Collateralization and Covenant Management: Best Practices for Lenders in Volatile Times


By Raja Sengupta and Dan Massoni

With COVID-19 cases surging in the United States, many small businesses are facing an existential crisis—how much longer can they remain open? A recent survey of 5,800 businesses conducted by the Harvard Business School revealed that the median business with monthly expenses of over $10,000 generally did not have enough cash on hand to cover two weeks of spending.[1] Accordingly, small business defaults have risen sharply to 2.7 percent of small business debt, up from approximately two percent as of 2019. By next year, models are predicting default rates to rise to five or six percent (Fig.1).[2]

While economic stimulus programs have been enacted, some funds from those programs are also beginning to dry out, leaving small businesses in a precarious situation. The Paycheck Protection Program (PPP)—which began April 3, 2020—was designed to cover eight weeks of payroll costs to keep businesses afloat. By April 16, 2020, 1.66 million loans were disbursed through this program. With far more than eight weeks passed and the pandemic still raging, many small businesses will be forced to shutter permanently.

Adding to the mix is the recently enacted Small Business Reorganization Act (SBRA), which has made it easier for small businesses to reorganize under Chapter 11 bankruptcy filings. These two factors mean that, for cash strapped businesses facing a potentially prolonged period of reduced demand, bankruptcy may be an attractive route to managing their debt burden. Lenders thus face a delicate balancing act between leniency and stringency for borrowers in distress. If lenders are too lenient and offer free, extended forbearances and waivers, lenders may eventually find themselves unable to reach the borrower, leaving them in an information black hole. This information black hole could leave a lender with higher than expected write-offs, as borrowers could potentially prioritize paying off other creditors or allow other creditors to collect their assets first in the event of default.

Conversely, if lenders are too strict and demand by-the-book interpretations of loan documents and the covenants within, it may force the shutdown of a business that would have, if given the appropriate amount of time, eventually paid off the loan after their business resumed. Stricter lenders further face negative brand impact, legal fees and potential alienation of future customers that would have been profitable relationships otherwise.

The key to managing this balancing act is workouts. Workouts should be for the benefit of both the borrower and the lender. They allow for the borrower to have time to recoup losses due to COVID-19 and resume normal payments, and for the lender to reduce risk. While ultimately on a borrower-by-borrower basis, determining how to work with each borrower will depend on the lender’s loan book overall and the staffing capacity with which the lender has to work. Manual review of each case should be considered given the tumultuous situation—while models have been tried and tested for earlier contexts, per Ash Gupta, former chief risk officer at American Express: “Lessons from data collected in spring through fall does not guarantee you can survive the winter.”

A review of a loan book should assess exposure by industry, confirm that documentation is sound, and monitor the borrower’s financial health and the condition of collateral. Industries have not been impacted equally by the pandemic. The shutdown has necessarily forced industries with high person-to-person contact to be hardest hit, with the aftereffects most likely lasting the longest. Segmenting your existing portfolio by industry will help assess the exposure within each industry as well as potentially dictate the risk mitigation strategies to take.

For higher-risk industries, consider the level of collateral protection afforded and your systems’ effectiveness in monitoring the collateral. If you are relying on receivables and inventory or construction in process for collateral protection, it is imperative that your systems for monitoring these assets and advancing funds are appropriate and functioning well. Unforeseen gaps in these systems become evident in difficult financial times. In addition, any loans secured by marketable securities should be closely evaluated at this time given ongoing financial market volatility.

Within each industry, a thorough review of loan documents is necessary to determine to what extent borrowers may be, or are likely to become, in default of financial covenants or in breach of representations and warranties or other covenants, or are required to provide notice to their lenders of their current or anticipated circumstances. Further emphasis should be placed upon secured loans, to ensure that liens are perfected and that the collateral can be secured.

Common financial covenants tested quarterly include (i) cash flow cove­nants, such as a debt service coverage ratio, a fixed charge coverage ratio, or an interest coverage ratio, (ii) leverage ratios comparing total debt to cash flow, (iii) liquidity cov­enants, such as availability of unencumbered cash or cash equivalents, marketable securities, receivables and inventory, and/or (iv) net worth covenants. Covenant testing in the duration of the pandemic will likely find many borrowers at risk of triggering a default under their loan documents.

For borrowers who may just need some time for the pandemic to pass and would be unlikely to pass covenant testing this quarter, a workout option that could be explored is a sliding scale extension period. Rather than requiring immediate resumption of normal payments as well as strict adherence to the original covenants at the end of the deferral period, a temporary extension could be made wherein the borrower is required to make interest-only payments. This approach will ensure the borrower remains engaged, and it could potentially serve as a risk indicator or early warning signal that the borrower may default if payments under the reduced terms begin to falter.

Another possibility is to explore securing the loan or requiring additional collateral. Securing debt in this fashion minimizes business interruptions for the borrower while reducing risk for the lender. Ensuring that lien filings are perfected as well as ensuring the lender’s lien priority is known are paramount for this option. While perfected liens guarantee that the collateral can be collected in the event of default, lien priority dictates the order in which a lender will be allowed to collect.

Ensuring the lien filing is perfected is a very exacting task—small typos in the debtor names can often lead to severe consequences and, in some instances, no reprieve for lenders in the event of a default.

Across all UCC filings, almost one in four filings has some sort of error that will cause the lien to be unperfected. Errors encompass mismatches of debtor name, jurisdiction, and/or entity status. Debtor name mismatches, which affect roughly one in five filings, are composed of misspellings, the usage of prior names, or the debtor name on the filing being listed as a trade name, fictitious name, assumed name, or otherwise non-compliant name in the debtor’s corporate charter.

Business entity mismatches are the second-most common filing error, found in 14 percent of all filings. Reasons for business entity mismatches include that the lien is filed against an entity that (i) ceased operations within a state but continues operations in their home state, (ii) underwent a merger, or (iii) changed either their entity type and/or their jurisdiction. Jurisdiction mismatches affect 3-4 percent of all filings.

With that in mind, a simple modeling exercise shows the potential consequences of the issue. In Q2 2020, the six largest banks posted an additional $36 billion dollars in reserves for future loan losses. In total, Accenture estimates that banks could put aside up to $320 billion dollars, 2.4 percent of their credit books, to cover expected losses (Fig. 2).[3] Assuming that, of the $320 billion dollars, 10 percent are commercial and industrial loans secured by collateral, which leaves these banks with $32 billion dollars in loans with a lien filed.

Now, with an average of 20 percent of liens that could potentially be imperfected due to debtor name or jurisdiction errors, there are $6.4 billion dollars in loans that are potentially uncollectable. If five percent of those loans default, lenders could potentially be on the hook for $320 million dollars in loans, legal fees and collection fees aside, as well as potentially opening a lender up to liability for wrongful collection.

While lenders negotiate with borrowers, it may also be prudent to offer resources for their borrowers to tap into government loans, grants, and other aid to help keep them afloat. A key resource lenders could provide is assistance with the PPP forgiveness applications. The SBA launched a portal for forgiveness on August 10th for lenders to seek approval of their PPP loan forgiveness decisions. Aiding borrowers with this application will lead to borrowers being in better shape when they get an actual forgiveness decision, and the lender can utilize their own assessment of the submission to recognize the applications likely to be approved as a lower risk borrower in advance—and perhaps, use that insight to expand the relationship earlier than any other competitor can reach that business.

Networking events could also be introduced for small and medium-sized business owners to share best practices, concerns, and ideas on how to manage through this period. This could be done in tandem with the local chamber of commerce, offering the lender exposure to new borrowers as well.

That said, while workouts should be explored as an option for most borrowers, not all borrowers necessarily warrant the efforts. While the lender can try to negotiate favorable terms, some borrowers will ultimately default due to no fault of the lender and negotiations are key to identifying these borrowers. However, not every borrower will be receptive to negotiations. Selectively filing lawsuits against these borrowers could be used to communicate the severity of the matter and potentially incentivize the borrower to come to an agreement with the lender.

Summary of Best Practices
In spite of the overwhelming volatility in the commercial lending space, there are ways for lenders to mitigate the risks.

First, strong rigor around workouts can benefit both the borrower and the lender and are valuable in mitigating a wave of defaults. Two examples of workout options are to offer a period of reduced payments or securing a loan. However, it’s important to remember that not all borrowers necessitate a workout. Utilize the practice only when necessary, such as when the borrower’s prospects in the future look bright and they are receptive to negotiations.

Lenders should also consider segmenting their loan books by industry and assess risk within each. This allows them to better understand borrower performance within their industry as well as where to focus efforts.

Next, ensuring that systems are in place to effectively monitor collateral and covenants can help ensure a borrower remains engaged in the relationship and, in addition, their continued involvement might eventually serve as a risk indicator.

Although it can be a very exacting task, reviewing both old and newly filed liens to ensure perfection is crucial in fragile economic climates. Small typos in the filing can mean no reprieve for lenders in the event of a default.

Finally, lenders can build stronger relationships during volatile times by offering resources for borrowers, such as networking or federal loan assistance. There are many ways to keep borrowers afloat until they recover. It’s well worth their time to explore all of the available options.

About the Authors
Raja Sengupta is Executive Vice President and General Manager of Lien Solutions. As the chief executive of the business, he leads a growing organization focused on providing search and filing services through its nationwide network and combines the latest technological advancements with deep domain expertise to increase speed and accuracy of end-to-end lien management.

Dan Massoni is former Executive Vice President of Institutional Credit Risk Management at American Express.