A creditor workout agreement is a deal between a borrower and a lender that resolves a loan default without having to go through the full foreclosure process. Workouts are “voluntary” because the borrower and the lender both have to agree to the solution. So a workout is a negotiation. But if your business has defaulted on a commercial real estate loan, it helps to know what the other side of the table is thinking.
The Lender’s Pressure Points
Throughout the entire time the two parties are negotiating, the lender never stops thinking about its options. What are they? One option is to prepare for a foreclosure and maybe other related lawsuits, including going to court to appoint a receiver. Another option is to try selling the loan. A third is to look for a discounted payoff–that is an offer from the borrower to pay less than the outstanding balance–but that’s unlikely. A fourth is to seek a deed in lieu of foreclosure, where the borrower would deed the property over to the lender. Of course a lender could choose to do nothing at all, but that is also very unlikely. Or it can pursue a workout with the borrower. It could ultimately decide that it will lose less money by suing you than trying to work with you. It will make an overall calculation as to which action is most cost effective.
In deciding whether to foreclose, a lender will look at how serious the default is, and at the borrower’s ability to make future payments. The lender will also weigh the value of the collateral and the cost of foreclosing and how long it will take, not to mention the time and trouble the lender will have caring for the property if it’s a building until it can sell it to pay off the loan. The lender will also assess whether the guarantors have assets that could be reached and what the likelihood is that the borrower or the guarantors will file bankruptcy. The lender will then take into account its own internal policies and regulatory concerns. The important thing for a small business borrower to remember when trying to negotiate a workout is to understand the lender’s pressure points.
Pre-negotiation Letter Agreement
Sometimes before a workout gets under way, the lender asks the borrower to sign what’s called a pre-negotiation letter agreement. Like a letter of intent, that document does not obligate the parties to do anything until a final workout agreement. But it may contain some binding provisions. One is that the borrower must cooperate with the lender in the workout, including by providing financial records and access to the property. Another is that the borrower may not get rid of any assets except in the ordinary course of business. But the most critical provision for the lender is one called an estoppel, in which the borrower agrees that the loan documents are all in place, that the loan is in default, and that the borrower has no defenses or counterclaims. Remember, the devil is in the documentation when it comes to a workout.
Three Types of Agreement
Business owners most commonly resolve defaults by means of one of these three types of agreement: a forbearance agreement, a reinstatement agreement, and a loan modification agreement. In each of these workouts the borrower will likely have to pay a fee and the lender’s legal fees and costs in connection with the workout.
The simplest form of workout is called a forbearance agreement. Here, the lender says that it will not enforce its rights and remedies for the existing default(s) for some period of time, or until a new default occurs. Of course, it includes the same covenant and estoppel terms that the pre-negotiation letter does. The lender may use the forbearance time either to consider other options for itself, or to give the borrower an opportunity to demonstrate that it can comply with the loan documents. An updated appraisal or the correction of whatever facts caused the default may be required.
In a reinstatement agreement, the lender agrees that the borrower’s defaults are cured and the loan is returned to a performing status. The borrower usually must have already fixed what caused the defaults, for instance by bringing loan payments up to date or getting its financial results back in line with loan requirements. The lender then withdraws its default notices or agrees they are no longer in effect.
Another common agreement is a loan modification agreement. Here, lender and borrower agree to change the terms of the loan. The changes made to the loan documents usually involve changing the maturity date (called an “extend & pretend” [an exercise in wishful thinking]), covenant relief (for example, lowering the debt service coverage ratio required by the loan agreement, or easing a leasing or occupancy covenant), or changing the payment (for example, changing from principal and interest to interest-only payments, or re-amortizing the loan to a longer term, if the maturity date was extended).
Expect strings attached to any modification. Often, when a business is out of compliance with a commercial loan, the bank will say, “Okay, but pay me a modification fee and my legal fees. At the same time, I want some of your principal paid down, or I want some new collateral (say, your money held here), and/or I want you to find me another person who agrees to personally guarantee this loan.” It may also be that the bank wants you to refinance the loan or sell the property by a certain date, paying off the loan early even though it wasn’t due that day. In short, the bank may want you to make some concessions.
In actual practice a workout agreement will often involve some combination of forbearance, reinstatement and modification, and all this will be conditioned on the borrower’s agreeing to adhere to the new terms of the modified agreement.
How good a deal a borrower and lender strike in a workout depends on their relative leverage, but also on how much risk each is willing to take. Often the borrower ends up getting better terms than the lender initially proposed. But sometimes the lender holds all the cards. On the other hand, if a borrower is in a better negotiating position - either because he or she is willing to consider bankruptcy, or just doesn’t think the lender will foreclose - the borrower may get a better offer. In any event, you should talk to a lawyer experienced in loan workouts before you agree to anything.
