Legal red flags banks can’t ignore: How to spot and navigate SMB borrower distress

In the post-COVID era many small businesses still face precarious circumstances, yet without the stimulus programs available during the pandemic that helped struggling operations survive.

Without that safety net, small businesses must navigate high interest rates that remain stagnant, inflation, tighter consumer spending, and uncertain trade policies. The collective impact is higher business costs, lower profitability, and reduced cash flow.

Traditional lending markets remain tight, which limits options for small businesses with maturing loans and capital needs. As they lose their ability to meet unanticipated expenses, or even ordinary business costs, many small businesses seek high-risk and high-cost loans such as merchant cash advances or other financing from non-traditional lenders (which put even more pressure on cash flow and can start a debt spiral).

Rethinking mid-term loan adjustments

One tool that banks use to manage risk—mid-term loan adjustments—is straining small business borrowers even more. Increasing adjustable interest rates or imposition of default rate interest make loans more expensive, reducing a borrower’s overall profitability.

Further, reducing availability on lines of credit or converting credit lines to amortizing term loans may limit working capital available for borrowers to cover increasing business costs or higher loan payments for principal amortization.

Strict enforcement of loan covenants will result in defaults and potential loan acceleration, forcing small businesses to seek refinancing in a challenging lending market. These actions may also force business borrowers to adjust and even downsize their operations, which could negatively impact financial performance and profitability and make it difficult for borrowers to refinance maturing or defaulted loans at par.

For many small businesses, restructuring through Chapter 11 bankruptcy is not possible (or not desirable due to perceived reputational risk). Bankruptcy is expensive and can be very disruptive for a small business with limited staff to manage all requirements.

Congress also neglected to extend the higher debt limits for qualification under Subchapter V, a less expensive and streamlined version of Chapter 11 that makes formal restructuring easier and more affordable for many debtors.

Accordingly, more small businesses are opting for “quiet restructurings,” which are out-of-court workouts and loan management transactions, and a wave of quiet restructurings is anticipated for the second half of 2025. These restructurings may be external, such as loan modifications or other negotiated changes to debt terms, or internal, such as the sale of unprofitable business lines, underutilized assets or other changes to the operating business.

How can banks identify and ease distress?

Banks need to be vigilant and proactive in this environment as their customers face growing financial distress. Signs of growing distress may include high reliance on lines of credit without periodic principal reductions, consistently late or missed payments, frequent overdrafts in deposit accounts, budgets showing reduced cash flow, and declining cash reserves and financial covenant defaults.

As warning signs appear that a borrower is in distress, lenders should closely monitor financial performance, projections, and bank accounts for unusual activity suggesting reliance on high-risk sources for capital (including large cash infusions from new debt or daily or weekly payments indicative of a merchant cash advance).

To help distressed borrowers avoid loan defaults, banks should be flexible with loan covenants and consider providing waivers or forbearance for technical defaults. Temporary payment relief, such as deferments of payments or interest-only payments, may help business borrowers better manage their cash flow. Many small businesses may also benefit from outside financial or turnaround consultants, so lenders should consider making temporary relief contingent upon the borrower bringing on a financial advisor or restructuring professional to help with budgeting, cash flow, or operational changes.

Early monitoring and engagement when signs of risk first appear will allow banks to discuss solutions with their borrowers to manage the situation before distress turns into a crisis or failure of the business. Temporary relief from existing loan terms may prevent desperate borrowers from pursuing high-risk loans that will only accelerate their financial decline and put a bank’s collateral at risk (due to competing security interests or advances against future receivables).

Consider the current climate and nurture the relationship

Lenders should be realistic about what a borrower can accomplish in today’s economic environment, where refinancing on viable terms may not be as available as it was in the past.

Loans may be modified to adjust interest rates, extend maturity or expiration dates, defer principal payments, or alter financial covenants to limit future defaults. Where a lender is comfortably oversecured or additional collateral is available, it may make sense to extend additional credit to provide an existing borrower with working capital to stabilize operations.

If a bank prefers to exit the relationship, it may want to consider short-term extensions, discounted payoffs, or structured repayment for matured loans. Active engagement early on and proactive loan management through temporary or permanent modifications may increase the bank’s chances for repayment of existing obligations and preserve the relationship for future transactions.

Jennifer Maleski is a partner at Dilworth Paxson LLP where she represents financial institutions in all aspects of commercial workouts, including loan modification, bankruptcy and litigation.