financial difficulties to estimate the creditor s probable recovery if all of its collateral is liquidated within a defined period of time. This liquidation analysis should consider the following alternatives: (i) a foreclosure sale to a single buyer, who would then continue the borrower s business in one form or another, otherwise known as a going concern sale ; or (ii) a foreclosure sale or sales at which the collateral is sold on a piecemeal basis to any number of purchasers, often referred to as a liquidation or hammer sale. In general, a going concern sale of collateral in bulk to a buyer that continues the business will generate a higher return to the secured creditor, but this is not always the case. As will be discussed in more detail below, the starting point of the liquidation analysis is the liquidation value of each category of collateral. For example, in determining the value of the borrower s accounts, the lender may apply different discount rates to different types of accounts. The lender may estimate that it will collect 10% of all accounts over 120 days, 30% of accounts aged between 60 and 120 days, and 60% of current accounts, i.e., those aged between 1 day and 60 days. In certain industries, such as the automotive industry, because the shutdown of an auto supplier may cause its customers significant actual and consequential damages, the lender may value most, if not all, of the borrower s accounts at or close to zero. 3 The borrower s inventory will often be classified in three separate categories and valued accordingly: (i) raw materials; (ii) work-in-process; and (iii) finished goods. Raw materials may be resold on the market and, consequently, a substantial portion of their cost may be recovered in a liquidation. Work-in-process and finished goods, however, may have value for a limited number of potential buyers in excess of scrap value. Again, an example from the automotive industry is instructive. In a normal transaction, a Tier II automotive supplier will contract with a Tier I supplier to produce a particular component for incorporation into a system which, once completed, will be sold to an assembler for inclusion in the finished vehicle. If the Tier II supplier is liquidated, the only potential purchaser for the work-in-process and the finished goods may be the Tier I supplier or the assembler. Equipment used in the borrower s business is normally valued by a professional appraiser with substantial experience in the borrower s industry. That person may also be an auctioneer who trades in this equipment on a regular basis. Depending upon the borrower s business, this collateral may range from relatively inexpensive restaurant equipment, such as tables, chairs, and glassware, to complex heavy machinery operated by computer software. The appraiser will normally supply the secured creditor with a written appraisal describing the appraiser s qualifications, its methodology, a description of the equipment, and its appraised value. This person should also have significant experience in testifying concerning his or her appraisal in litigation. 3 See Chapter 6, infra.
1.03 Overview 5 Real estate appraisals are performed in a manner similar to equipment appraisals. The secured creditor will normally retain a qualified real estate appraiser to estimate the value of real property collateral. This appraiser will physically inspect the collateral, determine its highest and best use, 4 and then value the property under three separate approaches: (i) income; (ii) sales comparison; and (iii) cost. The income approach focuses on the anticipated future cash flow of the collateral; this approach converts anticipated benefits to be derived from the ownership of the property into an estimate of value. Appraisers employing this approach will analyze the income production of similar properties in assigning a cost value to the collateral. The sales comparison approach relies upon what is labeled the Principle of Substitution. 5 Thus, this appraisal technique considers sales, listings, or options of other properties considered to be possible substitutes for the appraised property. These comparables are then compared to the collateral being appraised. Finally, the cost approach is an appraisal technique that is based upon the theory that a prudent purchaser would pay no more than the cost of creating a substitute property with the same use as the property being appraised. This approach is often used when the collateral involves new improvements or if no comparable properties exist in the relevant market. In preparing the liquidation analysis to be relied upon by a secured creditor in determining whether to foreclose upon its collateral, the amount of senior liens and security interests must then be deducted from the liquidation value of each category of collateral. For example, if applicable state law provides that unpaid real estate taxes become a senior lien on that realty so assessed, then the amount of those taxes must first be deducted from the collateral s value. Similarly, if the borrower s equipment or inventory is subject to purchase money security interests, then the lesser of that property s value or the amount of the purchase-money obligations must also be subtracted from the estimated value of that property. The following is an example of a simple liquidation analysis for a creditor with security interests and liens in all real and personal property of a debtor: A. Amount of Secured Debt: $3,500,000 B. Accounts Receivable 1. Current (1-60 days) = $300,000 face amount (@ 60% estimate of recovery) = $180,000 2. Over 60 days = $100,000 face amount (@ 10% estimate of recovery) = $10,000 3. Total liquidation value of accounts = $190,000 C. Inventory 4 The phase, highest and best use, is defined as [t]he reasonably probable and legal use of vacant land and an improved property, which is physically possible, appropriately supported, financially feasible, and that results in its highest value. The four criteria the highest and best use must meet are legal permissibility, physical possibility, financial feasibility, and maximum profitability. Dictionary of Real Estate Appraisal, Appraisal Institute (3d ed. 1993). 5 The Principle of Substitution is defined as when several similar or commensurate commodities, goods, or services are available, the one with the lowest price will attract the greatest demand and widest distribution. Dictionary of Real Estate Appraisal, Appraisal Institute (3d ed. 1993).