When Lenders Demand More Skin in the Game

With COVID-19 having shut down many businesses, lenders increasingly are worried about their borrowers’ ability to repay loans. Lenders are concerned about the value of their collateral because of the loss of the spring season and the distress of their borrowers’ customers. Further, many borrowers are reducing their sales projections for when the economy reopens and gets back to normal–whatever normal may turn out to be.

It should be anticipated that banks will reduce their lending to distressed borrowers either by reducing advance rates or by classifying assets as ineligible (no value for purposes of borrowing). Lenders may demand additional collateral as a condition for maintaining the outstanding loan amount or for maintaining current advance rates.

A lender may request from a shareholder a guarantee of what previously was a nonrecourse loan. Alternatively, the lender may request additional collateral not owned by the borrower. The pledge of collateral by a non-borrower is pursuant to a hypothecation agreement. The collateral can be assets of the borrower that are not currently encumbered or assets of a third party such as the borrower’s stockholders.

It is important to memorialize clearly the relief being granted by the bank. Most loan documentation provides that despite a loan commitment, the lender has discretion in making advances. Therefore, the guarantor (or additional collateral provider) should ascribe a value to the additional collateral and also set forth the specific remedies that the bank is refraining from exercising. The borrower also should require that upon the borrower’s curing a covenant breach or getting back into formula, the side/additional collateral will be released.

Persons giving guarantees must anticipate the possibility of bankruptcy even though the goal is to avoid it. In Chapter 11 bankruptcy, insiders and related parties are natural targets of the unsecured creditors committee. The committee may seek to subordinate the claim of insiders (making the insider claim payable only after other claims have been fully paid), disallow the insider claim, or recharacterize an insider claim as equity. The argument typically is that the debtor was undercapitalized at the time the additional collateral was pledged.

In order to avoid risk of subordination or recharacterization, it is better for the provider of additional collateral to purchase a participation in the existing lender’s loan. Nevertheless, anticipate that the bank will permit only a last-out participation. In other words, the bank receives payment of its loan first from proceeds of collateral.

A benefit of a participation is that it is not a new loan. It is more difficult to disallow, subordinate, or recharacterize.

Persons providing additional collateral pursuant to a new, second-position loan behind the bank would have to “perfect” the new loan by filing a UCC-1 (Uniform Commercial Code Form 1) document that is a public record for all creditors to see. There is the potential for other creditors of the borrower to see the UCC-1 and to think that the insiders are seeking to place themselves at an advantage over other creditors or are self-dealing. Purchasing a participation does not require the filing of a new perfection document.

The lender that requires a participation will often require that the participant give up all rights to question how the lender liquidates its collateral. If the provider of the additional collateral is making a new loan subordinate to that of the lender bank, the parties will need to execute an intercreditor agreement that sets forth the right of the new lender vis-à-vis the bank lender. Typically, the new lender will have very few rights.

Options for the junior lender or guarantor to negotiate:

• The right to purchase the senior lender’s claim.
• That the senior lender exhaust all remedies as to its borrower’s assets before pursuing the guarantor or before seeking to recover from the junior lender’s assets.
• To require the bank wait until the expiration of a specified period of time before the bank can pursue remedies against the guarantor or against the additional collateral.
• For the bank to consult with the guarantor during the liquidation process.
• A pecking order pursuant to which collateral (if other than cash) can be liquidated.
• The method by which the additional collateral will be liquidated.
• Consent of the bank for the pledger to substitute new collateral for the previously pledged collateral.

Lenders are likely to become more aggressive and more cautious until the economy settles down and there is more certainty in the marketplace. At the first sign of default or insecurity, they will seek to improve their position. Prudent borrowers should anticipate the next move of their lenders–especially including what they will ask of their lenders in return and also the potential impact on their business of accommodating their lender.

The views expressed herein are those of the author and are not necessarily shared by other persons at Lowenstein Sandler. Each case is unique. The law is subject to interpretation. The author is chair of the Bankruptcy, Financial Reorganization & Creditors’ Rights Department of Lowenstein Sandler. This article is for general information purposes and should not be taken as legal advice.

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