A demand letter means that the lender considers the loan to be in default and may be getting ready to act on it. What follows is not automatic. Many commercial borrowers in this situation reach out to their lenders and request a deferral of payment, an interest-only payment, covenant amendments or a waiver of the default, and the lender’s most common responses are either a loan modification or a forbearance agreement. Both of these agreements give a struggling borrower the opportunity to turn the business around, but each comes with its own trade-offs.
A Loan Modification Is a Permanent Change
A loan modification is a permanent change to the original loan agreement. It rewrites the terms to reflect the borrower’s current situation - for example, extending the maturity date, reducing the interest rate, or adjusting a covenant. The point is that the borrower no longer has to operate under the old, unrealistic schedule. Both parties have to agree to the terms of the modification. For the borrower, a modification is usually the better of the two, because once it is signed, the old defaults are washed away, and the loan is back on track. If the lender has already accelerated the loan, the modification reverses that as well. And it does not have to be a long-term fix: a modification can also deliver short-term relief, such as a payment deferral or a temporary change to financial covenants.
When you sit down to negotiate, the asks from the borrower side are fairly predictable. You might ask the lender to defer the next payment or subsequent payments for a set period. You might want to talk about restructuring the repayment schedule. If you are cash-constrained, you will need interest reductions. You can also ask for an interest-only period and a waiver of the prepayment premium (make whole) if the loan is refinanced. Other requests may include permission to bring in new equity investors or other debt, or changes to guarantor provisions. On a construction loan, the list can include a bigger interest reserve, more time to finish the project and force majeure language covering a pandemic or a government shutdown order. Note that this is not an exhaustive list; there are many other deal points you might negotiate.
The lender, however, will see things from a different angle. Even if it agrees to everything you ask for, it will want to make sure that it is protected against the borrower’s further risk. On the lender’s side, a mod is an opportunity to review the loan documentation and “clean up” inconsistencies or shortcomings. Lenders often want to add more collateral, cross-collateralize with other loans, cross-default with other loans, add more guarantors, or upgrade a limited guaranty to an unconditional guaranty, among other things. It may also want a cash management lockbox (where cash flows are automatically deposited into a designated account or accounts to ensure loan payments will be funded), more financial covenants and increased reporting requirements, a waiver by the borrower or guarantor of any claims, defenses or setoff rights it might have against the lender, and fees for the lender’s efforts (a modification fee and a monitoring fee).
Forbearance Means the Lender Agrees Not to Exercise Its Rights
Forbearance is the other path. This one is not about debt restructuring, but rather about freezing the action for a period of time. A lender reaches for it when it is not convinced the business can turn itself around, so it will not commit to rewriting the loan for the long term. Instead, it agrees to suspend enforcement of the defaults for a defined period, essentially “holding its breath.” Forbearance means the lender agrees not to exercise its rights and remedies while you’re in compliance with the agreement. It only is an interim agreement; it preserves the existing defaults and the loan is not restored to performing status.
Still, for a business owner who has just opened a demand letter, that breathing room is worth a great deal. A short forbearance can buy you time to gather data, stabilize the business, implement a turnaround plan, or even find a purchaser. During that period, the lender is on hold and cannot immediately act on the default, such as accelerating the loan. Payments can be deferred or reduced for a while, and the forbearance can be used to give the borrower time to resolve disputes with third parties (like taxing authorities and vendors), attempt to refinance, pursue the sale of some or all of the assets, or raise new capital or subordinated debt. But if there is a realistic chance that the company can turn around, the bank may be willing to temporarily waive or modify some of the terms and give you a chance to get back on track. Done this way, the borrowing company is not subject to all the expense and loss of control associated with a bankruptcy.
The terms themselves are where most of the fight happens. Borrowers typically ask for a deferral or reduction of monthly payments, a longer forbearance period of 12 months or more, reinstatement of the loan when the period ends, permission to continue marketing the business and its collateral during the forbearance without the lender’s intervention or approval, and an agreement from the lender that it will not accelerate the loan or, if the loan has already been accelerated, that a prepayment premium (“make-whole”) upon refinancing or upon sale of the collateral is waived. If the loan has already matured, they ask for more time to pay it off.
For the lender, a forbearance becomes the “blueprint” for its exit. So the borrower needs to be prepared for the lender to demand its best performance to earn the forbearance. That can mean required improvements such as better collections and inventory turns, better vendor credit terms or lower expenses. Lenders generally want a short forbearance period of 90 to 180 days, and if the borrower does not meet the forbearance terms, the lender may pull the plug early. Expect some periodic payments; full repayment of the obligation plus accrued interest and costs/charges at the end of the period; additional collateral and guaranties; timeframe for the asset sale/refinancing; a confirmation that the defaults exist and have not been waived; a turnaround advisor reasonably acceptable to the lender; a release of your claims and setoff rights; and a forbearance fee.
Lenders want forbearances because they minimize expenses and delay and also preserve the underlying defaults in case enforcement becomes necessary later. Forbearances also afford the lender the most opportunity to recover through either a going-concern sale of the business or an orderly liquidation of the business’ assets. A borrower might agree to a friendly foreclosure, in which the borrower agrees to peacefully surrender the collateral and the lender seeks a judgment against the borrower and schedules a foreclosure sale without opposition. The borrower can often more effectively market its assets under a friendly foreclosure.
There Are Many Factors to Consider When Negotiating
Two bankruptcy points deserve attention. First, if the borrower gives the lender any new collateral in connection with an unsecured or undersecured loan, it may be vulnerable to a preference attack under §547 of the Bankruptcy Code if the borrower files for bankruptcy in the future. Second, a lender may demand that the borrower waive the benefit of the automatic stay in the event the borrower files bankruptcy protection. There is a split of authority over whether such waivers are enforceable; some courts will enforce them when certain factors are present.
A demand letter, then, can be the opening of a negotiation rather than the end of one. In sum, there are many factors to consider when negotiating (and drafting) a modification/forbearance agreement. It is important that the parties enlist experienced counsel, as well as other professionals, at each stage of the negotiations through preparation of the document. At the end of the day, whether you get a modification or a forbearance, you are back on the path to doing the right thing as a borrower, dealing with your lender and addressing the defaults.
