- With little prospect of real estate values rising in the short-term, there is increasing pressure to maximise recoveries for lenders in the distressed real estate market through minimising costs of exits.
- This, coupled with other factors such as the complexity of borrower structures and the predominance of offshore holding structures which are now under review, has sparked a renewed interest in consensual work-outs of distressed real estate.
- There are many challenges to making a consensual work-out a credible and feasible proposition, however done properly and for the right situation the outcome for lenders and borrowers can be optimised.
Conventional wisdom has it that there is little prospect of property values materially increasing outside the prime London market in the short term. Accordingly, even greater focus is being placed on finding ways to make exits from distressed real estate exposures more cost efficient in order to minimise lender impairments and maximise returns for investors who have acquired distressed real estate at a discount. With this in mind, it is perhaps not surprising that the appetite for consensual work-outs has grown.
The “consensual work-out” is a wide concept. We are seeing it used increasingly to describe any method which provides a lender with a controlled exit, falling short of enforcement of security or a formal insolvency process. Unlike when the term is commonly used in the corporate restructuring context, a consensual work-out of distressed real estate may not necessarily result in survival of the property-owning entity. But it does give directors of a borrower the opportunity to take steps to maximise the return and minimise the loss for creditors in line with their fiduciary duties.
In a consensual work-out, the borrower will typically retain ownership of and day-to-day control over the asset. However, the strategy for the asset will be decided and agreed between the borrower and the lender; implementation of that strategy being mapped-out and delineated by a series of milestones that are agreed in advance. That agreement is typically documented in a standstill agreement.
The standstill stands at the centre of most work-outs. It gives the directors of the borrower breathing space and a clear basis from which to proceed to implement an agreed work-out plan. This benefits the lender too. By removing an element of uncertainty and restoring, to a degree, a sense of “business as usual”, the directors can get on with the job at hand, without constant worry about their personal position.
Whilst the terms on which the lender agrees not to take action in respect of its debt and security are critical components of the standstill arrangements, the standstill agreement will often contain detailed provisions of the work-out itself. This may include:
- asset-by-asset business plans setting out the proposals for each asset (eg capex investment, leasing strategy, sale strategy);
- a timetable for completing individual tasks (eg appointment of agents, preparation and approval of marketing materials, formulation of marketing strategy and the timing for commencement of a marketing process); and
- detailed budgets and rolling 13-week cashflows.
There will often be regular and detailed reporting requirements to enable the lender to monitor compliance, with non-compliance resulting in the right to withdraw the standstill. As these provisions tend to be operational in nature, lawyers face a drafting challenge in setting a clear boundary between compliance and non-compliance.
If a lender pitches its “ask” too high, it risks the borrower disengaging from negotiations and gambling that it can go “naked” on extant defaults without the protection of a standstill. The borrower may think that the lender's position is not as strong as it thinks — for instance:
- where the lender has shown its weaknesses in its "ask" (eg for enhanced security; which might imply that the lender's existing package is sub-optimal);
- where, in light of the current regulatory environment, there is a hedging instrument in place which the borrower thinks was miss-sold; or
- quite simply the borrower thinks that the lender has not sufficiently provisioned for its loss on the loan and is unlikely to want to crystallise that loss by enforcing.
However, with the cost of capital on defaulted loans being so significant, and banks keen to divest non-core assets, this may be a risky gamble for a borrower to make.
The standstill is essentially a bridging device and a borrower and its directors need to consider carefully what the standstill is a bridge to. Will it result in a liquidation (solvent or insolvent)? Will it enable the borrower to continue other aspects of its business? These are questions that need to be considered at the outset.
For both the lender and the borrower, deciding to proceed with a work-out is a careful balancing act. For this reason, it is not uncommon for both parties to obtain expert advice. Often, this advice will be provided by the restructuring teams of the major accounting firms. The advisors will also undertake detailed contingency plans which can be implemented if the work-out fails and supply a base case against which the work-out case can be compared.
In a work-out the lender will often be able to mitigate the risk of adverse PR which commonly arises on enforcement. The lender can to a degree control the flow of information from the borrower to the market through the standstill, keeping the arrangements private. Not least, this is necessary to avoid precedents being set for future workouts. The lender's role can be presented as supportive, allowing the borrower the time, flexibility and occasionally funding required to implement a lender approved strategy for the realisation of assets and the eventual wind down of the borrower's business. From the directors' perspective, there is no black mark against their name from being associated with a “failed” business. The outside world looking in will see the borrower maintaining control of and winding down its business and assets allowing the borrower to exit its position with a degree of respectability. The standstill also affords the borrower the opportunity to consider its other key stakeholders such as employees and how any losses that they suffer may be mitigated by for example implementing a phased redundancy process.
Additionally, it avoids the risk of cross-contamination from an insolvency process into other parts of a borrower's business. Being associated with enforcement could have a commercial impact on counterparties trading with the borrower and/or it could trigger cross-default provisions in arrangements with other lenders or key contracts.
In order for such a regime to work in practice, it will be necessary for the lender to consider the position of the borrower's other creditors (both secured and unsecured). Property-related creditors will have to be kept whole to preserve the value of the real estate asset. For example, head lease payments, VAT, service charge and insurance will all have to be paid, along with the fees of any managing agents (unless they are being replaced). Under most real estate finance structures, these costs are typically already deducted from the income generated by the asset before it is available to the lender to service the debt, and so should not be felt by the lender. Depending on the corporate structure of the borrower and how its debt is structured and collateralised, the consent, and standstill, of other secured creditors may also be required in order to prevent them forcing an insolvency process of the borrower or otherwise disrupting implementation of the work-out. Unsecured creditors may also require a financial incentive to stay their hand and avoid any winding-up petitions. It will be a judgement call for the lender as to whether the benefits gained outweigh the financial expense of advancing new monies to the borrower which may never be recouped, or permitting cash “leakage” from rental income to them. This can be a bitter pill if creditors who would be economically disenfranchised in an insolvency process would be funded through the work-out process. Conversely from the borrower's perspective, if the lender is willing to make available funds which can be used to repay those creditors (and no creditors' position is worsened as a result), the directors will be achieving a better result for those creditors and, in doing so, can further justify their decision to agree to the work-out.
Added to this is the cost of incentivising management to ensure that they are adequately compensated for the increased risks that they are assuming throughout the process, the increased stress and time commitments that are inevitably placed on them and to ensure that they remain motivated and their interests aligned with those of the lender. This may be unnecessary if the directors hold equity and there may be a return for them at the end of the work-out, or if the work-out facilitates the continuance of another part of their business. In any event, the directors' conflict position will have to be monitored by them to ensure that they are compliant with their duties at common law and statute. The borrower's advisers costs will also have to be met and, if the final exit is terminal (through a liquidation process or strike-off), provision will have to be made for those costs as well.
There can be economic advantages for the lender in pursuing a work-out which will mitigate and may outweigh the cost of leakage to other creditors. The borrower owns the assets that it will be disposing of and it should, therefore, have detailed knowledge of, and possess (or be able to obtain from its agents) information relating to such assets. In a non-consensual insolvency process, where there has not been a prior transfer of knowledge and information, reconstructing that knowledge and information can be costly and time consuming. Depending on the nature of the asset in question this lack of knowledge and information can have an adverse effect on the level of realisations as buyers will inevitability factor in the risk of the unknown into their pricing. In addition, retention of the corporate holding vehicle during a managed hold or staged disposal process may have other economic advantages, such as offering buyers the opportunity to structure an acquisition in a more tax efficient manner than could be achieved once an insolvency process has commenced.
Consensual work-outs may be desirable or necessary (for lenders) in situations where the lender's security package is less than perfect. For example:
- the security package may not be comprehensive (eg share charges and not asset-level security, or vice versa), reducing the lender's options in an enforcement scenario;
- offshore tax structures are involved, and the debt is secured against non- UK real estate. For lenders used to the ease and convenience of English law enforcement processes, the more debtor-friendly regimes in, for example, continental Europe, may be less attractive;
- there may have been a failure to register the charges at the Land Registry or Companies House (so that the security, whilst valid against the borrower, would be void as against a liquidator or administrator of the borrower); and/or
- the lender may simply have lost the loan and security documentation and so be unable to make an appointment.
In such circumstances, a work-out can present an opportunity for the lender to maximise its recoveries which it may be unable to do by commencing a formal insolvency process.
The obvious risk with leaving assets vested in the borrower is that the lender has to trust the borrower to act in its interests. The lender must have faith in the borrower that it can and will deliver the business plan, and that the borrower will treat the lender as economic owner of the secured assets. To an extent this risk can be mitigated where the borrower instructs agents to manage and sell the assets. In this situation not only has the implementation responsibility been delegated, so that the borrower is one step removed from the assets, but typically the lender would expect any such agents to enter into duty of care agreements with the lender such that the lender has direct recourse to the agent.
As set out above, notwithstanding the fact that the assets remain owned and managed by the borrower the lender exercises a degree of control through the standstill. The degree to which the lender exercises control should be monitored closely to avoid the lender treading into shadow directorship territory, and inadvertently assuming responsibility for decisions made by the directors. Shadow directorship issues arise where a borrower becomes accustomed to acting in accordance with the instructions or directions of the lender. In a consensual work-out, the borrower should take its own independent advice and should be left to implement the agreed strategy, subject to regular information flows and reporting obligations, and within parameters contained within the standstill/pre-approved business plan. This will afford the lender some comfort, but it is a question of fact and degree, and so the contractual arrangements themselves will only form part of the analysis. The risks can be amplified if, as occasionally is the case, the lender appoints a board observer or nominates an independent director to the board of the borrower to oversee implementation.
The directors of the borrower will be extremely conscious of their statutory and fiduciary duties given that they will likely be insolvent or in the “twilight zone”. Care will therefore need to be taken by both the borrower and the lender to ensure that there is no risk of a preference or transaction at undervalue arising under the consensual work-out structure. In order to protect the lender's and borrower's position it is important that this analysis is thorough and documented in board minutes. Given that the borrower may eventually end up in liquidation, there is a good possibility that such decisions may be subject to scrutiny. Furthermore, as the borrower will be trading in circumstances where it is technically insolvent, it will want to analyse the risks of wrongful trading and ensure that no creditor is put in a worse position as a result of its continued trading. It is for this reason that the lender may need to tolerate the leakage of value to unsecured creditors (as discussed above).
Each consensual work-out is different and poses its own unique issues. However, as recent trends indicate, they are becoming a more frequently used tool as, when used in the right circumstances, they can provide the lender with real benefits.
Corporate Rescue & Insolvency - (2012) 6 CRI 228