Ask the Workout Window: Facing the Five D’s of Financial Distress

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: Jason, I have a relationship with a manufacturer that is owned by two brothers. They’ve recently had a falling out and are now suing each other to gain control of the business. I expect the bank is going to get drawn into this fight and will have to produce documents and testimony. How should we handle this sensitive situation?  

JASON: I would get your legal partners involved as well as consider sending this to your workout department for monitoring. This disagreement is a major red flag and this fight will probably result in lower performance for the business: Ownership is distracted and the rancor could trickle down the organization and up through supply chain. Meanwhile, the litigation will eat up the resources of both brothers personally, who I assume are guarantors on the deal. Having a workout team monitor this deal is appropriate, given the probability of legal involvement. It is critical that the bank establish that it is 100% neutral in this disagreement and will not take sides. Additionally, deliver the message that the bank expects full compliance with its loan documents regardless of any legal outcome. This is especially true for any material change in ownership that may result—for example, one brother buying out the other or being awarded the ownership interests of the other, which would require a renegotiation of the documents / loan terms to account for the new ownership structure. Always remember the 5 D’s of Distress: Death, Disability, Drugs, Divorce, and Disagreements!  

Constrained by Course of Dealing Concern

QUESTION: I am a recent hire at my new bank and one of the loans in my portfolio has a debt service coverage ratio (DSCR) covenant that has been internally waived every year since COVID began. Management is getting frustrated about the borrower’s failure to improve operations and continuing covenant violations. Management has directed me to enact the default interest rate at the next opportunity. But I believe the customer will be very upset with me and our relationship will start on a negative basis. How should I approach this?  

JASON: Well, declaring default on day one is never a good way to start a relationship. But you will have an even bigger problem if you issue a default now after you’ve essentially waived three years of this covenant without taking any corrective actions. This is known as a “course of dealing” issue. If the bank never even issued a default / reservation letter on this covenant in the past, you’ll have very little basis to do so and enforce that condition now. You should tread lightly and engage your legal partners to assist. You may be able to send a notice to the borrower that they are in violation of the default, but the bank will have little ability to raise the rate or take other action for this first action. I would consider a modification that amends the covenant or gives a minor concession so that the loan is redocumented. That will allow the bank to appropriately and timely address covenants as they arise in the future. Good luck! 

Optimizing an Exit Relationship

QUESTION: I’m a new workout officer and I was just assigned a $3.4 million real estate loan secured by a commercial building on a well-traveled thoroughfare in the suburbs of a major city. The loan is currently paid as agreed, but the property has lost tenants recently and is set to violate their DSCR this year. This was a stretch deal for a personal friend of the former bank president and there is limited sponsorship to right-size the loan or support any losses. We also are saddled with a rate that is significantly below-market and the loan doesn’t mature for another six years. New management doesn’t necessarily want to keep this relationship. What is the best course?  

JASON: Since you’ve indicated management has designated this relationship as an exit relationship, I would strategize how to get the best resolution on a net present value basis. Given this loan is at a low fixed rate and is now graded criticized, your bank is likely losing money on it, given the increased loan loss reserve required on this asset. I would seek a resolution in two parts: 

First, at the actual event of the default for the DSCR (once you receive financials from the customer and test them to verify a covenant has been violated), declare the default and negotiate with the customer to either: a) change the rate to the current floating rate or b) reduce the maturity to six to 12 months while delivering the exit/ refinance message.  

Second, once the modification is closed/booked, market the loan to be sold to a distressed debt buyer. Yes, you’ll be taking a loss on the asset at that time, but the loss will be lessened if you increase pricing and/or reduce maturity. On a net present value basis, the bank will achieve a better result from the loan sale than by holding the asset at the higher reserve on a long-term basis with a higher risk of further deterioration to non-performing status. If the loan stops paying and you’re faced with non-accrual and potential litigation, the sales price you’ll receive from a distressed debt buyer will be much lower than had you sold earlier. Your first loss is often your best loss, especially on a standalone deal with limited future improvement or opportunity for new business.  

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.