Loan defaults and workouts are on the rise again. Why? Interest rates shot up, forcing many owners to deal with no option to refinance maturing loans on an affordable basis; costs of renovation and construction materials continue to climb; flood and windstorm insurance has become cost-prohibitive, if not un-obtainable; loans are maturing and the owner has no viable refinancing or exit options.
If you have fallen behind, the obvious question is what the lender can actually do. And knowing what the lender can do—or will do—sometimes helps the borrower avoid it. Most of it happens on paper, well before anyone files anything in court. Here are the options and how they might come to pass.
The Lender’s Lawyers
The first thing a lender often does after a default is have its lawyer draft a “reservation of rights” or “nonwaiver” letter. It enumerates the known breaches and says the lender reserves all of its rights under the loan documents and is not waiving any right or remedy even though the lender is taking no action at present. Is that just talk, or is it a serious matter? It is serious. The point is to reserve the bank’s legal rights so that the bank can file a lawsuit at some later date. A letter like this can scare the devil out of you, even if you have no reason to fear a legal action, but it is not a lawsuit, and silence afterward does not mean the lender has let things go.
Paperwork makes the loan. But when the loan goes bad, the lender’s lawyers redouble their diligence. They re-read the loan docs, the borrower’s organizational docs, the title policy, the survey, the closing diligence. They inventory the collateral. They look for any defects that might get in their way in enforcing the loan. Sometimes they bring in a fresh lawyer; the original counsel may have overlooked a detail.
Look carefully for the definition of “event of default” in the loan agreement. It is rarely just a missed payment. Most agreements carry financial and non-financial covenants, and violation of those covenants can trigger an event of default as well. The documents also spell out the notices that have to be given and the cure periods that apply, and those cut both ways.
Then the lender’s lawyers do “updated diligence.” They make some new searches, get an update on the title, get current financial statements on the business and the guarantors, maybe even a new appraisal, an environmental audit. All of this tells the lender how much leverage it has before it negotiates. Liens on or title defects to collateral slow the foreclosure process down. And the process is already long.
Modification or Forbearance
Next, a lot of lenders require a “pre-negotiation letter” when serious discussions about a modification or forbearance on a distressed loan are about to get underway. It’s essentially an agreement that defines the parameters for those negotiations. You and any guarantors will be asked to sign it. Often, it also requires the borrower (and guarantors) to update the lender’s file with whatever financial information is missing. This document is very important and should be scrutinized carefully.
If the lender agrees to suspend its remedies for a time, the document will be a forbearance agreement. It acknowledges a default, and the lender agrees not to exercise its remedies for a specified period if the borrower meets certain conditions. That sounds pretty simple. However, there are some issues to watch for. The agreement will typically include: an acknowledgement of the loan balance; the payments required during the forbearance; the time the forbearance will last; the conditions of the forbearance; default provisions on the forbearance and remedies for a default; an agreement for default interest from the date of the first default; a release of the lender; a waiver of the automatic stay in bankruptcy; a consent to receivership and foreclosure; a promise not to contest the foreclosure; and a reaffirmation of the guaranty by the guarantors. In plain terms, you give up your right to bring litigation against the lender, you agree to have a receiver appointed, and you don’t object to the foreclosure. Yup. This is scary stuff. And if this or that doesn’t happen, then it’s right back to enforcement, with far fewer defenses than you started with.
Moves to Enforce
If the talks fail, the lender moves to enforce. The procedure differs depending on the state or jurisdiction in which the borrower’s collateral property is located. The lender’s loan documents may authorize the lender to apply to the court to have a receiver appointed to take over the property until it’s sold at foreclosure. Each jurisdiction has its own standard for appointing a receiver. And having a provision stating that the lender “may request or apply for a receiver” does not mean the lender is entitled to a receiver. The court decides. Most states have recently adopted a model receivership law. So it is a bit easier to get a receiver today than it used to be.
Another thing that can happen is that when interest rates get higher, the borrower is desperate to keep his or her old financing in place, and they try all sorts of delay tactics. More delay, more time and expense.
There are limits on what the lender can do. There are “lender liability” claims, which can be brought by the borrower for failure to comply with obligations under the loan documents, unreasonable delay, and lack of good faith. What is reasonable, justifiable and not bad faith is a difficult concept. Those claims create the opportunity to launch discovery. The discovery process is slow and expensive. Any communication that isn’t privileged may be discoverable. That is why careful lenders keep their communications professional and documented, subject to the confidentiality provisions of the pre-negotiation letter or forbearance agreement.
So what should you, the owner, take from all this? The lender is going to prepare. You should do the same. You should know what the lender is going to want to see. Review the file and ask yourself the same questions that the lender will ask. Read your own loan documents for the definition of default, the notices and the cure periods. Have current financials ready for the business and every guarantor, because the request is coming. Make all your records accurate. Don’t let your bookkeeping fall behind. Keep your own emails and calls professional, since they may be read later by people outside the room. And before you sign a pre-negotiation letter or a forbearance agreement, know exactly what you are giving up.
