Debt restructuring – an overview

(Third of four parts)

V  What are the fundamental principles to follow in pursuing a restructuring exercise?       

There are two very important principles to follow when pursuing a restructuring engagement.

1) Take stock of the company’s liquidity and solvency and determine if it is still a viable company in the long run.

This is an imperative first step in any restructuring work. The objective is very clear here. The viability of the company which defaulted must be determined with an absolute certainty on the part of the lender/s. There should exist no doubt at all in the minds of any or all of the lenders that the company is solvent and viable before any restructuring is contemplated. If there is any doubt or if the lender/s find out that the company is not viable in the long run, then obviously the next step is liquidation or foreclosure. But there is a key issue here. Viability may not necessarily mean that the lender/s will get all of their credits repaid at full value. Why? There have been many cases where the recovery of the company will take such a long time that the repayment will take a longer time than what the lender anticipated or expects. A typical example is where the cash flows for the recovery period will only be enough to repay small portions of the outstanding debt for most of the period that the restructuring is being contemplated and that most of the payment will be done in the last two or three installments. In such a case, the present value all the cash flows is very low compared to the existing balance of the debt. The lender then doesn’t get full value.

So why go through the restructuring if the lender/s is not assured of getting full value in the repayment of their debt? The reason is more for practicality than anything else. Any lender will still want to be repaid for his investment. Lenders have to realize though that unlike the first time he granted the loan to the borrower, he is now facing a larger risk of not getting repaid or not getting back full value. This is the inherent risk of restructuring. Restructuring objectives, for these to be achieved, are inextricably linked and must be congruent to the cash flows of the company whose debt is being restructured. And in some cases, if the cash flow can only afford to repay a certain portion of the outstanding debt over a certain period, or even the whole life of the company itself, then the lender/s must content with that. Restructurings are never ALL OR NOTHING AT ALL activities.

2) If the viability of the company has been determined and accepted by the lender/s, then the next step is to try and preserve the assets of the company and where possible, try to enhance the value of some or all of it, so that repayment is somehow assured or enhanced too.

In all my experience in restructuring especially in multi-institutional debts, I think this is the most unappreciated of all the basic principles of restructuring, yet this is also the most important. A dear friend of mine, Ray Davis, an international restructuring guru and who I had the honor and pleasure to work with on several restructuring deals, said that this is the least understood and accepted principle by lenders when working on multi-institutional debts. And he said it is this lack of understanding that causes some restructuring deals to be delayed unreasonably or to fail altogether.

The reasons for this lack of understanding or sometimes the unwillingness to accept are simple. A borrower who has defaulted in a loan in a legal sense has VIRTUALLY LOST ALL HIS RIGHTS to negotiate for anything with respect to that particular loan. Conversely the lender who is the counterparty to that loan now has GAINED, BY VIRTUE OF THE DEFAULT, ALL THE LEGAL RIGHTS TO CALL ON THE LOAN, TO FORECLOSE ON ANY OR ALL PROPERTY MORTGAGED TO HIM, AND TO EXECUTE ANY AND ALL COVENANTS IN THE COVERING CREDIT AGREEMENT.

 So from a purely legal perspective, that lender is acting well within his rights in calling the loan or foreclosing. Morally also, since that lender is only a financial intermediary hence he is answerable to his depositors, capital providers and other stakeholders (including owners), he feels he has the primary obligation to protect the investment of these people. So under these two legal and moral bases, the lender feels justified in acting on his own and protecting his company’s interest.

But consider this example which has happened in some instances: the largest lender holds the operating property as collateral and institutes foreclosure proceedings when the borrower defaults even if this borrower has been determined to be viable in the long term. Or this lender is recalcitrant or uncooperative in any restructuring initiatives. What can possibly happen? All the other lenders scramble for possession of other free property of the borrower or become unyielding too, so you have a standoff. The borrower, due to this, doesn’t get the chance for any recovery whatsoever. The largest lender, in this case, may win financially, but in the end, all the other lenders and the borrower will definitely lose. Tough you might say? Or unfair?  C’est la vie! The largest lender in this example, acted well within his rights and for that matter, every other lender did too. But only one may win or probably get his investment back. The borrower, who earlier lost his rights on the debt, stands to lose much more than these rights. (To be concluded)

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(Vicente J. Sarza,  is a Principal for Business & Financial Advisory Services of  Manabat & Sanagustin & Co., CPAs, a member firm of KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. This article is for general information only and is not intended to be, nor is it a substitute for, informed professional advice. While due care was exercised to ensure the quality of the information contained in this article, readers should carefully evaluate its accuracy, completeness and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances. For comments or inquiries, please email [email protected] or [email protected]).