All operating loans in Canada are demand loans in nature. Most businesses require an operating line or working capital loan to help fund operations. At the onset of obtaining this type of financing the debtor, or business owner, will sign a number of documents that outline the terms of the loan. Clarity will be provided by the creditor, or lender, in relation to interest rates and terms of repayment. Many times, as a condition of receiving the loan or financing, some type of collateral or security will have been provided by the borrower. Security provides the lender with additional comfort that they will recover their outstanding debt. Common forms of security taken by a lender include personal guarantees; cross collateral guarantees; and finally, the registration of a General Security Agreement (“GSA”) which gives the lender first charge security over all of the borrower’s present and after-acquired property. So, what happens when the bank demands?
Prior To Demand
Most operating lines have some form of regular reporting required by the lender to determine how much of the loan the business has access to on a monthly basis. This type of reporting is referred to as a margin report or borrowing base report. Prior to a bank or other lender actually making a demand for repayment of their loan, there has usually been numerous communication exchanges between the lender and the borrower indicating the lender’s increasing discomfort in relation to the loan. The discomfort of the lender may be derived from what it perceives to be irregular or insufficient reporting from the borrower, it may be a result of concerns related to the borrower’s CRA liabilities, there may simply be a breakdown in the relationship between the lender and the borrower. Notwithstanding the reason, the bank or lender is within its rights to demand at any time.
Enforcement and/or Demand – what is it?
The termination of the lending relationship can take a number of forms. Typically, there has been written or verbal communication between the borrower (debtor) and the lender, most often the account manager, that additional reporting is required, there are some pain points that the bank or lender is noticing and would like to see resolved. If the matters remained unresolved, from the lender’s perspective, they may reduce the amount of margining. An example might be inventory, whereby previously a company could access its loan up to a maximum of $500,000 or 50% of inventory; the lender may reduce the amount available to a maximum $300,000. This “clamp down” or “cap” could have extremely negative consequences on the borrower who depends on the full access for operating capital. It may also have the effect of the borrower being outside of margins, meaning the amount owed to the lender is in excess of the amounts permitted.
Recognizing that the borrower may be struggling, the lending account manager may suggest to the borrower that they engage third party assistance to get the company back on track financially. If the account manager does not see the improvements they need to see, from a financial reporting perspective, they may be forced to transition the borrower to what is known as “special loans” or the financial recovery department of the bank or lending body.
The lender’s special loans team will usually continue to try to work with the borrower to determine if the account can be remediated or brought back on side. They may request again to the borrower that they engage a third-party financial advisor to assist. This request might feel more like a demand, as the alternative may be immediate demand of the loan.
Alternatively, the bank or lender may issue a letter advising that the lending relationship will be terminated effective at a certain date and that the loan will not be renewed. Or, they may issue what is called a Notice of Enforcement, a Section 244 Notice. The section 244 refers to the section of the Bankruptcy and Insolvency Act which requires that a secured lender provide the borrower with at least 10 days notice prior to enforcing upon their security. In the case of a demand or operating loan, the security the lender is relying upon is most likely the General Security Agreement (“GSA”). This security is separate and apart from any Personal Guarantees that may be in place.
Should the loan be called, this does put the guarantors at risk as well as the lender may try to recover its security from the individuals if unable to do so through the corporation.
What Can a Demand Loan be Used Towards?
Each facility agreement is unique, and as such, there may or may not be restrictions on the use of funds. Most often, there are not defined restrictions, though there are best practices and implied expectations. The most common use of a demand loan is to be used as working capital to support day-to-day operations. Prior to funding a demand loan, a lender will usually ask for a summary of the anticipated use of funds. This may include small asset purchases, partnership or investment loans, inventory purchases, day-to-day operations, as well as repayment of bridge financing. Bridge financing is a type of debt intended to be short-term while a company sources longer-term, lower-interest debt.
While not prohibited, a working capital loan is not intended to make large asset or equipment purchases. Doing so will almost certainly put a company in a tight cash flow position as well as risk putting the company in a negative borrowing base position. The borrowing base is the calculation noted earlier, which is determined using the underlying assets. In our example, we used the accounts receivable and inventory as the underlying assets. If the amounts outstanding to the lender are greater than the calculated amount available to the company, they will have maxed out their facility meaning the lender will make no further advances.
Some advanced demand loans will include direction on the use of funds, for example, paying out an existing creditor with the first advancement of funds. The lender is looking to better leverage its security and ensure that a company is not overextended on its liabilities.
Next Steps – Options
Engage a Third-Party Financial Advisor
If you have been transitioned to special loans, but the loan has not been demanded upon or notice of non-renewal of the loan has not been received, then you may still be able to repair the relationship with your lender and graduate back to regular banking and accounts. Banks and lenders work hard to gain their clients, their preference is to work with borrowers to keep them at their institution. Assuming the financial position of the company can be improved upon and the relationship between lender and borrower is still workable, then this is a viable option. The lender will often take comfort in the borrower engaging a third-party financial advisor who can provide an additional level of assurance to the lender that the borrower is proactively taking steps to get back on track. A third-party advisor can also act as a buffer of sorts between the borrower and the lender to smooth out any recent misunderstandings or mistrust between the parties. The advisor can provide the borrower with some tangible advice and suggested improvements and give the lender insight into the company. It is advisable that the borrower confirm with the lender that they are comfortable with the proposed financial advisor prior to engaging and paying one as if, for some reason, it is not an advisor the lender trusts their input may not be valued or relied upon.
Source New Debt - Refinancing
Sometimes the lender just wants to see a reduction in their exposure. Maybe they are comfortable to keep their term loans but want out of the operating loan, or there are a number of loans and they want to see only some of them repaid. Of course, if the current terms of the operating line, because the margining has been reduced, or you have been advised that the loan will not be renewed, then the borrower will want to source new financing. Often times this option has been suggested to the borrower in advance of a transition to special loans. The borrower may have tried to source new financing on their own or have promised to do so but has not. The reality is that it is far more difficult to source new debt or refinance on your own if a borrower is in special loans.
How much time a borrower has to source new financing prior to a lender enforcing depends on the lender, the borrower, and the state of the relationship between the two parties. Lenders rely heavily on “management integrity” and are far more likely to have patience if they trust the borrower is acting honestly and making best efforts to comply. The lender will also have a higher level of comfort, which translates to patience and time, if a third-party financial advisor is engaged by the borrower to assist.
S.244 Notice of Enforcement
Receipt of this notice is typically a precursor to Receivership, a court-mandated process. It is effectively advising the borrower that at the end of the 10 days’ notice, sooner under certain circumstances, a Court Appointed Receiver will be appointed by the Court on application of a secured creditor to take possession or control over all or substantially all of the assets of business. This outcome may be delayed or avoided, after the S244 notice is received but prior to the Court application, through active communication with the lender and lender’s legal counsel is unquestionably required. Typically, a delay will involve the execution of a Forbearance Agreement. The Forbearance Agreement may contain additional provisions such as forbearance fees, monitoring fees, an increased interest rate, and covenants to be met.
Conclusion
There are options available should a demand loan be called or if an operating line is prohibitively reduced. It most likely involves debt refinancing and open communication with the lender. Engaging a third-party financial advisor will often buy the borrower the extra time that may be required to take the necessary next steps to either source new debt or provide the lender with the additional comfort and reporting it requires in order to continuing supporting the borrower. Remaining transparent and communicative with the lender is the best course of action to avoid more aggressive recovery efforts on the part of the lender and will mitigate the exposure to any personal guarantees.
