Managing Lenders' Expectations: Strategies to Survive Loan Default

By Todd Alexander and N. Theodore Zink Jr. | May 09, 2008
As the effects of reduced crush margins begin to take their toll on ethanol producers, a number of our clients are searching for the appropriate strategy to manage the expectations of their lenders.

Given that each producer confronts a somewhat unique set of circumstances, there unfortunately is no universal strategy that can be employed. We, however, can share some of the lessons learned from advising clients in these situations. These can be sorted into three broad categories: 1) understand which covenants in the debt agreements you are likely to breach, 2) understand the mindset of the lenders, and 3) use the tools available to offer the lenders a proposal that will be mutually beneficial.

Typical Debt Structures
In general, there are two types of obligations that ethanol producers are most likely to breach in their loan documentation. The first type is financial covenants. The second is the obligations to repay interest, fees and principal.

Regional banks, which have financed the majority of the ethanol plants in operation today, tend to have more restrictive financial covenants than either the money-center banks or the capital markets. For instance, it is typical for regional banks to include tangible net-worth tests and minimum debt-service coverage ratios in their documentation. As a result, it is quite possible that many of the producers who have borrowed from the regional banks are, or will be, in breach of their financial covenants as a result of the current crush spreads even if they are currently able to service their debt.

The good news is that banks are generally reluctant to accelerate a loan solely as the result of the breach of a financial covenant. Instead, lenders typically use these breaches as an advanced warning mechanism to alert them that the loan requires additional attention, or to require their borrowers to provide them with additional access to their financial information. They do, however, usually take advantage of this opportunity to block further distributions to the owners until the breach has been cured.

On the other hand, lenders tend to take missed payments more seriously. Here again, the regional banks tend to have more aggressive principal amortization schedules than either the money-center banks or the capital markets and, accordingly, are more likely to find their borrowers unable to service their debt. The regional banks often adopt mortgage-style or straight-line amortization for their financings. In contrast, the money-center banks typically require only 6 percent of principal to be repaid in any year. Many of the capital markets transactions require only 1 percent of principal to be repaid.

Lenders' Mindset
If you are in breach or in potential breach of the loan covenants, take some comfort in the fact that as a general rule commercial banks turn to foreclosure only as a last resort. For several reasons, commercial banks are highly incentivized to work through any short-term liquidity issues that a producer may be confronting. One reason is that they are required to reclassify the loan as non-performing if they decide to exercise remedies. Banks are required to increase their reserves once a loan is classified as non-conforming. This has a de-levering effect on its own business.

Another reason is that, unless a bank views the liquidity issue as having been caused by poor management, a foreclosure will not solve the underlying credit issue. As a result, if high corn prices, rather than poor management, are viewed as the culprit, lenders are likely to express a willingness to re-work the terms of their debt to accommodate the realities of the situation.

A third reason is that foreclosure can wind up being an expensive and time-consuming process for the banks. In a foreclosure, the banks will be required to devote substantial time and energy to a process that in many cases will not leave them in a significantly better position to recover the value of their outstanding loan. The foreclosure process requires the lenders to put in place a management team to preserve the value of the ethanol facility. It also forces the borrower's junior creditors to do their best to preserve their own rights to the collateral, which may involve taking legal actions that compel the participation of the senior lenders.

One exception to this rule is where an ethanol company's debt has been acquired by a hedge fund or others who specialize in buying distressed debt. These entities have been known to "loan to own." In other words, they may be seeking an opportunity to initiate a foreclosure with a view toward acquiring an operating facility at a fraction of its original cost.

Consensual Workout
Companies that find themselves in breach or on the cusp of a breach have many proven tools from which to choose as a means of finding a solution to their liquidity problems.

Usually the first step is to request that the lender agree to enter into a forbearance agreement. Under the terms of the forbearance agreement, the lender agrees, for a set period of time, not to exercise remedies to which it is entitled under the loan documentation. In exchange for this commitment from the lenders to "standstill," the borrower may agree to provide its lenders with additional reports and possibly restrict the use of operating cash flow. The borrowers may also grant the lenders' consultants access to the facility and its personnel. It is generally important at this stage to increase the flow of information from the borrower to the lender to increase the level of trust between the parties.

During the standstill period, the lenders and borrower will attempt to modify the terms of their relationship in such a way as to allow the borrower to cure its defaults under the loan documents. The lenders will also likely try to assess whether the business has positive operating cash flow before debt service.

If the lenders conclude that the business is likely to have positive operating cash flow, the lenders are usually willing to offer the borrower several types of relief from a fairly well-accepted menu of options. These include reducing the borrower's current principal payments, along with an extension of the term of the debt or by creating a bullet payment at the loan maturity date. The theory behind relying on a bullet payment at maturity is that the borrower will refinance the existing debt as soon as operating margins improve.

In addition to reducing the principal, the lenders may also agree to reduce the interest rate on the loan. This may be necessary to allow the borrower the breathing space necessary to recover, but is usually offered in conjunction with some form of compensation to the lenders, such as warrants in the company's equity. Such warrants may entitle the lenders to purchase equity in the company in the future if the company's financial condition recovers. This equity will often have the right to receive distributions on a preferential basis to the existing equity in the company.

Finally, the lenders often relax the financial covenants that may have been the cause of the default in the first place. The modification of the financial covenants may be done in exchange for tighter reporting requirements, increased access to the company's records, and in some cases an agreement to change existing management.

If the lenders conclude that the business is not likely to have positive operating cash flow before debt service, the lenders are less likely to be lenient. In these cases, the borrower may be in a position where its owners are asked to contribute additional capital to the company or otherwise increase the lenders' collateral by contributing some other type of asset to the project, such as the right to receive delivery of corn at prices below the current market or a grain-handling facility owned by an affiliate of the borrower.

Filing for Bankruptcy
In cases where additional collateral is not available, borrowers may be forced to consider a voluntary bankruptcy. Bankruptcy offers the enticing feature of allowing owners to "reject" or terminate agreements, subject to court approval. This can be a nice tool for increasing the value of a business if an ethanol company has a particular set of contracts that have become unprofitable. For instance, if the ethanol facility agreed to pay a corn originator an above-market price for its services, the company could reject the agreement and then enter into an agreement with a new corn originator on more favorable terms.

Lenders dislike bankruptcy proceedings for many of the reasons stated earlier with respect to foreclosure. In addition, filing for bankruptcy introduces the concept of a bankruptcy judge with oversight over the debtor's estate. It also invokes an automatic stay, which precludes any creditor from enforcing any of its remedies against the borrower without the court's approval.

While a bankruptcy may disadvantage the lenders, it often completely wipes out the value of any equity in the company. As a result, it is customarily used by owners only where they either see little or no value in the ownership under the current contractual arrangements and is often better used as the "stick" to persuade a group of lenders to accept the "carrot" offered as part of a consensual workout.

In conclusion, if corn prices remain at their historic highs, many ethanol producers may be required to open a dialogue with their lenders regarding breaches and potential breaches of their loan documentation. If these discussions are well managed, they have the potential to increase the level of trust between lender and borrower, as well as create a more durable financial structure.

Todd Alexander is a partner in the project finance practice at Chadbourne & Parke LLP. N. Theodore Zink Jr. is a partner in the bankruptcy practice at the firm. Reach Alexander at talexander@chadbourne.com or (212) 408-5269.