Maximizing Recovery of Distressed Debt* By Scott A. Lessne and Vincenzo Paparo Lenders must understand the full scope of enforcement remedies. he past several years have been a busy time Restructuring the Debt for financial markets. The economy has Texhibited consistent economic growth, and Generally, a successfully negotiated restructuring an unprecedented amount of capital has been of a loan is preferable to outcomes achieved as a made available for investment. As a result, new result of enforcement actions. Lenders should not, debt structures, new debt providers and new debt however, shy away from commencing appropriate products have become available for commercial enforcement action if a borrower needs some en- borrowers creating an overheated and highly risk couragement to engage in or complete a satisfactory tolerant debt market. restructuring. As we will see below, enforcement While lending activity and opportunities have does not necessarily mean an all-out litigation battle. continued to grow, it appears that the steady eco- Timely and limited use of enforcement actions can nomic growth of the past fi ve years has slowed, be used effectively to achieve a tactical advantage possibly foreshadowing a slowdown that will to enhance the restructuring process. directly affect lenders in all parts of a company’s Lenders today are faced with numerous options capital structure. The recent rapid meltdown of when pondering the possibility of restructuring the subprime mortgage lending industry amply distressed debt. The options available are often demonstrates how quickly an industrywide credit narrowed by internal and external considerations, problem can leave lenders with little time to ratio- including (1) the investment return objectives of nally analyze a problem and to prepare a strategy the lender; (2) the nature of the borrower’s diffi cul- to enhance recovery. ties, that is, fi nancial covenant defaults vs. payment Similarly, the overnight shutdown of the capi- defaults; (3) industry-specifi c trends; (4) liquidity in tal markets in the early part of the decade found the market for distressed debt; and (5) third-party many lenders creating their debt recovery strat- pressures on the borrower. Most important, how- egies on the fly. Warning signs went unnoticed, ever, lenders should factor into the restructuring opportunities to prepare and plan recovery equation the contractual relationship between the strategies were ignored, and significant losses were incurred. While experience shows that one Scott A. Lessne is the General Counsel—Corporate Operations and Cor- should always be prepared for restructurings, porate Compliance Offcier of CapitalSource Finance LLC. Contact him at the impending shift in the economy suggests that [email protected]. there is not a better time than now to focus on potential problem credits. Vincenzo Paparo is a Partner in the Corporate Department and Co-chair When a credit exhibits signs of fi nancial distress, of the Finance Group of Proskauer Rose LLP. Contact him at vpaparo@ lenders have various enforcement and recovery proskauer.com. options. This article will review those options, with The authors thank Joseph Choi, an Associate in the Corporate Department emphasis on being prepared to act.1 and Finance Group of Proskauer Rose LLP, for his assistance with this article. JULY–AUGUST 2007 COMMERCIAL LENDING REVIEW 21 Maximizing Recovery of Distressed Debt borrower and the lender. One could argue that the losophy toward the specifi c credit, the borrower’s seeds of a successful or failed restructuring are sown industry or other internal portfolio management at the time the loan is initially negotiated and closed. concerns have not shifted in a signifi cantly dramatic Today’s “covenant-lite,” borrower-friendly credit fashion so as to warrant a wholesale revision of the agreements; multitranched capital structures; and underlying initial strategy. Many lenders, but par- lender syndicates comprised of various institutional ticularly those driven by quarterly public reporting interests will make consensual debt restructures requirements, are prone to adjusting their philoso- more challenging than ever. While consensual phies midstream in order to achieve big-picture restructurings will always continue to play an im- corporate goals. While there is nothing inherently portant role in the resolution of distressed credits, wrong with a philosophical shift in approach, it nonconsensual enforcement options (to the extent makes the job of the people in the trenches that not negotiated away at the outset of the transaction) much more diffi cult if the philosophy shift requires will likely play a more prominent role during the a signifi cant change in the restructuring strategy. next economic downturn. Review Your Enforcement: Enforcement Options When Does It Start? After identifying the strengths and weaknesses of Restructuring and enforcement is a process the credit together with the relevant industry trends moving along a continuum where institutional that may affect them, it is important to formulate a objectives are the control- strategy to enhance the re- ling factor. Institutional covery of the debt. While objectives will drive the deviations from the initial pace of the restructur- The recent rapid meltdown of the strategy are inevitable, ing and the breadth of subprime mortgage lending industry the initial path to achiev- available enforcement ing the end result should options. Lenders should amply demonstrates how quickly an always be kept in sight clearly communicate in- industrywide credit problem can leave as a benchmark. A lender stitutional objectives to lenders with little time to rationally may consider a number counsel and other profes- analyze a problem and to prepare a of options when devel- sionals engaged to assist oping its debt recovery in the restructuring and strategy to enhance recovery. strategy. A prudent lender enforcement process. For will carefully evaluate the example, some institu- widest array of options tions may view a series of fi nancial covenant defaults available to it at that point in time. These options as a signal that a credit weakness exists. The credit is will include contractual business decisions, such as moved to a restructuring unit, which then executes implementing a default rate or terminating advances the institution’s objectives. Another institution may (if contractually permissible) and decisions such as be more risk tolerant and view a series of covenant whether to aggressively pursue legal rights with or defaults as opportunities to obtain further leverage without judicial assistance. This determination may through waivers or forbearance agreements coupled depend on certain factors, including but not limited with additional fees; the defaults are not suffi ciently to the law of the state where the borrower and/or serious to sound the alarm. Therefore, the fi rst step any collateral is located, the cooperation of the bor- is to understand your institution’s restructuring and rower, the presence of other creditors holding an enforcement philosophy. Subsequent actions by the interest in the collateral and the various implications deal team and the restructuring team should align of a bankruptcy fi ling. with this philosophy. One should also periodically While a full discussion of a lender’s rights in step back and confi rm that the institution’s phi- bankruptcy are beyond the scope of this article, a 22 COMMERCIAL LENDING REVIEW JULY–AUGUST 2007 Maximizing Recovery of Distressed Debt note of caution is appropriate here. Enforcement op- stick approach is often advisable and should be tions should always be viewed against the backdrop considered as the situation warrants. Section 9-601 of a possible bankruptcy fi ling. More than once, a of the Revised Article 9 of the Uniform Commercial lender has marched down the path of enforcement Code (RA9) expressly sanctions the use of multiple only to be faced with a bankruptcy fi ling that the enforcement mechanisms. lender believed or was told would never occur. The Assuming the lender and the borrower have authors have been witness to explanations of lender reached an impasse, that is, the borrower is unre- surprise such as the following: “We believed that sponsive or unwilling to enter into a negotiated the CEO was too honorable to fi le.” “We thought resolution satisfactory to the lender (which can occur the company did not have enough money to fi le.” either before, during or after one or more forbearance “He wouldn’t dare do it without talking to us or agreements), the lender is now faced with the choice fi nding a new lender fi rst.” To the surprise and of either fi nding a method to motivate the borrower the detriment of these lenders, bankruptcy fi lings to cooperate or undertaking unrelated enforcement occurred in each instance. The analysis is simple. actions. Below, we describe actions that a lender What is the realistic likelihood that the enforcement may initiate that may result either in the borrower action will precipitate a bankruptcy? If the realistic reengaging in cooperative activity or in legal action answer is likely or better, then the lender should against the borrower and/or the collateral. consult with counsel and its fi nancial consultants to develop one or more bankruptcy outcome Nonjudicial Remedies models. Those outcome models should be used to balance the bankruptcy outcomes against outcome Part 6 of RA9 provides a variety of options for the alternatives that could result from restructuring