Informal creditor workout

Informal creditor workout as the second stage in the timeline of financial distress

Whereas the management-led correction turnaround process is debtor-led, the informal creditor workout is creditor-led. 

It follows negotiated agreement outside the legal framework.

It is effectively an out-of-court settlement between management of a distressed or defaulting company, and creditors on a plan to reduce indebtedness.

While relatively successful, workouts suffer from a number of constraints and practical problems, which can be overcome by formal business rescue in terms of new draft business rescue legislation.  But the latter comes at a huge cost, and carries the stigma of insolvency.

Workouts are best conducted long before insolvency has set in.  This is to allow time for a turnaround to take affect, since workout cannot be conducted if the company is insolvent.

Timeline of financial distress

 

View the position of informal creditor workout in the timeline of financial distress.

 

 

Click on Timeline of financial distress table for a popup table explaining the four stages.

 

Restoration of corporate value

 

View the restoration of corporate value at different levels of company health.

Triggering and managing the informal creditor workout

Should management-led correction not be successful or not take place, the company inevitably gets into a situation where it cannot meet its financial commitments anymore, or where it starts showing signals of its impending inability to do so.

The workout is triggered by creditors acting on events or in anticipation of events such as non-payment of their claims, in response to a breach of loan covenants, or when a company exceeds its overdraft limit. 

Management remains in charge, but the agenda is determined by the terms of the workout agreement.

The workout agreement is normally between the troubled company and its bank(s), although trade creditors are often included.

The role of banks in an informal creditor workout

Workout capability

Banks have strong "special portfolio", "credit recovery" or "intensive care" departments in their credit or risk management structures. 

This capability enables a bank to pick up early warning signals, place special scrutiny on troubled clients, assess risks, provide options to management, evaluate management's turnaround plans, negotiate debt repayment plans, and above all, safeguard the exposure of the bank.

Accordingly, a workout is normally triggered by a distressed company's bank or consortium of its banks rather than by other creditors who do not have similar workout skills. 

Triggering a workout may be preceded by action of other creditors e.g. a trade creditor taking or threatening action, perhaps following a down rating of a company's credit, or following a credit guarantee agency like CGIG withdrawing its support. 

In practice though, the distressed company sooner or later end up trying to negotiate a lifeline with its bank.

Banks may not cross the line

Banks cannot participate in the management or intervene in the affairs of a troubled company, since the rights of other creditors may not be prejudiced. 

Yet, banks have considerable influence on how management of a troubled company will address its problems. 

Banks can, for instance:

  • Make continued and/or further support conditional to an independent review of the affairs of a troubled client, and conditional to the submission of credible turnaround plan.
  • Insist on more regular, transparent, and in-depth reporting and communication.

Restructuring as workout

Restructuring may take place instead of a workout, or as part of a workout.

The objective is the reduction of a company's indebtedness, but avoiding insolvency. 

This is typically accomplished via the disposal of some of its assets, or via an equity injection by current or new investors.

Certain aspects of turnaround management such as crisis management and financial restructuring normally apply. 

However, fixing the distressed company is not necessarily the intention. 

Failure to sufficiently reduce indebtedness in this fashion will, however, exert pressure to develop a turnaround plan to trade out of trouble. 

Restructuring may, of course, form part of a plan to trade out of trouble in the first place.

Workout by trading out of trouble

In a workout, a distressed company's banks negotiate a turnaround plan with management with the objective of keeping the distressed company afloat as a going concern. 

In doing so, they support management, who remains in charge, through refinancing mechanisms e.g. bridging finance, a moratorium on interest, debt payment rescheduling, etc. 

In a multi-banked situation (much more common in respect of corporate clients with professional management teams) a consortium may be formed, but it is not a given. 

In a consortium, normally under independent chairmanship, affected banks join forces to:

  • Ensure a common approach to the problem.
  • Ensure that no single lender steps out of line and prejudices the overall situation for the other lenders.
  • Sometimes spread the risk.

In the absence of a consortium the situation may turn into a free for all which normally ensures liquidation (or business rescue in the new dispensation).

In charge of this type of workout, from the company's side, are the same parties as listed for management-led correction i.e. management or turnaround practitioners, with or without support from turnaround consultants. 

Turnaround practitioners in a workout cover the full spectrum of those with management, legal and accounting orientations. 

Other than creditors (banks, suppliers, Sars) being powerful stakeholders, the existence of a negotiated debt repayment program and more stringent emergency management, turnaround in a workout is essentially the same as for a management-led correction turnaround.

If happening at a listed company, workouts are normally closely followed by the financial press, but it is not always known whether a workout plan is in place.  Workouts in the news are listed in the box on the right.

Banks wish to steer clear from large corporate liquidations because they have become fraught with bad press (CNA, RAG, LeisureNet), have become politically sensitive (job losses, anti-business rescue) and are rather costly.

Informal creditor workouts are quite successful

A UK study on bank-controlled informal workouts found that:

  • 75% of businesses emerge from informal creditor workout and avoid formal insolvency processes altogether (note that in this article the term "rescue" refers to "informal creditor workout" and not to "formal business rescue").
  • The successful 75% are either turned around or they pay their debt by finding alternative banking sources.
  • The process takes 7,5 months on average.
  • The remaining 25% of cases enter some form of insolvency procedure, e.g. business rescue or winding up i.e. liquidation.
  • Turnarounds are often accompanied by management changes, asset sales, and new finance or directors’ guarantees.

Source: Franks and Sussman (see box on the right).

Benefits of a workout

General benefits of a workout

  • Cheaper than business rescue.
  • Flexibility in the absence of legal procedures associated with business rescue.

Benefits to directors and management

  • Secrecy.
  • Avoiding the stigma of a more public formal procedure such as business rescue.
  • Avoiding investigation and challenge of directors’ conduct.

Benefits to banks

  • Banks have a degree of influence over the distressed business that they will not have during business rescue (once new business rescue legislation has been implemented).

Disadvantages of informal creditor workouts

General disadvantages of workouts

  • A workout cannot continue if the business becomes insolvent and directors run the risk of trading recklessly.  With the present ineffective judicial management as the only business rescue mechanism, many a turnaround plan fails because not enough time is available to turn the business before the business becomes insolvent.
  • Creditors willing to break ranks and thereby make the necessary collective agreement more difficult to obtain:
    • No enforceable moratorium on the rights of claimants against the company.
    • No enforceable cram-down and binding hold-out: Dissenting creditors, normally the smaller ones, may derail the workout by by applying for liquidation, or holding out for a better deal by threatening to do so.
  • When running out of time, and when management does not perform according to the turnaround plan, banks run of out patience.  If banks are fully secured, which they normally are, they have little incentive to continue supporting the distressed company.

Disadvantages to directors and management

Although management remains in charge, the agenda is determined by the terms of the workout agreement.

Disadvantages to consultants

Consultants (turnaround, legal, financial etc.) involved in an unsuccessful workout will not be paid be their outstanding fees should the company be placed under supervision in terms of draft new business rescue legislation due to the moratorium provisions of business rescue as contemplated in new business rescue legislation.

Should the business rescue not be successful, the outstanding fees will represent an unsecured claim in liquidation.

This, however, is no different to the current dispensation where an unsuccessful workout results in liquidation.

Disadvantages to banks

By taking the leading role in workouts, banks face a number of problems:

  • Free-riding: Banks normally take the brunt, with other creditors such as trade creditors and Sars free riding - offering little by way of solutions, finance and sharing in the risk during the workout, but sharing in the benefits should the workout be successful.
  • Creditors have to rely on management's promises and capabilities to execute a turnaround plan, and their cooperation.
  • Should a workout not be successful, banks run the risk of being accused of having favoured themselves during the workout.
  • Banks rather than management are blamed if job losses occur as a result of the workout.

Formal business rescue in terms of Chapter 6 of the Companies Bill, 2007 is designed to overcome the disadvantages of a workout by allowing to trade while insolvent, a moratorium on claims against the company, overcoming the free-rider problem, and through cram-down of dissenting smaller creditors.  But business rescue expensive and carries the stigma of insolvency.

Impact of new business rescue legislation on informal creditor workouts

Will business rescue replace informal creditor workout?

At present, a failed informal creditor workout effectively means liquidation since current business rescue in the form of judicial management is a complete failure.  Hence the current reason for the existence of the workout (see benefits of workouts above).

The question can be asked whether formal business rescue, as contained in draft business rescue legislation for South Africa, will totally replace the informal creditor workout when implemented by 2009.

The answer is no. 

The main reason why the informal creditor workout will still be attempted, if it can be commenced with early enough and if it seems viable, is to avoid the high cost of business rescue, especially for smaller firms.

Another reason is illustrated by the UK experience where the Enterprise Act 2002 restricted the ability of banks to appoint administrative receivers under terms of their floating charges, yielding an increased focus from banks on the workout rather than formal business rescue in terms of legislation.

Source: Franks and Sussman (see box on the right).

Similarly, South Africa's draft business rescue legislation has the intent of the troubled company rather than its banks appointing the supervisor in charge with business rescue.

Will the duration of workouts increase or decrease as a result of new business rescue legislation?

Since shareholders, directors, creditors or employees can place a company under supervision in terms of the new business rescue legislation, it is too early to gauge how these dynamics will work in the South African context.

 

Overseas, workouts still take place on a large scale despite the introduction of formal business rescue procedures - it can therefore be expected that the same will happen in SA.


Failure of the informal creditor workout leads to business rescue (see next page) when the distressed company is placed under supervision.  Business rescue represents the third stage in the timeline of financial distress.  Compared to the informal nature of the creditor workout, business rescue takes place within the legal framework.


About turnaround management

Turnaround situations


 

 

Search internet or web site

Informal creditor workout documents

Managing a Workout - How Creditors, Shareholders, Regulators and Managers Interact (2003) (50k)

Statement of Principles for a Global Approach to Multi-Creditor Workouts (INSOL International, October 2000) (363k)

The Cycle of Corporate Distress, Rescue and Dissolution: A Study of Small and Medium Size UK Companies (Julian Franks and Oren Sussman, 19 April 2000) (121k)

Informal creditor workouts in the news

04-06-18   Financial Mail: Banks can play essential role

What is happening with workout in the UK

Second, after much discussion, the UK's Enterprise Act 2002 received Royal Assent on November 1.

A comprehensive overhaul of insolvency procedures, reform provisions restrict the ability of lenders to appoint administrative receivers under terms of their floating charges and remove the Crown's preferential rights in all insolvency situations.

These provisions largely relate to situations after the point at which a successful turnaround might be achieved.

However, they have prompted lenders to begin thinking about how to act earlier to avoid losing the ability to appoint receivers to recover their loans.

This has led to a third factor that will contribute to the growth of the turnaround management profession, the development of specialized teams within major UK banks to address client underperformance.

As a result, banks are gaining expertise in recognizing situations that may benefit from a turnaround or workout.

Similar scenarios a decade ago would have landed a company in receivership.

All of the banks now have experience with clients who were in difficulty but were turned around and returned to the good loan book. UK banks are nevertheless taking very different approaches.

Some see their recovery units as major fee earners.  They adopt a "hands-on" approach, working closely with management and its advisors.  They also typically restructure their exposure in a way that gives them substantial equity opportunities in return for some loan write-offs.

Other banks have invested effort in referring problems at early stages to their intensive care teams.  At that point, they should be able to recover their money without resorting to a financial reconstruction.

From: The Cycle of Corporate Distress, Rescue and Dissolution: A Study of Small and Medium Size UK Companies (Julian Franks and Oren Sussman, 19 April 2000) (121k).