Business Leasing and Finance News (BLFN)
BLFN STARTS ITS 8th YEAR!
By David G. Mayer
As if all of us did not know, it is official. We have been in a recession since December 2007. Until the last few months, the equipment financing industry performed as if we were in “normal” times of economic growth. However, our economy today is not, and for the foreseeable future, will not be, normal.
We have been fortunate to enjoy economic expansion for 73 consecutive months, but 2008 brought the collapse of our stock and credit markets, coupled with a loss of consumer and business confidence. The lessons and losses of the Great Depression in 1932 resonate today as many of us fear for our futures and those of our children. CEOs have ordered their troops to hunker down for a cold spell in the economy. Many people, even some of the best and the brightest, have lost their jobs. The beige book tells a sad tale of pervasive downshifting in the economic engine in the U.S. with exceptions in some sectors.
Despite the enormity and rapidity of the downturn in 2008, 2009 offers us a fresh slate – a new year, an opportunity to make new beginnings. We cannot undo the past year. Our imperative is to battle the economic elements in what may be recorded in the history of this century as the mother of all “perfect storms” in our economy – the deepest recession in decades.
I wish I had words of wisdom to impart to you for the New Year. Unfortunately, like many others, I cannot predict what 2009 holds. But this much I believe: we must all strive each day to stabilize or grow our businesses, put people back to work, help the less fortunate, and inspire new confidence in our capital markets. We must not waste time worrying about 2008. As lawyers like to say, “time is of the essence” to put an end to the economic crisis.
The new Obama Administration cannot accomplish this task alone. As President Obama has said, we must all do our part. In the credit markets, lenders must lend again; lessors must lease again; and each embattled company and bank must start anew to make money and recover from their losses, or even make the hard choices necessary to cope with the situation as it is.
We should look at 2009 with realism, much as I would like to give a Pollyanna view that we will rise above the recession. To move ahead we must add value everyday in our businesses. We must work hard to achieve positive – if only modest – results, using all the ingenuity, creativity, and entrepreneurialism we can muster. I often say to my two daughters: “One step at a time and you’ll be fine.” We too must take one step at a time to put this recession behind us. We cannot look back, but we can embrace the possibilities, pursue viable opportunities, and appreciate our chance to begin anew in 2009.
Thanks for reading BLFN and good luck to you as you begin your New Year! Look for BLFN’s next bi-monthly issue in March - April 2009.
Happy Anniversary to BLFN
It is amazing how fast time has gone since we published the first issue of this newsletter in January 2002. With this 81st issue we start our 8th year. We published issues monthly until July 2008. Since then, we have published BLFN bi-monthly. We thank each and every one of you in about 45 countries for reading BLFN and for sharing it with your friends and colleagues.
Originally called Business Leasing News, we changed the name of this newsletter in January 2007 to reflect the reality that secured lending has become an increasingly common way to finance equipment. This change in no way suggests that leasing is less important; only that leasing, coupled with a substantial increase in lending, supports capital investment in equipment around the world. Ironically, I expect leasing to reemerge in 2009 as an even more important tool to inject limited available capital into businesses.
Written in what I call the “quasi-Dummies style,” this newsletter sprang to life shortly after the publication of my book, Business Leasing For Dummies in September 2001. You can thank the “For Dummies” project team for helping me develop (and continually improve) BLFN’s style of clear, concise, and useful information, supported by research.
Starting with this issue, BLFN has added a new section called “PB Capital Resource Center” (PBCRC). By doing so, BLFN will enable Patton Boggs' lawyers, clients, and friends of the firm to describe and analyze legislative actions in Congress designed to help the financial services and banking industries pull through the economic crisis. PBCRC will also deliver concise and useful information written by or for PB about business opportunities and challenges during the Obama Administration.
As the leading public policy firm in the U.S., Patton Boggs keeps its resources fresh and meaningful for businesses today. According to BusinessWeek, “Patton Boggs . . . has more combined influence inside the Beltway than any other lobbying outfit. With hundreds of clients in virtually every business sector, the firm earned some $29.8 million in reported lobbying income in 2008 alone, more than any other firm. Its roster of clients includes Verizon (VZ), Microsoft (MSFT), E*Trade (ETFC), and the Managed Funds Assn.” See The Uber Lobbyists of Washington – Here Are the Lobbyists Who Are Likely to Wield a Big Influence in the New Washington, BusinessWeek (online) (Jan. 15, 2009).
This year will be exciting and challenging and BLFN and PB will help you manage through the crisis. Thanks again for reading BLFN and for continuing to send it to others! We welcome your feedback. Please contact me at email@example.com or at (214) 758-1545 if you have questions, comments, or suggestions about BLFN or the issues of the day.
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1. Deepening Recession Shatters Old Paradigms for Financing Distressed Debtors
As the U.S. government races to save the economy from one of the worst recessions in U.S. history, many borrowers and lessees (debtors) scramble to prevent their seemingly unstoppable spirals into default and bankruptcy.
Lessors and lenders (financiers) have not waited for these problems to reach the point of no return. Rather, in the face of the grueling financial crisis, many of them have taken actions to minimize their potential losses and develop alternative plans for distressed debtors to meet their financial obligations. However, the old solutions may not suffice as the current situation is so unprecedented as to shatter old paradigms for debtor financing.
The deepening recession and the severe constriction on credit have intensified the difficulty for debtors and financiers to manage potential defaults and/or bankruptcies. With the financial crisis firmly entrenched for 2009, the lessons of the past have some value in the deepening recession, but they no longer provide financiers with all the tools they need to resolve the unprecedented volume, complexity, and diversity of credit problems in today’s markets.
Before the current recession began in December 2007, lessors and lenders enjoyed prosperous times and relatively few defaults and bankruptcies. After the “crash” occurred last year under the cloud of the subprime mortgage crisis, refinancing options for troubled businesses and transactions dried up. Financing for new deals became less available and more expensive. Defaults and bankruptcies surged. In 2008, business bankruptcies increased 61 percent through the third quarter, most of which were Chapter 7 liquidations. See Business Bankruptcies Surge by 61 Percent, CFO.com (Dec. 15, 2008).
Debtors from a wide range of industries began to fall into difficult financial times with very few ways out. As financiers began to see more defaults, they deployed old-style workouts with some success. But as the credit crunch continues, 2009 will require creditors to revise their methods to evaluate and manage severe credit problems. Even the Obama Administration has to find new ways to fix banks in distress. See Obama Can’t Bank on Old Fixes, The Wall Street Journal, S.W. Ed. Page B:10, Col. 1 (Jan. 17-18, 2009).
*Paradigm Buster: Debtors cannot rely on old paradigms that a bankruptcy will provide time and refinancing to reorganize its obligations or find a buyer to make a fresh start.
In the recent past, bankrupt companies could obtain DIP financing to restructure their businesses or find a buyer to purchase the business out of bankruptcy. As dramatically illustrated in the retail industry today, businesses must liquidate when neither financiers nor buyers will come to their rescue. As businesses falter, their loans and leases often suffer a similar fate. See Traditional Turnarounds Hampered by Credit Freeze; More Liquidations on the Horizon, TMA Press Poll Press Release (Oct. 29, 2008); Fewer Restructurings, More Liquidations in Bankruptcy Court, New York Magazine, Intelligencer (Jan. 11, 2009).
*Term to Know: A “DIP” financing means financing arranged for a debtor-in-possession (of its business) under Section 11 U.S.C. 364 of the federal Bankruptcy Code.
That sad truth is that “[e]very major U.S. retailer that has sought to reorganize under bankruptcy court protection in the past year has eventually been forced to liquidate because of [a] lack of buyers or financing.” See Retailer Circuit City to Liquidate, The Wall Street Journal, S.W. Ed., Money & Investing, Page A:1, Col. 2 (Jan. 17-18).
*Insight Point: Some financiers will, if possible, stem potential losses by settling with a debtor for cash, even though the financier will take a loss at settlement rather than extend or restructure the debt or lease financing. As a debtor, check with your tax advisors about taxable income arising from the forgiveness of debt, and confirm that your financier intends to write off its loss.
The “Five Knows”: What Lenders and Lessors Should Know Before Financing a Debtor
Financiers should take steps immediately and systematically to ensure their payments and to protect their other interests – whether a transaction is a new one or part of their mature portfolio. Many financiers have implemented these efforts. However, the extremely rapid changes in the economy demand more proactive steps to manage risks of new deals and existing deals by applying the following “Five Knows” to every debtor:
I. Know the debtor’s and any guarantor’s financial condition.
Gain a full understanding of cash flows, income, and expenditures of the debtor and any guarantor.
Review each debtor and corporate guarantor’s business plan, operations, and results as a whole, including its balance sheet, cash flow statement, management team, operations, and industry exposure (especially troubled industries, such auto, real estate, retail, or construction). Although this effort is routine for many financiers, financiers can expand the process to evaluate all aspects of the business in greater detail, with an eye on managing risks of defaults, including non-payment.
Test important financial ratios and other financial covenants in the documents or proposal, if any, and discuss the results, good or bad, with the debtor.
Require and read the debtor’s financial statements and business projections with a management summary, at least quarterly (not annually), together with a compliance certificate. The certificate should, in part, give a confirmation to the effect that “the debtor is not in default, and knows of no facts or circumstances that could reasonably be expected to result in a default.”
*Tip: If the debtor has not provided its most recent financials, immediately request and review them. Remind the debtor in writing that the failure to provide the financials under its financing documents is a default. Some financiers do not receive financials as required; that is a mistake a financier can easily avoid.
Insist that each guarantor provide full financial disclosure and proof of selected items on its balance sheet or cash flow statement, including broker’s statements, property appraisals, and evidence of cash flow from income generating assets.
*Paradigm Buster: Before the economic crisis, lenders in some sectors, most notably business aviation, would not require guarantees from individual guarantors of private companies. If the lenders required a guarantee, they frequently would pass on full disclosure from guarantors. These structures are “history” in the U.S. markets. Further, if an aircraft had a high loan-to-value ratio (the value of the aircraft significantly exceeded the loan balance), lenders agreed to look solely to the value of the aircraft as its pay back collateral. In the U.S. markets, these “non-recourse” loan transactions are dead (possibly with rare exceptions).
*Tip: Ask whether the debtor is engaged in negotiations for any 2009 or 2010 extensions of its line of credit and how the negotiations are progressing. The goal is to determine whether the debtor will have necessary working capital during the term of a financing as a prerequisite to funding any lease or loan.
Conduct extra diligence, if any material information is suspect, to assure that a guarantor or debtor has not misstated its financial condition, financial statements, or worse, committed some kind of fraud.
Analyze accounts payable and accounts receivable. Businesses may be delaying payment to vendors and financiers.
Determine the extent the equipment or collateral is of “essential use” and value to the continued operations of the debtor.
II. Know your debtor by meeting the senior officers in person. This economy raises the burden on financiers to evaluate existing transactions before a default occurs. To get the best insight on a debtor’s financial position and prospects, financiers should regularly stay in contact with their debtors, see them in person, and discuss their prospects during 2009. This inquiry should include a close review of the debtor’s industry. Financiers should ask the debtor’s human resource personnel whether the debtor has recently fired key employees, as this action may be a red flag of financial trouble. Finally, a financier should ask the officers about mission critical business relationships, such as suppliers and debtors, to confirm that these third parties can and will perform for the debtor as projected by debtor.
III. Know the debtor’s insurance, tax, lien, and litigation status. Financiers should use public sources of information such as Standard & Poor's, Dunn & Bradstreet, and Uniform Commercial Code lien and judgment searches to conduct diligence on a debtor’s liens, debts, and legal issues/judgments. Talk directly to risk managers, such as a Chief Risk Officer or person who serves in a similar role about the type of insurance maintained by the debtor and whether the coverage is at least adequate to cover the financier’s assets. Confirm that premiums have been paid to carriers (evidenced by checks or receipts) and that the financier will receive the benefits of the policy in the event of a loss.
*Tip: If the debtor has not maintained insurance, the financier should pay for debtor’s insurance or obtain separate insurance to cover its risk of loss of the asset and of liability pertaining to the asset.
IV. Know the value and condition of the debtor’s assets. Whether an asset of the debtor is subject to a lease or secured loan, inventory the assets in person or through a trusted agent and confirm that the debtor has physically maintained each asset in accordance with the applicable loan or lease documents.
A financier should address the following situations immediately to protect the residual value of its leased asset or collateral and to determine whether the situation is a signal of financial distress:
a deferral of or stoppage of equipment maintenance;
a cancellation or downgrading of maintenance contracts;
excess usage or under-utilization of equipment over contractual limits such as flying a corporate jet over or significantly under contractual limits of 500 hours per year;
subleases, charters, or other third party use of the equipment or collateral to raise cash or minimize lease or loan payments to the financier; or
late payments to vendors who perform maintenance.
Each of these items should trigger a review of possible operational problems, deterioration of residual value, and a failure to comply with lease or loan documents.
*Tip: As a lender, you should consider imposing physical control of tangible collateral subject to your secured loan facility before a default or bankruptcy occurs. You can retain specialized (and insured) “collateral management,” “collateral risk management”, or other similar companies in the business of managing, segregating, valuing, remarketing, recovering, collecting, appraising, and controlling assets such as inventory or equipment.
Other firms perform similar work with more focus on fewer tasks, such as recovery and remarketing of leased equipment. See McCrae’s Blue Book for a list of a group of firms in these business sectors. The Federal Deposit Insurance Corporation (FDIC) exercises collateral control in agriculture by making periodic on-site inspections and verifications of the security pledged. The FDIC documents the results of those inspections and implements procedures to ensure sales proceeds are applied to the associated debt before those proceeds are released for other purposes. See FDIC Risk Management Manual of Examination Policies (Part 3 Asset Quality).
V. Know whether the debtor complies with its agreements. A debtor’s failure to comply with loan or lease documents may indicate that defaults exist and should be addressed immediately. A failure to comply with another significant agreement may, through a “cross-default” provision, trigger a default in a financier’s loan or lease documents. A failure to comply with covenants or agreements in loan or lease documents may trigger a default of which a financier may not have been aware. Early detection of a problem may at least enhance a financier’s chances to cut its losses, if not restructure a transaction, so that it can endure the current financial crisis.
Financier’s Need the Right Help to Manage Distressed Debtors
If a borrower or lessee defaults, financiers should take actions very quickly to preserve the value of their collateral or leased assets. They should hire advisors and/or use specially trained employees to deal with significant defaults or even potential defaults.
Risk Managers. Often leading the charge and displacing marketing people, risk managers will evaluate maintenance practices of the debtor, inspect the assets to assess their condition, and establish a value of the assets. Their work product can serve as a basis for the financier to decide whether to foreclose, repossess the assets, or initiate a restructuring transaction. Other financial institutions use transaction teams to rework transactions that give the debtor time to heal and move ahead without significant losses.
Lawyers. If a financier concludes that it must enforce its remedies, it considers the most efficient and least expensive way to accomplish the task. In some cases, a financier can use marshals or other services identified by the local courts to repossess, transport, store, or even hold assets idle in its place of use.
Because these circumstances involve the interpretation and exercise of legal rights and remedies, drafting of restructuring documents, or making court appearances, financiers should involve inside (if available) and outside counsel promptly to assist.
*Tip: Financiers often consider hiring a different law firm than the one that closed the original transaction (if any firm was involved). Hiring another firm increases the assurance of a fresh review of the underlying transaction. This work may reveal any weakness in the documents and enable the entire team to develop sound strategy for the workout process. Look for seasoned lawyers who have worked through other recessions and have a “deep bench” in bankruptcy, litigation, and financial transactions.
Turnaround Managers. If a lender, lessor, or debtor has the opportunity to rehabilitate a declining business (before or after default or bankruptcy), the company should promptly consider hiring a turnaround management firm with knowledge of the issues involved in the borrower/lessee’s business. The lessee/borrower should consult its primary creditors on the right turnaround firm and person. The goal should be to enable the debtor to execute a new and practical business plan covering its financial and operational elements while recovering from its credit woes. See Financial and operation solutions, Market Overview, Financier Worldwide, Turnaround and Corporate Renewal Issue, Issue 69 at Page 1 of Special Report (Sept. 2008).
Other Specialists. Depending on the type of asset and strategy, several other experts can help the financier realize its goals. In this crisis economy, the cost of other specialists may be far less than the potential loss in proceedings against the debtor or disposition of the asset. Brokers, repossession firms, appraisers, and asset consultants can each provide services relevant to the imperative of the financier.
*Tip: As a financier, your documents should include (or confirm that you have) provisions that require your debtor to reimburse you or pay you all reasonable transaction costs and collection, enforcement, or related costs. In a capital constrained market, this expenditure seems like a small cost to pay for a debtor that receives funding.
Do New and Restructured Deals Differently
Not all deals will go into default or even present a substantial risk of default. Although the economy faces a difficult 2009 (and perhaps beyond), financiers can structure, negotiate, and close new loans and lease transactions and successfully restructure existing ones.
However, the days of easy financing no longer exist and may not occur again. Specifically, lenders and lessors will not fund deals (with some rare exceptions) with weak or no covenants, super low rates, low residual value coverage, and inadequate financial reporting. In today’s markets, financiers should consider working through the applicable aspects of the “Five Knows” discussed above before saying “no” to companies in need of loans or leases. With the right diligence, creativity, and business judgment, the proposed transaction may merit a “yes” to the debtor’s requests.
*Insight Point: To get to the “yes”, bank lessors and lenders may require the debtor to establish or maintain a substantial banking relationship with the bank financier, with deposits and/or other services, before even evaluating the credit transaction. Banks may limit deals to a geographic “footprint.” As a lessee or borrower, you should be prepared to enter these relationships and allow your cash accounts to act as additional collateral security for your performance. You should also expect that to interest a lessor or lender during this period of constricted lending and leasing, you will need a compelling story as to why your deal is worth funding.
Documentation should change to reflect and mitigate higher risk and less available capital in the market. Documentation terms will include provisions that, among others:
Include or enhance financial covenants to lower leverage and establish stringent financial ratios. These covenants should, ideally, improve risk management and provide clear metrics for financial performance of the enterprise.
*Warning: Leases often have no financial covenants. Lessors should re-evaluate this approach in each transaction.
Tighten maintenance requirements and compliance, including regular reporting on maintenance work and maintenance contract payments.
Structure lease and loan documents to assign to lessor or lender, respectively, all and other sources of cash or tangible collateral to support the debtor’s obligations.
Add or enforce penalty provisions for excessive use of the asset/collateral over assumed (and contractually stated) levels, such as hourly limits on machinery or corporate aircraft.
Assure that the financiers have access to the debtor, guarantors, and its/their collateral or leased assets, more frequently and with less or no notice, to discuss financial condition and inspect the collateral or leased assets.
Reduce cure times in default provisions and confirm that bankruptcy default provisions are current under applicable law.
Impose on debtors the obligation to pay all reasonable transaction and collection costs throughout the entire period during which any document remains in effect.
Add cross-default provisions to other financings, events, or transactions to trigger early detection of financial distress or potential defaults.
Increase collateralization in favor of the financier as part of original documents to assure payment and to cover any loss of collateral or leased asset value during the term.
For example, financiers can require the grant of additional collateral in the form of a standby letter of credit, an assignment of cash reserves, maintenance contracts, and other equipment at closing that may be drawn or used if collateral or leased asset values drop below an assumed level consistent with residual assumptions and tax treatment of the transaction or otherwise to support a debtor’s obligations.
*Warning: As a financier, check on the impact of usury laws on your transaction structure and rent/loan rates of interest. Fees, charges, and security deposits may be included as part of “interest” and potentially violate applicable usury laws for charging, in total, interest higher than that permitted by law.
Structure arrangements creatively to take into account business and economic cycles to manage through the crisis in the economy, such as deferring payments, reducing permitted use of equipment to preserve its value, and finding sublease or other cash-generating use of assets.
The recession assures the financial services business and their debtors will face an extremely challenging 2009. For financiers and their debtors alike, the goal should be to avert defaults by maintaining frequent contact with each other and using appropriate advisors to sort out difficulties well in advance of defaults, if possible.
*Opportunity Point: Despite the grim economic conditions, lessors that price assets properly and keep them on lease for about five to seven years could realize “upside” on a final disposition of the equipment. The value of most equipment (such as business aircraft) is still falling. If a price is low on the purchase by a lessor, the potential gain or upside on its sale could significantly exceed lessor’s yield from rent payments. In other words, lessors can make serious “coin” by buying wisely today.
For those debtors who can present good reasons to enter into new or restructure existing loan or lease transactions, financiers have imposed, and will almost certainly continue to require, more stringent underwriting criteria.
The real world challenge appears to be managing a skyrocketing number of defaults and bankruptcies while approving new or restructuring existing transactions. This year promises to be a wild ride, but unfreezing credit and managing default risks may just be the ticket to a debtor’s business recovery.
Thanks to Joe Boles, Vice President, Corporate Aircraft Finance at Siemens Financial Services, Inc., and Dennis Bolton, Managing Director of Wachovia Equipment Finance, for commenting on this article. Thanks to Scott Wallace, for editing this article. Scott is a Partner in Corporate Finance, Mezzanine and Other Junior Debt Financing, and Project Finance groups in the Dallas office of Patton Boggs.
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2. Top 10 Actions Debtors Should Take Before a Default Occurs
In the current financial crisis, many lessees and borrowers (debtors) question whether they will be able to pay their lessors’ or lenders’ (financiers) bills during 2009. If a debtor foresees payment or covenant defaults in its loan or lease transactions, the debtor should take immediate steps to protect itself and to interact with its financiers to find the best solution before the default occurs.
To provide time to reach the best possible outcome, a debtor should take the ten actions listed below to mitigate its risk and reduce the potential losses of its financiers. For the most part, these steps should benefit both the debtor and financier.
I. Consult immediately with independent financial advisors and counsel about options well before a default or bankruptcy. The options include requesting financiers to ease its covenants, reduce payments, forgive debt, defer payments through forbearance arrangements, or even file bankruptcy. Each debtor should work closely with its financiers to structure a workout. However, the first step you can expect the financier to take is to develop and present a plan for approval by its finance or credit committee that balances the risks and rewards of the restructuring. The finance or credit committee or officers then determine whether the financier can or should use its limited capital to help its borrower or lessee. The debtor should benefit from developing a comprehensive, plausible and thoughtful plan to make a restructured deal succeed and to convince its financiers to accept and jointly execute the plan. As the saying goes, a debtor can not go to the bank on the “ready, shoot, aim” method (a premature and impulsive "solution"). See Effectively Managing Human Service Organizations, By Ralph Brody, Chapter 5 at 79 (SAGE 2005).
*Warning: As a debtor, if you plan to file a petition in bankruptcy, do not assume that you can find DIP financing. Some lenders have put a freeze on DIP financing, especially for weaker credits. Without such financing, you may slip into Chapter 7 under the bankruptcy laws, which ends with the liquidation of your business. See DIP loan freeze may cause preemptive bankruptcies, Reuters (Dec. 12, 2008).
II. Disclose your concerns to your lender or lessor and ask for help early and often. Do not wait until your business is in late decline before you do so, as these financiers may be unable or unwilling to bail you out.
*Insight Point: When debtors wait too long, turnaround management firms often can do little to help to correct course and fix the ailing business. As a result, the turnaround experts feel frustrated that debtors do not see the freight train coming until the light shines in their eyes. In such a case, financiers and purchasers have little incentive to cure the ailing business and turnaround experts can offer little or no assistance to the debtor.
III. Provide cash flow statements, business projections, calculations of important financial covenants, and other financial statements to your financiers when required by loan or lease documents or as part of a debt restructuring.
*Warning: Resisting the financier’s request can kill your chances for refinancing. Help your financier help you!
IV. Comply with your covenants and other obligations and make all payments while you work out the issues with your financier as a showing of good faith; otherwise, do not be surprised that your nervous financiers initiate remedies for your default that may result in closing or liquidating your business.
*Tip: As a debtor, you may have an advantage in negotiating a solution. Your lender or lessor will typically not want you to return or relinquish a leased asset or collateral. They realize that, in many cases in this market, their collateral or leased asset coverage may be “underwater” (that is, their loan or lease balance exceeds the value of the collateral or leased asset). Lenders and lessors often prefer to work out the credit problems, leave the assets/collateral with you, and avoid lawsuits to collect a bad debt.
V. Make timely trade creditor payments when due, if possible, to avoid a cash drain when trade creditors require cash payments in advance or other security for payments that further erode your cash position and ability to conduct your business as a going concern.
VI. Request that your lender or lessor enter into amendments of your documents to provide relief on your debt or lease payments, and ease your financial covenants to achieve the objectives set out in Item 1 above. See Companies Seeking Loan Amendments Up Sharply This Year: Hoping to Avoid Default, 142 Corporate Borrowers Asked for Easier Terms on Debt; 42% of requests came since Oct. 1, Financial Week (Dec. 19, 2008).
VII. Take telephone calls from your financiers, as your failure to do so is a red flag that may spur them to take action against your best interests.
*Warning: Financiers or their lawyers will find you, your guarantors, or your affiliates; so hiding or dodging them will ultimately fail.
VIII. Monetize any unencumbered assets or sell them. Consider raising cash by refinancing assets through sale-leaseback transactions.
*Remember: As a debtor, you may have to obtain your lender’s or lessor’s consent to do these deals even though they may not have liens that encumber your assets.
IX. Think creatively and collaborate with the financier. Unique solutions or structures can assist a debtor in buying time or receiving new cash resources.
X. Be realistic about your financing requests and objectives in an economic environment in which the first response from financiers is often negative.
*Tip: As a debtor, if you can convince a financier to furnish lease and loan financing, expect to pay your financiers between 100 and 500 basis points more in “spreads” (basis points over a financier’s cost of funds) than in any previous financing you have completed in the last year. Business Outlook Survey: As Confidence Plunges to All-time Lows, CFOs Prepare Their Companies for the Worst, CFO.com (Dec. 8, 2008). However, as a result of the drop in interest index rates such as LIBOR, the final interest rate (loans) or implicit rate (leases) you pay could still be less than rates you paid for your financing transactions during the last year.
The recession will not end soon, nor will it end easily. As the economic pressure increases, debtors should interact with their financiers as soon as possible, before a default, to take a shot at working out their credit problems. Dodging financiers or refusing to work with them can devastate a business and force the debtor into bankruptcy and/or liquidation. Debtors have choices; they must make the right ones to survive the current economic crisis intact.
Thanks to Joe Boles, Vice President, Corporate Aircraft Finance at Siemens Financial Services, Inc., and Dennis Bolton, Managing Director of Wachovia Equipment Finance, for commenting on this article. Thanks to Scott Wallace, for editing this article. Scott is a Partner in Corporate Finance, Mezzanine, and Other Junior Debt Financing, and Project Finance groups in the Dallas office of Patton Boggs.
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3. Can Financiers Use Economic Factors to Predict a Debtor’s Default?
The lack of available credit and the nose dive in economic activity has hurt the financial prospects of many industries. See CFO Survey: Credit Noose Is Tightening, CFO.com (Nov. 26, 2008). These industries include automotive, manufacturing, service businesses, healthcare, trucking, technology, banking, gaming, construction, business aviation, renewable energy, real estate, restaurants, retail, and even the development of independent power and infrastructure. Renewable energy seems less affected than other sectors, such as bridges, highways, and gas storage facilities that rely on project financing. See Less Strain on Renewable Energy Than Other Sectors, RenewableEnergyWorld.Com (Nov. 17, 2008). In short, almost no sector of the business world has avoided the negative impact of this economic downturn.
Reality Time: Dim Prospects for Economy in 2009
Financiers (lessors and lenders) have little to cheer about as they enter 2009. The expectation of the steep decline of investment spending has resulted in Fitch issuing a negative investment outlook for 2009 in the commercial finance and leasing sectors. Real data published by the Equipment Leasing and Finance Association (ELFA) already confirms Fitch’s outlook. According to ELFA, month-to-month business volume plunged by 13.3 percent over the same period in 2007 as of January 2009. Just as important, charge-offs continue to increase at levels unseen since 2006. See Less than a Lease on Life for Leasing, CFO.com (Dec. 23, 2008). Charge-offs to business borrowers rose nationally by 140 percent in the third quarter of 2008 from the same period in 2007, according to the Federal Deposit Insurance Corporation. See Commercial, Industrial Loans Souring - Sharp Increases in Delinquencies and Charge-offs Hit Banks, Chicago Tribune (Jan. 19, 2009).
Portrait of Defaults
The current portrait of defaults is anything but a pretty picture. Financiers already know that default rates rise in times of increased economic risk. But now defaults have soared to new levels and the end in nowhere in sight. As early as last summer, the Turnaround Management Association (TMA) predicted that the default rate would rise significantly. See Turnaround Pros Expect Debt Default Rates to Increase to Near-Recession Levels, Turnaround Management Association (June 25, 2008). This month, the TMA confirmed that prediction. See What to Watch in a Volatile Loan Market, TMA Publications, by Thomas Miele (Jan. 8, 2009).
Many executives view these business conditions as so negative that they have shifted to survival mode with a focus on risk management. See Executives Shift to Survival Mode, The Wall Street Journal, S.W. Ed., Page B:2, Col. 3, (Nov. 20, 2008).
Defaults tend to occur during economic slowdowns, and economic slowdowns tend to drive debtors (borrowers and lessees) into default. In this recessionary economy, these trends feed on each other and exacerbate normal credit operations and assumptions. Thus, financiers should not wait for defaults, but rather understand the reasons they can occur for each and every debtor so they can get ahead of the debtor before the decline of the debtor’s business becomes unrecoverable and the obligations to the financier become uncollectible.
Evaluating Economic Factors as Predictor of Defaults
Defaults occur for a variety reasons in this economy, but certain common factors are of paramount importance. Expressed below as questions, these factors, when applied to an individual debtor, may enable a financier to predict the debtor’s defaults in time to work out an alternative solution. If the answer to all questions is “yes,” then a financier may have sufficient cause for concern to predict a default even if the debtor is current on its payments.
1. Has the Debtor Lost or Is It About to Lose Its Working Capital Line of Credit? Financiers could find that this factor alone is useful in predicting whether the debtor is or could be in distress or default. With almost no borrowing power or cash reserves to weather the credit drought, many companies in a variety of industries, such as the retail industry, have spiraled into default and bankruptcy. Such a situation is becoming a much more frequent occurrence. See Lending Drops at Big U.S. Banks, The Wall Street Journal, S.W. Ed., Page A:1, Col. 3 (Jan. 26, 2009).
2. Have the Debtor’s Profits or Cash Flow Dropped Precipitously? If yes, financiers should evaluate the credit immediately. An increasing number of debtors can neither stabilize nor avoid significant drops or volatility in their profits and cash flow during this recession. As a result, when combined with high debt loads, the contraction in profits and cash flow can lead to more payment defaults. See Bankruptcy & Corporate Restructuring, Defaults Double in 2008, Deal Front, Financier Worldwide, Issue 72 at 10-11 (Dec. 2008).
3. Has the Debtor’s Business Experienced a Severe Reduction in Demand For Its Products and/or Services? The U.S. economy thrives and survives on consumer spending. Consumer spending has increased earnings and cash flow that enable retailers and other businesses to meet their debt and other obligations. As the crisis of confidence has strangled the economy, consumer and business demand for products and services has dropped. Consumers fear job losses. They have therefore begun saving for a “rainy day” instead of spending as they did during the economic expansion in the U.S. (before 2008). As the loss in consumer and business confidence has continued to deepen, vendors have experienced severe reductions in cash flow, which drive a business into default on loan or lease payments. See Forecasters Share Predictions for Economy's Outlook in 2009, USAToday.com (Dec. 24, 2008). If a debtor is dependent on consumer spending and operates in a weak business sector, this reliance should send up a red flag to review the debtor’s financial condition as a predictor of a default.
*Paradigm Buster: In the last recession, consumers shopped all the way through the down economy, softening and shortening the recession. Not so today - no one can count on consumption today to ease the depth and duration of this recession. The reality is that consumers have slowed or even stopped spending. See Another Record Drop in Consumer Spending is Latest Sign of Deepening Recession, Nation & World, U.S. News and World Report (Dec. 16, 2008). Similarly, businesses expect to cut capital expenditures by 10 percent in 2009. See Forecasters Share Predictions for Economy's Outlook in 2009, USA Today (Dec. 24, 2008).
4. Does the Debtor Have a High Debt Load and Weak Financial Covenants? About 18 months ago, companies could borrow heavily to finance business growth and complete acquisitions under very lenient standards, cheap pricing, and easy document terms. The lack of these provisions gave debtors time to weaken in the recessionary economy to the point that debtors could not or would not pay their debt or lease obligations, resulting in defaults. Heavy debt loads coupled with the other factors above can lead to the collapse of a business.
Whether these factors can help a financier predict debtor defaults, creditors should take action now to prepare for the continuation of a record-breaking number of business bankruptcies in 2009. In 2008, business bankruptcies, most of which were Chapter 7 liquidations, increased 61 percent through the third quarter. See Business Bankruptcies Surge by 61 Percent, CFO.com (Dec. 15, 2008). Cutting loan or lease lines is not enough to protect financiers from losses. Such action may be the worst one a financier can take to minimize its losses as it may force a debtor into a bankruptcy that ultimately increases a financier’s risk of non-payment and losses. Perhaps the worst outcome arises when a smart lender or lessor finds that, despite its predictive talents and risk management, the debtor is too far gone to save. Unfortunately, the “too far gone” scenario is occurring more often in businesses of all sizes.
Perhaps if the debtor maintains close communication with its financier during 2009, that connection will enable the parties to find solutions to the debtor’s credit troubles until the economy makes life easier for both of them.
Thanks to Joe Boles, Vice President, Corporate Aircraft Finance at Siemens Financial Services, Inc., for commenting on this article. Thanks to Scott Wallace, for editing this article. Scott is a Partner in Corporate Finance, Mezzanine, and Other Junior Debt Financing, and Project Finance groups in the Dallas office of Patton Boggs.
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4. Finance 101: What is a “‘Force Majeure Event?’”
In an effort to trump his creditors after defaulting on loans, Donald Trump filed suit in New York state court on November 6th, claiming that the current financial crisis constitutes a “Force Majeure Event” that suspended his loan repayment obligations. Trump argues that under the loan agreement for the financing of his Chicago high-rise, a Force Majeure Event would include, “any other event or circumstance not within the reasonable control of [Trump],” including a financial crisis. Such an argument begs the question: what is a force majeure event?
What is Force Majeure?
Force majeure is French for “superior force” or “greater force” and is also referred to as “vis major.” It includes both acts of nature and of people, and usually refers to an event or effect that cannot be anticipated or controlled. A force majeure clause is a contractual provision allocating the risk if performance becomes impossible or impracticable.
In essence, a force majeure provision provides an excuse for failure to perform as required in a contract. What qualifies as a force majeure event depends entirely upon the negotiated contract language. The following are examples of events that have been included in force majeure clauses: labor disputes, boycotts, fires, explosions, droughts, floods, hurricanes, acts of the public enemy, acts of the Government, epidemics, embargoes, war, riot, and sabotage. Obviously, the possibilities are endless. There are also so-called “catch-all” provisions that cover any other unforeseeable event beyond the reasonable control of the party failing to perform.
*Tip: When negotiating a force majeure clause:
State the events you want included or excluded within the clause. In general, the more specific you can be with the list, the better, as the list should clarify what is and is not a force majeure event.
Understand the language “including, but not limited to” at the beginning of the clause. If included, the list is merely indicative of the type of events the parties want included, but is not exclusive. Without the phrase, a court may find that only the events listed are covered by the clause.
How Force Majeure is Used
Force majeure is used to excuse the non-performance of a party to a contract. For example, in a construction contract a force majeure clause may provide an excuse if the builder misses a deadline because of a flood. In a supply contract, a supplier may be excused for failing to supply goods to a buyer if a labor dispute makes shipping the goods impossible. Again, the contract defines both the performance to be excused and what constitutes a force majeure event.
*Tip: Look closely at the force majeure clause to determine whether an event qualifies as a force majeure event.
Many clauses require that the event be “unavoidable.” Other clauses require that the non-performing party use reasonable efforts and expense to avoid force majeure events. For example, if a work stoppage occurs because of unsafe conditions at a plant, the party claiming that the stoppage is a force majeure event may be required to repair the unsafe conditions at reasonable expense, or attempt to do so, before claiming that a force majeure event has occurred. These points, while seemingly minor, make a vast difference in what qualifies as a force majeure event.
Traditionally, force majeure clauses require the party invoking the clause to notify the other party of the event. This notice will typically state the event that occurred and describe the party’s inability to perform. At that time the opposing party may respond to the non-performing party and either accept or dispute the force majeure event.
*Warning: Pay close attention to the requirements of the force majeure clause. The clause should specifically indicate what the parties must do to seek the benefits of the clause. As the party invoking the clause, you must adhere to the requirements in the clause to avoid losing your right to delay performance under the clause. Disputes may arise if you fail to demonstrate that the situation allows you to claim that a force majeure event has occurred. As the non-invoking party, you may argue that a force majeure event did not occur as agreed in the contract.
If a force majeure event occurs, the contract will outline how the parties proceed. In many contracts, performance is merely suspended or delayed until the conclusion of the force majeure event. If the contract contains a deadline for performance, often the deadline is extended in response to the force majeure event. In some contracts, performance is excused altogether and the contract is terminated due to the force majeure event.
Donald Trump’s Force Majeure Argument
The contract between Donald Trump and Deutsche Bank includes the following force majeure provision:
“Force Majeure Event shall mean any of the following (provided the same actually results in a delay of the development or construction of the Project)…(xi) any other event or circumstance not within the reasonable control of Borrower.”
Subsections (i)-(x) contain traditional force majeure events such as floods, earthquakes, suspension of government operations, and the like. Trump argues that the current financial crisis falls under the quoted catch-all provision since the recession is out of his control, and that his repayment obligations under the loan agreement should be suspended until the crisis subsides.
*Technical Point: Courts are unlikely to excuse non-performance under a catch-all provision for events that are dissimilar to events specifically listed in the clause. Also, “force majeure provisions simply do not apply to the vicissitudes of the marketplace.” Innomed Labs, LLC v. Alza Corp., No. 01 Civ. 2763, 2001 WL 406211, *2 (S.D.N.Y. Apr. 19, 2001). A force majeure provision cannot be used as an escape for bad economic projecting because performance is still possible, it’s simply not as profitable. The parties must bear normal market risks in the absence of a contractual provision directing otherwise.
Trump’s argument should not succeed for the following reasons:
First, even if the financial crisis could be a force majeure event, the contract between Trump and Deutsche Bank requires that such an event must delay construction or development, not merely hinder Trump’s ability to sell units in the building or repay the loan.
Second, claims that unfavorable market conditions constitute a force majeure event routinely fail.
Finally, in the Trump case, a financial crisis is dissimilar to the events specifically mentioned in the force majeure clause, making it more unlikely that a court would excuse his non-performance.
*Tip: As a borrower, unless your force majeure clause specifically states that a financial crisis is a force majeure event or you have plenty of money for litigation, don’t even bother making this argument. Courts have regularly rejected these arguments and your chances of success are not worth a fraction of the time and expense required to litigate the issue. However, in Trump’s case, he delayed payment by using litigation to test the force majeure theory. He also personally guaranteed $40 million of the loan. The delay may be just the leverage he needs to fix his defaulted debt and avoid personal liability.
A force majeure clause is an important part of a contract. It protects the parties from unforeseeable risks that make performance impossible or impracticable. Force majeure clauses shift the risk of non-performance to the innocent counterparty. Consequently, the clauses should be reviewed carefully and negotiated openly between the parties. A clear understanding of the force majeure clause will help avoid confusion when the clause is invoked and, hopefully, minimize the risk of litigation.
Thanks to Austin Henley of the Patton Boggs Business Transactions Group, for contributing this article.
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About Patton Boggs LLP (PB); PB Capital Resource Center; Publications; Business Aviation Panel
Patton Boggs LLP (PB) is a law firm of approximately 600 attorneys and other professionals located in Washington DC, Northern Virginia, New Jersey, New York, Dallas, Denver, Anchorage, and internationally in Abu Dhabi, United Arab Emirates and Doha, Qatar.
PB has major practice areas in Business, Intellectual Property, Public Policy, and Litigation. These areas are composed of many practice groups designed specifically to meet client needs and the trends in developing legal markets. David G. Mayer often focuses on aviation, energy, transportation, infrastructure, and technology transactions, workouts, and litigation.
The firm provides a broad array of skills in domestic and international business transactions, including equipment finance and leasing, corporate finance, secured transactions, syndications, mezzanine finance, aviation, federal leasing, project finance, real estate, health care, pharmaceuticals, technology transactions, and public policy work.
The equipment finance practice at PB regularly involves the buying, selling, financing, and leasing of personal property of all kinds, including business aircraft, energy facilities, power plants (including wind farms and other renewable energy facilities), and technology and health care assets.
When these transactions encounter defaults or other disputes, PB responds with a team of business transaction lawyers who have extensive restructuring and workout experience; litigators who manage court actions and alternative dispute resolution proceedings; and bankruptcy lawyers who assist in restructuring transactions, handle workouts, advise on potential bankruptcy filings, and litigate and otherwise participate in the entire bankruptcy process.
New! PB Capital Resource Center
PB Podcast and Capital Thinking Internet Radio Show - PB Partner Kevin O’Neill hosts both a weekly podcast series and a weekly Internet radio show that deliver the latest news and insight into policy, law, and politics in Washington. The PB podcast series is updated every Monday and is available on the firm’s website and iTunes. Capital Thinking, Patton Boggs’ weekly Internet radio show, airs live every Thursday at 9 a.m. ET on VoiceAmerica Business network. Top guests, including politicians, business leaders, and public policy advisors, join Kevin to discuss how legislation in Washington impacts businesses in the U.S.
Capital Markets Website – PB Capital Markets is the firm’s dedicated website offering current political news and in-depth analysis of the most important legislation pertaining to the crisis in the financial services and banking industries today. Topics include discussions of unprecedented federal legislation, including TARP, TARP Reform, and EESA. To read these materials and much more, click on Capital Markets.
Capital Thinking Magazine – For insightful interviews with business and political leaders and more in-depth information on business, finance, politics, and the law, pick up a copy of Patton Boggs’ Capital Thinking magazine. Published quarterly, Capital Thinking features articles from top business and legal minds providing readers with actionable tips on timely topics.
New! Business Aviation Panel
Please plan to attend the 16th Annual Aircraft Registry Forum, in Naples, Florida at The Ritz-Carlton Golf Resort, February 9-10th, 2009. On Tuesday, February 10th (2:45 p.m. - 3:40 p.m.) join David Labrozzi, President, GE Capital Solutions, Corporate Aircraft; David G. Mayer, Partner, Patton Boggs LLP, and William J. Quinn Jr., Director of Aircraft Sales & Acquisition Cerretani Aviation Group, LLC for a panel discussion titled - Aircraft Markets in Distress: Opportunities to Maximize Value and Minimize Risk. Thanks to Amy Rhodes and Tony Kioussis of GE for their contributions to and comments on the written materials.
Partial List of Publications
The following is a partial list of articles written or co-authored by David G. Mayer:
U.S. Court of Appeals Upholds Graves Amendment in Garcia v. Vanguard, by Connie Ariagno and David G. Mayer, with the assistance of Tyson Wanjura, LNJ Leasing Newsletter (Dec. 2008).
Equipment Leasing and CERCLA Liability, by Russell V. Randle and David G. Mayer, LNJ Leasing Newsletter (Dec. 2007).
Navigating the New Reality of Equipment Leasing and CERCLA Liability, by Russell V. Randle and David G. Mayer, LNJ Leasing Newsletter (Nov. 2007).
Unique Pad Gas Lease Supports Project Financing and Development of Gas Storage Facility in U.S., by David G. Mayer (with Fortis Capital Corp.), Asset-Based Lending Review, Financier Worldwide (Nov. 2006).
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Thanks to BLFN’s Team
I would like to thank BLFN’s team at Patton Boggs LLP. The team includes editor, Tyson Wanjura, an Associate in Dallas and the Patton Boggs staff: our staff Senior Writer, Jennifer Becker; our Marketing Manager, Mark Holub; our Project Manager, Melissa Green; our Subscription Coordinator, Penny Utley; my assistant, Michelle Sims; and our designers, Winston Jackson and Kiasha Sullivan. Thanks also to Douglas C. Boggs
, a Business Group/Securities partner and web site reviewer for BLFN, and our Chief Marketing Officer, Mary Kimber, for assisting BLFN through our firm’s editing, design, and posting process.
All the best,
David G. Mayer
Founder: Business Leasing and Finance News
(formerly Business Leasing News)
Partner: Patton Boggs LLP
2001 Ross Avenue
Dallas, Texas 75201
(214) 758-1545 phone)
(214) 758-1550 (fax)
© David G. Mayer 2009
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