What is a forbearance agreement for a defaulted business loan and its key terms?

Loan terms afford the borrower room to maneuver, grow, and avoid accidentally stepping on a landmine. But defaults still happen. Loans can go into default on either an actual or anticipated basis. A borrower in default will usually ask the lender for a waiver. There is no way to draft a credit agreement for every possible event. But a lender might agree to forbear for a specified period. During this time the borrower must cure a default or achieve a new covenant or milestone. A waiver removes a default entirely, while a forbearance merely holds off enforcement of a default during a specified period. There is room to restructure the covenants and secure more collateral. A forbearance is an effective way for borrowers and lenders to address defaults and realign expectations.

Agrees Not to Pursue the Listed Defaults

Forbearance means to hold back from acting against someone. A forbearance is when a lender agrees not to pursue the listed defaults for a certain period of time. The borrower might get a forbearance and pay a fee or accept new covenants or collateral. The borrower may also agree to cure defaults that are curable and undertake new obligations. The borrower agrees to restructured financial covenants, which gives headroom to the borrower while the lender’s credit position gets stronger. The forbearance in this case might allow the borrower to restructure the covenants so that the lender has an acceptable amount of risk as defined by its credit parameters. Keep in mind that you’re now on the hook for a fee and collateral, and a new deal will bring new terms. Breaking any can constitute a fresh default. So if the borrower breaches the agreement, the forbearance can end and the lender can exercise rights. It is not a waiver of the lender’s claims or a cure of a default.

It’s important to negotiate a period of time that gives the borrower enough of a window to fix the issue while making sense for the lender, taking into consideration their collateral’s value. The borrower wants as much time as possible to correct the condition. But if the forbearance is too long, the lender might not be willing to grant it given the risk of decline in collateral. A forbearance period can end early if the borrower violates any of the terms of the forbearance or any other default occurs. At that point the lender may use every remedy that it deems fit.

Best Practice

There is no such thing as a standard forbearance agreement. Any forbearance agreement will be subject to the unique facts and circumstances of the default, and the borrower’s credit profile. Still, there are some “best practice” items that any forbearance agreement should include.

At the beginning of the forbearance agreement, there is a section called “Recitals,” which lays out the “facts” of the deal. The borrower can’t dispute those facts in court later. It’s important that the borrower understand this and write as accurate recitals as possible. Be sure to specifically list every default that will be covered, and keep in mind that any defaults not listed or that occur after the signing won’t be covered by the agreement. If the borrower does something that is considered a default but not specifically covered in the forbearance agreement, the lender can terminate the agreement and go after its rights right then. If you know that you will miss a covenant after closing, it is wise to include it in the forbearance agreement so that your pre-agreed miss won’t later be a new default that terminates the agreement. It is also a good idea to confirm the balance owed by the borrower to the lender and any prior default notices given. The loan balance includes principal, interest and any other sums due. List any reservation-of-rights letters too.

A reaffirmation is a confirmation between the borrower and the lender that a loan agreement and its related liens are still in place, and that the borrower reaffirms its commitments to the lender. The forbearance agreement has no effect on and does not change, affect or remove the liens. All lien positions remain valid and enforceable in full force and effect to secure all debts. The borrower reaffirms representations and warranties. Defaults continue to exist. The borrower acts willingly and consents to all terms. That means that the borrower accepts that it is taking its own risk.

A lender may also impose new covenants. These may include a cash paydown amount, a restriction on future advances, a deposit account directive or new financial covenants and targets. Forbearance can include a deposit covenant that requires a minimum amount of cash, or a percentage of the worldwide balance, to be kept in deposit accounts at the lender. Such covenants may continue after the forbearance period too. When planning to forbear, a lender also has the flexibility to insist on milestones. These milestones can be the closing of any new equity commitments, for example. Hitting a milestone can be a condition precedent for a conditional waiver. When considering new collateral for a debtor in a possible bankruptcy, the lender must consider the risk of the preferential transfer, since a bankruptcy can potentially strip it out in a preference action down the road and may cost the lender all the new collateral.

Broad General Release

Your release of claims and the lender’s reserved rights

Any forbearance agreement should include a broad general release by the borrower of the lender. The general release should cover both known and unknown claims up to the effective date of the agreement. A release includes claims, demands, actions, losses and liabilities under the loan papers and the forbearance agreement itself. The released party is clear of the claims by the releasing party. A full release can be a complete defense to any suit filed in violation of it. The lender would be induced to enter the forbearance agreement based on the receipt of a general release.

The reservation of rights of the lender is important too. Nothing in the forbearance agreement should be considered a waiver of the lender’s rights, including its right to foreclose on collateral, immediately upon the expiration of the forbearance period. The reservation of rights provision should reference every right of the lender, including not just the right to foreclose on the collateral, but all of its rights, including the right to pursue any default at the expiration of the forbearance period.

Forbearance is a very useful tool for the borrower and lender to work through a default together. A forbearance agreement for the borrower is a chance to cure or fix an issue. It will often come with more flexibility. The borrower may gain a waiver down the road. For the lender, it means new covenants, more collateral and a general release. So read carefully what you sign, especially in terms of a release and the lender’s reserved rights.