Three Borrower Traits Asset Based Lenders Need to Recognize in their Loan Portfolio
Author: Ashley Trexler, Supervising Field Examiner
If a borrower possesses significant fixed assets, owns its real estate, or operates several lines of business, you may be exposing your bank to unnecessary risk. To avoid that situation, be sure you review your loan portfolio for clients with certain traits.
Commercial property ownership can be quite risky, especially for retailers. Why? Because the store’s owner can be held liable for crimes or accidents that occur on the site if a victim proves there’s inadequate security.
Liability insurance can help mitigate losses. But many policies may be based on outdated business appraisals, and damages might exceed the borrower’s coverage.
For an added layer of protection, borrowers may want to create a separate legal entity for their real estate ventures. That way they can lease the property to the operating business at a fair market value. The same will hold true for businesses with significant fixed assets.
Doing so will protect the operating business entity from property liability claims. The real estate venture can still be pledged as collateral for loans to the operating entity.
Suppose a dry cleaning establishment diversifies and explores the health food market. If the experiment doesn’t work, it will drag down the dry cleaning business (or vice versa). If the borrower sets up a separate legal entity for each business segment, however, the borrower will not only limit its “spillover liability,” but it will also allow for more flexibility in the ownership structure. Keeping things separate from the get-go — with separate bank accounts and balance sheets — can be quite helpful if the owners subsequently decide to sell or seek additional financing.
If a family business wants to transfer wealth to subsequent generations, the company will likely benefit from establishing separate legal entities. For example, suppose an operating business carves out its real estate into an LLC or a trust. Those who are active in the operating business are “gifted” interests in the company. Passive heirs are then given pieces of the real estate venture.
This setup serves several goals beyond limiting liability. First, the parents can use the annual gift tax exclusion ($14,000 in 2013) and the lifetime unified credit ($5.25 million in 2013) to gradually lower their taxable estate. Gifts are typically discounted for marketability and lack of control.
Second, those who are active in the business will get a stake in something they can directly impact — the value of the operating business. Passive investors will have access to a steady income stream. Plus, the family will be able to minimize its overall tax liability if the children are in a lower tax bracket.
Insight and Guidance on the Legal Theory of “Deepening Insolvency”
Author: Emmon Khan, Senior Field Examiner
Suppose a borrower is experiencing financial trouble. His company is trying a turnaround and has asked you to continue to advance him funds under its working capital line. What should you do? As you apply professional criteria in regard to the customer’s request, keep this in mind: Your financial institution might be held accountable by your customer’s creditors under the legal theory of “deepening insolvency” if the customer chooses bankruptcy protection.
Defining deepening insolvency
Balance sheet insolvency occurs when a company’s assets no longer exceed its liabilities, thus preventing the business from repaying its debt. One court defined it as the “fraudulent prolongation of a corporation’s life beyond insolvency, resulting in damage to the corporation caused by increased debt.” Misrepresentations, mismanagement, and fraud can cause and even hasten insolvency.
Deepening insolvency has come forth in some jurisdictions as a creative remedy for creditors who assert a company delayed filing for bankruptcy and, instead, unnecessarily prolonged its corporate life by obtaining loans while already insolvent. By taking on additional equity financing or debt, a business compounds its insolvency and greatly impairs its ability to repay creditors.
Ever since deepening insolvency emerged in the 1980s, it’s been alleged against officers and directors who breach their fiduciary obligations. It’s also been alleged against professional advisors as well as secured creditors who help conceal the extent of financial turmoil, exert undue control over distressed customers and support unrealistic workouts.
The legal history
The first case that suggested secured lenders may contribute to customers’ insolvency was In re Exide Technologies, Inc. In this Bankruptcy Court case, a banking syndicate lent substantial funds to Exide Technologies in spite of the fact that the company had reported significant losses and an insolvent balance sheet. Exide used these funds to help support its faltering operations and acquire a competitor.
As the company’s financial condition continued to crumble after the acquisition, the syndicate received credit enhancements — including additional collateral and guarantees — in exchange for continuing financial support. Moreover, the lenders leading the syndicate acted as advisors and received investment banking fees from the acquisition. Over time, bankruptcy became inevitable, and the creditors’ committee filed suits against the lenders alleging, among other charges, deepening insolvency.
When the court refused the lenders’ request to dismiss the claim, it opened the door for deepening insolvency claims against secured creditors who make risky loans to insolvent borrowers to the detriment of other creditors.
Deepening insolvency claims have had mixed results in courtrooms. For example, courts in several cases, such as Trenwick America Litigation Trust v. Ernst & Young and In re Global Service Group, have narrowed or rejected the scope of claims based on the theory of deepening insolvency. Until the legal community can clearly define and consistently apply the concept of deepening insolvency, this issue will remain a wild card in bankruptcy litigation.
A properly managed turnaround can increase creditor recoveries and even help avert formal bankruptcy proceedings, thereby allowing borrowers to regain profitability. Fiduciaries of an insolvent business might conclude that the business should continue to operate to maximize its long-term wealth-creating capacity — that is, its “enterprise value.” There’s no absolute duty to shut down and liquidate an insolvent corporation. So, as long as the loan is made without violating the business judgment rule, a court should not impose liability.
However, it’s important to carefully review a client’s workout plan for errors, omissions and unrealistic assumptions. In many cases, bankruptcy may provide a better alternative — then you can lend funds to a debtor-in-possession under the court’s supervision.
A lender might find itself on either side of an insolvency claim. In addition to being charged with contributing to a borrower’s financial distress, a bank may initiate similar charges against directors, owners, or insolvency professionals to recoup any outstanding loans upon the borrower’s insolvency.
That’s why it’s critical to bring in independent financial advisors to help substantiate or refute deepening insolvency claims, including unraveling complex transactions, investigating fraud allegations, tracing assets or funds, and calculating economic damages. They also can objectively determine whether a company’s turnaround plans are reasonable or, alternatively, whether bankruptcy is imminent.
Pulling the plug
It can be quite difficult to deny financing to a loyal customer who is in financial distress. But if your client’s financial health adds up to deepening insolvency, you may need to pull the plug.
4 Tips for Protecting Your Lending Portfolio
Author: Phil Pence, Field Exam ManagerAs you know, finding new borrowers for your asset based lending institution can be a very time-consuming and expensive venture. As a rule of thumb, the costs of wooing new customers can be six to seven times more than the costs of retaining existing ones, according to marketing firm Flowtown.
With today’s competitive lending market, your bank risks losing borrowers to more assertive lenders who promise higher credit lines, lower interest rates, and faster closing dates. And as you know, high customer turnover can make you look bad to senior bank executives. So, how can you protect your portfolio? Here are some tips.
TIP 1: Approach potential borrowers first
You simply can’t wait for customers to come to you about refinancing options or more borrowing opportunities. After all, interest rates are at all-time lows, and there’s ample credit supply for customers who sport strong credit scores. If you don’t act quickly, proactive borrowers might seek greener pastures.
You can’t let a competitor beat you to the punch. So make sure you review your customers’ financial statements. Go for those with strong credit, high growth and high interest rates. These will be your best prospects for refinancing or add-ons. A borrower might not even look into what your competitors are offering — so long as you contact them first, make a fair offer and maintain a long-term relationship.
TIP 2: Make sure you’re responsive and approachable
Touch base with your customers on a regular basis. Consider visiting their businesses and take them out to lunch or for coffee. Many prospects will be happy to give you a tour of their facilities. Do it. And above all, make sure you return their calls and process paperwork promptly. The top frustrations that borrowers experience when refinancing or applying for a credit line increase is the amount of time it takes for lenders to simply process the paperwork.
In fact, one borrower actually switched banks because his application with its existing lender was delayed for months over a missing 2011 tax return. A quick phone call might have remedied the omission and possibly retained the customer. But instead, the application just sat in a junior lender’s inbox — and a rival bank got the borrower’s business.
Don’t be afraid to seek feedback from your customers. Make it a point to talk to every decision maker in the business. You might find that the CFO is your best contact rather than the owner. Finally, learn what they like and dislike about your bank via written or phone surveys.
TIP 3: Offer to become a referral source
As the old saying goes, it’s not what you know but whom you know that counts in business. The best way for a professional services provider to gain customer loyalty is to become a referral source for value-added services. Work to become the go-to person in your business community. Encourage borrowers to come to you for accounting, legal or even advertising referrals. And make sure you forward borrowers any relevant e-mails or trade journal articles.
Networking can turn lenders from pesky outsiders to members of the customer’s “team.” This will help keep you in the loop when they face key changes. Plus, it will help you become irreplaceable. You might very well find that happy, loyal borrowers will be more likely to return the favor and refer some business back to you.
TIP 4: Make ’em happy
The best way to make borrowers happy is to avoid treating new and old applicants in the same manner. After all, a long-standing business relationship and a handshake should be something special in today’s business world.
Bottom line? If a client has a strong credit score and proven track record of timely debt service, make sure you streamline the refinance and application processes as much as possible.
If you have any questions about retaining borrowers or any other asset based lending issue, give us a call at 716.847.2651, or you may contact us here.