Many companies are facing crises in the current economic environment. Whether it is failure of a major customer, a decline in an industry, a dramatic increase in the cost of operations, or a number of other disruptions in our economy, businesses are increasingly facing challenges unseen in recent history. Two themes, however, are recurring -- a banking relationship that has gone sour and severe cash-flow problems.
Most operating companies have some form of bank loan coupled with a relationship with the lender. These relationships have changed dramatically in the last year. Companies that were being courted by their bank a few short months ago now find their lender not only is not interested in increasing a line of credit, but wants all loans paid off and the company to find a new source of funds. This can occur because the line of credit is a demand note and has been called, or a default has occurred. Whatever the reason, management should not panic, but immediate and cogent action is required.
A company in this situation should immediately call its attorney and assemble a team of advisors. A bank expects to see a company take appropriate action and will welcome the appearance of an attorney to help guide it through the process. The company’s CPA and other advisors should also be mobilized.
Management should open and maintain lines of communication with the company's lender. The lender will not assume that no news is good news. A thorough analysis of the loan documents and the company's financial position is imperative.
If the company’s note has been called, don’t panic. There are other possible lenders, including some nontraditional sources. Be prepared, as the replacement may be somewhat more expensive or may require personal guarantees. A reduction in the amount of credit may be required, which will entail the company tightening its belt. The largest expense items for most companies are inventory, advertising and personnel. Reductions or scaling of economies in each of these areas may be necessary.
If a default has occurred, the lender may require the borrower to enter into a forbearance agreement. A forbearance agreement is an opportunity for the company, not an aggressive move by the lender. Generally, it is in the best interest of the lender to work toward a viable solution. The lender will be patient, so long as an achievable goal is being diligently pursued. The company will be required to acknowledge the debt and the default, waive any defenses to the default and agree to certain conditions and covenants.
Although forbearance agreements are usually short, they must be carefully scrutinized and negotiated. The purpose of the forbearance agreement is to allow the company time to find new financing, sell itself or, in the rare case, to demonstrate to the lender that it is entitled to a second chance. The interest rate will be significantly higher than the pre-default rate, the financial covenants will be demanding and some degree of financial oversight or reporting will be required. Examples include audited statements or even the engagement of consultants who are authorized to report to the lender.
During the forbearance period, a company must quickly and carefully review its options. Can it refinance the debt? Is an infusion of capital possible? Is a reorganization of the company likely, and will it help? Is a sale of some or all of the company an option or a necessity?
Each of the possible options must be thoroughly analyzed because there is no time for correcting mistakes. In the current environment, each approach has its challenges.
If a lender that has loaned to a company in the past is not willing to continue the relationship, it's unlikely a replacement will be found through a whirlwind courtship. Unless there is something remarkable about the company or its industry, there is little hope of raising new capital in these times. Drastic operational changes that obviously include reducing payroll are obligatory but must be done with the skill and care.
A company experiencing the rough seas of this economy may face these issues:
- The zone of insolvency. The board of directors owes a duty of due care, loyalty and good faith to its shareholders. The board of a company that is nearing insolvency may legally owe a similar duty to the company’s creditors. Once a company begins worrying about breaching its financial covenants or is concerned about cash flow, it should be aware of its potential obligations to creditors.
- The Worker Adjustment and Retraining Notification Act. This applies to companies with more than 100 employees, which includes managerial supervisors. It requires 60 days' notice to employees in the event an work site will be shut down, and as a result, 50 or more employees will lose their jobs in a 30-day period.
- Trust-fund taxes. Failure to pay withholding taxes and Social Security taxes can result in a 100% penalty against the company and individuals responsible for making sure the taxes are paid. The definition of a “responsible person” has been interpreted broadly to include officers, employees, consultants and even outside CPA firms.
- Loan or short-term capital infusions. Often in closely held companies, a shareholder or family member will lend to the company to ease a cash-flow shortage and receive repayment or return of the “paid-in capital” once the crisis has subsided. This can result in a preferential payment if the company files a petition or has a petition filed against it under the Bankruptcy Act. The repayment may be required to be returned to the company, and the person who provided the loan or capital will have an unsecured claim in the bankruptcy proceeding. The normal preference period is 90 days, but, if the person is an insider, the bankruptcy court can reach back as long as a year.
In many, if not most, instances, prompt and knowledgeable action can save a company in these extraordinary circumstances.