How should a bank handle a workout or forbearance on a troubled commercial real estate loan?

A huge chunk of outstanding commercial real estate loans is coming due this year, and many borrowers won’t be able to repay or refinance, which could spell trouble for their lenders. Commercial real estate values are falling and interest costs are rising. The delinquency rates for CRE loans are much lower than they were in 2008, but the situation in the market could change dramatically by the end of this year.

Many lenders are suddenly having to do something they haven’t done in quite a while: Re-examine their commercial loan portfolio for possible problems and decide what to do about loans that seem to be headed off the rails. Workout skills are not part of the genetically inherited bank DNA. Instead, they are passed down to each new generation of bankers only through the “lived experience” of going through a restructuring. It has been a long time since some of these skills were in common use, and since then some new lenders have joined the market. So brush up on some timeless workout skills.

A Thorough Review of the Loan Files

Every problem loan strategy starts with the same basic activity: a thorough review of the loan files. Work through the entire closing file, and any modifications, credit memos, correspondence, appraisals, environmental reports, title documents, other collateral, financials on guarantors and any other credit extended to the borrower. It’s a big task, but time spent now will save far more later. Often, while digging, problems or inconsistencies come to light that allow a very different approach to the workout. Small disagreements or miscommunication are discovered that can sometimes be fixed through a short agreement that also corrects a document deficiency or other problem.

Get an update of the real estate title commitment or title letter from a title company. Take the time to compare it to your deed of trust or mortgage. Make sure the legal description you have is actually correct and that you didn’t overlook any parcels that were supposed to be released. Double-check the owner/grantor because they don’t always match. Sometimes you run into problems with prior mechanic’s liens that you didn’t know about, or someone has taken out a newer and junior lien on the property. Borrowers who are having cash flow problems will often get behind on their property taxes, too. Verify all the liens and taxes are paid, and do an updated UCC search on the borrower and all entities involved. It’s important to know your priorities as far as perfected security interests in personal property. The worst thing that can happen is to be caught off guard when a priority problem develops, and you find your mortgage is not properly recorded against a parcel or that IRS or a state has liens against the borrower.

Finally, look at your own bank’s internal reports and approvals for errors. Make sure what the bank thinks it financed is what you actually did. Missing or unsigned documents are a huge red flag. UCC statements can have incorrect collateral descriptions, or a filing might have been made in the wrong filing office or have lapsed. Determine if any guaranties were released or letters of credit retired due to the work of a departed loan officer. Skipping this step just guarantees those problems will remain unfixed, leaving the bank exposed and the borrower confident they are in control of the negotiation.

Entering Negotiations

Define what you want, because it’s not always the same as you might think. Your primary goal is to have the borrower perform and pay you back on schedule. How realistic is that now? Define a best case, worst case, and expected case. What do you think the borrower wants? Lenders often want to maintain a good banking relationship, avoid a foreclosure and the attendant environmental risk, and potentially save jobs and value for a going-concern borrower. The key is to find out the root of the problem. Was it poor management? If the business’ poor results are temporary because its anchor tenant downsized, will better tenants move in? Are the problems temporary due to some unforeseen event, such as a construction project overrunning its budget and falling behind schedule? That can change your strategy, because a borrower with a good plan has a chance to pull out of a tailspin. The idea is to have a clearly defined set of goals from which to start work on a solution.

The first thing to discuss before entering negotiations should be a pre-negotiation agreement (PNA). The pre-negotiation agreement can be a letter or a more formal document, but in any form it keeps the status quo and prevents the parties from being bound by a handshake until a formal agreement is signed. Never skip this step. It is vital that a borrower know and agree to this set of negotiating boundaries and guidelines upfront. Without the agreement, a cornered borrower can easily throw legal dust in the air with allegations of forbearance or modification, which can poison the water of good faith negotiation, and may give rise to a claim of detrimental reliance.

Loan Workout and Forbearance Agreement

Workout agreements can be used when a borrower’s ability to repay may improve, or the loan can be restructured, allowing more time for a borrower to refinance or switch to interest-only payments until cash flow recovers. Forbearance, on the other hand, is typically a short fixed period in which the lender holds off foreclosure while the borrower cures a default or refinances. With a forbearance agreement, the lender still retains the right to go to foreclosure should the borrower fail to cure the problems. Workouts, by contrast, can be used in longer-term restructuring of payments, covenants, and maturity extension. The two types of agreement can be combined into one document.

There are some core terms and provisions that should be included in every loan workout and forbearance agreement.

Every agreement must first identify the borrower and note or loan, and describe all the related loan agreements and documents you have.

Second, the borrower and every guarantor who signs the agreement must confirm in writing how much is owed and admit the defaults that exist - missed payments, broken financial covenants, past-due taxes.

Borrowers and guarantors should reaffirm they will repay the loan. Make sure to identify every guaranty and loan agreement that will survive, and if a new default occurs (for example, a breach of a new collateral security agreement), it will trigger the right to declare a default and demand immediate full payment. Also stipulate what happens when the borrower does or does not perform. Terms do not have to be harsh, but they must be clear.

The number of meritless claims that can be brought to harass, delay, or destroy a lender are limited only by the imagination of the borrower’s attorney. Minimize them ahead of time. Include waivers and releases, along with a covenant to not sue. This provision is aimed at “stalling” claims of lender liability or negligent loan administration.

Each agreement should also have terms tailored to the specific default you’re dealing with. If the bank is contemplating forbearing or modifying, or giving the borrower a break on an important loan term, it is only fair to ask for something in return.

Look for alternative collateral from a guarantor, or for other ways to improve your own security. The bank may ask for a paydown of the loan.

Offer more time or flexibility in payments or reserves in return for more guarantors on the bank debt.

The bank can also add new remedies (e.g., an automatic receiver) in the case of another default. Finally, having the borrower agree to a confession or stipulation of judgment to pay can significantly reduce the cost of pursuing a recalcitrant borrower.

Sometimes the business cannot be saved. But even if you reach a deal and the borrower does not recover, a well-drafted forbearance or workout agreement will make the path of collection or the liquidation of the property easier and less costly. Start early, act quickly and reach out to knowledgeable, experienced counsel for help before you’re inundated in nonproductive negotiations or are paralyzed with fear. Approach it with a sense of urgency and informed action, because time is always working against a lender - and better decisions made up front will improve recovery, even if a workout doesn’t happen.