Running a business is a rollercoaster. While the highs are exhilarating, the lows can be daunting, especially when debt becomes overwhelming. Think retail industry restructuring including Toys “R” Us, Sears, and JC Penny, airline and pandemic-related debt, energy sector volatility, and technology and startup failures. These are examples of situations where banks have likely been involved in business debt settlement with well-known companies.
What is business debt settlement?
Debt settlement is a process where a company negotiates with its creditors to pay off its debts for less than the full amount owed. It’s a way to restructure debt, potentially avoiding bankruptcy and legal actions. This can apply to various types of business debt, including credit lines, vendor bills, accounts receiving financing, outstanding invoices, and business loans from lenders. Compared to filing for bankruptcy, debt settlement can often be a faster and less costly process.
Business debt settlement can be a tricky area for lenders
Banks face several risks when dealing with business debt settlement, presenting a range of concerns they need to navigate carefully. Here is what lenders typically worry about:
Loss of principal and interest: The core of debt settlement is that the business pays less than the full amount owed, directly impacting their bottom line. Moreover, banks make money on the interest accrued over the life of a loan. With a settled debt, they forgo a portion of that future interest income, affecting profitability.
Increased risk of default: Businesses seeking debt settlement are often already in financial trouble. This raises concerns about the increased likelihood of the business defaulting on the settled amount or other obligations, leading to further losses for the bank.
Impact on loan portfolio: If a bank agrees to settle a business debt, it might set a precedent for other struggling borrowers. This could lead to a surge in settlement requests, affecting the overall performance of the bank’s loan portfolio. Furthermore, high rates of debt settlement within a particular loan category can signal broader economic issues or weaknesses in the bank’s lending practices, requiring adjustments to risk assessment and underwriting standards.
Administrative and legal costs: Business debt settlement negotiations can be time-consuming and require significant effort from bank staff, adding to administrative costs. And if the settlement agreement is breached or disputes arise, the bank might incur legal costs to recover the remaining debt.
Reputational damage: While banks often work with struggling businesses, aggressive debt collection tactics can negatively impact their reputation.
Regulatory scrutiny: Regulators keep a close eye on how banks handle debt settlements to ensure fair and consistent treatment of borrowers, preventing discriminatory practices, while banks need to maintain thorough documentation of the settlement process, demonstrating compliance with relevant laws and regulations.
How distressed loans and trading documents fit in
Distressed loans can be part of a business debt settlement. These are loans where the borrower (a business) is facing significant financial difficulties and is at risk of default.
Distressed trading is an investment strategy that involves buying debt or securities from companies that are struggling financially. The goal is to profit from the company’s eventual recovery. A distressed trading document is a legal document used to facilitate the sale of a debt security, like a loan, when the issuing company is considered to be in financial distress, meaning they are nearing bankruptcy and the security is trading at a significantly discounted price compared to its face value; these documents are typically standardized by organizations like the Loan Syndications and Trading Association (LSTA) and include specific terms and conditions tailored to distressed situations.
Distressed trading documents, while not directly part of a business debt settlement between a company and its creditors, play a significant role in the broader context of distressed debt and can indirectly influence the settlement process. These documents facilitate the buying and selling of distressed debt, such as loans that are at risk of default, and provides a market mechanism for valuing distressed debt.
Strategies to mitigate lender risk
Mitigating lender risk when dealing with distressed loans and trading documents as part of business debt settlement requires a multi-faceted approach, with key strategies as follows:
Robust loan origination and monitoring: Before extending a loan, banks must conduct rigorous due diligence on the borrower’s financial health, industry, and management team, and actively monitor the financial performance of their borrowers.
Proactive distressed loan management: When a borrower shows signs of distress, banks should proactively engage with them to understand the situation. Early intervention can help prevent the loan from deteriorating further, which may include developing workout strategies for distressed loans, which may include restructuring the loan terms, negotiating a debt settlement, or pursuing foreclosure or bankruptcy.
Prudent distressed debt trading: Banks that participate in distressed debt trading need to have a deep understanding of the market dynamics, including the factors that drive prices and the risks associated with different types of distressed debt.
Legal and regulatory compliance: Banks need to stay informed about the legal and regulatory requirements related to distressed loan management and trading, including bankruptcy laws, lending regulations, and securities laws.
Risk management framework: Banks should have clear policies and procedures for managing distressed loans and participating in distressed debt trading, and should implement appropriate controls to mitigate these risks.
By implementing these strategies, banks can effectively mitigate the risks associated with distressed loans, while maximizing their potential for recovery in debt settlement situations.
Delivering assured outcomes
Business debt settlement presents a complex challenge for banks. They need to carefully weigh the potential losses from settling against the risks of further default or bankruptcy. Banks also need to consider the broader impact on their loan portfolio, reputation, and regulatory compliance.
They need not go it alone, however. By partnering with specialized providers offering par and distressed bank loan and trade claim settlement services to the leveraged loan markets, for example, lenders can reduce processing time, thereby reducing counterparty risk, improving funding and liquidity management, and mitigating regulatory capital requirements.
Contact us to see how LexLoan, UnitedLex’s loan closing and trade claim settlement services and one of the largest loan settlement operations in the U.S. and EMEA, can help your organization.
