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By: Daniel G. Egan, Ropes & Gray LLP with updates by the Lexis Practice Advisor Attorney Team
As the Coronavirus pandemic continues to impact our economy, many companies will need to consider whether to pursue a loan workout. This article examines considerations that affect whether and in what manner a company may restructure its loans and bond debt. A workout in the context of a financially distressed company generally means an attempt to negotiate a consensual solution to a company’s financial troubles with that company’s lenders (and/or other creditors).
WHEN CONSIDERING A WORKOUT, THE COMPANY WILL typically analyze the types and nature of the company’s various obligations, as well as the extent and nature of the company’s defaults in respect thereof (i.e., whether the company is currently in default on certain of its obligations or merely anticipates a default in the near future). In a loan workout, the lender and the borrower often negotiate a solution to a defaulted loan to avoid a bankruptcy proceeding. A company and its lender(s) may restructure the loan by, among other things, amending its existing agreements or entering into a forbearance or waiver agreement. Before making any agreement, the company will need to consider the potential tax consequences, any subordination agreements, and potential preference exposure. Companies that have issued public debt securities may initiate an exchange offer for purposes of a workout. In an exchange offer, bondholders are offered an opportunity to exchange their existing bonds for new debt, equity, or some combination of both, in order to reduce the amount or change the timing of the issuer’s principal and interest payments.
The company will need to ensure that it addresses the right problems, and it cannot begin to do that until it understands whether, and the extent to which, it is in default under its current loan or other obligations. Once the company has a full and complete understanding of its debt-related defaults (or potential near-term defaults), it can then begin to consider the alternatives for addressing such defaults. In other words, until the company knows what is broken and why, it cannot ask its creditors to help fix its problems.
Potential Borrower Defaults in Loan Documentation
A typical loan agreement will contain numerous covenants and other obligations with which a borrower must comply during the term of the agreement and will often specifically list events that will give rise to a default or event of default. Upon the occurrence and continuation of an event of default, the lender will generally be permitted (following any applicable notice period) to exercise various rights and remedies against the company, which may include an acceleration of the indebtedness, the accrual of interest at a default rate, the right to commence litigation seeking payment on the indebtedness, and the right to foreclose on or exercise rights with respect to collateral securing the indebtedness. Often, a loan agreement will provide that the failure to comply with certain obligations constitutes a default (rather than an event of default). The event of default section of the loan agreement will specify the circumstances in which a default will lead to the occurrence of an event of default. Often, the company will have a period of time to cure the default before it ripens into an event of default. If the default is not timely cured and it becomes an event of default, typically the lender will then be permitted to exercise its remedies against the company.
To the extent that a lender has control over the company’s working capital or other bank accounts, the company’s access to its own funds may be significantly curtailed following the occurrence of an event of default. Therefore, a company must be thoroughly familiar with its covenants and obligations under the agreement and the rights available to the lender if the company fails to comply with these covenants and obligations in a timely manner. If the company fails to comply with certain of its obligations under the loan agreement, the company should engage the lender in discussions regarding the reasons for the failed compliance, whether the company is able to cure any existing default, and/or whether it believes a waiver, forbearance, or amendment is appropriate. If the lender believes that, under the circumstances, it is not in its best interest to declare an event of default, the parties may then begin negotiating the terms of a waiver, forbearance, or amendment, as appropriate.
The following terms may be included in a loan agreement:
Most loan agreements also contain a provision allowing a lender to accelerate and declare all outstanding indebtedness to be immediately due and payable following the occurrence of an event of default (and the expiration of any applicable notice and cure periods) under the terms of the loan agreement. By accelerating the loan, the lender typically can pursue its remedies (such as litigation) and seek payment in full of all amounts owing under the agreement, including the full amount of principal, plus accrued and unpaid interest and any other fees and expenses, and/or a foreclosure on any collateral.
Acceleration is a powerful remedy, and a lender will need to carefully consider whether to accelerate the debt following a default since such an acceleration may force the company to file bankruptcy. In addition, the acceleration of debt may also jeopardize the lender’s ability to negotiate and work out a consensual agreement with the company for the repayment of debt. Therefore, if a lender believes that a workout is possible, it likely will be in the best interest of the lender to engage in discussions with the company prior to exercising any right to accelerate. In these discussions with the company, the lender will be looking to determine the reasons that the event of default occurred and whether the company will be able to remedy the event of default in the near future. The lender should also analyze the company’s financial information to determine the likelihood of timely receiving debt service payments as and when they become due going forward.
Near Term Anticipated Defaults
Just as important as considering existing defaults is determining whether there are any defaults on the horizon. Therefore, a company should carefully consider, among other things, its current financial situation, impending loan obligations, cash flow and other financial projections, and economic and industry forecasts. It will do little good to fix current defaults only to then have new or the same defaults appear a week, a month, or several months later. The company should try to achieve, if possible, a long-term solution and should not be satisfied with obtaining a temporary, stopgap measure.
When faced with an existing or impending default under a loan agreement, a company may request that the lender forbear for a limited period of time from taking legal actions that it may otherwise be entitled to take in order to allow the company some time to resolve its financial problems. In such a scenario, the lender will need to analyze the situation to determine if it believes that the company can remedy the defaults (or that a more global restructuring can occur) during the forbearance period and that the lender’s interests will be adequately protected during this period. In some cases, the lender may determine that the borrower’s financial situation will only worsen and that the lender’s prospects of being repaid will only decrease over time. Therefore, it may reject the company’s request for a forbearance and proceed with the exercise of its rights and remedies under the loan documents. However, in many cases, the lender will determine that legal action and the enforcement of remedies is a costly and unpredictable option that may further delay repayment or cause more damage to the company’s reputation or business. Such damage could lead to a loss of customers, a decrease in sales or other drop in revenues, or an increase in expenses, as applicable. Therefore, the lender may decide that it is more advantageous to its interests to negotiate a forbearance (or standstill) agreement with the company. The lender will need to consider what, if any, changes to the loan agreement or other consideration are warranted in order for such lender to consent to any forbearance. Such changes to the loan agreement may include, among other things, modifications to financial reporting requirements or financial covenants.
Key to negotiating any forbearance agreement is a clear understanding of, among other things, the defaults under the loan agreement, the rights and remedies available to the lender, and what the parties are hoping to accomplish during a forbearance period to address the company’s underlying business and/or financial problems. In analyzing these issues, the parties will need to carefully review the loan documentation to determine the nature and scope of the defaults and what remedies are available to the lender. Once the parties understand these issues, they can then analyze the company’s performance and financial situation to determine the best way to address the defaults, whether through modifications to the loan documents, a refinancing or other restructuring, or otherwise.
Below is a non-exhaustive checklist of items that parties should consider in determining whether a forbearance agreement is appropriate under the circumstances and the conditions under which the lender will agree to such a forbearance:
Forbearance agreements are generally heavily negotiated and may vary significantly from deal to deal depending on the particular circumstances. For example, where there is a payment default, the parties may seek to include provisions that reschedule the payments and provide milestones for the company to address its financial condition. Where there is a default on a covenant to provide financial reports or other information to creditors or comply with financial covenants, the forbearance agreement may contain requirements for the company to engage outside consultants or advisors to assist the company’s current management. In some cases, the parties may determine that the best course of action is for the company to seek new financing to repay the indebtedness to the current lender. A forbearance agreement under this scenario would likely contain milestones to ensure that the company is on track towards obtaining the new financing.
A typical forbearance agreement should clearly state the extent of the lender concessions sought, which will include an agreement by the lender to forbear for a specified period of time from accelerating the debt and otherwise exercising or pursuing remedies or other legal actions available to it under the applicable agreements or law. The company may also request additional concessions from the lender, including a modification of certain contractual covenants (such as financial covenants) or other terms of the loan documents. The particular covenants and loan terms addressed in a forbearance will depend on the particular circumstances of the company.
As a condition to entering into a forbearance agreement, a lender will usually require the inclusion of various provisions designed to protect its interests. Typical provisions include, among other things, (1) acknowledgments by the company as to existing defaults and the amount and validity of the indebtedness and the validity and perfection of any liens granted in favor of the lender, (2) a ratification of the loan documents, (3) a waiver by the company of any defenses to repayment of the indebtedness, and (4) a general release of claims by the company against the lender. Many of these provisions are similar to those generally included in a waiver agreement. However, the key difference between the two agreements is that a forbearance will have a fixed expiration date after which the lender will be entitled to exercise rights and remedies, while a waiver is an agreement by the lender that it will not, at any time in the future, exercise rights and remedies in respect of the particular default being waived.
The lender may also require payment of a portion of the overdue debt service to be made by the company during the forbearance period and/or the payment of a forbearance fee as a condition to entering into the forbearance agreement. In addition, the lender may also seek to add additional covenants for the company, including increased financial reporting requirements or monitoring rights in favor of the lender.
A primary goal for a company seeking a forbearance from a lender is often to allow the company time to work out a consensual restructuring agreement and/or improve its financial situation through a restructuring transaction. Accordingly, a lender may require that the forbearance agreement contain various milestones that the company is required to achieve within a specified period of time to ensure that the company is progressing either financially or operationally. These milestones may include events such as closing on an asset sale, obtaining new capital, or consummating a refinancing transaction, and are designed to help manage the lender’s risks and ensure that it is ultimately repaid on the loan. The company’s failure to achieve these milestones likely will cause a termination of the forbearance agreement and permit the lender to exercise its rights and remedies under the loan documents and applicable law.
When a company experiences financial distress and anticipates a potential default under its loan documents, it should approach its lender(s) to discuss the company’s financial condition, performance, and potential ways to avoid a default or event of default under the loan agreement. One option that the parties may consider is to enter into an amendment to the existing loan agreement that addresses potential defaults and other foreseeable issues with the company’s ability to comply with its covenants and obligations under the loan agreement. Being proactive in seeking an amendment can help a company avoid a default and, consequently, avoid the need to request a waiver or forbearance from its lender. One note of caution, the company must balance (1) what is often a firmly held belief at many companies that creditors should not be consulted as to the company’s potential financial problems until there is no choice but to do so, and (2) the practical realities of the situation and the need to bring creditors into the fold so as to fix the company’s financial and other problems as quickly as possible.
Below is a non-exhaustive checklist of items that parties should consider in determining whether an amendment is appropriate under the circumstances and the conditions under which the lender will agree to such an amendment:
Prior to requesting a loan amendment, a company should have a full understanding of potential defaults and the provisions of the existing loan documents with which it believes it will be unable to comply. Once this is determined, the company should approach the lender with a plan regarding a potential amendment to the loan agreement and how the company believes that an amendment is in the best interest of both parties. The provisions to be amended will vary depending on the type of anticipated default or compliance issue but may include such things as a reduction in interest rates, an extension of payment deadlines, an adjustment to loan covenants, or a change in collateral securing the loan. In exchange, a lender may request a fee for agreeing to amend the loan agreement; however, agreeing to pay such fee and amending the documents may be in the company’s best interest in order to avoid a default and the potential exercise of remedies by the lender.
In addition, in considering the amendment of loan provisions, the company and the lender should consider addressing not only immediately impending issues but also any foreseeable issues that may arise down the road. That way, the parties can position themselves as best as possible to avoid a situation where the company needs to ask for an additional amendment to the loan documents in the near future. For example, a company may be seeking to address a financial reporting default through a loan agreement, but the company may also be aware that it is unlikely to be able to satisfy certain financial covenants in the loan agreement, such as a debt service coverage ratio that is to be computed in the near future. In such a situation, it may be in the company’s best interest to address this potential future default in the current loan amendment.
Waiver agreements will most often be used when there is a onetime covenant breach that the lender determines will not materially prejudice its ability to receive payment on the loan. A waiver by the lender of a default or event of default will allow the relationship between the lender and the company to continue unimpeded despite the occurrence of a default under the agreement.
These defaults may include such things as failure to timely deliver financial reports and information or failure to maintain certain required financial ratios over a certain period of time. When these events occur, a lender will analyze the company’s financial situation and may determine that, under the particular circumstances, the pursuit of remedies under the loan agreement is not beneficial to the lender. A lender will need to consider what, if any, changes to the loan agreement or other consideration are warranted in order for such lender to consent to a waiver of a default. In determining what changes need to be made, the parties will need to identify the particular covenant or covenants as to which the company is in default and any other covenants with which the company anticipates having trouble complying in the future. The parties may then need to engage in discussions, if necessary, because the default is expected to reoccur in the future, as to how such covenants can be modified in a manner that will reduce the likelihood of a future default. For example, if the particular default relates to the timeliness of satisfying financial reporting obligations, the parties may determine that it is necessary to amend the agreement to extend the time in which the company is required to provide such financial information to the creditor.
Below is a non-exhaustive checklist of items that parties should consider in determining whether a waiver is appropriate under the circumstances and the conditions under which the lender will agree to such a waiver:
A waiver agreement typically will recite the default or event of default that occurred (or is alleged to have occurred) under the loan agreement and will clearly state that the lender agrees to waive the specified default or event of default and agrees not to pursue its rights and remedies against the company as a result thereof. As a part of the waiver agreement, the lender may require the inclusion of various provisions designed to protect its interests, including, among other things, (1) acknowledgments by the company as to the amount and validity of the indebtedness and the validity and perfection of any liens granted in favor of the lender, (2) a ratification of the loan documents, (3) a waiver by the company of any defenses to repayment of the indebtedness, and (4) a general release of claims by the company against the lender. These provisions are common in waiver agreements and, unless a borrower has a valid reason to dispute any of these items, will generally be part of the final waiver agreement.
The parties may also need to analyze the circumstances that led to the company’s request for a waiver in order to determine whether it is appropriate to modify the loan agreement to reduce the likelihood of a similar situation arising in the future. For example, the parties may determine that the current time frame for delivery of financial reports or other information is not feasible for the company and, therefore, it is necessary to modify such time frame.
A company engaged in a loan workout or refinancing will need to consider whether there is any subordination agreement in place between the lender and other creditors and what effect this agreement may have on negotiations.
Where there is junior debt issued or obligations incurred by a company, the senior lender may seek to enter into a subordination agreement with the junior creditors in order to define the rights as between the parties. A typical subordination agreement may include provisions providing for (1) payment subordination (i.e., providing that the junior creditors will not receive payments until the senior lender is paid the full amount of what is owing to it), (2) lien subordination (providing that the junior creditors’ lien on collateral is subject and subordinate to the senior lender’s lien on the collateral), and (3) limiting the junior creditors’ ability to pursue remedies against the company or its assets if there is a default.
Such an agreement may provide more flexibility to a company and its senior lender in working out potential default issues since the junior creditors may be significantly limited in the actions that they are permitted to take against the company. However, it is important for a company engaging in workout or refinancing negotiations to fully understand the rights of junior creditors under any such subordination agreement.
The company also will need to properly analyze, among other things, whether the consent of other creditors is required in order to enter into a forbearance, waiver, or other agreement, and whether there are any cross-default issues that need to be addressed by the company. In making this determination, the company will need to review not only the provisions of any intercreditor or subordination agreements, but also any applicable credit and loan documents with other creditors.
If the consent of other creditors is needed in order to consummate a workout or refinancing in connection with a loan agreement, then a company should begin discussions with the appropriate creditors regarding such consent as early in the process as is practicable. Failure to do so could jeopardize the company’s ability to complete a workout with its lender within the required time frame. In addition, the company may need to enter into separate agreements with other creditors to waive or forbear on exercising any rights in connection with any cross-defaults that may occur. If such agreements are necessary, the company should consider contacting the appropriate creditors to inform them of the default situation and what effect the workout or refinancing may have on the company’s ability to perform under the agreements with such creditors. In many cases, a workout or refinancing of the senior debt will improve the company’s ability to satisfy junior debt obligations and to otherwise perform under its agreements with junior creditors. Therefore, such creditors may determine that granting a waiver or forbearance of potential cross-defaults is beneficial to them as well.
Parties engaged in loan workout negotiations must be aware of potential tax consequences of restructuring indebtedness. Therefore, undertake a tax analysis as part of the restructuring and workout process. One of the major tax issues that can arise is the incurrence of cancellation of indebtedness (COD) income by the company, which is expressly included in the definition of gross income under the Internal Revenue Code. COD income will be an issue where there is a modification of the loan that reduces the amount of the indebtedness. For example, if, as part of a loan workout, the lender agrees to reduce the principal amount of indebtedness owing from $5 million to $4 million, the company would realize $1 million of COD income in the year of the loan modification.
There are, however, certain exceptions that may protect a company from having to recognize COD income. Two common exemptions are if the indebtedness is discharged as part of a bankruptcy proceeding or while the company is insolvent. Under these circumstances, the company may be able to exclude COD income from its gross income; however, the company may instead be required to reduce certain tax attributes by the amount of COD income that is excluded from gross income. In order to avoid any unexpected tax consequences as a result of a loan workout or refinancing, the company must analyze any potential tax implications and should engage outside advisors to assist in this process as necessary.
A loan restructuring or workout may involve an agreement pursuant to which the company makes periodic payments to a lender or grants additional liens on otherwise unencumbered assets to the lender as security for the loan. However, if the company subsequently files for bankruptcy, there is a risk that these payments or the grant of the security interest may be subject to avoidance under the applicable provisions of the Bankruptcy Code.
One power that a debtor or trustee possesses in bankruptcy is the power to commence actions to avoid certain prepetition transfers as being preferential to one creditor over another creditor or creditors. The basic elements of a preference include (1) a transfer, (2) of an interest of the debtor in property, (3) to or for the benefit of a creditor, (4) on account of a preexisting debt, (5) made while the debtor was insolvent, (6) made on or within 90 days of the bankruptcy or one year in the case of transfers to insiders, and (7) which enables the creditor to receive more than if the bankruptcy estate was liquidated in a chapter 7 case.
There are certain defenses that may be available to a lender that is a defendant in a preference action. One defense is the ordinary course of business defense, which prohibits the avoidance of a transfer in payment of a debt by the debtor if the transfer was made in the ordinary course of business or financial affairs of the debtor and the transferee or the transfer was made according to ordinary business terms. Some courts have held that payments made pursuant to a workout agreement do not fall within the ordinary course of business exception; however, other courts have found such payments may fall within this exception depending on the particular facts and circumstances.
Another defense that may be available is the new value defense, which prohibits the avoidance of a transfer that was intended by the debtor and the transferee to be a contemporaneous exchange for new value given to the debtor, and the transfer was in fact a substantially contemporaneous exchange. Several courts have held that a forbearance from exercising remedies does not constitute new value, such that a lender may need to consider providing other concessions and value to the company as part of a loan workout if it wants to fall within the new value defense to an avoidance action. Such concessions may include an adjustment to rates or fees or to certain covenants in the loan documentation that make compliance therewith easier for the company.
In the event that the parties with which the company needs to negotiate in order to achieve its restructuring are a small group of creditors, such as one or two lenders under a loan agreement, the holder of a promissory note, a handful of debt security holders, and/or a landlord or trade creditor, the company may find it relatively easy to contact, communicate, and agree upon a resolution with such creditors. However, in the event that the company has issued public debt securities (whether they are regularly traded or not), the company may have a difficult time (1) locating all of the holders and/or (2) obtaining the consent of the requisite holders of such securities in order to achieve approval of the proposed restructuring. In such a case, the company may need to initiate an exchange offer in compliance with federal and state securities laws in order to solicit consent to the company’s restructuring proposal. An exchange offer typically involves a company’s offer for existing holders of the company’s debt securities to exchange such securities for new securities. Often the new securities will have different terms, maturities, and/or face value than does the company’s existing securities. Often the indenture or other documents under which a company’s debt securities have been issued will provide that certain amendments to the securities can be achieved with less than 100% holder consent.
Moreover, with respect to those amendments that require the consent of each affected security holder (typically any amendment to the amount or maturity of the security will required consent of the affected holders), to the extent that the company can achieve a significant percentage of consents to the proposed amendment (typically more than 90% of existing debt), the company may be willing to leave the remainder of the existing debt that does not consent outstanding. In such a case, the company would need to continue to pay the debt that is not restructured according to its original terms.
Often in a workout situation a group of bondholders will band together to form an ad hoc committee of bondholders in order to pool resources to hire advisors and coordinate the negotiations with the company. Doing so will often give a group of creditors a larger, more coordinated voice in negotiations with the company. From the company’s perspective, the formation of such a committee can have positive and negative implications. The positives include that it is often easier for a company to negotiate with one group of creditors that are in sync with one another (assuming that is the case) than it would be to negotiate with many different independent creditors all having a different perspective on the restructuring. However, that positive can also be a negative if the committee is dominated by individuals who the company believes are not being reasonable in their demands. A bondholder committee can be very useful in the company’s efforts to achieve a restructuring via an exchange offer as security holders that have not been involved in the pre-exchange offer negotiations may be influenced by the recommendation and support of the proposed restructuring by the bondholder committee. In addition, the members of any such committee typically will enter into a lock-up agreement agreeing to exchange the securities they hold pursuant to the exchange offer.
Simultaneous Solicitation of Chapter 11 Plan
The Bankruptcy Code allows a company to obtain approval of its restructuring plan over the objection of certain creditors so long as at least two-thirds in amount and more than onehalf in number of the claims in a particular class accept the plan. Thus, to the extent that a company has the consent of a sufficient number of its bondholders to meet this threshold, the company can obtain approval of its restructuring plan in bankruptcy and bind all bondholders, even those that have not provided their consent. For this reason, a company should consider seeking votes on a bankruptcy plan at the same time that it seeks consents for its exchange offer. In this way, if the company fails to achieve the threshold that it has targeted to accomplish an out-of-court exchange of debt securities (again, typically more than 90%) but does obtain the 66.67%/50.1% threshold noted above, the company could choose to file for bankruptcy and seek to bind all of its bondholders to the proposed restructuring.
During normal economic time, distressed companies will need to explore these options by expending significant time and resources assessing their financial situation and communicating with lenders. These difficult tasks are exacerbated by the Coronavirus pandemic. Companies need to now re-assess their financial condition, analyze their short-term and long-term liquidity needs, re-forecast their projections, and review their loan documents. Given the uncertainty and changing nature of the pandemic response, companies should continuously re-evaluate their financial condition and maintain an open dialogue with their lenders. Companies can maximize their chances of a successful loan workout by starting this process early and understanding the options outlined in this article.
Daniel G. Egan’s practice at Ropes & Gray LLP is focused on corporate restructurings and bankruptcies and complex distressed situations in a broad variety of industries. Dan has represented debtors, creditors, asset purchasers, secured lenders, bond insurers, and other strategic parties in Chapter 9 cases, Chapter 11 cases, and out-of-court restructurings. He advises and represents clients in all aspects of bankruptcy and restructuring transactions, including Section 363 asset sales, DIP financings, plans of reorganization, and bankruptcy litigation and appeals.
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RESEARCH PATH: Bankruptcy > Prepackaged Plans, Workouts and Other Out-of-Court Restructuring > Workouts > Practice Notes
For a comprehensive guide to prepackaged bankruptcies, see
> PREPACKAGED BANKRUPTCY RESOURCE KIT
RESEARCH PATH: Bankruptcy > Prepackaged Plans, Workouts and Other Out-of-Court Restructurings > Prepackaged Bankruptcy > Practice Notes
For information on defaults and the remedies available to a lender, see
> EVENT OF DEFAULT PROVISIONS IN CREDIT AGREEMENTS
RESEARCH PATH: Bankruptcy > Financing the Debtor’s Estate > Bankruptcy Issues from a Lender’s Perspective > Practice Notes
For an overview of drafting defaults, events of default, and related provisions, see
> LOAN AGREEMENT EVENTS OF DEFAULT: LENDERS’ REMEDIES RESOURCE KIT
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> FORBEARANCE AGREEMENT (BANKRUPTCY, LOAN, AND OTHER DEBT WORKOUTS)
RESEARCH PATH: Bankruptcy > Prepackaged Plans, Workouts and Other Out-of-Court Restructurings > Workouts > Forms
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For guidance on exchange offers in a workout and other debt securities restructurings, see
> BUSINESS WORKOUTS
RESEARCH PATH: Bankruptcy > Prepackaged Plans, Workouts and Other Out-of-Court Restructurings > Workouts > Practice Notes
For a discussion of considerations related to whether and how a company may restructure its debt securities, see
> DEBT SECURITIES RESTRUCTURING OPTIONS
RESEARCH PATH: Bankruptcy > Prepackaged Plans, Workouts and Other Out-of-Court Restructurings > Other Out-of-Court Restructurings > Practice Notes
For a sample waiver document, see
> WAIVER (BANKRUPTCY, LOAN AND OTHER DEBT WORKOUTS)
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RESEARCH PATH: Bankruptcy > Bankruptcy Litigation > Avoidance Actions > Practice Notes