South Bend / Mishawaka, IN – Each day lenders are faced with borrowers who default under the terms of the lending relationship. This article will address the various steps a secured lender should consider undertaking when its borrower is in default.
Evaluate your Collateral. Evaluation of the collateral that is acting as security for the indebtedness is essential. Following the below enumerated secured collateral assessment will undoubtedly make the choice of which path the secured lender wishes to pursue much clearer.
- Is your security interest in the collateral properly perfected? The very first step for a secured creditor to undertake is to ascertain whether its security interest in the collateral is properly perfected. If the security interest is properly perfected, then the secured creditor can proceed as outlined below. If it is not properly perfected, then the secured creditor should determine how it can best perfect its security interest. Depending on the nature of the deficiency, it may be as simple as the secured creditor filing a UCC-1 Financing Statement or as difficult as drafting and securing the debtor’s signature on a Security Agreement or obtaining possession of titles to rolling stock.
- Determine the net liquidation value of collateral. Once you determine that you are properly perfected, you should make a determination of the conservative net liquidation value of your collateral. Again, depending upon the result of this calculation, the secured lender will be directed to different courses of action. Are you under secured or are you over secured? The answer to that question will send the secured lender in different directions.
- Ascertain the value of any secondary sources of payments. Are there other sources of recovery other than the debtor? Are there guarantors of this indebtedness? If so, what is the realistic dollar value of these guarantees? This may require an additional net liquidation value of collateral if the guarantor has pledged collateral to secure the guaranty.
- Determine whether there are any third party claims to your collateral. The next step is to ascertain whether any third party has a claim to your collateral which may result in reducing the net liquidation recovery prospects. In particular, ascertain whether any taxing authorities have obtained a lien which may have in fact primed your security interest in the collateral. Additionally, determine whether there are other creditors claiming a security interest in your collateral. If so, they will have to be dealt with during the liquidation process and you should try to determine what effect that may have on the net liquidation recovery.
- Assess Business Forecast of Debtor The secured lender should do the best it can to honestly assess the short and medium term business prospects of the debtor. What is the likelihood that the debtor will lose money in the short and mid-term range? If you determine that it is likely that the debtor will in fact lose money, you should assess how any such loss would affect your net liquidation recovery.
If you are an equipment lender, short term losses of the debtor may not necessarily affect your net liquidation recovery amount. CAUTION: You should pay close attention to the use and maintenance of the equipment to ensure that the debtor is not simply running the machinery and equipment into the ground. The net liquidation value of equipment that is being heavily used and not properly maintained can diminish the net liquidation value of the equipment rapidly.
If you maintain a blanket security interest in the debtor’s assets, then a short and mid-term loss will definitely affect the net liquidation recovery from your collateral.
Consider your Options Once you have evaluated the collateral and performed your analysis of short and mid-term business operations, you are then in a position to make an informed decision regarding the various alternative courses of action that are available. Some of the options include:
- Forbearance Agreement: In a Forbearance Agreement situation, the secured lender allows the debtor to continue to operate while in default under the lending relationship for an agreed upon period of time as long as the performance of the debtor meets or exceeds certain terms and conditions. The terms and conditions include not only payments to the secured lender, but should, in most cases, include financial covenants.
- Chief Restructuring Officer: If your confidence in the debtor’s management is lacking, the pursuit of a chief restructuring officer may be the best course of action. Under this scenario, the debtor would continue to operate but it would be managed by an outside person or team. This type of an arrangement is most effective in those situations where the debtor’s business has suffered due to mismanagement. With new management the operations can improve to a point where the debtor can reestablish a normalized lending relationship or become a more valuable acquisition target.
- Appointment of Receiver: If you are unable to reach a consensual arrangement such as a forbearance agreement or a chief restructuring officer, then you may want to consider pursuing appointment of a receiver. This is much like the chief restructuring officer; however, it is almost in all instances a much more costly alternative to the chief restructuring officer arrangement. Further, under a receivership, all creditors will have an opportunity to become involved with the business decisions facing the debtor.
- Filing of a lawsuit for Breach of Contract and Foreclosure of Security Interest: If all else fails, one option available is to file a lawsuit against the debtor for breach of the lending documents and foreclosure of your security interest. Again, this option is usually one of last resort and is only pursued if the other options available have either failed or cannot be agreed upon.
In conclusion, when a secured lender is faced with a defaulting borrower, it should take a deep breath, take time to honestly assess the situation and then decide upon, and implement, a course of action.
The content of this article is for informational purposes only, and does not contain, nor should be construed as containing, legal advice.