What makes the current economic crisis unique is that it is systemic. Despite businesses historically being well managed, not being overly leveraged, innovating in the marketplace and not facing a large litigation judgment, many such businesses are being devastated by the Covid19 pandemic.
The post-pandemic world will be very different from the pre-pandemic world. As we learn more about the speed at which the economy will return to normal and what the new normal will be, few, if any loans in a bank’s loan portfolio will not need review, amendment, or restructuring.
The economic situation triggered by the current pandemic can be relieved in part by providing regulatory flexibility to banks that enables them, in turn, to provide relief to their customers to avoid bankruptcy. Secured loans (and the collateral encumbered by such loans) lose more value in chapter 11 proceedings. As a result, net losses to the bank increases. Out of court workouts preserve more value for all stakeholders.
The CARES Act provides regulatory relief to financial institution lenders for loan modifications that otherwise would be considered to be Troubled Debt Restructurings (TDRs), thereby incentivizing lenders to engage with borrowers about loan modifications and providing additional flexibility for lenders to modify loans. However, the relief is not adequate.
Under Section 4013 of the CARES Act, during the period beginning on March 1, 2020, through the earlier of Dec. 31, 2020, or 60 days after the termination date of the national emergency concerning the Covid-19 outbreak declared by the president on March 13, 2020, under the National Emergencies Act, a financial institution may elect to suspend the requirements under U.S. Generally Accepted Accounting Principles (GAAP) for loan modifications related to the Covid-19 pandemic that would otherwise be categorized as a TDR, including impairment accounting.
This TDR relief is applicable for the term of the loan modification, but solely with respect to any modification that defers or delays the payment of principal or interest, that occurs during the applicable period for a loan that was not more than 30 days past due as of Dec. 31, 2019.
Further, Section 4014 of the CARES Act provides that banks are not required to comply with the current expected credit losses methodology for estimating allowances for credit losses (CECL), from the date of the law’s enactment until the earlier of the end of the National Emergency or Dec. 31, 2020. However, the relief above is for regulatory and supervisory purposes only. It does not impact a bank’s income statement and, therefore, does not sufficiently encourage or enable a lender to be sufficiently flexible or to accept greater financial risk in a workout or restructuring.
The problem with the relief under the CARES Act is that GAAP accounting still impacts the bank’s income statement. No bank executive wants to explain that to shareholders. Regulatory relief is one thing. But, concern over profitability is another—and it is equal or more important.
The CARES Act is beneficial to fostering workouts by providing regulatory relief. However, it fails to connect regulatory relief to real financial incentives. Providing banks with additional relief is needed for banks that enable them to agree to an out of court workout with less impact on their income statement and balance sheet. This can be accomplished by reducing taxes on income derived from loans that have been worked out or restructured as a result of Covid-19.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
The views expressed herein only are those of the author. They are not necessarily shared by other persons at Lowenstein Sandler LLP. The law is subject to interpretation. Each case is unique. The author is chair of the bankruptcy department at Lowenstein Sandler LLP. He received his BS from Cornell, JD from Yeshiva (Cardozo Law) and MBA from Columbia.