Short-Term Debtor/Creditor and Insolvency Considerations

9 min

The Venable Bankruptcy Group is mobilized to help you address debtor, creditor, cash, insolvency, and director/officer obligations matters, and related questions—including eligibility for emergency funding—during this uncertain time. Below are examples of the kinds of questions we have been addressing and that we anticipate in the coming days. Of course, these are generalizations, and any specific situation would need consideration and analysis. This is an unprecedented situation, and our thinking will likely evolve over time. As a general matter, we think efforts of creditors to attempt to aggressively enforce remedies for default related to the COVID-19 crisis in the very near future will be minimal and will mainly be reserved for unique and pressing circumstances. Nevertheless, there will still be significant consequences for decisions made during the short term by businesses on both the lending and borrower sides, as well as by those businesses that may be planning to sell or purchase distressed assets.

1) Our borrower cannot make its debt service payment. What should we do?  Or, we cannot make our debt service payment. What should we do?

Federal and state agencies and authorities are starting to temporarily limit lenders' exercise of remedies for pandemic-related defaults. While the focus of the limitations has been on residential real estate, some limitations also apply to commercial real estate.  For instance, New York recently announced (a) that regulated banks will need to grant borrowers payment deferral requests for 90 days, and (b) an indefinite moratorium on judicial foreclosures. Even where these restrictions are not in place, immediately enforcing all remedies could be viewed as aggressive during the COVID-19 emergency and may be poorly received if not warranted by facts specific to the case. Still, one should consider loan issues now. Lenders and borrowers need to understand whether the borrowers are in default under their loan documents, what those defaults may be, and what rights the parties have with respect to them. Has the borrower missed a payment? Is the borrower in violation of a debt ratio covenant? Is the borrower in violation of another covenant, if its business is currently shut down? Are there notice or cure periods related to any defaults? If the borrower is in a forbearance period, is it prepared to address what happens when the forbearance period ends?

Parties may enter into forbearance agreements, potentially providing for the turnover of any cash flow, and may put cash management measures in place. For loans with reserve accounts, forbearance agreements may contemplate the release of some amount from reserves to be paid toward debt service, with the borrower being required to replenish the reserves later. There are case-by-case considerations, but, as a general matter, this is an opportunity to provide some certainty for both sides.

If you lend to businesses in hospitality, transportation, retail, energy, construction, or other affected areas, or if you operate such a business, we can help you understand the ramifications of a default, and evaluate loan documents and potential modifications to the loan documents.

Operating businesses should consider their eligibility for funding from the various contemplated federal and state emergency funding vehicles, as there is also relief in the form of loans and grants available to some companies facing a liquidity crisis as a result of the pandemic. Understanding what funds will be available and the timing of the money will inform your conversations with existing lenders.

2) We do not have enough cash to pay all of our obligations. Who should we pay first?

This is a fact-intensive analysis that can be complicated and should be considered on a case-by-case basis. Consideration needs to be given to both legal and practical limitations. On the legal side, what are the ramifications (e.g., interest, penalties, acceleration) for not paying certain obligations like debt service (discussed above), leases (discussed below), and financed equipment? Keep in mind that when a company is insolvent, and often in the period approaching insolvency (the "zone of insolvency"), the directors' and officers' fiduciary duties extend to all stakeholders, including creditors, rather than just to shareholders. Companies in the zone of insolvency can typically choose to prefer one creditor over another, or groups of creditors over others, such as critical vendors. From a practical standpoint, which suppliers are going to stop delivering (or demand the return of goods) if there is a disruption in payment or insolvency exists? Can a supplier be deemed critical? Can employers pay their employees or are pay reductions or reductions in force necessary? Will there be WARN requirements? Can a deal be struck with some creditors but not others? Can certain services be reduced or terminated during this period (i.e., can expenditures be reduced, including insurance or other fixed operating costs? Do payroll and/or other employee benefits need to be paid?).

3) We do not have the money to pay rent. What should we do? Or, our tenant cannot pay us. What should we do?

The answers to these questions depend in large part on the relevant jurisdiction. Some states and localities have put a pause on all evictions, including commercial evictions, and the number of these restrictions has continued to grow, including the lack of access to courts for landlord remedies. For practical purposes and appearances, an eviction at this point is unlikely to make any sense, even if it could be done. That being said, it is worth reviewing lease documents and understanding what defaults may be occurring, such as missed payments and going dark, and the ramifications of defaults, such as penalties and the effect on larger issues, like purchase options. For both landlords and tenants, it may make sense to be proactive and enter into some type of short-term agreement to set expectations and offer some certainty, potentially avoiding future litigation.  We expect these issues to come up often, with national restaurant chains already announcing that they are not going to pay rent for April.

4) We think we are or will be in a position to receive money from federal, state, or local governments. How do we go about doing that? What are the considerations for our current debt structure?

Congress has approved a $2T stimulus bill that, among other things, permits eligible borrowers (big and small) access to funding. $367B is allocated for eligible small businesses, and $500B for eligible larger distressed entities. In addition, the Federal Reserve announced its own funding program. The Fed's program will, among other things, provide (a) $300B for support for distressed industry players, (b) cash support for mortgage servicers, and (c) market/securities support by buying treasuries and municipal debt. Our Legislative Group is monitoring these and similar state funding mechanisms to help Venable's clients best understand eligibility standards and the process for seeking assistance. Any borrower with existing debt must also consider whether covenants may need to be waived to accept such new debt.

5) Can we file for bankruptcy in the middle of the COVID-19 pandemic?

Yes. While an immediate filing may not be necessary, given the kinds of moratoriums states are starting to put on loan enforcement, if your business wants to file bankruptcy, bankruptcy courts across the country are open. All are accepting electronic filings and considering time-sensitive (emergency) issues, including "first day motions." The bankruptcy courts in all jurisdictions where Venable has offices—Delaware, New York, California, Maryland, Virginia, and DC—are holding hearings remotely. While the procedures vary by jurisdiction, and some of the courts are prioritizing urgent matters, continuing non-urgent matters, and extending other deadlines, many bankruptcy courts are holding regular hearings by phone or videoconference with little interruption.

6) We want to shut our doors and hand over our keys to the lender. Can you help?

Yes. While there may be some logistical hurdles with the closure of many businesses and the shelter-in-place orders, there is no barrier to approaching the lender and offering to turn over the collateral, if that makes the most sense for your business. We have been brainstorming about paths to a turnover in this environment, including consensual changes in property management pursuant to loan documents. In addition to bankruptcy (discussed above), in these circumstances, and notwithstanding that many courts are reducing non-emergency proceedings at this time, we may be able to convince state courts to consider consensual receivership appointments for commercial real estate. We can help facilitate the turnover of property.

7) Our customer is about to make a payment to us or just made a payment to us, but we fear they are about to be insolvent. Do we need to worry about this?

If a customer pays your business in the 90 days prior to the customer filing for bankruptcy, or within one year if the client is an insider of the customer, then your business may have some exposure to a potential claw-back action, known as a preference, or possibly to a fraudulent conveyance claim. There may be defenses against such claims, including if the payment was made in the ordinary course of business, and/or your business provided the customer with "new value" at or after the time of payment. First, if you are owed money, you should try to collect it, subject to the business considerations of trying to collect in this environment, and any applicable state or municipal order pausing such activity. Even if there does not appear to be a defense against a future claw-back action, it is always better to have collected the debt and deal with later claw-back efforts given settlement negotiations, and the possibility that the claw-back action will never be brought. Second, you should be cognizant of whether the customers' invoices are being paid with timing consistent with pre-pandemic practices, trying to keep customer payments as regular as possible. Third, you should consider developing reserves or letters of credit to protect from downside risk. Fourth, although not available in all industries, credit insurance may be an option and is something Venable's insurance lawyers can address further. If you have concerns about a particular customer, you can consider selling their goods cash-on-delivery or on similar terms. These actions can help protect you if your customer files for bankruptcy.

8) We are considering buying or selling a distressed business. How can you help?

If you are considering buying or selling a distressed business or assets, Venable's Bankruptcy Group can work alongside their transactional colleagues to assist with trying to minimize potential claims relating to fraudulent conveyance arguments, and known and unknown creditor claims.  Venable has significant experience buying and selling assets in bankruptcy cases (known as "363 sales").

Venable can appear in all of the bankruptcy courts in which it has offices, including the busiest bankruptcy courts in the country—Delaware and New York—without the need for local counsel. Venable also appears regularly in bankruptcy courts nationwide, working with an extensive network of local counsel that it has developed in other jurisdictions.

Whether in or out of court, we know these are difficult and sensitive issues. Strategic planning and good counsel now can minimize the pain and disruption to your business. We would be happy to help with these issues.