Let’s start with the three basic rules that guide a lender in deciding to accept a settlement that discounts indebtedness.

The debtor’s argument would usually involve a proposal containing a liquidation analysis of the assets of the debtor, and of any outside credit enhancements such as guarantees. The analysis would incorporate factors that affect the value of assets in liquidation and all costs associated with the pursuit of the claim. Delays due to preliminary legal proceedings, subsequent bankruptcy proceedings, discounts on asset sales, the cost of professionals such as lawyers, accountants, collection agents, appraisers and auctioneers and the time value of the future collection would all play into a final, net present value of a recovery on the debt. The “uncertainty” of the assumed outcome is also a factor that is weighed in the analysis.

If the debtor or it’s professionals can convince the lender that the assumptions are reasonable, and the net collection calculation is significantly less than the proposed settlement, many lenders will opt for the discounted cash payment over an uncertain future potential. You should note that the difference between liquidation and cash settlement must be “significant.” If it is not, often times the lender may bet on the uncertain future return.

This negotiation gets tricky however, when valuation assumptions are not easily ascertained, or are at odds with the lender’s idea of a liquidation scenario. Worse, is when there is as lack of credibility with the lender, or a perception of untrustworthiness that must be overcome. In those instances, you usually find the compromise in the hands of a bankruptcy judge weighing both sides.

Alternatively, it may be that the recovery on the books today has some political merit within the institution (e.g. sprucing up a year end financial statement.) In these cases, the liquidity offered by cash settlement may be preferred even over a long term payout in full.

Mind you, this avenue for settlement is usually a tough path to tread. It will involve the engagement of legal counsel that is experienced in such matters, and litigation may have to be instituted before the real risk to the lender is recognized. The net result may be the investment of sizeable legal dollars to bring the true nature of the litigation risk to the lender/creditor.

I should note that all of the above compromise situations are conditioned upon cash settlements, not long term payouts. As you might expect, cash motivates settlement negotiations and the debtor will have to find a source to fund the settlement. To accept a compromise and have to get paid over time means a double risk to the lender. It is not impossible however, and some deals are struck this way with a “snap back” provision that reinstates the full claim if a default in payments occur.

Finally, if a debtor does not fall into one of the three categories, there are still many other ways to settle a lender situation to the benefit of the debtor. Reductions in interest rates, restructured payment terms and future discounts based on financial performance are examples of alternative settlement structures that do not involve discounts up front.

So the next time a client says, “the lender should accept a discount,” remind him or her of the three general rules and find out if their situation falls into any of the above parameters. If not, better to dissuade the client’s false hope and focus on more viable alternative to a restructuring.