Workouts Are Good Medicine for a Sick Business

by Roger Hughey

“Workouts” don’t just happen at your local health club; they happen in business too. A workout is a negotiated means of fixing a troubled loan. Typically, a business (let’s call it “Widgets”) finds itself with so much debt it can’t keep up. Its banker (“Lender”) notices and begins to worry.

Both Have Something to Gain/Lose

They each have a big concern. If Widgets can’t get out of its debt problem, it will fail and have to close or be taken over; its employees will probably lose their jobs and its stockholders will surely lose their investment. And if Widgets fails, Lender will probably not recover the money it loaned to Widgets, much less its interest.

The relationship between Widgets and Lender has changed, too. Lender is in business to make money, not just to break even on its loans, so it needs to head off the problem before it is too late. It cannot afford to care about the friendship that has developed over the years with Widgets’ management. Management wants to save its investment and its reputation and is no longer quite so concerned with taking care of Lender.

Each party is thinking about the worst case scenario. Lender’s big stick is its collateral. If Widgets has granted a mortgage on its business location and security interests in its bank accounts, receivables, machinery, fixtures and vehicles, then it cannot stop Lender from eventually taking over the business. Lender can fire management and either put new managers in place to run the company or sell it as a going concern. Or Lender can simply shut the business down and sell off the collateral in pieces.

Lender has a bigger stick if Widgets stockholders gave Lender their personal guaranties of the loan; then they are directly liable to repay the loan even if Widgets cannot. The most leverage, in addition to everything else, is if the stockholders gave Lender a pledge of their stock in Widgets, in which case Lender has lock, stock and barrel.


Widgets has a big stick too: bankruptcy. As most borrowers in financial trouble, Widgets is entitled to file for protection and reorganization under the United States Bankruptcy Code (“the Code”). The customary business bankruptcy proceeding is a “Chapter 11,” which is designed to facilitate the debtor’s reorganization. The key element is a reorganization plan that is approved by the Bankruptcy Court, after input from creditors. Under supervision of the Court, the debtor can continue to operate its business without interference from creditors. The debtor and the Court can restructure debts by reducing interest rates, reducing or stretching out principal repayments or adding new debt to property that had equity. Unsecured creditors always have to give up some or all of their right to be repaid. The bankruptcy proceeding almost always lasts several months, and the bankruptcy plan can last for years. Compliance with the Code and terms of the reorganization plan adds expense to the business operations. If Lender has a solid collateral position, it can limit Widgets’ flexibility in developing a plan or prevent a reorganization, because the Code is very protective of secured creditors’ rights. However, even though Lender is not much worse off with Widgets in bankruptcy, it is almost certainly no better off. A borrower that is not making money will sooner or later cost its lender money. And if a business has kept a large part of its assets free of liens, it has more room to maneuver in a reorganization.

The Workout—An Alternative to Bankruptcy

So with each side holding a big stick and worrying about the worst case, each has an incentive to make a deal—to work out a plan to salvage the business and the loan. A workout plan can look a great deal like a bankruptcy case reorganization plan, but it is negotiated, not forced by bankruptcy or foreclosure. Each side gives up something and receives something. Typically, Widgets will have some assets it has not pledged to anyone and some stockholders who have not signed a personal guaranty; Lender will ask for that additional collateral. Widgets will ask Lender for assurance of more time to get on better footing and for some of the financial concessions that might be in a bankruptcy plan. Lender will insist on rights to monitor Widgets more closely and on a time limit. Each party will insist on remedies if the other does not perform the new promises. Don’t try this at home; the detail can be extensive.

What drives a workout is the mutual understanding that each side has a big stick but only wants to use it as a last resort. Like any business deal, everyone can wind up better off.

(Article appeared in Adams Jones August 2008 Newsletter)