Running a business involves taking risks, and deciding what risks are appropriate. A company’s future might be jeopardised by a poor economy, setbacks and/or internal conflicts – and waiting for the tide to turn is not an option. With time running out, the company needs to make choices and decisions to ensure its survival as a going concern. As a rule, whatever the company chooses and decides, it will impact the company and its stakeholders. Doing business in difficult times demands more focus and decisiveness than normal, like playing multiple games of chess simultaneously with different stakeholders. Those stakeholders – including the bank that finances the company – will reconsider their position. The bank will hand over the company’s portfolio to its Financial Restructuring & Recovery department. The closer scrutiny that this brings can be a daunting prospect for many companies.
This contribution explains what Financial Restructuring & Recovery departments do. How do they go about their work? What does it mean if a company’s portfolio is handed over to Financial Restructuring & Recovery? Is the daunting image of this process justified? How do Financial Restructuring & Recovery departments give shape to their duty of care? Lastly, a number of developments are described that are important for distressed companies to bear in mind. The contribution ends with a conclusion and a number of tips for doing business under the guidance of Financial Restructuring & Recovery.
When Financial Restructuring & Recovery will be brought in
Banks regularly monitor their clients, looking at information such as their annual results, half-yearly results and/or financial KPIs. With access to vast volumes of sectoral data, they can compare the results and financial ratios of similar companies in the same sector to determine how their client’s performances measure up against the market and the competition. If depressed financial results cause a significant increase in the credit risk that a client poses, the bank’s Financial Restructuring & Recovery department will become involved. The difficulties might stem from macroeconomic, business economic and/or internal circumstances, for example evolving markets, government-imposed measures, increasing competition, production issues, loss-giving projects/investments, lack of innovation or internal conflicts: in other words, circumstances and situations (either separately or – frequently – in conjunction) with the potential to jeopardise the company’s continued existence as a going concern.
Such difficulties can manifest themselves, and come to the bank’s or financier’s attention, in countless different ways: from successive years of losses to large liquidity deficits, negative cash flows, excessive overdrafts/payment arrears, failure to comply with financial and other stipulations and reports in the media. Banks distinguish between “soft” and “hard” warning signs. “Soft” warning signs generally involve people and their conduct, and mostly surface early on: internal conflicts, high turnover rates at the senior and middle management levels and media coverage, for example. “Hard” warning signs are data and information, such as operating losses, liquidity deficits and profit warnings. Although they are objective, they take longer to come to light, and the root cause will have arisen much earlier. Banks regularly receive financial information from companies, which they incorporate into risk models and use to establish credit risks. This information (deriving chiefly from hard warning signs) is taken as the basis for determining whether the credit risk has increased to a level where the portfolio needs to be handed over to Financial Restructuring & Recovery. However, soft warning signs such as internal conflicts will also cause banks to monitor developments carefully and demand to know what is happening, although this does not automatically mean transferring the client’s portfolio to Financial Restructuring & Recovery.
Transferred to Financial Restructuring & Recovery: what now?
What should a company expect if its portfolio is handed over to Financial Restructuring & Recovery? How should it conduct itself? Although it goes without saying, doing nothing is not an option. Unless action is taken, the company’s finances will continue to deteriorate, and it is vital to stay in constant communication, not only with Financial Restructuring & Recovery but also with other stakeholders.
In some situations, a discussion will arise about whether the company’s survival as a going concern is in fact in jeopardy, and whether the harsher terms that the bank then sets for continued/additional credit are reasonable: if the bank runs more risk it will naturally want to keep a tighter rein on the situation. For example, a bank’s loan documentation will state that an increased credit risk will allow it (among other measures) to raise its interest rate margin/pricing, charge fees and require valuations of security, as well as demanding additional security. The bank will also require restructuring measures as a condition for continuing the credit. It is important to engage in a dialogue with the bank, and to bring in an experienced business economist and restructuring lawyer. Has the credit risk in fact increased? If so, does this justify the harsher terms? Banks have an extraordinary duty of care, and need to consider the interests of the company and third parties, for example the company’s workforce.
How does Financial Restructuring & Recovery go about its work?
For most banks, the Financial Restructuring & Recovery department consists of two units: i) “Restructuring”, which focuses on restructuring and preserving the relationship with the client and ii) “Termination”, which cancels the credit relationship and ends the relationship with the client.
During the 2007/2008 banking crisis and in its aftermath, many companies (particularly SMEs) described unpleasant experiences with how their portfolios were handled by Financial Restructuring & Recovery, the measures that were imposed, communications with clients and banks’ willingness (or lack thereof) to extend credit. Based on those complaints, the Dutch Authority for the Financial Markets (AFM) conducted an exploratory inquiry, and in 2015 announced that no evidence had come to light that SMEs received structurally unfavourable treatment while under the supervision of a Financial Restructuring & Recovery department. However, the AFM also found that the information that was provided about the processes and the degree to which the companies’ interests were considered was unsatisfactory. In response, the Dutch Banking Association (NVB) prepared a “Guidance on Financial Restructuring & Recovery”, with a list of ten items describing how these departments may be expected to conduct themselves. Banks now also publish information about their own Financial Restructuring & Recovery departments online.
In a crisis, it is vital to take appropriate and decisive action despite the pressure of time constraints. Internal and/or external causes need to be identified and analysed before they can be resolved. Key factors here are the availability of cash, an understanding of the liquidity position and realistic cash flow projections. Also important is keeping a tight grip on debtors (which can be achieved through shorter payment deadlines, for example, or by making arrangements about repayment, collecting outstanding debts, factoring, etc.), creditors, inventories and work in progress. This will require a current and reliable management information system (or “MIS”).
Taking information provided by the company and other sources, Financial Restructuring & Recovery will use the warning signs and the underlying causes to analyse how much the credit risk has increased, and in what way, and what the likelihood is that the credit will need to be written off. A key question is how realistic the company’s future prospects are. To answer that question, the company will need to present a restructuring plan. If the current situation and the future outlook are so bleak, however, that insolvency becomes inevitable and restructuring no longer offers a way out, the company’s portfolio will be handed over to the Termination unit within Financial Restructuring & Recovery (see also below).
In the overwhelming majority of cases, the possibilities of restructuring will be explored. This requires a restructuring plan. However, sometimes a company’s finances are in such a poor state that its operations are in immediate jeopardy, without the financial resources to carry on. It is important, therefore, to make arrangements about financing the company while the inquiries are underway and the restructuring plan is being prepared. To safeguard its operations in the meantime, the company will generally need additional credit, combined with a deferment of its repayment obligations. To analyse the company’s credit requirements, the bank will demand not only details of how the situation came about and how it will be resolved, but at a minimum also a substantiated cash flow projection and lists of debtors, creditors and inventories. In these situations, banks will only agree to continue or expand the credit (even temporarily) on strict terms.
Next, the bank will require the company to present a restructuring plan on short notice, within a month or two. At a minimum, the plan must include a presentation about the company, its market position, opportunities and risks (in the market and elsewhere), an analysis of the causes and the starting position, with a view to measures and goals, together with an associated timetable, and the impact on the company’s commercial operation, balance sheet and liquidity, workforce, communications, etc. How the plan will be financed and executed must not be overlooked. How much time will this take? Can the board do it itself, with external advisers? Should a chief restructuring officer (CRO) be appointed (at least temporarily)? Will the bank agree to continue or expand the credit, what changes should be made to the operating capital, do any assets/participations need to be sold and/or should group companies be wound up or merged, should the legal corporate structure be updated, will creditors be offered an extrajudicial composition, will the company reorganise, does it need to agree on a redundancy plan with the unions, what will the shareholders contribute, can the company raise additional equity from elsewhere, could a debt-to-equity swap help, can the company borrow capital from elsewhere? The plan must also describe various scenarios (financial and otherwise): generally at least management case, bank case and worst case scenarios. Which of those scenarios is the most realistic? What built-in safeguards can be incorporated? Scenarios are based on assumptions, and those assumptions might fail to emerge. What allowances does the plan make for that eventuality, how will the plan take shape and what chances does the company have to survive as a going concern if the proceeds from selling a participation fall short of the projected amount by 25%, for example? What are the alternatives? In summary, therefore, a restructuring plan needs to be properly substantiated with economic, strategic, financial and legal data.
The board of a distressed company will need to process vast amounts of information. Outside assistance is vital, to advise, communicate and negotiate with Financial Restructuring & Recovery and to research and draw up the restructuring plan. In fact, Financial Restructuring & Recovery will commonly require the company to bring in an external restructuring adviser and lawyer, and even make this a condition moving forward.
Once the restructuring plan is ready, and arrangements have been made with Financial Restructuring & Recovery/the financier about the plan and the credit (and the terms for providing that credit), the restructuring plan will need to be executed and put into practice swiftly. Carrying out restructuring measures is specific work and a major project, with a significant impact. An external restructuring adviser and lawyer will still need to be involved during this phase, to help with matters such as updating the corporate structure, selling assets/participations, reorganising, agreeing on the social plan and offering an extrajudicial composition, as well as for tax issues, dealing with other financiers/stakeholders, etc.; the board will need to focus its attention on operating the company as a going concern, and providing the bank with regular updates on how the restructuring is proceeding.
All this energy and all these measures should be geared towards structural recovery of the company’s returns. If and when the restructuring has succeeded, the client relationship will be handed back to the bank’s commercial department and the Financial Restructuring & Recovery file can be closed. Companies should remember to make arrangements with Financial Restructuring & Recovery about this in advance, as part of the restructuring and refinancing. That way, it will be clear when the commercial department will resume the client relationship, what results need to be achieved before this happens, and whether the credit will be continued on more favourable terms (including pricing, information, etc.).
If the bank no longer believes that the company will be able to recover/continue as a going concern, the relationship will be handed over from the Restructuring unit to the Termination unit, which will proceed to cancel the credit agreements. At this point, it is strongly recommended to hire a restructuring/insolvency lawyer. If a credit agreement is cancelled, this will have serious consequences for the company and its stakeholders. In many cases, it will mean discontinuing the company’s business operations (at least in part) and in extreme cases might even lead to insolvency. However, even in this phase the bank has an extraordinary duty of care. Is the bank permitted to simply cancel the credit agreement? If it is, has the bank given a reasonable amount of notice and allowed a reasonable amount of time to pay off the credit? Case law provides criteria, drawn from a number of judgments, for cancellation, when banks may cancel credit agreements and what interests they need to consider.
If a credit agreement is cancelled, it is important to negotiate with Financial Restructuring & Recovery and make arrangements about repaying the debt to the bank. This involves preparing exit scenarios and making arrangements about matters such as the timetable for taking out new credit elsewhere, private sales of assets on which the bank has established security, how the credit should be used (if applicable), the terms on which Financial Restructuring & Recovery will agree to relinquish its security rights and (in extreme cases) public sales of the security. Insolvency is an ever-present possibility in these exit scenarios. In some cases, the company will even need to prepare and file for insolvency, which could affect the chances of restarting the operations (at least in part) from insolvency. Again, it will be important to make arrangements about the terms on which Financial Restructuring & Recovery will agree to cooperate, what credit the bank is willing to provide to finance a restart, and on what terms, and for what amount it will relinquish its security rights. If any third parties have provided the bank with security separately from the company/borrower, for example if directors and/or shareholders have provided surety or if third parties have granted mortgage rights, the exit scenario will also need to include arrangements with Financial Restructuring & Recovery about enforcing or releasing those rights.
The position of the board of directors
Where a company’s continued existence as a going concern is in jeopardy, this puts strain on the board of directors, supervisory board and shareholders, and creates unusual dynamics. The board of directors should take the lead in these situations. Its members might fear that they might lose control – or have lost control already – of their company to Financial Restructuring & Recovery. The bank’s people will demand large amounts of new information, lines of credit will be curtailed, a restructuring plan will need to be presented on relatively short notice, valuations will be needed (and have to be paid for), and in some cases further demands will be placed on the board (for example to appoint a CRO) and continued or additional credit will be subject to further terms in the form of pricing, additional security and financial targets that need to be achieved. The board of directors will need to bring in an experienced restructuring lawyer from outside to negotiate these matters with Financial Restructuring & Recovery. The new terms will restrict the company and its directors in their movements, but should never result in the company being effectively managed by Financial Restructuring & Recovery, for example if the bank mandates the appointment of a specific CRO. Financial Restructuring & Recovery must also be aware of this possibility: it exposes the bank to risks of liability that it will want to avoid. So what conditions can Financial Restructuring & Recovery impose? Is the bank justified in imposing those conditions, given the circumstances, and what do they mean for the company’s operation? This is where the bank’s extraordinary duty of care comes in. At a minimum, the board of directors needs to consider whether it is reasonable, sensible and realistic for the company to accept the new terms. Even facing these challenges and difficulties, the board may not abdicate its own responsibilities, and it needs to be critical in its dealings with Financial Restructuring & Recovery.
As has already been emphasised, it is vital for a distressed company’s MIS to provide additional information, including about the company’s liquidity position and cash flow projections, as well as a carefully substantiated restructuring plan. Unless unforeseen government measures or international sanctions cause a sudden loss of revenue, a company’s financial struggles generally will not come out of the blue: as a rule, they are the result of a slowly simmering situation that has gone on too long without being properly addressed. The board should guide and manage the company, and take action as appropriate.
The bank’s duty of care
Banks play an important role in society and the economy. This means that banks – and therefore their Financial Restructuring & Recovery departments – have an extraordinary duty of care, not only in respect of their clients, but towards third parties as well. That duty of care is formalised in various places, including the Dutch Civil Code and specific legislation such as the Dutch Financial Supervision Act (Wet op het financieel toezicht), general banking terms and relevant case law (including judgments on suspending and cancelling credit agreements).
As a rule, the interests of Financial Restructuring & Recovery will run parallel to the company’s own interests, as long as the relationship is geared towards the company’s survival as a going concern. However, their interests might start to diverge if and when the bank decides to cancel the company’s credit: often, this will mean the end of the company’s operations (or at least some of them) and might even lead to its insolvency. Given the impact of cancelling a client’s credit, banks must have sufficiently profound reasons to do so. The decision must always be proportionate and reflect the least severe measure that will achieve the desired outcome. As already highlighted above, one question that the bank should consider is whether the circumstances justify cancelling the credit agreement. If so, the next question is whether the notice period and the deadline for repaying the credit are both reasonable. As established in case law, the bank must give due consideration to the company’s interests, the jobs that the company provides and the company’s stakeholders. If the bank cancels a credit agreement without legitimate grounds, the company will need to take action and the bank will have to be sued – in preliminary relief proceedings if necessary – to reverse the cancellation or claim continuation of the credit.
As promised, this contribution also includes some recent developments that will affect companies in financial distress. The Dutch Act on Confirmation of Extrajudicial Restructuring Plans (“CERP Act” or “Dutch Scheme”, in Dutch: Wet Homologatie Onderhands Akkoord or “WHOA”) is expected to enter into force shortly. The Dutch Scheme provides a facility for essentially healthy companies that are struggling with excessive debt to enforce a composition (instead of requiring a provisional suspension of payments or insolvency) that, once it has been confirmed in court, also has binding effect (within the parameters of the CERP Act) on creditors and shareholders that voted against the composition. Offering considerably greater possibilities for restructuring, the Dutch Scheme will provide companies with a very welcome range of options. It is moreover very topical, considering the harmful impact that numerous companies are suffering as a result of the COVID-19 pandemic and the restrictions that the government has imposed in response. The pandemic has created difficulties for many companies that are essentially viable: the Dutch Scheme could provide a solution for them.
The introduction of Basel IV is another topical development, although it is currently uncertain how it will affect distressed companies. This international regulation contains criteria for the solvency of financial institutions. It will require banks to maintain larger financial buffers for clients in distress. Basel IV will become effective on 1 January 2022. The implementation deadline is five years. It is difficult to estimate what its impact will be on the processes of Financial Restructuring & Recovery departments. It might mean that banks will become more eager to terminate their relationships with financially distressed clients, and might be more amenable to granting discounts to individual clients in exchange for terminating the agreement, to make it more appealing to take out credit elsewhere. However, it might also cause more and more banks to sell their portfolios of “bad performing loans” to non-banking parties. In a recent judgment of 10 July 2020, the Dutch Supreme Court determined that it is possible to transfer claims comprising portfolios of bad performing loans, and that third parties acquiring those claims do not have the same extraordinary duty of care that banks do; instead, they might have a derived duty of care. Depending on the acquiring party’s capacity, it will generally have one interest, and one interest only: to make a profit on the acquired portfolio. One of the paths to achieving that profit is by raising interest rates/pricing on the credit facilities to the maximum extent possible. This means that such methods could be disproportionately burdensome for companies in financial distress, and it will be very important to stay particularly alert to such situations. Considering the circumstances, a higher interest rate/pricing or shorter payment deadline for credit might be incompatible with standards of reasonableness and fairness, and therefore would be unlawful.
Conclusion and tips
Companies whose portfolios are transferred to Financial Restructuring & Recovery face a challenging and highly intensive process that demands decisiveness and action. Although this step is often regarded with scepticism, experience shows that input from Financial Restructuring & Recovery can be positive for restructuring efforts, that these departments have short lines of communication and that this means swifter decisions. In practice, around two thirds of companies handed over to Financial Restructuring & Recovery achieve a successful restructuring, and the client relationship is then handed back to the bank’s commercial department.
So what factors determine the success or failure of a restructuring attempt?
- Doing business is like playing multiple games of chess simultaneously. It requires a clearly defined strategy, for example, and an appropriate level of risk management. Information and warning signals about operations, results, markets, regulations etc. need to be available. The MIS should be up-to-date and reliable, to make it possible to properly manage and guide the company.
- The sooner that difficulties are identified, the more likely it is that appropriate action can be taken that will help to ensure the company’s continued existence as a going concern. Action is necessary, passive reaction is not an option.
- Maintain open lines of communication with key stakeholders, including banks/financiers.
- Do not wait too long to bring in a restructuring lawyer from outside who has the necessary level of experience with assisting and advising companies whose portfolios have been handed over to Financial Restructuring & Recovery.
DVDW has years of experience assisting and advising companies and business owners in financial distress, including in their dealings with Financial Restructuring & Recovery departments. Having previously worked in Financial Restructuring & Recovery, Erwin Bos and Bert Winnemuller are very familiar with how the process works.