Strategies for Resolution of Defaults under Commercial Loans

Attorneys practicing in the field of commercial finance and special assets professionals should keep up with the latest strategies to resolve borrower defaults through negotiated forbearance agreements. As discussed herein, professionals seeking to maximize lender recoveries on distressed debt should consider strategies including, without limitation: (i) preliminary loan workout analysis, (ii) pre-negotiation agreements, and (iii) forbearance agreements, which may be utilized to address deficiencies in loan documentation, collateral, or covenants.

I. Defaults

Defaults under commercial loans may be monetary in nature, i.e., a borrower may fail to pay principal at maturity, interest installments when due, or other indebtedness such as insurance premiums and taxes (collectively, “monetary defaults”). As monetary defaults generally may be cured, lenders must work with their counsel to strategize about potential business plans to resolve such defaults that limit the lender’s risk. Other defaults—such as the unauthorized sale or transfer of collateral, the death of a guarantor, and the failure to comply with applicable laws (collectively, “nonmonetary defaults”)—may not be curable, a factor that lenders should keep in mind when evaluating potential enforcement strategies.

Lenders also should be aware that their remedies must be appropriate for the specific default. For example, courts will examine the fairness and equity of a lender’s choice to accelerate a loan in the context of the nature of the default at issue. In addition, lenders should review the loan documents to determine whether the borrower’s default is automatic or requires the lender to provide notice and a time period to cure.

Most often, the nature of the collateral will compel treatment of the defaults. For example, a lender may be more willing to work out a loan default for a construction loan where the building is nearly complete and only requires minimal costs to complete it, as compared to a lender’s willingness to work out a loan secured by collateral that may not have value in a sale (e.g., computer components or auto parts). In evaluating their options, lenders also should understand that not all default interest may be recoverable, particularly where interest is assessed pre-maturity on the entire loan amount. Depending on the jurisdiction, lenders and their counsel should watch for one-action (or “single action”) rules, which require that lenders exhaust their security before suing the borrower directly on the debt or employ a modified anti-deficiency approach to recoverability. While default remedies often apply the laws of the lender’s preferred jurisdiction, lenders should be aware of recent legal developments that impact the court’s application of contractual choice of law provisions.

II. Pre-Negotiation Agreements

Lenders should strategize about a potential pre-negotiation agreement (“PNA”) prior to entering into workout agreements with their borrower. A PNA sets the ground rules for any workout discussion and expressly reserves the lender’s rights and remedies. PNAs also acknowledge the voluntary nature of workout discussions, and they should confirm that either party can terminate negotiations at any time.

Lenders and their professionals should consider utilizing PNAs to maximize lender interests by, for example: (i) stating the existing defaults with clarity and acknowledging that the lender is free to exercise all rights and remedies as a result thereof, (ii) requiring borrower’s cooperation with pre-meeting inspections of collateral, and (iii) including a detailed release of claims in any way connected with the loan documents as of the date of execution of the PNA.

III. Forbearance Agreements

Forbearance agreements can be important tools in a lender’s arsenal for the informal resolution of defaults, as such agreements provide a clear roadmap for resolution and limit a lender’s credit risk while providing a borrower with sufficient time to resolve its financial difficulties and get back on track. Forbearance agreements also are helpful in reducing lender liability concerns, as any disputes by a borrower concerning the factual aspects of a loan and the existing defaults can be addressed in the agreement. A lender also can reduce the risk of its borrower alleging that the lender made oral promises by documenting the terms and conditions for its forbearance in the forbearance agreement.

Lenders should avoid waivers of existing defaults if at all possible. Where they cannot be avoided, waivers should be specific and short term, prepared by counsel, in writing, and clearly labeled as a waiver of existing default. Oral waivers should be avoided at all costs. Lenders also often are able to collect forbearance fees as consideration for their agreement to conditionally forbear from exercising their rights and remedies upon the borrower’s default, as well as releases. In addition, lenders may utilize forbearance agreements to clarify that attorneys’ fees, appraisal fees, litigation costs, and all other costs of collection are recoverable under the parties’ loan documents. Also, any forbearance agreement should clearly state the benchmarks, conditions, or milestones that a borrower must meet—including the timeframe for such compliance—in order for the forbearance to take and stay in effect. Finally, should lenders discover any insufficiency with their collateral, perfection, or documentation, they should strive to fix the deficiency in the forbearance agreement.

IV. Conclusion

Lenders should confer with their counsel to strategize over options to address defaults under their commercial loan documents. The nature of the borrower’s default, the type of collateral, and the lender’s business goals in resolving any default all should be considered when exploring whether a PNA and forbearance agreement may be the best option for a negotiated resolution in any given situation.