1 know the storm signals and work out area. what bank should try to communicate to troubled obligor ...

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NON PERFORMING LOANS

Know the Storm Signals and Work Out Area

What Bank Should Try To Communicate To Troubled Obligor What obligor should think about

before trouble starts (from perspective of obligor) Make sure you are complying with

all the loan covenants you can accommodate If your loan covenants require you to

submit your interim financials monthly, get them to the bank by the specified date each month

Know your financial ratio covenants, and calculate them yourself each time you prepare interim financial statements

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What Bank Should Try To Communicate To Troubled Obligor If you fail to meet a certain key ratio,

prepare a memo to the bank explaining why you missed the ratio and your plan for getting your ratios back where they should be

Seeing an improving picture of your business makes bankers feel more comfortable. They will work with you much easier than when business circumstances continue to change for the worse, without explanation or commentary from you 3

Other Measures Obligor Can Take To Help Circumstances When Times Tough Try to never miss a payment to the

bank. The fastest route to foreclosure is to get 60 days past due on your loan If you are going to be late on a payment,

let your banker know in advance and tell them when the payment will get there. Make sure you get it there when you promise

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Other Measures Obligor Can Take To Help Circumstances When Times Tough If your total debt service is too high,

first try converting accounts payable into notes payable. Many trade vendors will do this if they

think it is in their best interest. They will rarely wait over 12 months to be repaid the current A/P you owe them, but this negotiation helps. Make sure you show the A/P as being current, on your balance sheet, according to the new arrangements.

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Other Measures Obligor Can Take To Help Circumstances When Times Tough If you need to consult a bankruptcy

attorney, don't announce it to the bank or anyone else (other than your CPA or corporate attorney). It is important that the bankruptcy filing occur before the bank moves to foreclose.

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Other Measures Obligor Can Take To Help Circumstances When Times Tough Trim your owner's draw or

distributions to the lowest level you can. Don't take long vacations or buy expensive luxury items while your company is having trouble. Nothing will irritate a banker more than seeing you spend personal money on non-essentials while your business is in trouble.

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Major Causes Of Loan Problems

Compromise of Credit Principles Granting loans carrying undue

risks or unsatisfactory terms, with full knowledge of the violation of sound credit principles timidity in dealing with individuals

having dominating personalities or influential connections

friendships or personal conflicts of interest involved;

salary incentives and bonuses based on loan portfolio growth

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Self Dealing Overextension of credit on an

unsound basis to directors or large shareholders

Anxiety for Income Earnings factor permitted to out

weigh that of soundness Credits representing undue risks or

unsatisfactory repayment terms are granted. Unsound loans usually cost far more than the revenue produced 9


Incomplete Credit Information; must obtain Adequate and comparative financial

statements Operating statements, and other

pertinent statements Purpose of the borrowing and the

intended plan and source of repayment

Progress reports inspections, and memoranda of outside

information minutes of loan conferences 10


Failure To Obtain or Enforce Repayment Agreements

Loans granted without a clear agreement governing repayment

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Complacency Lack of adequate supervision of old

and familiar borrowers. Dependence on oral information

furnished by borrowers in lieu of reliable financial data. Optimistic interpretation of known credit

weakness' based on past survival of recurrent hazards and distress.

Ignoring warning signs pertaining to the borrower, economy, region, industry or other related factors.

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Lack of Supervision Technical Incompetence;

Competence is defined as: The technical ability to analyze

financial statements and to obtain and evaluate other credit information, thereby protecting the bank in the placement and supervision of loans

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Poor Selection of Risks Loans wherein the bank

advances an excessive proportion of the required capital relative to the equity investment of the borrowers.

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Loans for the speculative purchase of securities or goods.

Collateral loans carried without adequate margins of security.

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Know Early Warning Signs of Trouble So History Won’t Repeat Bookings way down

compared to benchmarks or industry

Negative trends – losses, weak gross margins, slowness in accounts receivable, and decrease in sales volume.

Intercompany payables/receivables are not adequately explained. 16

Prepare for the Problem: Early Warning Signs of Trouble

Cash balances reduce substantially or are overdrawn and uncollected during normally liquid periods.

Management fails to take trade discounts because of poor inventory turnover.

Low probabilities operating cash flows cover debt service. 17

Early Warning Signs of Trouble Withholding tax liability

builds as taxes are used to pay other debt.

Frequent “downtiering “ of financial reporting sparked in an effort to bring on a more “liberal” accountant..

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Early Warning Signs of Trouble Changes in financial

management. Totals on receivables and

payables aging schedules do not agree with amounts shown on the balance sheet of the same date.

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Early Warning Signs of Trouble At the end of the cycle,

creditors are not completely paid out. The bank sometimes can be paid out when the borrower leans on the trade.

This often gives bankers a false sense of security, but the company may be unable to borrow from the trade for the next buildup of inventory. 20

Early Warning Signs of Trouble Sharp reduction in officers’ salaries

brings a lower standard of living home, and might suggest a last ditch effort to save a distressed business. Alternatively reduced salaries might signal a concerted effort to make headway.

Erratic interim results signaling a departure from normal and historical seasonal patterns

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Early Warning Signs of Trouble The lender does not allow

cushion for error if seasonal loan is not repaid and there is no other way out but liquidation of the collateral

Lender is taking possession of collateral at worst time. It is the end of the season, and if the obligor cannot sell, how will the bank? 22

Early Warning Signs of Trouble Financials are submitted late

in an attempt by management or their accountants to postpone unfavorable news.

Unwillingness to provide budgets, projections or interim information.

Suppliers cut back terms or request COD. 23

Early Warning Signs of Trouble Changes in inventory,

followed by an excessive inventory buildup or the retention of obsolete merchandise.

The borrower changes suppliers frequently, or transient buying results in higher raw material costs.

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Early Warning Signs of Trouble Increased inventory to one

customer or perilous reliance on one account.

Changing concentration from a major well-known customer to one of lesser stature pointing to problem inventory. A good mix of customers is the best defense against “seasonal shock therapy”.

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Early Warning Signs of Trouble The lender permits advances on the

seasonal loan to fund other purposes, notably payments on the banks own term debt. Indeed, the term debt is handled as agreed, but the seasonal loan goes up and stays up.

Company loses an important supplier or customer.

Concentrations in receivables and payables. Failure to get satisfactory explanations on these concentrations. Failure to conduct investigations on the credit worthiness of larger receivables

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Early Warning Signs of Trouble The lender finances highly

speculative inventory whereby the borrower is trying for a “home run.”

Intangible signals such as failure to look the banker in the eye, letting the condition of the business deteriorate, or taking longer to return calls.

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Early Warning Signs of Trouble Management orders three-

pound lobsters during a banker’s lunch because the bank is picking up the check. This weekend they won’t be able to afford this dish - the firm has just gone off the cliff.

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Cash Flow Problems

Merchandise shipped out at the end of the year to window dress the financials

Unearned income Shifting sales to future periods

via reserves; income smoothing gimmicks

Creating gains and losses by selling, retiring debt

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Cash Flow Problems

Hiding losses inside discontinued operations

Selling assets after pooling Moving current expenses to

later periods by improperly capitalizing costs

Amortizing costs too slowly and failing to write off worthless assets.

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Cash Flow Problems

Income contributing less and less to overall financing

Dividends large in proportion to net income Depreciation is greater than capital expenditures

– assets running below optimal levels evidenced by weakening gross profit margin

Gross operating cash flow well below new income Net operating cash flow well below gross

operating cash flow

.

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Cash Flow Problems

Large overdue receivables Overly dependent on one or two

customers Related-party receivables Slow receivables turnover

(annualize frequently) Right of return exists

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Cash Flow Problems

Unjustified LIFO to FIFO changes Insufficient insurance Inclusion of inflation profits in

inventory Large, unexplained increase in

inventory Gross profit trends bad but no

markdowns Inclusion of improper costs in

inventory; capitalized instead of flow-through

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Cash Flow Problems

Outdated equipment and technology High maintenance and repair

expense Declining output level Inadequate depreciation charge Lengthening depreciation period Large write-off of assets Distortions re: currency translations

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Cash Flow Problems

Deferred taxes are running off Fixed asset turnover (Sales/NFA)

indicates sharp increase and tied to: Backlogs significantly increased GPM significantly below historical

and industry WIP inventory embedded in very

weak inventory turnover

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Don’t Wait To Classify Loans

Specially Mentioned Loans

Doubtful Assets Loss Assets

Substandard Assets

Partially Charged-Off

Loans

Specially Mentioned Loans

Loans in this category inherently weak

Regulators define exposures “undue and unwarranted” credit risk but not justifying a classification of substandard

Economic or market conditions may produce adverse operating trend but will likely collateral liquidation jeopardized

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Substandard Assets

A substandard asset is inadequately protected by obligor’s financial condition or collateral pledged

Well-defined weaknesses that jeopardize debt liquidation

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Substandard Assets

Characterized by distinct possibility that bank will sustain some loss if deficiencies not corrected

Loss potential does not have to exist in individual assets classified substandard

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Doubtful Assets.

Weaknesses inherent in one classified substandard with added characteristic: weaknesses make collection or liquidation

in full highly questionable.

Auditors determine a reasonable carrying value for distressed asset and request write-down through a charge to: Loan loss reserve Operating expenses Or auditors may look for additional capital

allocation

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Loss Assets

Banks required to promptly charge off identified losses Loans classified as losses considered

uncollectible and of such little value that their continuance as bankable assets are not warranted

Classification does not mean that the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off what is clearly appraised as basically worthless

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Classified Loan Write Up

A general description of obligation:

Amount of exposure (both outstanding and contingent or undrawn)

Location of obligor and type of business or occupation

Description and value of collateral

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Classified Loan Write Up

Notation if borrower is insider or a related interest of insider

Guarantors brief description of ability to act as a source of repayment, especially if financial strength changed significantly since initial guarantee of credit facility

Amounts previously classified 43

The Classified Loan Write Up Repayment terms and historical

performance, including prior charge-offs, and current delinquency status

Summary listing of weaknesses resulting in classification or special mention treatment

Reference to identified deficiencies dealing with loan administration or violation comments elsewhere in the report

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The Situation

While line bankers know the borrower, workout department has more experience solving credit problems

They make decisions fast, usually without conferring with other departments (the legal department being the notable exception)

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The Situation

Objective of the workout group: Correct problems that can be

corrected and return the company a tradition banking relationship

Secondary objective if first not realistic: maximize the potential for ultimate

collection of outstandings

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The Meeting

When a loan transferred to workout, relationship officer and workout officer to review all information dealing with relationship

After reviewing file, workout officer schedules meeting with borrower and relationship officer .

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The Meeting

Legal council may also present Function of meeting

Define specific role of workout group and its interaction with the borrower

The borrower usually informed new account officer is the workout officer.

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The Meeting

Workout officer notes additional sources of repayment or collateral that could be available from the customer

Keep credit rating frequent Arrangements made for

workout banker to visit company

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The Meeting

Sound workout programs begin with full disclosure of relevant information and are based on a realistic evaluation of the abilities of both the borrower and workout to resolve problems

Role of turnaround specialist

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The Eleven Big Questions

Are 90-day cash budgets positive or negative?

See Acme cash budget. Measure variances

Will the firm be able to extend trade terms?

Can company file for expedited tax refund to provide quick injection of cash?

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Can outside consultants assist Accountants, investment bankers,

turnaround specialists, outside counsel)?

Are there other sources of cash, e.g., guarantors, new equity?

Is the company or any part viable, so restructuring is a viable alternative?

Shareholder valuation and simulations are key 52


Does firm plan alternative legal moves, preventing restructuring?

If a move isn't made quickly, will delay cause partial or full dissipation of assets, actions by other creditors, or increased carrying costs for the Bank?

How should the bank treat new loans (new money)? Do advances enhance collateral value?

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Is there a plan to repay new money within reasonable time frame, and will portion of imbedded debt be repaid with it?

Will new money be LIFO and senior to embedded debt (rule of thumb: new money should not exceed more than 1/3 of embedded debt)?

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Required Documentation

Obtain properly signed note Review subordination

agreements Maintain complete credit file Make sure guarantees are in

order and completely understood

UCC filings should always reviewed to insure that they have been properly filed and are up to date

Check for unencumbered assets55

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Compliance Watch List

Compliance with Agreements Did the lender act in full compliance

with the express terms of the documents governing the loans?

Were the terms of the document modified or waived by the subsequent writings, statements, or conduct?

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Compliance with Agreements Do loan documents unambiguously

give lender the right to terminate funding or to demand payments?

Is this right consistent with the other terms of loan?

Did borrower breach any contractual covenants or conditions precedent contained documents?

If so, can breach be established by objective criteria?

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Compliance With Duty Of Good Faith And Fair Dealing Assuming lender terminated

funding, did lender give borrower reasonable notice of its intent?

Was borrower afforded reasonable opportunity to obtain alternative financing?

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Compliance With Duty Of Good Faith And Fair Dealing Was the lender's action

supported by objective criteria?

Was lender's action consistent with its institutional policies for terminating funding?

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Compliance With Duty Of Good Faith And Fair Dealing Did lender cause the

borrower to believe that additional funds would be forthcoming?

Did borrower act in reasonable reliance and to its determent on the anticipated financing?

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Compliance With Duty Of Good Faith And Fair Dealing Has a relationship of trust or

confidence been established between the lender and borrower?

Did the lender routinely offer advice or suggestions to the borrower?

Is there a disparity of sophistication or bargaining power between the parties?

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Domination and Control

Is lender actively participating in the day-to-day management of business or does the lender merely possess "veto power" over certain business decisions?

Is the lender the sole or primary source of credit for the lender? 63

Domination and Control

Did the lender wrongfully use threats in an attempt to control the borrower's conduct?

Does lender have control over a substantial amount of stock of the debtor?

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The Law Of Workouts: A Large NY Bank’s Advice - Before It’s Too Late Review the file for all the facts. Audit all loan documents. Interview all the personnel involved. Assess you borrower's motivation to

settle rather than to sue. Look for enforcement alternatives

to suit. Will giving a little in a restructure gain a lot such as collateral? New guarantees? Time to overcome adverse courses of conduct?

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The Law Of Workouts: A Large NY Bank’s Advice - Before It’s Too Late

Review all waivers the bank might possibly have given, whether in writing or orally.

Provide ample notice of bank action (including demand, setoff), when that is at all practical. If working towards deadlines, make sure they are clearly understood by the borrower. Put them in writing, if possible. When deadlines are extended or modified, a writing to the borrower should detail the new terms and conditions now applicable.

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The Law Of Workouts: A Large NY Bank’s Advice - Before It’s Too Late

Work with good attorneys, called in as soon as practicable. Reliance on advice of counsel may demonstrate good faith, adding to you chances of a successful defense.

Never (never!) sue for small sums or for spite: consider the advisability of suing when

the borrower can't pay.67

The Law Of Workouts: A Large NY Bank’s Advice - Before It’s Too Late Always be businesslike, avoiding

abusive language, harshness, table pounding.

Management changes can be effected, when necessary, but they require care to accomplish without liability.

Let the borrower and its advisers be the source of business plans, not the bank.

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1 know the storm signals and work out area. what bank should try to communicate to troubled obligor ...

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