Ask the Workout Window: When Environmental Risk Surfaces

In each issue of The RMA Journal, veteran workout leader Jason Alpert gives advice on thorny workout challenges. Have a challenge you would like Jason to address? Send your question to WorkoutWindow@rmahq.org.   

QUESTION: Our bank is prudent about conducting appropriate inquiries and risk-based environmental diligence when making loans. But as we considered foreclosing on one of our borrowers, we found out hazardous waste had been dumped illegally on a property adjacent to our collateral. Should we proceed with the foreclosure and take possession of the property securing our loan? Or does the risk associated with possible contamination create even more risk than the potential loss on the loan? This has never happened to us before. Please help!

JASON: Proceed with caution! Assuming the borrower is in payment default (including maturity default) and proper default and demand notices have been issued to all borrower(s)/ guarantor(s), your bank will need as much information as possible about the contamination before making the strategic decision to file a foreclosure lawsuit. This means ordering an updated Phase I environmental site assessment and, if needed, a Phase II to determine the extent to which your collateral has been contaminated by the illegal dumping. The last thing you want is to go through the litigation and realize you do not want to take ownership.  

From a strategy standpoint, consider how to resolve this deal so that the customer ultimately leaves the bank. Offer a short-term forbearance on the payment default (and other defaults) to give time for environmental review and testing. As part of the agreement, obtain as much information as possible and pick up additional credit enhancement—collateral/guarantees—if it exists. Additionally, press the borrower to prepay the cost of all necessary environmental reports and updated valuations, or at least include it in the borrower fees within the forbearance agreement.  

The borrower will likely want to share the reports with their attorney as they consider action against the adjacent owner. If you do share them, ask the borrower to sign a release letter beforehand stating that the bank disclaims any conclusions, warranties, etc. in the reports. Finally, as with any forbearance and modification, obtain a waiver of all claims and defenses in the forbearance agreement so no lender liability or servicing claims can be brought up as affirmative defenses by the borrower in a potential foreclosure litigation (if the property is clean or not impacted).  

If the environmental reports show the property is impacted, assess the risk with your internal legal partners (and your other real estate (ORE) person if the bank has one)—and establish your risk appetite, if any, for foreclosing. If it seems too risky or expensive to assume the title, the bank might consider a few options. One is to sell the loan, with all proper disclosures, to a firm that buys environmentally compromised assets, though the discount on the note could be severe. The second option could be encouraging the borrower to refinance the property with a private lender. (Very few regulated lenders will take the collateral.) A private lender with higher risk tolerance may take the loan on, especially if there is a claim against the other property owner that can be quantified, awarded in litigation, and is collectable. Here, too, you may need to offer a discount to the private lender, but potentially not as large of one as in the note sale option.  

Finally, depending on the jurisdiction/state, a special master or receiver could be appointed to market and sell the foreclosure judgment (you would still need to litigate) but the bank will not have to credit bid the judgment and will stay out of the chain of title. You’ll need outside counsel from that jurisdiction who can walk you through the process. One last item: Make sure you are accounting for the loan correctly and taking any appropriate charge-offs to the asset given the updated condition/valuation. Good luck!  

Throwing Good Capital After Bad?  

QUESTION: A borrower with a fully tapped revolving loan let us know they are having a significant liquidity crunch. The company has done a good job scaling revenue, but has not translated that to cash flow. In addition, the drawdowns on the revolver over the past 18 months or so have been for acquisitions and more permanent working capital. As a result, the company is entering their busiest time of the year seeking the bank’s assistance, with no liquidity remaining. Management has explained that savings from cost-cutting measures have not been realized yet, but they are optimistic they will improve profitability in line with the revenue scale. 

Should the bank provide more assistance to a watchlist credit knowing that inaction will impact the company as a going concern? Is there a point where we stop throwing good capital after bad at the borrower? If so, what is that point? 

JASON: If the revolver was expressly for supporting working capital needs, discuss with bank leadership the best way to address the borrower given its improper use of the line for acquisitions and permanent working capital. Decide if the customer is strategically important to the bank; otherwise, encourage them to refinance or find financing elsewhere.  

But do something. If a bank fails to act when first notified of a defined problem, it almost invariably leads to further credit deterioration, increased costs, and losses on the asset. If it has not been done so officially yet, this relationship should be downgraded to “watch” status and transferred to the bank’s workout function. In addition, if the main revolver is in default for failure to rest or other improper line usage, issue a default or reservation of rights letter to the borrower. Finally, if there is some equity in the totality of the available assets, a new short-term revolver (or an increase in the current revolver under a new sublimit) may be warranted to get the borrower through the busy season.  

The maturity on this short-term deal should be 30-60 days after the end of their busy season and after they collect their receivables. Any available credit enhancements must be picked up via cross-collateralization/cross-default with the primary revolver as well with all other loans held at your bank or collateral that is held free and clear by the borrower. If the line was used to acquire new assets, those assets must be added as collateral, as well as any available guarantees. Concurrently, the main revolver should be modified to recognize the new permanent working capital utilization, which will need to be amortized (as repayment is now from profits turned to cash rather than conversion of current assets to cash). The bank could provide some runway by allowing interest-only payments prior to amortizing the loan (probably after the repayment of the short-term busy season advance). Or the bank could split the revolver into a smaller revolving line based on the new working capital needs and amortize the portion that is permanent working capital or was used for acquisitions. Finally, as part of any agreement/modification, the bank should require the borrower to provide quarterly cash budgets and statements (if they haven’t previously done so). If the borrower is not cash flowing or management is not strong enough, you can require them to engage a turnaround consultant. Give them three acceptable firms to choose from and incorporate that into the modification/forbearance agreement. You can also make engaging a turnaround firm a condition if they default further on the deal after the modification or restructure.  

If the borrower has no equity in the available assets, then declining the funding increase request may be warranted. This is justified given that they are overleveraged and need to start right-sizing operations and funding the gap. Institute a maturity for the main revolver or, when it matures, require the start of amortization, a principal curtailment, or a switch to another lender.  

 Jason Alpert is managing partner at Castlebar Holdings, a distressed debt fund and financial institution advisor. Jason led and managed workout and special asset teams at major financial institutions for two decades. He is on the editorial advisory board of The RMA Journal and is an adjunct professor at the University of Tampa. Email Jason at jason@castlebarholdings.com or reach out to him at 813-293-5766.   
 

Disclaimer: The Workout Window is not intended nor is it to be considered legal advice. As The Workout Window stresses, consult with legal counsel and your institution’s management to be sure you are acting within the parameters of your institution’s policies and banking law. 
 

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