When a lender is working with a borrower to get a problem commercial loan resolved the loan typically goes to “workout”. When a commercial loan is criticized internally, when it’s out of covenant, or when the borrower fails to pay or pays late the loan will often go the workout department of a bank unless the bank uses a special servicer or, at really small banks, the workout is handled by the commercial loan officer on the line. Commercial loans can end up in the workout department if they are in monetary default or in technical default. A commercial loan can be considered to be non-performing whether it’s in monetary or technical default.
Technical Default vs Monetary Default
A monetary default occurs when the borrower is late on or does not make payments. A technical default occurs when the borrower violates other terms or covenants within the commercial note.
Typical technical defaults that will land a commercial loan in the workout department are:
• The value of the collateral (the property) and therefore the LTV (Loan to Value) dips below the prescribed percentage
• The owner fails to maintain the property as prescribed.
• Borrower fails to maintain insurance
• Borrower fails to pay taxes
• Borrower fails to submit financial statements on schedule (if required)
• Borrower fails to maintain liquidity or reserve ratios
• Borrower misallocates or mis-distributes profits
• A separate loan with the lender goes into default
The list goes on. And since commercial loans are between two businesses the borrower is expected to be more savvy and be more equipped than, say, a consumer. Therefore the terms and covenants in commercial loans are not regulated to the same degree as residential property loans and that means that the borrower should pay close attention to the covenants and be prepared to meet them lest she be caught blindsided by the workout department. Make no mistake the private lenders are much more flexible and creative in their workout strategies than traditional lenders are. Private lenders:
• Reduce principal
• Reduce interest rates
• Extend terms
• Modify the loan so its interest-only
• Accept a deed-in-lieu
Private lenders can do just about anything that’s legal and the borrower agrees to in their workouts. Banks and credit unions cannot, they’re regulated and those regulations dictate their workout options.
Commercial Loan Workouts at Banks
A commercial workout officer’s job is to collect what the bank is owed, in full, and make the bank “whole” on the loan. A good commercial workout officer knows about his assets, his borrowers, the local market and his vendors and uses all of those resources to collect. Depending on the size of the bank and the size of the loan a commercial workout officer may be very hands on or may direct the recovery and workout from behind a desk across the country. Because banks are regulated the rules and guidance around workouts varies significantly from those of private lenders.
Loan workout arrangements need to be designed to help ensure that the institution maximizes its recovery potential. Further, renewed or restructured loans to borrowers who have the ability to repay their debts under reasonable modified terms will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount that is less than the loan balance. So in short, if the borrower and guarantors of a distressed commercial real estate loan can write the check and you’d rather extend the loan, restructure the loan or what-have-you, the fact that the property is worth less than is owed is not the determining factor for whether or not the bank has to action on a CRE loan in technical default (default for reasons other than non-payment). It also say that bank’s must do whatever will allow them to maximize capital recovery (essentially).
Analyzing Repayment Capacity of the Borrower
Basically look at the whole borrower and the guarantors. If they have the ability to continue to pay and their future ability to pay is defensible then carry on.
Evaluating Guarantees
A good guarantor with a solid contract means you can keep reporting the loan is in good standing.
Assessing Collateral Values
A new appraisal may not be necessary in instances where an internal evaluation by the institution appropriately updates the original appraisal assumptions to reflect current market conditions and provides an estimate of the collateral’s fair value for impairment analysis. The documentation on the collateral’s market value should demonstrate a full understanding of the property’s current “as is” condition (considering the property’s highest and best use) and other relevant risk factors affecting value.
Classification of Renewals or Restructurings of Maturing Loans
Many borrowers whose loans mature in the midst of an economic crisis have difficulty obtaining short-term financing or adequate sources of long-term credit due to deterioration in collateral values despite their current ability to service the debt. In such cases, institutions may determine that the most appropriate and prudent course is to restructure or renew loans to existing borrowers who have demonstrated an ability to pay their debts, but who may not be in a position, at the time of the loan’s maturity, to obtain long-term financing. The regulators recognize that prudent loan workout agreements or restructurings are generally in the best interest of both the institution and the borrower.
Classification of Troubled CRE Loans Dependent on the Sale of Collateral for Repayment
This section speak specifically to how to classify the loss or potential for loss with a CRE loan. Specifically it indicates that when the sale of CRE is necessary to repay a loan the amount that that property is under water should be classified as “doubtful” but use that term sparingly.
Classification and Accrual Treatment of Restructured Loans with a Partial Charge-off
When you restructure a loan and charge off a piece the remainder of the loan is at worst substandard (rather than ‘doubtful’). It goes on to say that one workout strategy might be to separate the loan into two enforceable loans, and then you put the senior piece on your books as ‘accrual’ in many cases (meaning ‘its all good’).
Implications for Interest Accrual
If you restructure a loan that is not already in nonaccrual keep it out of there but document everything. If the restructuring happens after it hits nonaccrual then you’re going to need 6 months more of good history before you move it back to accrual. A sustained period of repayment performance generally would be a minimum of six months and would involve payments of cash or cash equivalents.
Commercial loan workouts from the secured lender’s perspective
Every loan workout of a distressed company is distinct. Numerous factors drive the secured lender’s strategies and tactics, including whether the borrower has a sustainable core business, strength of management, the type and value of the lender’s collateral, cash flows, industry strengths and weaknesses, junior debtholders and lienholders and the potential effects of a Chapter 11 bankruptcy proceeding. These factors and others affect the strategies and leverage of a secured lender in taking action to protect and assert its rights and interests, as well as its ability to structure an exit strategy. No single strategy is effective for every workout situation. Lenders, workout counsel and consultants must be prepared to roll with the waves and change their strategies and tactics. However, certain steps should be considered in most workouts by a secured lender.
Distressed borrowers tend to hope that financial problems will go away and solve themselves over time. Secured lenders often do the same when issues surface with their borrowers. Seldom, however, do such problems solve themselves without special and immediate attention. Red flags—such as declining cash flow and sales, loss of major customers, ineptitude or changes in management, failure to meet budgets and projections, requests for over-advances, borrowing base issues and failure to pay as agreedrequire immediate explanation, evaluation and attention. If management’s explanations or the secured lender’s field audits do not provide adequate explanations and solutions to the issues, independent workout consultants should be retained, as discussed below.
Retention of Experienced Workout Consultants
Experienced workout consultants are critical to a successful workout and restructuring of a distressed borrower. Too often, a secured lender and/or borrower will delay the retention of a consultant, unwilling to incur additional costs. However, the cost of a secured lender’s consultant typically can be added to the outstanding debt, and the consultant may later be a critical witness for the secured lender in a bankruptcy proceeding or litigation. An experienced workout consultant retained by the borrower can produce cash savings that more than cover the retainer agreement. The consultant should examine special issues such as unfunded pensions, leases, long-term contracts, litigation, cash flows and management issues. Advice in these areas can dramatically improve the results of a workout. Secured lenders should always consider having their counsel retain the consultant in order to potentially protect the consultant’s work product as Attorney Work Product. At times, a secured lender may require its borrower to retain a consultant as a condition to further lending under a forbearance agreement, as discussed further below. Whether retained by the secured lender or borrower, an experienced workout consultant can provide significant value. However, it is important that the scope of work and fees be addressed in advance to minimize disruption to the borrower’s operations and to keep costs as low as reasonably possible, so the borrower benefits from the process.
Documentation and Collateral Perfection Analysis
Prior to proceeding with a workout, a secured lender and its counsel should always perform a documentation and collateral perfection examination. Updated Uniform Commercial Code, tax lien and judgment lien searches should be performed on an urgent basis at the beginning of a workout. Security and loan agreements, landlord waivers, deposit account control agreements, intercreditor agreements and guarantees should be examined to assure that all executed copies are in the file. Perfection on special collateral, such as trademarks, patents and other intellectual property, in addition to causes of action of the borrower in litigation, should be examined. Secured lender’s counsel should also examine whether any delays in perfection might cause any concerns that the secured lender’s liens could be avoided as a preference or fraudulent conveyance in a bankruptcy proceeding. Finally, the effects of a bankruptcy proceeding on the rights of the secured lender should be examined and considered by the secured lender and its counsel in forming the strategies for the workout.
Collateral Review, Analysis and Valuation
Field audits of inventory, accounts receivable and equipment should be performed to assure the accuracy of the borrower’s borrowing base and other collateral reports. The potential of obtaining additional liens on unencumbered assets and second liens on collateral in which another party has a lien should be considered as consideration for continued lending. Going-concern and orderly liquidation appraisals should be considered in the event of a bankruptcy proceeding or foreclosure. The retention of the appraiser by secured lender’s counsel should be considered in order to potentially protect the appraiser’s report as attorney work product. All of the above should be completed in order to help the secured lender, its counsel and other advisors form a strategy going forward, both in and out of a bankruptcy proceeding. The secured lender and its advisors should develop a special strategy for any “icebergs,” i.e., collateral that deteriorates without the ability to move it.
Cash Flow Budgets and Projections
Short-term (four weeks, thirteen weeks) and long-term cash flow budgets and projections should be performed by the borrower and tested by the secured lender and its advisors to determine what additional over-advances or funds from equity or other interested parties are necessary to accomplish the restructure. “Budget-to-actual” reports should be required on at least a monthly basis in order to assure budget compliance.
Forbearance Agreements
Forbearance agreements are often requested by distressed borrowers during the restructuring period to avoid interruption by the secured lender. However, a properly drafted forbearance agreement can also provide signifi cant benefi ts to the secured lender. The following benefi ts to the secured lender should be considered in the forbearance agreement:
• acknowledgment by the borrower of the outstanding balance, to avoid or reconcile any disputed balance
• acknowledgment by the borrower of specific current defaults and the right to accelerate, to avoid future disputes or defenses regarding defaults (defaults should be waived only in rare instances)
• acknowledgment by the borrower that it has requested the forbearance, to establish consideration for any concessions to the secured lender
• establishment of a “forbearance termination date” or “drop dead date,” by which the borrower must resolve certain issues (i.e., over-advances, refi nancing, covenants, defaults or sale of the business or division)
• amendments to the loan agreement, such as reducing the amount of the loan commitment, increasing the interest rate or providing forbearance fees
• acknowledgment that the secured lender has a valid and properly perfected security interest, without any defenses
• acknowledgment by the borrower that the loan agreement is enforceable, without defenses
• full release and waiver of defenses by the borrower
• conditions of the forbearance, such as:
• retention of a workout consultant, who will provide regular status reporting to the secured lender
• retention of an investment banker or broker to sell the business, or a division or certain assets on an agreed upon schedule
• liquidation of excess inventory
• utilization of additional collateral, guarantees or credit support
• execution of additional documents, giving the secured lender an opportunity to cure any document or lien perfection issues
• additional fees and increased interest in consideration for the forbearance
The secured creditor should always avoid exerting excessive “control” over the operations of the borrower, to avoid a claim of equitable subordination to other creditors or becoming a “responsible person” for taxes or environmental claims. For example, a secured creditor should never force or tell a debtor to pay or not pay other specific creditors.
Credit Support
Guarantees, letters of credit and other modes of credit support such as “last out” participation in favor of the secured lender, which may have been refused at the loan inception, may be obtained from equity owners in a restructuring. Guarantees, letters of credit and certain other types of credit support are not affected by the automatic stay in the event of a bankruptcy proceeding (discussed below) because they represent third-party agreements between the secured lender and a nonborrower third party.
Pre-Bankruptcy Remedies
All realistic pre-bankruptcy proceeding remedies should be considered by the secured lender, its counsel and advisors. This includes:
• Reservation of rights
• Notice of default
• Acceleration of all obligations
• Uniform Commercial Code foreclosure on personal property collateral
• Real estate foreclosures
• “Friendly” foreclosures, where the borrower surrenders the collateral to the secured lender
In all events, the secured lender should assert only those rights provided “within the four corners of its documents” and applicable law, to avoid claims by the borrowers and other creditors such as “equitable subordination” or the much-maligned theory of “deepening insolvency.”
Potential Actions of the Borrower
All potential actions of the borrower should be anticipated and considered by the secured lender internally with its counsel and advisors, and then discussed and considered with the borrower. This includes:
• Out-of-court restructuring, including concessions by both the secured and unsecured creditors
• Assignments for the benefi t of creditors—an orderly state law process whereby all assets are transferred to an independent third-party trustee, who performs an orderly liquidation and distributes the proceeds in accordance with the priorities of law (often different from state to state)
• Liquidation under state law—the borrower and its advisors perform an orderly liquidation under the corporate laws of the applicable state statute
• the automatic stay—creditors are prevented from collecting amounts owed by the debtor, foreclosing on the debtor’s collateral and terminating contracts
• at least initially, the debtor cannot pay any unsecured creditors that existed as of the commencement of the bankruptcy
• expensive litigation against the debtor can be stayed
• the debtor is allowed to assume the contracts it desires and reject the contracts it considers burdensome.
Real Estate Attorney
When you need legal help to solve Troubled Real Estate Loans, call Ascent Law LLC for your free consultation (801) 676-5506. We want to help you.
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