January 12, 2011
Published in Business in Savannah
Many businesses and business owners are in financial trouble during the current “Great Recession.”
Real estate related companies such as developers, community banks, mortgage brokers, realtors and contractors are particularly at risk. The reasons are simple: the bubble has burst, the value of commercial real estate has declined by 30% or more, the borrowers are required to continue to pay interest, the banks are required by the regulators to “clean up” their books by dumping real estate loans and demanding higher interest and earlier pay-downs of principal, and the borrowers have run out of cash at a time when their incomes are severely depressed.
When a business owner’s liabilities exceed his assets, or when his cash flow is too low to pay his debts as they come due, the owner is effectively bankrupt. At that point, the owner has three choices. He can bury his head in the sand and wait for the inevitable foreclosures, lawsuits, garnishments of his accounts and ultimately failure, he can attempt to negotiate a “workout” with his creditors, or he can file for bankruptcy.
Responsible business owners will not avoid the issue, but will proactively meet with their attorneys and accountants to plan strategy, and will meet with their creditors to propose solutions before events overwhelm them.
Some TV ads would lead one to believe that filing for bankruptcy, or putting your fate in the hands of a debt settlement company is a simple solution. However, the consequences of not paying your debts or filing for bankruptcy can be very severe. Either of these approaches will destroy credit, damage reputations and sometimes can carry a social stigma.
Often, a negotiated workout is a better solution. Essentially, a workout is a mutually-agreed upon plan to restructure debt. It can be proposed by either the borrower or the lender. It can involve selling collateral through a “short sale,” reducing principal or the interest rate, or extending the loan payment period to make the payments more affordable, surrendering collateral to the lender in exchange for debt, posting additional collateral, obtaining additional guarantors, or a combination of these strategies.
Take a typical case: a developer owns a building which was valued at $1 million in 2007. Today, it’s appraised at $650,000. In 2007, the developer financed the building at 80% loan-to-value, so he now owes $800,000. He’s “under water” by $150,000. He cannot make the loan payments because his tenants have moved out. Even if he could find a lender willing to make a new loan backed by real estate, he cannot refinance the building today because the value is under water.
The borrower could file for bankruptcy, or he could propose to the bank that he put the property on the market, and aggressively try to sell for $650,000. If the bank agreed to the “short sale” it would lose the $150,000. However, if the bank were to foreclose, it would incur expenses, the property would decline in value, and it may very well lose more than $150,000. The borrower could also propose to pay out the loan over a longer time, reduce the interest, and post additional collateral. In this case, the bank could recoup its money, but it would have to administer a “substandard” loan for a lengthy period.
While workouts make very good business sense for many lenders, it is difficult to negotiate a workout because lenders often require multiple layers of approval to modify loan terms, and they may be operating under constraints which are not obvious to the borrower. For example, they may have sold participations in the loan to other lenders, or they may be under regulatory oversight by the FDIC, and the persons who must approve the workout may be more concerned with complying with regulations than with making what seems to be a reasonable business deal.
When banks or other creditors won’t work with you on alternate payment arrangements, and instead elect to pursue litigation or unreasonable foreclosure strategy, it is time to consider filing for bankruptcy. In some business cases, Chapter 11 may be the best option. Unlike Chapter 7 bankruptcy, which involves liquidation of assets, Chapter 11 may allow a business owner to keep operating his business while he reorganizes his debts.
Both workouts and bankruptcies are governed by complex laws and regulations. An attorney who specializes in workouts and bankruptcy law can assist you in formulating a strategy, negotiating with creditors, representing you in court, helping you to implement a plan to settle with creditors or, if necessary, guide you through the bankruptcy process.
