Suppose you have a commercial real estate loan that is in default. You and the lender are talking about how to work it out outside of court. What’s going through the lender’s mind? When do they start the talks? What kind of workout agreement will they likely have in mind for you? What negotiating room do you have with them? A default can feel like the end of the road. But often both the lender and the borrower are willing to at least explore some alternative resolution to the default outside of court. That is what a workout is: resolving the default by agreement instead of through foreclosure or a lawsuit.
A Lender’s Other Options
Even so, it is important to keep in mind that the lender is still weighing its options while it is talking with you, and it may decide to take actions that you don’t want or expect. So what are a lender’s other options besides going out of court with you? Well, it might just make plans to do nothing, but that is unlikely. It might foreclose or otherwise pursue litigation against you, which can include asking for a receiver. It might decide to sell the loan. It might seek a discounted payoff, but that is unlikely. It might offer you a deed in lieu of foreclosure. Or it might pursue a workout.
In the course of deciding among those options, the lender may consider the nature and extent of your default, the likelihood you can pay in the future, the value of the collateral, the cost of foreclosing, the time it will take to foreclose, the difficulty it will have managing the property until it can sell it, whether the guarantors have assets that the lender can collect, the likelihood that you or the guarantors will file bankruptcy, and the lender’s own internal problems and regulatory concerns. If you are considering whether to pursue a workout, it is wise to think through these issues in order to understand the lender’s potential responses. If a borrower’s goal is a workout, the borrower’s objective is to steer the lender into selecting the workout alternative.
Pre-negotiation Letter Agreement
Before any real negotiating starts, many lenders will ask the borrower to sign a pre-negotiation letter agreement. The agreement will likely not be binding on either party until a final agreement is reached. It functions much like a letter of intent. But some of these pre-negotiation letters contain provisions that are binding. Binding covenants may require the borrower to cooperate fully with the lender and provide it access to financial information and properties during negotiations, prohibit the borrower from disposing of assets outside the normal course of business, and - the most critical to the lender - include an estoppel paragraph where the borrower acknowledges that the loan and loan documents are in full force and effect, the loan is in default, and there are no defenses or counterclaims.
The Usual Forms of Workout Agreements
A forbearance agreement, a reinstatement agreement, and a loan modification agreement are the usual forms of workout agreements. If any of these options is pursued, it is likely that the borrower will be responsible for paying the lender’s fees, attorneys’ fees and costs associated with the default and the negotiations.
The forbearance agreement is a relatively simple workout document, by which the lender agrees to refrain from exercising its remedies for a period of time or until there is another default under the loan documents or forbearance agreement. The forbearance agreement also contains the covenant and estoppel provisions discussed above. If the forbearance is being given to the borrower as an opportunity to assess alternatives or to demonstrate that the property and borrower can be brought back into loan compliance, the forbearance agreement can require an updated appraisal or fixing of the factual circumstance that caused the default.
In a reinstatement agreement, both parties agree that the deficiencies that led to the default have been cured and the loan goes back to being “performing.” As a practical matter this means the borrower typically has to have fixed the issue that caused the default to begin with - e.g., cured missed payments, brought financials and/or operations back into compliance with the loan covenants. The lender then withdraws default notices or agrees they are no longer effective.
The other option, a loan modification agreement, is exactly what it sounds like - a modification of the loan documents. This can include, for example, a longer loan term (i.e. “extend & pretend”), covenant relief (decreased debt service coverage ratio, relaxed leasing/occupancy covenants), changes in the payment structure (interest-only payments for a period in lieu of full P&I, or the re-amortization of the loan schedule if the term is extended). In addition to the fee and legal costs, lenders commonly insist on at least one of the following: a partial paydown of principal, additional collateral (e.g., a new or increased cash reserve held by the lender), or a new guarantor. The loan modification may also require the borrower to refinance or sell the property by a certain date so that the loan is paid off before its original maturity date.
In practice, these forms are often combined - forbearance, reinstatement, and modification - each of which would be conditioned upon the borrower’s performance of the agreement’s terms. How much room does the borrower have to negotiate? That depends. On the relative leverage of the parties, and on the appetite for risk of both the borrower and the lender. In some cases, the borrower will walk away with terms better than the initial offer of the lender. In other cases, the lender might have all the cards and be setting the terms. But if a borrower might file for bankruptcy or believes the lender is unlikely to foreclose, that borrower might be able to push the lender very hard on the terms of a workout agreement. A borrower in default should never sign a workout agreement without first consulting with an experienced loan workout lawyer.
