When times are tough, the tough start restructuring. Restructuring is one of the options that may be available to companies in managing the repayment of a loan.
Like building or renovating a house, debt restructuring has many building blocks and factors. The purpose of this article is to provide a very basic legal foundation of some points that should be considered in relation to debt re-structuring.
In restructuring a debt, there needs to be agreement between the lender and the borrower as to what aspects of the loan will change. They can include the repayment schedule, the maturity date of the loan, the financial covenants and the reporting requirements. For example, in extending the maturity date, the lender may want there to be more reporting in relation to the financial operation of the business, or the parties may agree that the debt service ratio is to change.
The important question to ask about changes to loan agreements (or to any agreement) is whether the agreement is being varied or whether it is being rescinded. The rescission of an agreement means that the agreement is extinguished; the variation of an agreement means that it continues to exist as varied.
Generally under the law, an agreement is rescinded where the changes to its terms are altered to the extent that it becomes an entirely new agreement, which is not consistent with the existing one. It is not always easy to draw the line between a variation and a rescission, and each situation needs to be taken on a case-by-case basis.
A rescission can have potential effects, and neither the lender nor the borrower would want to find that, in restructuring a debt, it has built a house of cards. For example, if a new agreement has been created, consideration would need to be given by both the lender and the borrower as to how the loan is to be treated. That is, does the lender have to book a new loan, and does the borrower have to treat the loan as a new one in its books. If the answer is yes, then there may be, for example, tax or accounting implications for the borrower, and approval and other requirements for the lender.
It is also important to be clear on what the parties intend, and in this regard a variation should be distinguished from a forbearance.
Forbearance in very basic terms is when a lender agrees not to pursue its right to enforce its security. Forbearance normally happens when a default has already occurred. It does not do away with the existing agreement between the borrower and the lender, but is a temporary arrangement whereby the lender gives the borrower time to catch up on its payments. The lender may agree a moratorium on principal for a certain amount of time or to reduced payments for a certain amount of time.
The security is one of the pillars of a loan. It is therefore important to ascertain what effect, if any, a restructuring would have on the security. In previous times, the form of security that was used was like a small house with little room to put more things in. That is, it referred to a specific loan and contained provisions relating to that loan in it, such as the interest rate. It did not create security over other agreements or arrangements that the borrower and lender may enter into.
In modern times, the all-monies form of security is often used by lenders and borrowers. It is bigger and broader, and provides more room to manoeuvre. That is, it would cover variations to existing arrangements and agreements that have already been entered into by the lender and borrower, as well as new agreements entered into between the borrower and the lender.
In certain cases, specific security is still appropriate or may be used at the request of either party. If a loan is re-structured, whether the specific security will apply depend on its form. That is, it may provide for any amendments or variations to the existing agreement, but it may not cover an entirely new agreement. In that case, new security may need to be granted by the borrower to the lender. This factor is of fundamental importance to a lender who will want to ensure that valid security is in place.
In these difficult economic times, re-structuring a loan may be an option for lenders and borrowers to consider. As mentioned above, re-structuring is a multi-faceted area, which can be designed in different ways. Each situation is to be taken on a case-by-case basis in order to determine what needs to be done to ensure that both the borrower and the lender have built a solid foundation and that each of their interests are protected.