A few borrower strategies and considerations in a loan default and workout scenario

Many lenders are now seeing borrowers that have survived this long, struggle to refinance assets in a high-interest rate environment and with some assets continuing to underperform. Those borrowers that did not have to refinance during the COVID-19 crisis or with high rates in 2023, did not, but now many borrowers have no choice but to refinance in a tight lending environment, with the continued uncertainty in certain property values and debt service coverage ratios being hard to meet with high operating expenses even if revenues are consistent. The illiquidity in the market requires that many borrowers come to the table with additional equity in order to refinance and not be forced into a sale of the asset when the bid/ask in prices continues to remain wide. Despite the promise by chairmen of the Federal Reserve to lower interest rates in the second half of 2024, that alone may not be enough for certain asset classes to avoid a default under their loan(s). The distress that has not fully arrived to date is expected to rise in 2024. Given that, we recognize the need to brush off lessons from the 2008 financial crisis and help our borrower clients think through strategies when facing a possible looming mortgage default, failure to complete construction, or a maturity default, to keep from losing their property in a foreclosure.

Additionally, a borrower needs to keep in mind when dealing with their lender that their lender may have pledged the loan to a repurchase lender or "repo" lender and as such, there may be two layers of lenders involved that would need to agree to any plan of restructure, forbearance, or the terms of a loan modification. 

Borrowers do have the ability to raise additional capital with new investors or increase capital contributions by existing investors, but that market has increasing rates and tightening in how Fannie Mae and Freddie Mac are expected to revise their rules in how it views common equity vs. preferred equity. 

When discussing solutions or alternatives with borrower/investor clients, consider the following strategies and considerations: 

1. Prior to a default by the borrower under the loan documents, advise the borrower not to call its lender about any kind of anticipated default, as a lender would be obligated to report any such anticipatory breach internally and this may in and of itself put the lender on the offensive and the borrower at a disadvantage. The borrower must first decide on its objective, does the borrower want to keep the asset or get out from under the asset?

2. The borrower needs to know or have its lawyers review and analyze the existing loan documents for covenant breaches, required notices to the lender(s), the instances that trigger cash management, and any other borrower obligations triggered by its anticipated default. With up-to-date information as to the performance of its asset, a vetted business plan that illustrates to the lender how the client will meet its objective to either keep its asset by solving its financial issues or at least stabilizing the same so it can be sold or refinanced or getting out from under the asset. In the meantime, if the guarantors are able to continue to fund operating costs deficits and pay debt service that will place the borrower in a better negotiating position with the lender if requesting a loan modification. The default causes problems for a borrower, but it also causes problems for a lender internally and, if regulated, externally keeping in mind capital adequacy requirements imposed on regulated institutions.

3. Similarly, to inform a borrower’s plan and in protection of the guarantors of the loan, borrower’s counsel must review and analyze the guarantees provided to the lender and any major third party (for example, a hotel franchisor). The personal liability of the guarantors is the most important issue in a non-recourse loan. Borrowers will have weighed when entering into the transaction the possible loss of the asset in a non-recourse loan, but will not have assumed any personal liability in that equation. The guarantors need to be advised of the terms of its guarantees, what actions could result in their breach of the terms of the guaranty that could result in such guarantor’s personal liability. Any existing guarantor breaches, including failure of the net worth and liquidity covenants therein. This will inform your strategy in working out the loan or whether to try an exit. In many instances, the loan documents will allow a supplemental, additional, or replacement guarantor to be provided to the lender to cure a breach of the guaranty. This may be a strategy to propose to the lender. Lenders will customarily require that the additional guarantor own a direct or indirect interest in the borrower, be in a position of control of the borrower, and comply with any net worth and liquidity covenants of the guarantees in order to be acceptable to the lender. 

4. Additionally, the loan documents should also be reviewed by local counsel in the state of the law that governs the loan documents as well as the state where the property is located. Various states have anti-deficiency statutes that protect the guarantors from being sued for a deficiency under the loan documents that may provide cover to the guarantors and should be reviewed and analyzed, and will inform the borrower’s decision to opt for a deed in lieu versus a foreclose on the property by the lender. Finally, be aware of the dreaded "waste" recourse carve-out. Depending on how this recourse carve-out is written, it may require that guarantors contribute additional capital to the entity to pay for operating expenses to avoid the allegation that the property is wasting, and as a means to avoid personal liability under the bad boy guaranty. This would include payments of insurance premiums and taxes owed, and to avoid mechanic’s liens. Oftentimes a lender will send a default notice to borrowers and include the guarantors for the purpose of advising the guarantors of their obligations under the guarantees. 

5. Once you have reviewed and the borrower’s proposed plan needs to contain the clear ask by the borrower. If the objective is to retain the property and modify the loan, the request must be clear as to what lender concessions are requested, such as release of reserve dollars, an extension of the maturity date, waiver of a missed financial covenant, in return for borrower concessions such as agreeing to cash management, providing an additional guarantor, providing further equity to the project. The concessions need to show the lender a clear path to the stabilization of the asset or a sale or refinance of the asset that will pay off the lender. If the objective is to give the keys back to the lender, that also must be laid out to the lender in a plan, whether a deed in lieu, the appointment of a receiver for purposes of selling the asset, or a foreclosure. The lender needs to have faith in the borrower’s ability to right the ship or cooperate in an exit. An unprepared borrower will not instill the level of confidence and trust a lender needs to have to work with the borrower and owner of a distressed asset regardless of the objective. Note that a lender’s ability to work with the borrower is not only dependent on the borrower’s plan and preparedness, but lenders are subject to many factors and stressors that it must work with internally when holding a defaulted loan on their books that will inform how far it can work with a borrower. Unfortunately, there is not one governing solution possible for every loan, asset, and lender, and the situation is often very fluid, requiring that you bring all of your experience to bear when concocting a solution that works for both the borrower and the lender. Additionally, be prepared for any solution to take months. Any workout path is complicated and takes time to maneuver. 

6. Property diligence will be requested by any lender, so it is best to have it ordered and reviewed to avoid a delay. It is advisable that the borrower order and review the below diligence in formulating its plan before contacting its lender. Be aware that the lender will typically request that you obtain and share the following customary items in almost all instances, even if you are requesting a hard-wired extension under your loan documents or any sort of forbearance or modification to your loan document:

   1. Updated borrower, guarantor, and property financials;

   2. An updated title search, to make sure there aren’t unauthorized encumbrances or mechanic’s liens or tax liens on the title that you need to advise the lender of (they do not like to be surprised);

   3. If you are in construction, the updated construction budget, construction schedule, and completion date;

   4. Confirm that the insurance coverage expected to be in place at the property per the loan documents is in place, and obtain updated certificates of insurance to the lender if the same have not been properly delivered under the loan documents; and

   5. Updated rent roll with copies of any default letters or modification of leases with tenants.

7. Loan document covenants to analyze include:

   1. Prohibitions on transfer. Most loan documents prohibit further secured or unsecured indebtedness without lender consent, and before approaching the lender, if a borrower has participated in an additional equity raise for the company which admitted additional members directly or indirectly in the borrower, or perhaps a preferred equity or a mezzanine loan, make sure the borrower obtained a waiver of the covenant by the lender to avoid a default or that the same was permitted of right under the loan documents. If such actions were taken and consent not obtained or actions permitted, a borrower needs to take note that it may already be in default. Make sure to know what is permitted or prohibited by your loan documents with respect to a mezzanine lender and preferred equity if considering this as a possible vehicle to bring additional dollars to the table in a refinance of the asset. If you are raising additional equity or anticipating having to also obtain a mezzanine loan, so long as you can coordinate the timing with the refinance of the senior loan, you may only have to get the approval of the same from the new lender rather than the existing lender and the new lender.

   2. Single purpose asset or bankruptcy remote entity covenants. These covenants have been included by all types of lenders for the last 20 years and as such, it is likely your loan documents prohibit certain actions and additional indebtedness that could result in the piercing of the corporate veil of the borrower entity, and could result in a substantive consolidation in the bankruptcy of an upper-tier parent with the asset underwritten and financed by a lender in reliance on that the debts and liabilities of the property and the borrower were siloed and segregated from other debts and obligations. Review these provisions versus what has been the actual practices of the borrower. Be prepared to correct any breaches, if possible, prior to entering into lender negotiations.

   3. Cash management. Certain financial covenant failures (loan-to-value and debt service coverage ratio thresholds) result in an event of default that permits the lender to spring or request that the borrower execute documents that trap all cash revenue at the property to pay the amounts set forth in the waterfall set forth in the loan documents, including the payment of debt service, the funding of tax and insurance reserves, and the payment of operating expenses, with any excess cash remaining being escrowed in a cash collateral account with the lender pending the cure of any event of default. In many instances, once you enter hard cash management, there is no avenue of getting out. If clear cures for cash management were negotiated, you will need to understand what those are. Note that preferred equity investors are typically unpaid their preferred return if cash management is implemented under the senior loan and the dynamic, rights and obligations arising under the borrower or its member’s operating agreement need to be reviewed and maneuvered around. Typically a mezzanine lender will be paid at the bottom of the senior loan waterfall to the extent of available cash flow. If the mezzanine loan remains unpaid, the foreclosure of the equity pledge by the mezzanine lender is another complexity to be dealt with in more complex finance scenarios.

   4. Tax consequences. Consult with your tax counsel on the impacts to the borrower of loan forgiveness by the lender, a deed in lieu of foreclosure initiated by the borrower. If the lender is willing to engage in a deed in lieu of foreclosure (there are assets a lender does not want to own), there are structures that can be coordinated to lessen the tax burden on the borrower. Hope certificates or notes that allow a borrower to recoup some of its losses may be a tax vehicle to be considered. Of late, hope notes that proved to be somewhat worthless in the 2008 financial crisis have not been used, but that may change.

8. Note that prior to entering negotiations with the lender, it is customary for a lender to ask the borrower to sign a pre-negotiation agreement, which confirms that the discussions are only that – non-binding discussions – and which preserves the lender’s right to exercise remedies at any time before a forbearance agreement or modification agreement is executed by the parties. The borrower will also be asked to confirm it has no claim against the lender or the indebtedness and release any such claims. 

9. Keep in mind that any notice to the lender conforms strictly to the terms of the loan documents and there may be other agreements that require that you send a copy of any such notice or correspondence with the lender to a third party, including any existing mezzanine lender, EB-5 lender, a PACE lender, preferred equity members in the borrower, or any hotel manager or property manager under their respective agreements. Any loan modification will need to include the restructure of any other existing debt or major third-party agreements to make it work. A borrower needs to work into its plan any required modifications to any other debt documents or major third-party documents so the solution works cohesively. The borrower must have a clear ask in mind of the most senior lender, supported by the performance of the asset and the financial wherewithal of the guarantors.

10. If the borrower’s plan results in requesting that the lender accept a deed in lieu of foreclosure, note that there have been instances where lenders have refused to engage in this as an exit strategy as lenders do not want to own certain type of assets. Ownership will require that the lender pay operating expenses and taxes and carry an asset for an uncertain period of time. This is happening quite a bit with office assets having high vacancy rates in undesirable markets. Generally speaking, it appears that even if lenders are willing to entertain stepping into a borrower’s ownership of the asset, deed in lieu agreements have fallen into disfavor, and instead, the preferred path of late is to have the parties work towards a stipulation appointing a receiver. The negotiation is now with respect to a receivership order and being very clear as to the powers of the receiver, including the power to sell the asset. This will expedite the process. The parties can agree to the appointment of a receiver. The lender would file a complaint with one cause of action – to appoint a receiver under an order approved by the parties. In many instances, the court will approve the appointment of a receiver, and although the receiver acts for the court under the four corners of the order, there are instances lender consent as set out in the order which would include the lender’s consent to a sale of the asset. The appointment of a receiver buys the lender time to consider its best course of action, whether to sell the note, foreclose on the security instrument or have the asset sold by the receiver (who would hire CBRE or JLL to sell the same. Typically a receiver will also hire a property manager. Having the receiver in ownership also removes the financial obligations concerning the property although the lender would be free to make protective advances under the loan while a receiver is in place to pay operating expenses if it so elects. 

If the lender agrees to take ownership of the property through a deed in lieu arrangement, the documents tend to be straightforward; however, note that a deed in lieu agreement would customarily include (i) a cooperation and non-interference covenants to be signed by both borrower and guarantors, (ii) a requirement that borrower participate in the smooth transition of the asset, which will require quite some work in the case of a hospitality asset with many employees, and (iii) the breach of these covenants usually result in guarantors payment obligations. Borrower should consult its tax lawyers to avoid any surprises in the tax treatment afforded to the borrower in a deed in lieu transaction, and whether any type of hope note or certificate can be beneficial to the borrower. While in the past a hope note or certificate was entertained, it was not usually helpful or often used. 

11. Situations at the property may require third-party consents and as such, the borrower must remember to review hotel management agreements, brand agreements, construction contracts, or operating agreements, which require notice if changes are occurring at the property and which make a change of control of the borrower a default whereby you lose the benefit of these meaningful contracts and can trigger liability to any guarantors of performance by the borrower. Provide notice promptly under these agreements to avoid defaults, fees, or terminations.

12. If you attempt to work out your senior loan with the senior lender, remember a modification will not be valid unless and until any junior lender has consented under its loan documents. Under applicable law, a modification of the senior loan would not be enforceable against a junior lender if it did not consent as it would put it in a worse position as to its repayment, so keep this in mind. Note that the borrower and its attorney need to fully review the borrower’s operating agreement as to the rights of the other members, especially a preferred equity investor. In many instances, the consent of any preferred equity investor is required under the operating agreement before a borrower can modify the loan encumbering the asset and such loan event of default may allow the preferred equity investor to take over control of the borrower. Cooperation with the preferred equity member – by way of meetings and inclusion in plans with the lender – is very important to keep preferred equity members from taking over control of the borrower. 

13. Note that many lenders need to see forward progress or they will commence foreclosure proceedings, and once a date for a sale is set (in a deed of trust state with a public trustee sale) or a court date is set for a judicial foreclosure in a mortgage state, the borrower will be under a lot of pressure to actually reposition the asset, refinance a pay-off of the existing loan, or sell the asset in an already depressed market or give the keys to the lender (to the extent lender will accept the keys – they do not have to accept the keys). Once foreclosure is commenced, if there is equity in the property, the borrower should consult a bankruptcy lawyer to determine if bankruptcy is a path to restructure. In jurisdictions where non-judicial foreclosure is possible, a foreclosure may occur in a matter of months. A borrower needs to know the timing and mechanics of foreclosure in the state where the property is located. Bankruptcy is very expensive and the answer if there is no equity. Take note that if the borrower is formed as a single purpose borrower owning only this one asset, it would be subject to the expedited single purpose entity bankruptcy rules

Authored by Ana Tenzer.