Administrative Insolvency Whats a Secured Lender to Do
When businesses hit rough spots, loan-to-value ratios become compressed as the struggling business pushes its lender to become more aggressive on the borrowing base. Tranche A senior secured debt, Tranche A junior secured debt, Tranche B mezzanine debt, convertible debt/preferred stock, Tranche C secured debt and trade liens all make their way to priority positions in the struggling business's balance sheet. Intercreditor agreements have reached new heights of sophistication and specialization. Lenders have developed well-thought-out strategies, agreements and solutions to meet the needs of the struggling business.
Unfortunately, while all of these efforts, services and products may address the borrower's short-term liquidity problems, not every business is salvageable. Often increased liquidity provides a struggling business the "breathing room" to work through its restructuring. However, we are all aware of cases where the only thing that increased liquidity accomplished was to delay the day of reckoning for a business model that just does not work.
Because asset-based lending formulae necessarily focus attention on availability, questions concerning the wisdom of continued financing of an unworkable business model often go begging. The ultimate cost for the additional liquidity provided to a doomed business is paid when there are insufficient funds available to provide for an orderly wind-down, maximize asset value, fund administrative expenses and provide for a distribution to unsecured creditors.
In any restructuring, interested parties will likely all have strong and very different views as to what is right and practical. Management, especially if it has an equity interest in the enterprise, will seek the increased liquidity necessary to allow it to operate out of its difficulty. Meanwhile, the secured creditor's risk increases with each and every advance and over-advance. Its challenge is to make sure it intelligently controls and protects that risk. Unsecured creditors have an incentive to make sure that the struggling business has adequate working capital (given that the business is a distribution outlet for their goods and services), all the while knowing that in the end they increasingly diminish their own chances for survival in the event the struggling business ultimately fails. For equity, increased leverage allows it to avoid increased exposure or dilution of ownership interests.
As the "equity cushion" (the difference between the value of the assets pledged to secure a loan and the amount of that loan) decreases, the restructuring enters the "protection-of-self-interest phase." This phase of a restructuring gives rise to a contradiction. Fees are charged, carve-outs negotiated, covenants are put in place. Bankruptcy courts place confidence in the restructuring professionals. These devices are necessary to ensure a responsible restructuring effort. All of these good and needed protections serve each party well, yet they further diminish the available funds necessary to fund the administration of the bankruptcy case.
The perceived solutions are varied and diverse. It is sometimes suggested that secured creditors should be prepared to discount their fees in the event that a borrower's case liquidates and there are insufficient funds remaining to pay other administrative expenses. The secured creditors answer back, "I'm taking the lion's share of the risk going forward; I should be protected." The debtor will instinctively do whatever it can to fix itself, and usually that requires additional funding. The bankruptcy court is faced with the dilemma of giving the debtor the room it needs while making sure the case is administered in a financially practical and responsible way.
Bankruptcy courts have handled these difficult issues with increasing concern and frustration. Losses by secured creditors continue to increase. The initial answer for the secured creditor is more conservative underwriting and stricter covenants. If the secured creditor's losses continue to increase in terms of frequency and amount, the marketplace will take care of that on its own. The unsecured creditors, generally comprising the largest group (usually in number) harmed in these situations, confront challenging issues of what is best. They usually want to keep their customers in business. They shout loudly about making sure there is adequate availability, essentially further subordinating their claims in the event the case turns into a liquidation. This becomes further complicated as secured lenders (in practical terms) will not let "carve-outs" increase their risk.
Experience suggests that liquidating chapter 11s continue to provide the most efficient and useful platform for converting non-cash assets to cash. Bankruptcy court-supervised §363 sales provide for an orderly process, credible marketplace and reasonable time frames. However, unless a liquidating chapter 11 promises a benefit for unsecured creditors, they will advocate the conversion of such cases to chapter 7. Such procedures tend to diminish the recoveries that can be realized from the sale of the secured creditor's collateral. Also, litigation over issues such as conversion, dismissal and adequate protection leads to the incurrence of additional expenses as time marches on and ultimately contributes to administrative insolvency.
The secured creditor must be prepared to address the question of how it will liquidate its collateral up front if it wishes to maximize recoveries. In its analysis, it must form a realistic opinion of what a case will cost to administer and work with the debtor and unsecured creditors to develop a budget and action plan to which all of them must commit. In creating this budget, the secured creditor has the opportunity to shore up its collateral position as a trade-off for its commitment to a budget that creates a stake for all of the key players. All parties should be specific and involved in addressing these issues. A clearly defined exit strategy should be a priority sooner rather than later. Is a chapter 11 plan feasible? At what point in the process is a consensual dismissal or conversion to chapter 7 desirable? By addressing these questions up front, a program can be created that creates a common identity of interests and leads to the achievement of a better result.
Having been on all sides of administratively insolvent cases, we can comfortably say that administrative insolvency hurts everybody. However, by being involved and addressing the challenges inherent in the administration of an administratively insolvent debtor, a secured lender has the opportunity to enhance recoveries through a process that does not leave a bad taste in everyone's mouth.