A number of factors have combined to cause an almost “per- fect storm” for commercial real estate distress. The COVID-19 pandemic led to a rise in remote and hybrid work, increasing vacancy rates and decreasing property values. Rising interest rates and inflated operating and maintenance costs made the properties more expensive to maintain, further depressing values. The collapse of several regional banks and greater reg- ulatory scrutiny caused the credit markets to tighten, making financing and refinancing extremely difficult. And difficulties in maintaining existing tenants, and finding replacement ones, have further deflated value. All in all, commercial real estate values in various sectors have plummeted, causing some owners to choose to default or even “hand over the keys” to the mortgage lender.
As a result, lenders have faced increased numbers of troubled commercial mortgage loans and are spending more and more time on workouts, short sales, debt sales, DPOs, and foreclo- sures and other enforcement remedies. It is in those situations that lenders are most vulnerable to facing lender liability claims from borrowers and third parties.
In this article, the Morrison Foerster Distressed Real Estate Group provides some helpful tips for lenders to avoid lender liability claims while dealing with distressed commercial real estate loans.
During the period leading up to the decision to exercise remedies, it is important to create a record that documents the facts, so that they can be used later as evidence, if need be. Keep records and communications as factual as possible and seek to include two representatives on calls and meetings with borrowers/guarantors/other lenders to enhance credibility of future testimony.
Do not send emails, texts, or other communications to the borrower containing inflammatory, defamatory, derogatory, or confrontational comments or threats. Keep your communica- tions (and files) clean and neat and avoid a “lender liability” roadmap. Control all of your communications, always keeping a good paper trail. Recall that all communications could be subject to disclosure in a future litigation, so best to follow the “Wall Street Journal” test and avoid saying anything that you would not feel comfortable appearing on the front page of the Journal. Consider signing up a well-drafted pre-negotiation agreement (more on this in part 2).
You should exercise approval rights consistently with your sta- tus as a lender, taking into account any applicable standards in the loan documents when granting or withholding approvals or consents. Avoid taking inconsistent positions and precipi- tous actions that could be viewed as “pulling the rug out from under” the Borrower. When you make changes that affect
the course of dealing in a material way, make sure to provide reasonable time and notice, e.g., canceling a line of credit, to provide the borrower reasonable time to arrange alternatives. Bottom line is to observe the Golden Rule, namely, always be fair and treat the borrower as you would expect to be treated if you were in the borrower’s situation.
Only take drastic actions under the loan documents as a last resort. Do not make decisions or exercise remedies in a manner that harms the borrower without reasonable justifi-
cation, even if technically within your contractual rights. For example, you should not commence a foreclosure or refuse to disburse the balance of a construction loan or future advance
for immaterial or technical defaults. Do not declare construc- tion loans to be out of balance without adequate substanti- ation. You should also avoid being careless or unreasonably slow in processing disbursement requests. Overall, strive for quick, thoughtful replies and actions. Avoid overreacting and appearing arrogant. Before denying borrower requests in regard to major leases or other material business decisions, consider consulting with counsel regarding applicable legal principles. While it’s best to always take actions within the
four walls of your loan documents, be aware that doing so does not always absolve you from potential future liability claims. Be familiar with lender’s credit and other policies with respect to distressed real estate loans and adhere to them.
Be honest in regard to the lender’s intent with respect to renewing a loan or enforcing the lender’s rights under the loan documents. Do not threaten to take actions that have not yet been authorized or actually contemplated. Do not give oral assurances that “soften” the strict language of a loan agreement and then turn around and attempt to enforce the documents as written. Avoid giving rise to false hopes. Do not give the borrower any cause to complain that it took actions in reliance on words or conduct by the lender that was less than candid and forthright.
Viable lender liability claims have arisen in circumstances where a lender exercises control over a business or its manage- ment to the extent that the lender is viewed to have taken on fiduciary duties to the borrower or to have exercised undue co- ercion on the borrower’s business. As a lender, you should not be dictating a borrower’s day-to-day business decisions, such as which trade creditors to pay, when to pay them, or what personnel to hire. You should not make payments to contrac- tors or subcontractors that the borrower has not authorized.
You should not be interacting with third parties in a manner that causes confusion as to who is in control of the borrower. You should not make threats that the lender does not intend to carry out in order to induce the borrower to follow a course of action suggested by the lender. Generally, steer clear of any form of intimidation tactics. Do not coerce the borrower to
accept a third party or an employee of the lender to operate the borrower’s business, especially to the exclusion of the bor- rower’s own officers and employees. Overall, do not run your borrower’s business.
If you choose to take on a role of “financial advising” regarding lease terms, marketing strategies, contractor selection, etc., make sure to give informed and sound advice. It’s alright to monitor the borrower’s business and financial affairs, and/or to insist upon detailed information, but limit your “financial advising” to advice and consultation on discrete business mat- ters. In the end, it’s “borrower’s call.”
Try to identify litigious borrowers early and avoid making loans to them. If you find yourself with a litigious borrower on your hands, take additional care with following all of these tips. If a personality conflict develops between the borrower
and the loan officer, consider changing the loan officer to avoid escalation of the situation.
When ordering an appraisal, environmental report, property condition report, or other consultant’s report in connection with a distressed loan, consult with the lender’s legal staff to determine whether your outside counsel should engage those consultants directly. Doing so may possibly enable such work product to be treated as attorney work product protected from disclosure in a subsequent litigation.
When counsel has been involved in providing advice in connection with a distressed loan, exercise care not to waive attorney-client or attorney work-product privileges that might otherwise apply to documents and communications by shar- ing them with third parties. Any time attorney-client commu- nications or work product is shared outside of the lender, any applicable privilege may be deemed to be waived. Extreme care should be used before sharing documents or advice externally, including with third-party consultants providing fi- nancial or public relations advice. Even sharing work product and communications with co-lenders, mezzanine lenders, and subordinate lenders can be problematic. Seek out advice of your counsel in these situations.
A PNA—also referred to as a “pre-workout agreement” or a “negotiation agreement”—is essentially intended to set the framework for discussions among the parties. It permits the borrower and lender (and perhaps other parties) to sit down together to discuss the viability and terms of a workout or oth- er resolution. The essential terms of a PNA are that each party reserves its rights against the others, that nothing is binding until final and definitive documentation is entered into among all parties covering all issues of concern, that nothing said
is admissible in court, and that any party can terminate the discussions at any time without liability to the others. Signing a PNA is a means to an end, namely a successful resolution.
It’s best, if such an agreement is deemed helpful, to work to negotiate and execute it expeditiously, because while the PNA is being negotiated, the lender is likely not dealing with its un- derlying problem, namely a defaulted loan secured by a lien on a likely deteriorating asset. PNAs come in various shapes and sizes and often seek some “controversial” provisions, such as releases, waivers, estoppels, document and lien confirmations, and the like, which can slow a PNA’s final execution. It’s best to discuss with inside or outside counsel the lender’s internal policies regarding the use of PNAs, and what is best for any given credit and in each specific factual situation.
