Making the Best of a Difficult Situation

How Hypothecation Lenders Can Navigate the Bankruptcy Process

Lenders who approach the bankruptcy process as a science are often frustrated and disappointed; it’s much more art than science. No two cases are alike. The plots may be similar, but even the same play varies with different casts, and one of the key elements in determining the path of a bankruptcy is the cast of characters.

In a play, we know the identity of the lead actors; they’re listed in the playbill. In a bankruptcy, the leads aren’t advertised in advance; roles evolve as the situation plays out. The lead player could be the debtor’s counsel, it could be the debtor, or it could be an active and persistent creditor. Perhaps it will be the judge. Maybe you will play the lead. The evolution of the cast depends on the situation, the personalities of the individuals, the history of their interactions, the issues at stake, and other factors.

I’ve always believed it’s preferable to resolve issues outside of bankruptcy court, because of the cost, the negative publicity, and the disruption of business operations. Any Chief Financial Officer who’s been through bankruptcy will tell you that it’s all consuming. The reporting requirements are voluminous and the workload crushing; if the bankruptcy is of the debtor in possession variety, it’s nearly impossible to find time to run the business.

But sometimes bankruptcy is unavoidable. Perhaps the parties need the court to dismiss or restructure a liability that would otherwise destroy the company. Sometimes a creditor simply won’t settle, either because they don’t trust management or think they’re hiding value. That’s when the entity files for bankruptcy and the fun begins.

The initial stage of the process is determining the likely path. What was the reason for the filing? Is there one large creditor whose debt can’t be paid without relief? Does the business have a future as a going concern?
If the answer to the last question is no, the next step is generally a Chapter 7 (liquidation) filing. The possibility of a Chapter 7 filing can be used as a threat by the judge or debtor to bring recalcitrant parties into line, for a creditor will generally get less in a liquidation scenario than from a going concern generating income.

If bankruptcy is a possibility, a creditor needs to hire bankruptcy counsel in the jurisdiction of the filing. The retention of counsel is one of the most important decisions you will make. The safest option is to hire a large national firm. If you do that, you can be assured they have the resources to do the job, they are unlikely to commit blunders, and they will charge you a lot of money. And no one will blame you if you have a bad outcome. Hiring a smaller firm has advantages and disadvantages. On the plus side of the ledger, you invariably deal with a senior partner. If the firm regularly practices in the courts in which the case will be heard, they know the players and should have good working relationships. That may not be the case with a large firm. The smaller firm’s billing rate is likely to be lower than that of a national firm, but they may not have the resources, such as commercial lending or tax specialists who can advise on specific issues. Chemistry is also important. Are your goals and work styles compatible?

Once you’ve hired counsel, you need to review your documentation to see where you stand and where you might have vulnerability. We are primarily receivable lenders, and there’s nothing like bankruptcy to make one appreciate the intricacies of perfecting a valid first security interest in your collateral. Misery loves company, and the main goal of the unsecured creditors is to make you one of them by attacking your security interest. What may have seemed like overkill at closing may be the thing that saves your bacon. We haven’t been involved in a lot of bankruptcy proceedings, but we’ve never been successfully challenged on that issue, which is a testament to our documentation.

As the players feel each other out, it becomes relatively clear where each party stands. One of the most important negotiating skills is a good understanding of your relative position in that negotiation. Some people use the same style regardless of their position but coming on strong when wielding a slingshot won’t get results. Be sensitive to that dynamic and act accordingly.

Related – One More Time Around the Bases…

What is your desired outcome? Do you want existing management to remain in place, or do you want new direction? Are you willing to continue to fund the operation? Do you want a sale of the assets that will pay you in full (often wishful thinking)?

What do the other parties want? Whose goals align with yours? Whose are in conflict? Can you build an alliance with those whose goals are congruent? Is there a squeaky wheel that thinks they’ll get their way if they throw sand in everyone’s gears? Can the obstructionists be mollified with a compromise offer that will get them at least part of what they want?

Going to court with a negotiated plan agreeable to the primary parties is much better than a protracted battle. One of the most shocking aspects of bankruptcy is the cost, which can escalate precipitously if there is conflict. Counsel for the challenging party prepares a motion, lawyers for each party read it and respond, and with each keystroke, the meter runs.

For receivable lenders, the performance of the portfolio is the key to ultimate repayment. Assuring that the property remains open during the bankruptcy process and that the third-party servicer continues collecting and processing payments is critical. If there is no money in the bankrupt estate, the lender may need to subsidize either or both of those functions. The lender should also ensure that communications are sent to the timeshare owners assuring them that the property is open and they can utilize their accommodations as usual.

No amount of skill can assure a positive outcome. But there are several things you can do to increase your chances of success.

• If you think trouble may be on the horizon, keep the borrowing base in line and obtain replacements for defaulted notes. You’ll probably need the cushion. Examine your collateral position and see if there are any holes that need to be plugged.
• Think long and hard about counsel. Make sure the firm, and more importantly, the lawyer who’ll handle the case, understands your goals, has local knowledge, and has the resources to handle the case.
• Set a goal. Decide what you want to accomplish and work toward that goal rather than reacting to the process.
• Read the bankruptcy court documents. Don’t just rely on your attorney’s interpretation. There may be business points they don’t pick up and, in any event, it’s a good education process. Ask your lawyer about the process. What can be accomplished under the rules? What can’t you do?
• Pick your battles. Like military operations, legal battles have a cost, both in money and burnt bridges.
• If you’re a receivable lender, protect the portfolio. It’s your source of repayment. Protect it from creditors challenges and don’t give the timeshare owners reasons to stop paying.

The best lessons in life, from childhood on, tend to be painful lessons. There’s nothing like a good bankruptcy to teach you how to be a better lender; you’ll learn the consequences of underwriting and documentation mistakes and chances are you won’t make them again. Institutions have moved away from a “loan officer” who handles the account from inception to final payment in favor of originators, portfolio managers, and workout specialists. That’s unfortunate in this instance, since the people who would benefit from the experience aren’t part of it.

Being involved in a bankruptcy case is usually painful and expensive for lenders, but if you consider it a learning experience, you’ll emerge a better lender than when you started—I promise.

Reprinted from the Colebrook Chronicle; courtesy of Colebrook Financial Company, LLC