A borrower defaults under a loan agreement with a syndicate of lenders. Being realistic, the borrower’s owners recognize that a successful restructuring would require additional equity as well as the cooperation of the lenders. Rather than investing additional money and resources (and potentially “throwing good money after bad”), the owners decide they want a clean break, and agree to surrender the collateral, i.e., turn over the business to the lenders. However, the owners demand a steep price for their cooperation, including a full release and a share of the upside. The following article explores what happens when a lender group has an opportunity to take over a borrower’s business. Part one deals with issues that the lender group should consider before agreeing to take the keys, and part two discusses practical issues once the lender group takes action.
Part I: Whether to Take the Keys
The threshold question for the lenders is whether the borrower’s business is, or will be, worth more than its liquidation value, net of liquidation costs and risks. An answer to this question requires an assessment not only of the value of the borrower as a going concern, but also of the anticipated cost of acquiring the borrower’s business.
The lenders should obtain third-party appraisals of the business as a going concern, industry expert recommendations for improving operations and an analysis of projected cash flows, including capital expenditure requirements. The analysis and due diligence required is not much different than what would be done by an acquirer in a typical M&A transaction. The lenders should evaluate the assets and liabilities on the borrower’s balance sheet as well as off-balance- sheet-contingent liabilities, including pending and threatened litigation. All material contracts, including those with customers and suppliers, should be reviewed both for their economic terms and for third-party consent requirements. Leases and joint venture agreements and similar arrangements with third parties should be analyzed. Consideration should be given to any regulatory requirements applicable to the borrower, and to the transferability of permits and licenses needed to operate the business.
A key factor in determining value is the condition of the business. That the owners are willing to walk away is generally a good indicator that the business has been significantly challenged. The lender group’s financial advisor should determine the root causes of the borrower’s problems, and not just the final symptoms. It is not enough to conclude that the borrower has declining cash-flow without understanding the reasons for the negative performance. The financial advisor should also assess whether the business can improve with a change in ownership and whether there is value in retaining some or all of the borrower’s management.
Changing ownership does not change the underlying business or its problems or satisfy the need for a turnaround process. The decision to “take the keys” is essentially a declaration that the lender group can do better, as well as recognition that since the lender group bears the financial risks, it should also have the benefit of the upside.
A significant difference between a typical M&A transaction and a lender acquisition of a distressed borrower is that it is generally not a viable option for the lenders to walk away if they are not satisfied with the results of their due diligence or if the agreement cannot be reached on a purchase price. The lenders have essentially prepaid for their acquisition with their now-defaulted credit facilities. The primary purpose of the lenders’ due diligence is to help them decide whether they should attempt to preserve the borrower as a going concern or liquidate the borrower, either through a bankruptcy proceeding or foreclosure sale.
In addition to an assessment of the relative going concern and liquidation values of the borrower, this decision generally involves considerations unique to each lender. For example, each lender may have different objectives based on a variety of factors, including whether it acquired the borrower’s debt at par, and whether it would prefer to defer any sale and avoid an immediate write-off if the likely sale price will result in a deficiency. In addition, each lender should consider applicable regulatory requirements that may limit its ability to hold equity in an operating company.
Potential Risks & Acquisition Costs
The lenders’ due diligence should include an analysis of potential “successor liability” under state law and a review of any potential environmental issues. As a preliminary matter, current environmental Phase 1 studies with respect to the borrower’s real property should be obtained.
Other acquisition costs that the lenders should factor into their decision include state and local transfer taxes, payments necessary to obtain third-party consents and the lenders’ professional fees (which can include the fees of attorneys, financial consultants, investment bankers and appraisers). The lenders should also consider the potential need to either provide or consent to a third party providing a senior working capital facility or an interest rate hedge. The risk of extending new credit or allowing a third party to extend new credit on a senior basis, even to an entity owned and controlled by the lenders, can be substantial. This potential risk can be the determining factor in deciding whether it is worthwhile to preserve the borrower’s business as a going concern.
The Price of the Borrower’s Cooperation
Generally, a borrower in default does not turn over the keys to its business along with a list of everything the lenders need to know without asking for something substantial in return. A borrower’s “requests” are likely to include some or all of the following:
• A share in the upside value of the business for the borrower’s owners, either through equity or a “hope note”
• A continuing role for management or contracts for key employees
• Releases from any personal or corporate guarantees
• General releases from any causes of action in favor of the lenders (such as, for example, causes of action for improper transfers of assets or for the board’s breach of fiduciary duty to the lenders while the borrower was insolvent)
• The right to consent to the structure of the transfer, so as to minimize adverse tax consequences to the borrower’s owners, e.g., for forgiveness of debt income (be wary of owners who initially say they are indifferent to tax issues)
• Indemnification against third party claims
• The right to remain at the premises or sublease space for a related business
Accordingly, the lenders will have to determine how much the borrower’s cooperation is worth to them, and at what point they are better off either forcing a liquidation or a bankruptcy filing. There is no right answer to this question: The answer will depend on the circumstances of the case, the relative negotiating leverage of the two sides and the lenders’ assessment of the cost and estimated recovery from available alternative courses of action.
The Lenders’ Alternatives
If the lenders refuse to make concessions to the borrower, resulting in the borrower withdrawing its offer to transfer its business on a cooperative basis, the lenders can foreclose on their security interests in the borrower’s assets or, if the lenders have a pledge of the equity in the borrower, on such equity. Either enforcement action may result in a bankruptcy filing by the borrower where the borrower again has an opportunity to seek concessions from the lenders.
1. Asset Foreclosure
Although the lenders can potentially realize value by foreclosing on the borrower’s assets, it is not an efficient way to acquire the borrower’s business as a going concern, unless it is done through a UCC Article 9 “friendly foreclosure,” with the borrower’s cooperation. The lenders may have to bring separate foreclosure actions on real and personal property to extinguish junior liens or combine the foreclosures in one court proceeding. A court proceeding can take months to complete, even without the borrower’s opposition. If the borrower decides to oppose the foreclosure or assert claims against the lenders, the proceeding can take over a year, depending on the jurisdiction. In addition, the borrower has no obligation to cooperate with the lenders after a foreclosure proceeding has begun, and therefore a smooth transition of the borrower’s business to the lenders will be difficult, if not impossible, to accomplish. Further, it should be expected that while the foreclosure is pending, the borrower’s business will further deteriorate, making it more challenging to sell or acquire the business as a going concern.
2. Equity Foreclosure
Lenders with a security interest in the borrower’s equity can foreclose on such equity under the UCC and acquire ownership of the borrower relatively quickly and inexpensively. However, in doing so, the lenders will acquire the borrower’s assets subject to all of the borrower’s liabilities. There will be no opportunity to pick and choose which of the borrower’s liabilities to assume. As with the asset foreclosure, the lenders will likely have to attempt to rebuild the business without a cooperative transition from the borrower.
3. Borrower’s Bankruptcy
Perhaps the best alternative for the lenders to acquire the borrower’s business without the borrower’s cooperation is through a bankruptcy proceeding. This can be done through a sale under §363 of the Bankruptcy Code, the confirmation of a Chapter 11 plan of reorganization or a sale of all of the assets of the borrower by a Chapter 7 trustee. However, it is impossible to predict whether any of these alternatives will be successful in a timely manner, especially if the borrowers and/or its unsecured creditors oppose the lenders’ efforts.
Any bankruptcy proceeding will involve significant transaction costs, including professional fees for the debtor and creditors. All such fees, as well as the other administrative expenses of the bankruptcy, will directly impair the lender’s recovery. The lenders should weigh the additional bankruptcy-related expense and potential delay against the potential benefits from a bankruptcy. Such benefits can include obtaining the borrower’s assets free and clear of all liens and claims pursuant to a court order that approves the transaction, avoiding liability for any of the borrower’s pre-petition obligations, having the option to walk away from unprofitable leases and contracts or to assume profitable contracts, all regardless of change in control provisions and potentially benefitting from a transfer exempt from transfer taxes.
Part II: The Decision is Made to Take the Borrower’s Business — What’s Next?
If the lenders decide to move forward after completion of their due diligence and analysis of their alternatives, the next step is to agree on the best structure to acquire the borrower’s business. Structuring objectives include minimizing liability for the obligations of the borrower, maintaining some level of control over the business, avoiding adverse tax consequences and complying with applicable regulatory requirements. If the lending group is large and diverse, the lenders may be constrained in their options by internal requirements of some of the lenders. For example, a lender may not be permitted to (or may not want to) hold equity, another lender may have limitations with respect to certain industries and a third lender may insist on retaining a substantial amount of debt. These and other intercreditor issues must be addressed and resolved before proceeding.
Form of Acquiring Entity
Generally, to benefit from advantageous tax treatment and a limitation on potential liability, the lenders will form a limited liability company (Newco) that is owned by the lenders or their designees in proportion to the lenders’ claims against the borrower. Each lender will have the option of acquiring its interest in Newco through a special purpose entity, thereby removing itself from direct ownership of Newco. Newco will take title to the borrower’s assets and assume only those liabilities that the lenders and the borrower agree Newco must assume.
Capital Structure of the Acquiring Entity
The capital structure of Newco will be determined based on a negotiation among the lenders, and can range from the conversion of all the lender debt to equity, to the assumption by Newco of all of lender debt. In some situations where the lenders acquire both equity and debt in Newco, the equity is “stapled” to all or some of the debt, preventing transfers of equity without a transfer of the same pro rata debt share. There is no solution that applies to all cases. Issues to consider in setting Newco’s capital structure include internal regulatory requirements, how buyers in the distressed market will react to the capital structure and the attributes of the debt and equity, the lenders’ exit strategy, and tax considerations.
Organization and Management of the Acquiring Entity
Newco should be governed by an LLC operating agreement that provides for the election of a board of managers or directors, the appointment of officers and the allocation of authority among management, the board and the equity holders. Whether the board should be independent, the selection of directors and officers, and the division of power may a the source of disagreement among lenders that may have different views of the level of control that should be retained by the lenders and whether significant decision-making authority should be entrusted to management or the board.
1. Selection of Board Members
Views vary on whether a lender group should select board members who are independent of the lender group and the former borrower, or form a board made up of officers of the lenders and the lenders’ financial consultants. The primary advantage of selecting an independent board is that it helps insulate the lenders from lender liability-type claims and claims that any debt they retain against Newco should be subordinated to the claims of Newco’s other creditors. Perhaps, more importantly, the lenders should consider whether it makes sense to have the board run by bankers (who may retain a bias from dealing with the borrower) as opposed to industry experts with proven track records and experienced turnaround professionals with hands-on operating experience and no political agenda. If time allows and the expense can be justified, the lender group might seek the assistance of a qualified executive search firm that regularly performs board member searches, especially in situations where the lenders cannot otherwise agree.
2. Governance Policies
The governance policies of Newco’s board should be up-to-date, with well-defined board committees, committee charters and board member accountability. The former lender group and new owners of Newco should make their wishes known to the Newco board on key issues, such as their appetite for operating and financial risk, their time horizon to seek an eventual sale or other exit strategy, and management’s compensation and performance reviews.
It is likely that new management will be needed to either replace or supplement the borrower’s former management. Although advantages may exist for some management continuity, new leadership is often the key to making a clean break from the past and restoring the confidence of vendors, customers and employees. Again, if time and expense allow, an executive search firm might be engaged to recruit new management with a strong turnaround track record.
While a borrower’s offer to hand over the keys may sound very enticing, it is frequently only the beginning of lengthy negotiations not only between the lenders and the borrower, but also among the lenders, over the terms and conditions of the proposed transfer and the structure and governance of the acquiring entity. Whether the lenders accept the offer will generally depend on what consideration the borrower and its owners seek in return, the lenders’ assessment of the value of the business as a going concern and whether the lenders believe that a liquidation of the borrower’s assets or a bankruptcy of the borrower is a better course to follow. Providing for strong governance and management of the post-takeover business will help to reduce and manage risk, and increase the likelihood of a favorable exit in the future, which will make the takeover risk worthwhile.
Richard Stern is a partner and Richard Favata is an associate at Luskin, Stern & Eisler LLP. The firm specializes in representing financial institutions in out-of-court workouts, bankruptcy proceedings and related litigation with a particular emphasis on complex financial restructurings. It has represented a number of lender groups and individual lenders in connection with the acquisition of assets and operating businesses from borrowers in default.
Howard Brod Brownstein is a Certified Turnaround Professional and president of The Brownstein Corporation, a turnaround and restructuring firm that provides advisory and management services to companies and their stakeholders. He has served as an independent board member of businesses up to $1 billion in sales after they have “tossed the keys” to the lender group.
This article is intended to be a general overview of certain key issues that lenders should consider before taking over a distressed borrower’s business. It is intended for educational and informational purposes only and should not be construed as legal advice. As circumstances will vary greatly, a lender should confer with legal counsel to fully identify and address all available issues and options in its specific situation.