Keeping Vendors Informed During a Turnaround Engagement
What (and When) To Tell Them
By Mark Pfefferle, CTP, Partner and Walter Denekas, CTP, Managing Director,
Carl Marks Advisory Group, LLC
Originally published in the Journal of Corporate Renewal, July 2009\
The relationship between turnaround professionals and a client’s lenders can have a significant impact on the outcome of an engagement.
Lenders have a considerable financial stake in a corporation and need to feel confident that their loans are secure, or at least that their positions are not worsened. Consequently, it’s crucial to establish and maintain trust with lenders from the start of an engagement.
Many times, the only reason for a lender’s continued support of a company is its belief that the turnaround professional represents the best hope for maintaining or maximizing the recovery value of the client’s loans.
A company’s reporting obligations to its lenders customarily are set forth in its credit agreements and include representations and warranties, affirmative and negative covenants, and events of default.
Lenders expect to receive reasonably complete, accurate, and timely information about a client’s fiscal health and prognosis for recovery. They want to hear about any significant developments, good or bad, as soon as they occur.
Obviously when the news is good, or at least better than expected, delivering a straightforward report is easy. The bad news is harder to share, but, when it is delivered in an honest, straightforward manner, it gives lenders crucial information they need to do their jobs.
Being frank about a situation also can foster cooperation that leads to the development of productive options for the client, a goal for everyone involved. This article explores potential client conflicts or questions that legitimately can arise regarding what and when to report to lenders.
Balancing Duties
A turnaround professional’s letter of engagement almost always establishes the scope of engagement, responsibilities, obligations, and confidentiality restrictions between the turnaround professional and the client.
Additionally, turnaround professionals who are members of TMA are bound by the organization’s Code of Ethics. These obligate professionals to act by applicable laws and maintain a sole duty of integrity and loyalty to the client, which prohibits disclosure of confidential information without a client’s consent.
Problems can arise when a client refuses to disclose or authorize the disclosure of information that a turnaround professional believes should be reported – particularly if the information poses materially negative consequences for the company or its lenders.
However, circumstances in which reporting obligations are less clear-cut also may arise. A turnaround professional may be uncertain about the materiality of an event, may hear a significant but unsubstantiated rumor, or may lack adequate facts to determine or properly articulate the seriousness of a potentially reportable problem.
The following hypothetical situations are typical of those that arise daily in the life of a turnaround professional, and can leave even the most seasoned consultant searching for a feasible resolution that appeases both the client and its lender.
Each scenario assumes that the professional has been engaged by the company and is subject to strict confidentiality standards, with no contractual provisions for open communications with the lenders.
Scenario 1: A turnaround professional discovers misreported financial results, fraud, or other illegal or questionable activity.
A turnaround professional who has been hired to develop a 13-week cash flow forecasting process and is reviewing cash requirements discovers and confirms that the client company’s borrowing base is materially overstated.
This is a reportable event under the company’s credit agreement. The professional approaches the CEO and CFO, who at first deny there is a problem. Then, they refuse to report the situation or authorize the turnaround professional to report it to the lenders.
How to respond:
If fraud or other highly questionable situations are encountered, a prudent turnaround professional should seek legal guidance.
Because the turnaround professional in this case is engaged by the company and not by the CEO or CFO, he or she should bring the facts to the attention of the public company’s audit committee and corporate counsel or the company’s board if the business is privately held.
In the unlikely event that those governing bodies refuse to take action, the turnaround professional should consider resigning from the engagement. That will speak loudly in ways that the professional’s words might not.
Scenario 2: A turnaround professional encounters an unverified but potentially materially adverse event.
A professional is serving as the interim CEO of a private company and has been working for two months to complete rescue financing to avoid a Chapter 11 filing. The financing is progressing well and is expected to close in several days.
Rumors of the company’s imminent collapse have circulated in the marketplace, many of them spread by the client’s chief competitor. So far, however, the turnaround professional and the company’s management team have been able to keep customers comfortable.
One evening, the turnaround professional receives a call from a normally reliable supplier. The caller says that the company’s largest customer, who accounts for more than 15% of sales revenue, is in the process of moving its business to a competitor.
The turnaround professional’s heart sinks because this information, if reported – even if it is unsubstantiated – at best, could delay and at worst, kill the refinancing.
After talking with the sales team and making several calls to the customer, the professional is unable to determine if the customer is switching or whether this is just another rumor being spread by the competition.
What should the professional communicate to the lenders and when?
How to respond:
This turnaround professional has encountered a situation for which reliable information likely will not be forthcoming in a satisfactory timeframe, and for which the potential consequences for a client are quite severe.
It is always prudent to research the facts thoroughly, check as many verification points as possible, get advice from trusted counsel, and use one’s best judgment in making this difficult call.
One possible option would be to notify the potential lender and propose that the loan close as scheduled but include contingency language, allowing the lenders to reduce their exposure in some way if the rumor turns out to be true.
Scenario 3: A turnaround professional assesses a notably different prognosis for a company’s financial stability and prospects for future health than the client admits.
A company hires a turnaround professional to validate its business plan and prepare a report for its lenders that justifies additional borrowing required for the business to continue operations.
The professional’s review of plan assumptions, operations status, market and competitive conditions, working capital requirements, and other facts of the plan leads to a different conclusion than management’s about the condition and prospects of the business, perhaps to the degree that obtaining additional financing will be impossible.
The CEO of the client company makes several thinly veiled threats about what the company will do, including refusing to provide the report to the lenders and withholding further payments to the turnaround firm if the consultant does not change his conclusions.
How to respond:
Preparing realistic financial forecasts, particularly in a business turnaround situation, is difficult at best. Professionals who are too conservative in developing underlying assumptions take the risk that lenders will constrain the liquidity needed to execute the turnaround. If they’re overly optimistic, they risk losing their credibility and that of their firms with the lenders.
As they proceed with their work – from start to finish – the turnaround professional should review their analyses and related conclusions continuously with management, consider the executives’ point of view, and try to reconcile their rationale and differences of opinion before making conclusions.
However, it is never acceptable practice for turnaround professionals to compromise simply because of pressure brought by management.
Scenario 4: A turnaround professional discovers that a company has overstated its inventory collateral.
A client company has reached the limit of its borrowing capacity. Each day’s checks are restricted to the availability generated the day before from sales and inventory receipts.
The turnaround professional and the company CFO are working closely on this turnaround engagement, spending long hours on the job and trying to do the right thing.
One day, the team uncovers the possibility that the inventory collateral is overstated. Perhaps, purchasing placed a purchase order for material that already should be in stock, or the warehouse personnel complained that they can’t find the listed inventory.
How to respond:
If there is collateral shrinkage, the company must inform its lenders, who could well be within their rights to reduce the company’s availability for the reduction in collateral.
What if the information is wrong? What if an unusual purchase was intended to replace a defective shipment? What if some inventory simply was put in the wrong bin?
A liquidity crisis triggered by a false alarm, even one that lasts only days, could lose sales, cause it to miss its payroll, or even force the enterprise into bankruptcy.
This kind of mistake also exposes a turnaround professional to potentially severe legal repercussions.
Moreover, even if one is convinced that inventory shrinkage has occurred, how serious is the problem? Guessing wrong could jeopardize a professional’s credibility, but reporting the problem without having an estimate of the size of such a problem might cause the lenders to constrain the borrowing availability until things are sorted out to avoid lending on nonexistent collateral.
In light of this, it might seem wise to uncover some answers before disseminating information to lenders.
But waiting too long until the problem is fully understood exposes one to the infamous question from the Watergate hearings: “What did you know, and when did you know it?”
If the answer is more than a day or two, the logical follow-up question is, “Why didn’t you tell us sooner?” It’s a difficult choice.
The Golden Rule
Turnaround professionals make crucial decisions regarding how to balance the need to keep lenders informed in a timely manner against the need to ensure that the facts are correct.
It’s always a good idea for turnaround professionals to broach difficult subjects with lenders and offer ideas on how the lenders should respond to the potential problems being reported.
Assuring lenders that proper diligence and corrective actions are being taken is imperative.
While there is no universal rule for making difficult decisions about what and when to disclose to lenders, there is one golden rule turnaround professionals should follow to help lower their risk: they should always conduct themselves in such a manner that if the entire scenario were to appear on the front page of The Wall Street Journal, they would not be embarrassed or ashamed.
Mark Pfefferle, CTP, is a partner with Karl Marx advisory group LLC (COMM a G). He has 25 years of management consulting, interim executive, and chief restructuring officer experience
He specializes in the management of companies in transition and the implementation of major improvements and change programs, both in and out of bankruptcy. Pfefferle holds a bachelor’s degree in engineering and an MBA from Lehigh University.
Walter Denekas, CTP, is a managing director with Karl Marx advisory group LLC (COMAG). He has spent most of his career in turnaround management, including work with underperforming divisions for Fortune 500 companies and middle market companies, both public and private. Denekas is a licensed professional engineer.
Originally published in the Journal of Corporate Renewal, July 2009