The most common approach that lenders have taken is a forbearance or a loan modification, but both come in a number of different flavors, and it’s important for both sides to understand the mechanics of each one before taking one approach over another.
Loan Modifications
A modification changes terms in a lasting way and brings the loan back to performing status. It can include, for instance, temporary payment relief (like a deferment or amortization change) and perhaps temporary covenant changes or waivers for the prior period. It puts the borrower in good standing going forward and reverses any prior acceleration. Loan modifications wipe the slate clean for past defaults. Modifying a loan can reset the entire relationship, so it’s more attractive to borrowers as they often want a fresh start.
Borrowers generally want one or more of:
- Payment reduction or deferment
- Interest-only payments, smaller amortization payments, or a maturity extension, to postpone a balloon payment
- A reduced interest rate
- A waiver of prepayment fees like a make-whole payment when refinancing
- Changes to financial covenants, or waivers of broken ones
- For construction loans, a larger interest reserve with a longer project schedule. Also, language added to force majeure provisions excusing delays from the pandemic, or government shutdown orders.
- The right to bring in new equity partners or take on other debt
- Changes to guarantor provisions
The lender’s own wish list may include:
- Additional collateral security
- Cross-collateralization and cross-defaults with affiliate loans
- Converting unsecured loans to secured ones
- More guarantors added, a limited or springing guaranty converted to an unlimited guaranty, and recourse added when the loan was originally nonrecourse
- The right to grab rents or cash from the borrower when certain conditions are met through a “lockbox” or cash dominion arrangement
- Added covenants and reporting requirements, including more or different reports or more frequent reporting
- Lenders may seek waivers of claims that borrowers might be making against them, along with defenses and setoffs
- Reimbursement for the lender’s legal fees associated with granting the relief
- Monitoring fees to pay for more hands-on management of the troubled loan
A Forbearance Agreement May Be the Answer
If a lender thinks the borrower may not recover in the long term and is unwilling to restructure the loan, a forbearance agreement may be the answer. It involves the lender holding off on remedies such as foreclosure or calling default while the borrower complies with specific conditions and performance criteria. Unlike a loan modification, a forbearance doesn’t bring the loan back to performing status. A forbearance doesn’t wipe out the original defaults, nor the lender’s right to take action.
With the forbearance, the lender keeps the loan classified as nonperforming on its books, which can matter for regulated lenders. It’s still possible, however, for borrowers to gain from a forbearance. It can temporarily defer or reduce payments for a brief time period. For borrowers, forbearance is a short-term remedy that buys time to sort out tax or vendor disputes, bring on new capital or equity partners, or line up a refinancing or asset sale.
If there’s hope of turning things around, forbearance may include a temporary waiver or modification of some loan terms so the loan can be reinstated. If the borrower turns a corner, a forbearance avoids legal and bankruptcy costs, and allows the borrower to stay in the driver’s seat.
Borrowers aren’t the only ones with reasons for preferring a workout rather than litigation. Enforcement takes time and costs money, and forbearance can cut both. Also, a default in the loan documents stays preserved. If the workout ends in a friendly foreclosure, the borrower voluntarily surrenders the collateral, avoiding a contested foreclosure and drawn-out fight. That means an unopposed judgment and no contest to the sale, while the borrower markets its assets.
For the lender, there’s the opportunity to clean up any messiness in the documentation, add new collateral security, or obtain other terms that are better for the lender. The problem is that new collateral added as part of the new deal may be attacked as an invalid preference under the Bankruptcy Code §547 if the borrower later files for bankruptcy. Another benefit of forbearance is that it gives the lender time to maximize recovery. For example, if the borrower stops paying on a loan secured by an on-going business, that forbearance time lets the lender either structure an orderly going-concern sale or an orderly liquidation of the assets in time.
Usually a borrower in forbearance requests:
- A payment deferral or reduction
- A term of at least 12 months
- That the forbearance bring the loan back to a performing status when it ends, even if the lender doesn’t restructure the loan or take a modification
- Freedom to market the collateral during the forbearance, without the lender looking over its shoulder
- A waiver of the lender’s right to accelerate the loan
- Waiver of any make-whole payment if the borrower refinances or sells the property to pay off the loan after a loan acceleration
- Extra time to pay off the loan after maturity
The lender should look at the forbearance agreement as a blueprint for the exit they want. It should include:
- An acknowledgment by the borrower that it has defaulted and still is in default, which the lender isn’t waiving, so that the lender can avoid forfeiting any of its remedies, along with a waiver by the borrower of any defenses it could have used before the forbearance
- Reaffirmation of the collateral
- A short term from 90 to 180 days, that ends early if the borrower defaults
- Some payment required during the forbearance
- Full payoff of principal and interest at the end of the term, plus the lender’s costs
- More collateral and guaranties
- A time limit to sell or refinance the asset
- The appointment of a turnaround advisor acceptable to the lender, and that the lender may see the work the advisor does.
- A release of borrower’s claims, including defenses and setoffs, and the same from guarantors
- A forbearance fee to cover the expense of delay, drafting and monitoring
- A waiver of the automatic stay in any future bankruptcy, as it applies to the collateral. But automatic-stay waivers won’t always be enforceable. Courts are split on that question, with some enforcing them under certain conditions.
- For larger borrowers, a board of directors with truly independent members, and a requirement that minutes and materials for board meetings be shared with the lender.
About Delancey Street
Delancey Street is a premier, and award winning, business debt settlement company that helps business owners nationwide. Our goal is simple: help you escape debt in a safe and legal manner. Based out of New York, we can help in 49 of 50 states. We tell you how it is; because your business and future is on the line.
