Businesses enter into agreements with other businesses all the time. Agreements are made to buy products and services, sell products and services, borrow money, lend money, lease buildings and equipment, and more.
But what should a business do when one or both parties can no longer honor the agreement and defaults? It’s an important consideration, especially in our current environment of economic uncertainty from the Coronavirus.
Here are the things you need to bear in mind…
Understand what the agreement says.
If the agreement is informal, write down what you think has been established. Then go back through notes, e-mails, files and such, to confirm and better understand the specifics.
If the agreement is contractual, read the documents. If you issue or receive purchase orders and order acknowledgements, check those terms, too.
When reading these contracts and agreements,
keep in mind some wisdom a general counsel passed on to me early in my career. I was working for a now merged many times company called Container Corporation of America. The company made paperboard, corrugated boxes and folding cartons. I was in a new group formed to trade paperboard with our competitors to reduce freight and other costs. That meant lots of contracts. Our group was concerned about all the legal implications of things, but the general counsel’s advice was that
all a contract does is set the bargaining table when the contract no longer works for one or both parties.
So, what are the key parts of the contract to review, to establish how the “table” is set?
- What are the basic performance obligations? Loans are simple. The lender provides the money and the borrower pays it back as scheduled with interest and mandated financial reporting. Leases are similar. The landlord provides space and the tenant pays the landlord. Supply agreements say how much one party will supply, the other will purchase and so forth. Here, the key is to understand what both parties are committed to perform.
- What are the covenants? Covenants are conditions one or both parties must meet to stay in the agreement and not default. They can be both positive and negative. In loans, positive covenants usually require meeting certain financial ratios and conditions at specified times. Negative loan covenants typically restrain the borrower from doing certain things, such as borrowing more funds, limits on dividends and so forth. In leases, landlords may be restricted from leasing to a tenant’s competitors; tenants may be required to maintain certain hours of operation.
- What are the cures? This is what a defaulting party must do within a certain period of time to no longer be in default. In a lease, for example, rent that is due on the 1st of the month and not paid can be “cured” if it is paid by the 10th.
- What are the remedies? In secured loans, for example, the lender can repossess collateral, take funds from other accounts and so forth. In the car industry, purchasers of parts often have the right to force a supplier to build, at its expense, a “supply bank” of parts to allow a new supplier time to start making the parts needed. Note, there are likely remedies not specified in the document, but available by statute or common law.
(Note that while the specific
terms used in different types of contracts will vary, they serve the same purpose.)
Understand your situation.
If your company is in default of a loan, or late paying a vendor, can you reasonably expect to resume payments? If your supplier can’t supply what is needed, are there alternatives or not? What are the switching costs? If your business defaults on a lease, what are the landlord’s options? Is the building full and your lease below market, or is the landlord having difficulty leasing space? Would either party have difficulty exercising their remedies (many remedies require legal action that takes time and money)? Also understand your own financial situation. If you are a landlord, how are you financed and do you have flexibility to work with a tenant or not?
Understand your counterparty’s situation.
Your counterparty has its own set of obligations, requirements and constraints, so consider the same questions as above from its point of view. Knowing (or at least, estimating) what these are gives you leverage and the information you need to negotiate your best option, given the current situation.
For both your company and your counterparty, determine whether the default is systemic or idiosyncratic.
I have talked about this
. A default is “systemic” for your company or your counterparty if all borrowers, tenants, etc., and the reverse are in default. With the Coronavirus, defaults are systemic for most companies. Note that a systemic default need not be worldwide; it can be an entire industry or perhaps just a large geographic area, such as after a hurricane.
If it is
just your company or your counterparty, the default is “idiosyncratic.” These strongly suggest the default is a result of poor execution and the other party will have lots of options.
A systemic default suggests the default was beyond the defaulting party’s control. Note, however, that if the default is
idiosyncratic for the counterparty, they likely have more options. So, if your plant is wiped out in a hurricane and you can’t produce, your customer likely can buy elsewhere. On the other hand, if you are a mall-centric apparel company and you default on your lease, since that industry has its troubles and malls are full of your competitors, to the landlord your default is systemic and so the mall owner has few good options, if any. That is why mall owners have been taking over bankrupt apparel companies.
Communicate early and often.
This is key.
Don’t keep the other party in the dark. Be upfront, tell the other party your situation, and explain how it may change over time. This is also true if your counterparty defaults. Reach out to them and find out what is going on and why.
Develop and negotiate a solution.
Ideally, this is consensual and out of court. For example, I was brought into one very distressed company that could not be saved. The principals couldn’t execute well, secured debt was 40% of revenue and they were headed into their slow season, a time that is always cash flow negative. My clients had personally guaranteed the loans and the lenders had mortgages on their homes.
So, we developed a plan to sell the business assets to the big kahuna in the industry (it also picked up the leased trucks), sold the real estate, and the owner of one expensive home took out a second mortgage. This was not ideal for the principals, but if handled differently, both would have lost their homes.
Maintain your individual integrity and that of your company.
Trust is everything in these situations. Don’t make a commitment you know you can’t keep just to kick the can down the road. And make sure you know what commitments you can make. Explain to your counterparty what the risks are, so if later on you can’t make a commitment, it is likely to be for a reason you had already identified. And by the way, incompetence undermines integrity just as much as lying.
Today’s circumstances are unique. Nobody knows how things will unfold or how soon we can expect a return to some degree of normalcy, economic and otherwise. That said, we have seen crises before and, for the most part, the rules for managing safely through them still apply.
Understand what you’ve agreed to, understand what your options are, and move forward honestly and transparently. Your actions today will be remembered by employees, partners, customers, lenders and others for years to come.