Forbearance as part of a lender's toolkit

Enforcement action in response to a customer default (or pending default) is often the least desirable option from a lender's perspective. There are alternative arrangements that you may consider when determining the appropriate response to a default, and potential wins from implementing a well thought out and structured workout plan (whether the strategy is to retain or exit the customer) through a formal forbearance arrangement.

In this article, we describe what a forbearance is, when it is appropriate, some of the commercial justifications for forbearing and why it is critical that a forbearance arrangement is carefully considered and properly drafted. We also suggest some practical tips (for both lenders and their customers) to assist in determining whether a forbearance is in the best interests of all stakeholders.

What is a forbearance?

In a lending context, a forbearance is an arrangement (sometimes called a business support agreement, a standstill or part of a wider restructuring agreement) by which a lender agrees to forbear from exercising the enforcement rights available to it by reason of the customer's default under the finance documents. The quid pro quo is that the lender will often require the customer to do certain things within defined time periods.

Often the key objective of such an arrangement is to give the customer a period of time to depart from strict performance of its contractual obligations and to:

• give time to lenders to properly assess their position (often with the assistance of suitably qualified legal and financial advisors) without the threat of other financial creditors from taking enforcement action;
• allow for a workout plan to be structured and then implemented; and
• create stability and a level playing field among lenders so that no single financial creditor takes precipitous action and steals the march on others.

A forbearance which results in a standstill period will often be accompanied by a number of conditions which the customer must perform in order to remedy the circumstances of the default. Those conditions may extend to the customer delivering a written plan of how and when it will remedy the circumstances of the default and return the lending relationship to the status quo existing before the default.

If the customer does not comply with the forbearance conditions to the lender's satisfaction, the forbearance will come to an end and the lender will again have the option of taking enforcement action under the finance documents to recover the debt due and owing to it.

Forbearance as the key to unlocking value

A successful corporate turnaround or financial restructuring typically requires a plan to remedy the circumstances of the customer's existing or looming defaults, as without that, there is a risk that the lender or secured creditor will exercise enforcement rights, typically by way of receivership, and selling the customer's assets.

A forbearance arrangement is a useful instrument to ensure that both the lender and the customer are aligned on the proposed turnaround or workout, so that the customer has the comfort that the lender will allow it time to implement the turnaround or workout conditional on the customer satisfying its obligations to the lender under the forbearance arrangement. The forbearance may initially provide for only a short standstill period so that the customer can have some breathing room to devise a more substantive plan which, if the lender is agreeable, can result in a longer term forbearance arrangement, allowing for time to implement the plan.

Commercial justifications for forbearing

The commercial justifications for parties to enter into a forbearance are many, with the preservation of value (or prospects of realising future value through implementation of a workout plan and improved efficiencies) and the relationship being the most common and fundamental. The benefits of a period of forbearance include:

1. avoiding an immediate breakdown of the lending relationship by providing certainty to the parties as to the future direction of that relationship;
2. providing both lender and customer with the time to properly consider their options in relation to the existing indebtedness and future lending requirements; and
3. providing an alternative to receivership or other formal insolvency appointments, which may erode the value of the customer's business and assets.

Whether a forbearance agreement is appropriate and can satisfy the needs of both the lender and the customer will depend primarily on the nature of the customer's default (typically whether it is a monetary or non-monetary default), and the lender's confidence in the customer's ability to remedy the circumstances of the default, often including restoring debt to manageable levels and ensuring future debt serviceability.

A forbearance arrangement is often preferable to a variation to the finance documents simply because the circumstances giving rise to it are capable of remedy and may only be temporary, so it may be quicker and more cost-effective for a lender to offer a period of forbearance where the minor departure from the terms of the finance documents does not necessitate a significant variation to the existing finance documents. Further, a forbearance arrangement can introduce contextual flexibility not provided for in the finance documents.

So long as the forbearance is linked to realistic and achievable conditions which result in the circumstances of the default being remedied, the lender is protected during that short period, and retains its rights to enforce if the conditions of the forbearance are not met by the customer. The customer benefits from the reprieve from enforcement, as it can still conduct its business for a period of time (often subject to heightened cash flow and operational monitoring and supervision from investigative accountants) with a view to returning to a regular relationship with the lender.

In the second part of the this article, we'll look at some of the risks to forbearance, and the practical issues to consider when using it.