Ask the Workout Window: A Field Exam Uncovers a House Built on Sand

In each issue of The ProSight 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 [email protected].  Jason would like to thank the Oklahoma Chapter of RMA for submitting the following question.

QUESTION: I manage a commercial portfolio that includes a sub-$10 million asset-based revolver to a manufacturer of consumer durable goods whose sales are closely tied to new residential construction. The facility is secured by a borrowing base consisting of eligible accounts receivable and inventory. At origination, the collateral mix and advance rates were considered appropriate, and the borrower had historically complied with reporting requirements.

As new home construction slowed, the borrower’s operating performance deteriorated. Sales declined, margins tightened, and liquidity became increasingly constrained. The borrower relied more heavily on the revolver to fund working capital, but borrowing base certificates continued to show availability.

A recent field exam changed our view of the credit. The field auditor identified multiple accounting and reporting issues, including ledger entries that did not reconcile and borrowing base calculations that could not be adequately explained by management. The exam ultimately concluded that the borrower had incorrectly calculated the borrowing base, and that the errors had been masked in prior submissions to the bank.

The audit report cited weaknesses in the borrower’s books and records, internal controls, and borrowing base methodology. Based on these findings, we now have material concerns regarding the reliability of the financial statements and the accuracy of historical borrowing base reporting.

The borrower is currently out of borrowing base compliance and materially over-advanced, with no meaningful liquidity to cure the deficiency. We have already taken all available additional collateral outside of the original borrowing base in an effort to support the outstanding exposure. Overdrafts have begun showing up in the operating accounts as the borrower runs out of working capital.

We are now preparing a default and over-advance notice and are in process of transferring the relationship to workout.

To sum it up, we are seeing continued borrowing base noncompliance, limited liquidity to cure the deficiency, and erosion of confidence in the accuracy of financial reporting and borrowing base calculations. Given the fact that all readily available collateral has already been taken, how would you prioritize next steps to protect the bank’s position, evaluate borrower credibility and viability, and determine whether there is a realistic path forward versus an early shift in focus toward recovery?

JASON: I agree that this credit needs to be downgraded and transferred to workout. Given the apparent operational and financial reporting deficiencies, the bank will need to immediately issue a formalized default letter for the over-advance (and any other defaults) and start taking control of the situation. The bank will move from relationship management posture to a risk containment position. This is especially critical with C&I loans secured by working capital assets, given that “soft” collateral is subject to leakage if not outright evaporation  as liquidity evaporates from the business. The bank’s key objectives need to focus on (i) preventing further collateral erosion and limiting additional exposure (via additional credit exposure or through any lender liability actions; (ii) obtaining visibility of the company’s liquidity position and encouraging the borrower to pursue actions that preserve it; (iii) establishing a reliable baseline of financial reporting; and (iv) preserve optionality while the bank determines the best resolution strategy for the asset.

 My recommendation would be  the following steps to accomplish the bank’s objectives with this asset at this initial default moment:

1. Prepare a formalized default letter in coordination with bank counsel (internal or external—if already assigned).
2. Concurrently, the bank should notify the borrower (and any guarantors) of the impending default and request a meeting with the customer to discuss the situation and next steps. Also, request any/all information that needs to be obtained to get a sense of the business results and operations. While the financial reports are potentially unreliable, whatever the borrower can provide is somewhat helpful, although taken with a large grain of salt.
3. At the meeting with the borrower, introduce the new workout banker, who can discuss the workout process and goals as well as establish the new working relationship with the borrower (risk containment). Walk through all issues outlined in the audit/field exams as well as ask all relevant questions to fully understand the nature of the problem(s). Note: most initial workout transfer calls are difficult given the change in relationship nature, so be sure to have two bank reps at the meeting, take very good minutes of the meeting, and email all parties that attended the meeting to establish a “transcript” of the interactions between the parties.
4. If the borrowers are amenable to cooperating with the bank while the workout process is ongoing, consider a short-term forbearance with the customer to delay acting on the default (a benefit to the customer) and obtain initial strategic goals of the bank. The forbearance is not an endorsement of the borrower’s viability, rather it is a tool to buy time and impose structure on the process. Given the reporting issues and the lack of controls at the borrower, the bank should require the borrower to engage a third-party turnaround consultant. Give the borrower a list of qualified consultants who are acceptable to the bank.
5. The consultant will be able to work hand-in-glove with customer to institute operating controls, preserve liquidity, identify and implement operational efficiencies, and remediate the financial reporting problems and prepare new managerial reports to guide the customer through their turnaround (i.e., a 13-week cash budget and other reports).
6. The forbearance should also identify and address any other requirements of the bank—such as collateral perfection documents, landlord lien waivers, more frequent reporting or audits, enhanced dominion of cash, changes in exposure, or other services such as ACH exposure and credit cards. Most importantly, the forbearance agreement must contain a “Waiver of Claims and Defenses.” Such a paragraph removes any potential lender liability issues that might be brought up by the customer in any adversarial proceedings.

Other terms of the forbearance such as any payment relief, interest rate increases/decreases, deferral of costs, and duration/term of the agreement would be negotiated and subject to the bank’s risk appetite. However, the bank’s willingness to entertain some of the above terms might be a challenge, especially any deferrals or payment relief until more accurate financial reporting is obtained. Nevertheless, the default deferral should give the customer adequate time to start the turnaround process (60 to 90 days), which should allow them time to start the process and the bank time to make an informed decision of its overall strategy.

Finally, the bank should keep its options open throughout the turnaround process. Early on in the workout process there are a lot of unknowns; however, if the customer’s financial reporting failures were a deliberate attempt to obfuscate the true financial condition of the business, the relationship should be treated as an exit relationship because the customer broke their trust with the bank. If the reporting problems were the result of an honest managerial problem (inadequate employees, lack of sophistication, etc.), then the bank may want to retain the relationship, assuming those problems are fixed for good.

If an exit posture is assumed by the bank, the message that the borrower should seek alternative financing should be delivered as soon as possible. Getting the customer in a refinancing mindset earlier is usually better—unless there are identifiable strategic reasons to stay silent, such as  the need to obtain documentation or collateral perfection as well as executing a document with the “Waiver of Claims” language in it). If the customer isn’t bankable (which given above, they probably wouldn’t be), then other solutions such as private credit or private equity should be introduced. If the balance sheet is redeemable, a private credit solution would probably be the best, although it would probably require both a senior secured lender for the primary revolver and a mezzanine slug of capital to plug the over-advance. However, if the balance sheet is too far broken (bordering insolvency), then an equity infusion or sale might be the only solution short of bankruptcy or other alternative strategies. There are a number of private lenders and equity providers that have the risk tolerance to invest in the company and provide the bank a resolution of the loan. The turnaround consultant  would also be a resource to assist in that process as well.

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 [email protected] 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.  

Please note: Sending a Workout Window question indicates you approve of the question’s publication, without attribution to you, and its use in the development of scenarios, practices, and advice that could be included in the Workout Window or other RMA content, properties, and platforms.