Preparing for challenging times

How to recognize signs of potential problem credits and how to deal with them

By Nelson R. Block

The signs of potentially challenging times in the economy have begun to appear: The bond yield curve briefly inverted during 2019 and, though recovering until the end of the year, was immediately followed by a new decline.

In addition, there is increased instability in the oil-producing Middle East, weakness in the manufacturing sector and, of special concern for Texas, a softening energy market, including plant closings and permanent layoffs in oil field services. Bankruptcies in the oil and gas sector have been on the uptick.

The financial oversight agencies have been active in response to these indicators. The Office of the Comptroller of the Currency’s “Fiscal Year 2020 Bank Supervision Operating Plan” identifies, among other priorities, development of supervisory strategies for commercial and retail underwriting practices, with a focus on evaluating credit risk appetites, risk layering and portfolio risk exposure, commercial and retail credit oversight and control functions, including portfolio administration and risk management, independent loan review, concentration risk management, policy exception tracking, collateral valuation, stress testing and collections management.

The FDIC’s fall 2019 edition of “Supervisory Insights” highlighted its Interagency Guidelines Establishing Standards for Safety and Soundness regarding leveraged lending, expressing concerns about eroding covenant protection in loan agreements, failure of banks to monitor enterprise value, inadequate valuation methodologies, insufficient loan review procedures and outsourcing of risk management in syndicated credits and participations.

In response, regional and community banks preparing for a possible economic downturn should consider including the following steps in their plans:

Stress test the portfolio

Review potentially troubled parts of your bank’s loan portfolio for compliance with the original loan approval and underwriting. The review criteria will vary with each bank, such as loans constituting the largest 10% of the portfolio, or the 20 largest loans at the bank or a concentrated portfolio of loans to potentially distressed industries.

Review borrowers for tell-tale signs

Certain borrowers may have difficulties because of market conditions or other factors and may be unable to respond adequately based on their specific problems. Indicators for these loans include:

Financial reporting issues — chronically late or incomplete financial statements.
Poor management — lack of experience or expertise, or too lean a management team.
A tall capital stack — stakeholders in multiple tiers of preferred equity, mezzanine financing or subordinated debt often have divergent business goals when cash flow tightens.
Ownership in denial about its challenges.
Lack of responsiveness to bank requests.
Unexplained loss of customers, changes in vendors and changes in lines of business.
Tax issues.
Poor internal controls or key employee misbehavior.
Personal problems diverting management’s focus away from the business.

What to review

In addition to a general review of compliance with the original loan underwriting and current financial information on the borrower and any affiliates, subsidiaries and guarantors, special attention should be paid to issues that frequently arise with distressed credits that could affect your bank’s position or strategy in a workout or bankruptcy:

Is there additional collateral that can secure the facility? Check this by reviewing collateral reports and tax filings and having the borrower complete a perfection certificate or other questionnaire asking about its assets and those of its subsidiaries. The bank will want to take and perfect liens promptly, as liens perfected within 90 days of a bankruptcy filing may be subject to avoidance as preferential transfers.

Are there any secondary sources of payment, such as guarantors, credit insurance, property insurance claims, lawsuits filed by the borrower or letters of credit? Has the bank reviewed its secured position in those assets?

Would the customer’s collection process, or the bank’s confidence in it, be improved by having accounts come to a lockbox?

Are collections deposited at another bank? If so, can you obtain control and perfection through a deposit account control agreement?

Does the borrower have other Uniform Commercial Code security interests, federal tax liens or judgment liens against it? Update your UCC and lien searches to check. Obtain copies of the borrower’s federal tax returns for the last three years and check for tax liens under the name on the returns in case that name is different from the name on the borrower’s certificate of organization filed with the secretary of state; a federal court case has upheld the priority of the Internal Revenue Service’s UCC-1 filing using the company’s name on its federal tax filing.

Is there special collateral that cannot be covered by the filing of a UCC-1 financing statement, such as promissory notes or stock certificates that should be held by the bank, federal filings on copyrights, patents or trademarks or liens to be noted on vehicle titles?

Is out-of-state property subject to lien documents specifically designed for enforcement of rights under the laws of those states? For example, obtaining perfection on “as extracted” minerals varies from state to state.

Is there inventory located at a premises not owned by the borrower, such as a leased location, a third-party warehouse, a repair facility, a consignment location, a manufacturing plant where it is being processed or incorporated into a piece of equipment or on board a truck, railcar or vessel? Consider getting an acknowledgment of the bank’s first lien position and a waiver or subordination of liens from the company that has possession of the collateral.

Has there been a change in capital structure or incurrence of subordinate debt? This may reveal other creditors of which the bank was not aware and from whom a subordination agreement should be obtained.

Have state and federal sales taxes been paid current? Trust fund doctrines may give governments priority rights in receipts representing taxes your customer collected and remitted to the bank instead of to the taxing authority.

Has the borrower changed its name, started using an assumed name or begun doing business through an affiliate or subsidiary? These changes could indicate accounts receivable are being funneled away from the borrower and to an entity that has not pledged its assets to the bank.

Is the borrower building up cash reserves? That action could be a precursor to funding a bankruptcy. Consider instituting an “anti-hoarding” provision, requiring that all amounts in excess of an agreed-upon cash flow amount will be automatically paid as a mandatory pre-payment against the loan, perhaps through a sweep account mechanism.

Is the borrower’s insurance complete and appropriate in amount and coverage to protect the bank’s collateral? Is it up-to-date? Does the bank have a copy of the endorsements naming the bank as secured party or mortgagee, additional insured and lender loss payee? If all the bank has is a typical certificate of insurance, the bank may only have a claim against the broker that issued the certificate rather than against the borrower’s insurance carrier.

Does the bank have current appraisals or other information about the value of the collateral? Should new orderly liquidation value or forced liquidation value appraisals be obtained?

Does the bank have accurate information about the borrower’s accounts receivable and other payment streams, including outstanding balances, any offsets and credits and contact information in case the bank has to collect?

Do the loan documents provide adequate rights to call a default and accelerate the maturity of the loan? In Texas, special waivers are required in order to accelerate the maturity of a note payable in installments. Do all guaranties have enforceable waivers of the surety statutes and each, every and all other defenses?

Has the borrower made any claims against the bank that might be used as the basis for a lender liability claim? In any event, the bank should condition any forbearance or other accommodation on confirmation that no such claims exist and agreement that any claims that might exist are waived and released.

Has the bank potentially waived performance under the loan documents by failing to give the borrower notice of defaults and either requiring performance or reserving the bank’s rights? If so, consider sending a curative letter to the borrower, requiring strict performance going forward notwithstanding any prior lax enforcement or entering into a similar letter in which the borrower agrees the failure to require performance in the past is not a waiver of rights in the future.

Does the borrower have a viable plan to turn around its financial picture? Do the loan documents provide ways the bank can monitor the plan, require the borrower to adopt and adhere to a budget and permit the bank to call defaults if the borrower does not comply? Are the bank officers clear about how to undertake this process without being accused by the borrower of being “in control” of the business?

Train your team

In the recovering economy of the last decade, once real estate settled down, the significant workout and turnaround projects involved reserved-based credits and oilfield services loans.

Most bankers early in their careers have not experienced a cycle of non-performing loans and will not be prepared to recognize signs of potential problem credits or how to deal with them before management assigns them to the special assets group.

They may even hesitate to bring signs of trouble to management’s attention for fear that they have missed something they should have noticed earlier or made some other mistake. These bankers will need training and coaching on a wide variety of unique issues and skill sets by experienced bankers and their outside specialists.

Connect with professionals

Problems in the loan portfolio often arise without warning, and typically time is of the essence. You will want to be prepared to respond quickly to challenging situations with the necessary outside professionals — appraisers, turnaround specialists, liquidators and attorneys.

It helps to have relationships with several firms; part of the value of these professionals is their experience in representing both debtors and creditors, and your first choice firm may be representing your borrower or another creditor or have another conflict which prevents it from representing your bank.

Some kinds of businesses or collateral require special expertise; for example, an equipment appraiser may not be qualified to value an offshore supply boat. Finally, complex credits may require professional firms that have many specialties and broad experience under one roof, such as law firms with transactional, litigation and bankruptcy expertise.

Nelson R. Block, a shareholder in the Houston office of Winstead PC, advises clients in finance, with more than 40 years’ experience in guiding lenders in workout, turnaround and distress situations in commercial, industrial and real estate loans. The author appreciates the many insightful comments of Michael W. Hilliard, fellow finance shareholder at Winstead PC.