With billions of dollars of commercial real estate (CRE) loans coming due this year, it seems inevitable that large numbers of borrowers will struggle to refinance their CRE loans, as property values have declined and interest costs have risen, fueling predictions that banks should brace for significant losses on commercial real estate loans. So far, however, bank-reported delinquency rates have remained much lower than during the global financial crisis of 2008. For now, at least, a widespread reckoning in commercial real estate has not materialized.

As the current environment for CRE loans persists, banks increasingly will face the need to restructure loans in their portfolios. Lenders and bank counsel who were around during prior real estate downturns have engaged in the loan workout process countless times before. But many of the hard lessons learned from prior recessions have faded from our collective memory, and the intervening years have brought new lenders that were not on the scene during the last recession. For those without prior workout experience, as well as those who have not handled a troubled real estate loan in years, it is helpful to review the fundamentals of dealing with problem real estate loans.

Start with a Thorough Loan Review and Other Due Diligence

Any strategy for handling a problem loan must start with a thorough review of the loan file and other due diligence. Before sitting down to negotiate with a borrower, the lender must understand what leverage it brings to the table. Moreover, a forbearance or loan workout agreement is an opportunity to fix or remedy any errors or oversights in the loan documents. The lender’s review should include all documents in the original closing file and all loan modifications, credit approval memorandum, correspondence files, appraisals and environmental reports, title commitments and a thorough review of any non-real estate collateral, financial statements and other financial information pertaining to the borrower, guarantors and any pledgors of collateral, and relevant information relating to other loans and extension of credit to the same borrower or its affiliates.

At the outset of the review, the lender should obtain an updated title commitment or letter report prepared by a title company. This will allow the lender to determine whether there are any title issues that need to be fixed in the context of a forbearance or loan workout agreement. For example, does the legal description in the deed of trust match that in the updated title commitment? Has any property been released from the deed of trust? Is the property owner the same as the grantor in the deed of trust? Is the property subject to any mechanic’s liens that may take priority over the deed of trust or to any junior liens or encumbrances that are not permitted by the loan documents? The title work should also reveal if there are any delinquent real estate taxes. Similarly, the lender should conduct an updated Uniform Commercial Code (UCC) lien search to determine that the security interests in any personal property governed by the UCC are properly perfected, whether there are any issues with lien priority, and if there are any IRS or state tax liens against the borrower.

The lender’s loan review should verify that the information contained in the loan file is consistent with the bank’s internal reports, memorandum and credit approvals, and any discrepancies should be identified and noted. For example, if a loan was approved based on a guaranty or letter of credit as credit support, but the guaranty or letter of credit was released by a loan officer who is no longer with the bank, this discrepancy should be flagged. Common errors in loan documentation include: some documents are unsigned or missing; UCC financing statements contain incomplete or inaccurate collateral descriptions, were filed in the wrong place or have lapsed; and guaranties were not properly confirmed when loan assignment of rents. Failure to conduct a thorough review of all loan documents and related files before discussing a workout strategy with a borrower may have unforeseen and unfortunate results, including missed opportunities to fix documentary errors and shore up collateral.

Identify Specific Problems and the Bank’s Goals for any Workout Scenario

Of course, a bank’s primary goal in dealing with any problem loan is to realize full and timely repayment of the debt. However, when changes in the interest rate environment, collateral values and the borrower’s and guarantors’ overall financial condition make that unlikely, the bank should be realistic about best- and worst-case scenarios for resolving the loan and what it hopes to achieve in a workout. For example, is the bank interested in preserving a lending relationship with the borrower, avoiding foreclosure due to possible environmental concerns related to the property, or preserving jobs or the going-concern value of the collateral? Also, the bank must determine if the borrower wants to continue to operate the property or if they are resolved to hand over the keys. Moreover, what are the primary causes of the underlying loan default – poor management of the property, downsizing of a major tenant, construction cost overruns and time delays, or something else? All of these considerations, among numerous others, will factor into the bank’s strategy for addressing the nonperforming loan.

Start with a Pre-Negotiation Agreement

A pre-negotiation agreement (PNA) is a critical step before sitting down to negotiate with a borrower and should be thoughtfully drafted. A PNA may take the form of a letter agreement or a more formal document, but the main purpose is to maintain the status quo so that the bank and the borrower may freely engage in discussions and not be bound until a formal agreement is executed. The PNA also ensures that the borrower cannot use the negotiations themselves to oppose the lender’s efforts to enforce the loan documents or assert claims against the lender on the basis that the lender agreed during the course of the negotiations to a forbearance, or that the parties’ communications themselves constituted a modification agreement. Failure to obtain a PNA before starting negotiations can be prejudicial to a lender; a borrower whose back is against the wall is more likely to claim that the bank made promises on which the borrower relied to its detriment.

Loan Workout and Forbearance Agreements

If a borrower’s ability to repay a defaulted loan may improve over time (e.g., if the borrower is given more time to refinance), or if the loan is restructured (e.g., to require interest-only payments until cash flow improves), then a forbearance or loan workout agreement may be a good option. Technically speaking, a forbearance agreement and a workout agreement are different, although they share many of the same characteristics and goals and may be combined in a single form of agreement. A forbearance agreement temporarily defers the bank’s rights to pursue legal remedies such as foreclosure while giving the borrower a finite and short period to bring the loan current or refinance it altogether. By contrast, a workout agreement is typically intended to be a longer-term solution for dealing with a problem loan, which may involve restructuring payment terms and financial covenants, extending the maturity date of the loan, or reducing the loan commitment over time.

Key Provisions to Include in Loan Workout and Forbearance Agreements

Loan workout and forbearance agreements should always incorporate several key terms and conditions, including:

• Identifying the existing loan documents, including promissory notes, guaranties, security agreements and pledge agreements, and any amendments or modifications;
• The borrower and any guarantors should acknowledge the amount due on the debt and the existing defaults under the loan documents, including any payment defaults, breaches of financial covenants, or past-due taxes;
• The borrower and guarantors should reaffirm the continuing validity of the loan documents and their obligation to repay the debt; and
• Events that will constitute defaults under the loan workout agreement or terminate the bank’s obligation to forbear, including the expiration date for the forbearance, should be clearly identified.

It is also prudent to include waivers, releases of claims and covenants not to sue the bank, especially based on claims of lender liability, negligence in the administration of the loan or other claims that may be advanced for the primary purpose of hindering or delaying the loan enforcement process.

Beyond these basic considerations, forbearance and loan workout agreements must include provisions that are specific to the circumstances surrounding the defaulted loan. For example, in exchange for the bank’s agreement to forbear for a period of time or to modify the loan, the bank may require:

• The pledge of additional collateral and/or partial paydown of the loan;
• Additional guarantors;
• Additional remedies that were not included in the original loan documents, such as the automatic right to the appointment of a receiver in the event of a further default under the loan documents; or
• Confession or stipulation of judgment, which can save significant time and expense associated with obtaining a judgment against a borrower and/or guarantors.

Ultimately, if the borrower is not able to get the loan back on track, a carefully negotiated and well-drafted forbearance or loan workout agreement can strengthen the bank’s collection position, streamline the liquidation process and protect the bank against claims by a borrower. Prompt and decisive action, based on a thorough understanding of the loan, the borrower and the bank’s negotiating leverage will improve the bank’s prospects for recovery on the defaulted loan. When dealing with a problem loan, it is important to engage outside counsel with workout expertise early in the process, who can develop an appropriate legal strategy, issue spot and quickly move to enforce the bank’s rights and remedies should the workout not be successful.

Sherry Dreisewerd helps lenders close complex financial transactions, working with national, regional and community banks to originate real estate, commercial, industrial and asset-based loans. She also helps lenders maximize loan recoveries through restructurings and workouts and has assisted numerous secured creditors, creditors’ committees and business acquirers in bankruptcy proceedings. Sherry can be reached at (314) 333-3934 or sdreisewerd@spencerfane.com.