By Jay Steinman and Karina Leiter
Loan defaults and workouts are on the rise again due to a confluence of factors causing headwinds including: the surge in interest rates and real estate owners inability to refinance maturing loans at affordable rates; the continued rise in the cost of certain materials needed for renovation and construction; the staggering cost of flood and windstorm coverage and the impossibility of even obtaining coverage; and the loan maturing in the near future without satisfactory options to refinance or be otherwise paid off on time.
Anticipating the fallout from potentially billions of dollars in distressed loans, lenders must be on high alert. Drawing from lessons learned in the last two historical downturns, where we witnessed unprepared lenders face severe consequences, it is imperative for lenders and financial institutions to act now.
Identifying distressed borrowers and projects is a critical first step, acknowledging the inevitability that many loans are already or may default in the near future. By taking proactive measures now, lenders can not only brace for the storm but also enhance and protect their available legal remedies in the event of a borrower’s default.
The subsequent steps outlined in this article offer a strategic guide for lenders, empowering them to navigate the complexities of loan workouts and enforcement actions with resilience and foresight.
If a default has occurred the lender may want to have counsel draft a form of reservation of rights or nonwaiver letter. The letter should identify the known breaches and should also include “nonwaiver” type language which generally states that notwithstanding the breach or default the lender is reserving all rights under the loan documents and is not waiving any right or remedy thereafter even though it may be taking no action at that time to enforce its remedies.
Review Loan Documents
Before discussing a potential loan workout with a borrower or proceeding to exercise the remedies available, lenders should first evaluate their legal position, which includes conducting a thorough review of all loan documents including all organizational documents, title insurance policies, surveys and other due diligence materials received at closing and thereafter. Taking inventory of all collateral is also important if possible. A careful review of the loan file should be conducted to identify any documents and correspondence that may adversely impact enforcement of remedies. You don’t want to go to war with defective loan documents or due diligence issues that should have been addressed before the loan closed or thereafter.
We recommend that a new pair of eyes go through all relevant documents. Unfortunately, it is human nature that the counsel who handled the loan previously may have missed or overlooked something that will become critical during the workout, foreclosure or REO sale thereafter. Further, lenders should consider whether there are any technical issues with the loan documents and loan structure that could complicate enforcement.
Lenders should pay particular attention to what constitutes an “event of default” under the loan documents, keeping in mind the borrower’s financial and non-financial covenants, as well as the remedies available to both parties when an event of default occurs, including, without limitation, any required notices and applicable cure periods.
Perform Updated Diligence
After the lender and its counsel have reviewed the loan documents and defects if any have been identified, it is also prudent to conduct an updated review of diligence items with respect to the collateral which secures its loan, the borrower and any guarantors, including, without limitation, updated searches, title, review of financial information with respect to the property, borrower and any guarantor and current organizational documents. The lender may also want to obtain an updated appraisal and environmental audit.
By performing loan document review and analysis and the updated diligence, the lender will better understand its position and leverage before entering into negotiations with the borrower. Any existing liens or other title defects may complicate any foreclosure sale and further slowdown enforcement, which is already a lengthy process.
Execute a Pre-Negotiation Letter
Before beginning any substantive discussions with a borrower regarding a loan modification or forbearance agreement, we recommend that the lender require that the borrow and any guarantor execute a pre-negotiation letter agreement. A pre-negotiation letter agreement sets forth the parameters of the negotiations between borrower and lender prior to memorializing such negotiations in any written document. We recommend that the pre-negotiation letter agreement include a requirement that the borrower and any guarantors provide certain updated due diligence information described above to the extent that the lender’s file does not include this information.
To the extent that a lender elects to withhold from enforcing its rights under the loan documents as a result of a borrower or lender default, the parties should enter into a loan modification or forbearance agreement. Generally speaking, it is best practice that the forbearance agreement include an acknowledgement by the borrower and any guarantors that a default has occurred under the loan documents and that the lender agrees to refrain from exercising its rights and remedies for a specific period of time, provided that the borrower and any guarantor comply with the conditions set out in the loan modification or forbearance agreement. The forbearance agreement at a minimum should include the following provisions: recitals, admission of outstanding loan balance, debt service payments during the period of forbearance, forbearance period, conditions precedent to the effectiveness of the forbearance agreement, forbearance events of default and remedies, retroactive default interest from the date of the initial default, release of lender, waiver of bankruptcy stay, consent to appointment of a receiver and foreclosure, agreement not to contest foreclosure and reaffirmation of guaranty.
The process for enforcing a loan through foreclosure varies across jurisdictions, so lenders should understand the unique process in their jurisdiction.
The loan documents may allow the lender to ask a court to appoint a receiver to take possession of and manage the property until the foreclosure is finalized and the property is sold through a foreclosure sale; provided, however, the applicable standard for the appointment of a receiver varies by jurisdiction. Lenders should also be aware that language in a loan document that allows a lender to “request” or “apply” for the appointment of a receiver does not necessarily entitle the lender to that appointment in most cases. Most states have recently adopted a model receivership law making it a bit easier to obtain a receiver in different venues around the country.
In light of the current interest rate environment, borrowers are getting more desperate to hold onto their current financing and will employ various delay tactics to prevent lenders from enforcing their rights. These types of defensive tactics can significantly increase the time and expense associated with enforcement of the loan.
Be Aware of Lender Liability
Throughout the workout and/or enforcement process, lenders should be aware of their exposure to potential lender liability claims. Borrowers may bring claims based on a lenders’ failure to honor its obligations under the loan documents, unreasonably delay, or lack of good faith. These claims will open lenders up to discovery, which can be time-consuming and expensive. Therefore, lenders should keep in mind that all non-privileged communications may be discoverable and keep all internal and external communication professional. Lenders should ensure that all discussions with the borrower and any guarantor are well documented and subject to confidentiality requirements set forth in the pre-negotiation letter agreement and/or forbearance agreement.
In conclusion, with loan defaults and workouts on the rise due to various challenges, lenders must act proactively to safeguard their interests. By taking measures now, lenders can enhance their readiness to navigate the challenges ahead, protecting both their assets and legal remedies. In the evolving financial landscape, foresight and preparedness are key to resilience.
—Meagen E. Leary and Phillip Hudson, attorneys with the firm, assisted in the preparation of this article.