ShutterstockWhether a result of the coronavirus pandemic, the suddenly dislocated capital markets, the end of the lengthy commercial real estate boom, or changes in the real property or its revenue, the property owner reaches out to the lender for urgent, needed debt relief. The owner is not nefarious, malevolent or incompetent and may have merely fallen prey to market or other—COVID-19—forces outside of its control. The lender, which strives for a performing asset, an on-going relationship with its customer and repayment—not foreclosure or distress—makes concessions.
The lesson here, and the focus of this article, is that in exchange for concessions the lender should obtain credit and legal enhancements. These should put the lender in a far better legal framework to recover the debt and minimize any loss should a subsequent default—malevolent, ill-advised or not—occur. These should also enable the lender to make concessions that are more meaningful to the property owner, its investors, its tenants and its business.
The exchange of concessions for enhancements is the “art of the commercial real estate loan workout.” The exchange itself—the trade—is intuitive; yet bankers (especially “loan originators” or relationship managers), while adept at negotiating a business deal, routinely fail to seek, or obtain, enhancements of this type; their “business deal term sheets” may not disclose that such enhancements are available—and should be delivered quite readily for that most coveted of commodities, debt relief.
The lender’s economic or legal concessions cover a wide range of benefits to the property owner. They include: (i) extension of the maturity date; (ii) deferral or postponement (today’s focus everywhere, “top of mind,” as the economy has been shut down since mid-March and the “revenue apocalypse” has taken hold) of debt service installments, for several months, with extensions if revenue is not restored; (iii) forbearance (until a “forbearance expiration date”) of enforcement of remedies, also with extensions if identified milestones are achieved; (iv) waiver of defaults; (v) waiver of covenants, such as debt service coverage and loan to value ratios, annualized operating income, leasing requirements, continuous operations (e.g., hotels), substantial completion deadlines, financial reporting; (vi) modification—when debt service payments resume, if applicable—of the contractual interest rate into a “note rate” and a “pay rate”; (vii) suspension of principal amortization payments, either for the duration of the pandemic, or longer; (viii) reduction in “release prices” upon the sale of collateral, such as individual condominium units; (ix) a substantive restructure of the business deal and/or recapitalization of the borrower, including new investors, capital and subordinate debt; (x) release of guarantors (investors or partners exiting the project); (xi) release of collateral or a consent to a pledge thereof; (xii) additional funds for capital improvements or a resumption of loan advances; or (xiii) the “crown jewel” concession—a discounted repayment of the indebtedness tied to a realistic re-appraisal of the value of the property.
The foregoing “compendium of concessions,” or permutations thereof, often combined, populate the workout negotiations from the borrower’s perspective. The lender should make a business, asset-based, market driven and reputational analysis and respond. The borrower’s concessions wish list may be pared down. The lender should seek business accommodations in return, such as the infusion of fresh investor capital or additional tangible collateral. The business deal is preliminarily in hand.
But the deal’s not done, and shouldn’t be done. Here’s what the lender should seek, in exchange. The following “secret sauce” is in response to the quality of the lender’s concessions, the parties’ leverage, and their good faith efforts to achieve a fair, mutually beneficial, workout.
Acknowledgement of Debt
Borrower and guarantor should unconditionally and irrevocably acknowledge their default (unless the default is waived) and the entire indebtedness, without defense, offset or counterclaim. This acknowledgement covers the outstanding principal balance, accrued interest at the contract and default rates (even if the default rate component is later waived), protective advances, late charges, prepayment premiums and all other indebtedness due under the loan documents, including legal fees and expenses.
Cure Loan and Defects; Ratify Documents
The lender should utilize the workout to cure existing loan and perfection defects, if any. Signatures may be missing; guarantors may not have ratified all loan amendments; there may be a gap in the mortgage “chain of title”; certain original mortgage notes in the chain (there cannot be a lien without a corresponding debt) may be missing, or were never transferred to the lender; security interests lapsed or were never properly perfected; scrivener’s error occurred (an absent “maturity date” or incorrect debt amount contained in the mortgage).
These, or any other, defects should be fixed as part of the workout. This could be accomplished via ratification by borrower and guarantor of the loan documents, the guaranties, the collateral for the loan, the lender’s perfection of its security interest (mindful of the bankruptcy preference risk), and receipt of updated title insurance—all as of the date of loan origination, and as of the date of the workout agreement.
Expanded or Additional Guaranties
Guaranties may be expanded; or, there may be additional guaranties furnished by new or existing investors in the borrower entity. These are nuanced: perhaps a portion (or increased portion) of the principal balance; new loan advances; completion of capital improvements; longer duration of recourse for debt service and carrying charges; or expanded full debt events covered by an amendment to the non-recourse carve-out guaranty (the “Bad Boy Guaranty”).
(a) Interference with Remedies. Expansion of the Bad Boy Guaranty may be an art form unto itself. The traditional Bad Boy Guaranty has evolved over time and is commonplace, standard fare. However, there is no “market” in the workout, and a guaranty against interference with remedies should be pursued vigorously by lenders. Concessions are made; upon a subsequent default the lender will or may pursue remedies, including receivership. If the borrower or guarantor interferes with, contests or delays these remedies (after having secured meaningful economic concessions), the guarantor should do so at its peril—interference with the lender’s remedies would trigger full recourse under the guaranty.
(b) Intervening Liens. The Bad Boy Guaranty may be expanded to cover other events or actions that could prevent the lender from enforcing its remedies or realizing on its senior lien. For example, unbeknownst to the lender, the borrower may permit the recording of an intervening or priming lien or judgment. The borrower may challenge a “lost note” in the chain of title or (in New York) a delay in filing a building loan agreement. Those “impermissible acts,” wholly within the borrower’s control, should bear a consequence—guarantor recourse in whole or in part.
(c) Future Promises. The workout may include a transfer of the property—a deed in lieu of foreclosure—at a defined future date to a third party purchaser marketed and procured by the lender. In New York a deed in lieu of foreclosure, held in escrow, to be delivered or released later deprives the borrower of its “equity of redemption.” As such, it is treated, under Section 320 of the Real Property Law, as additional collateral in the nature of a mortgage and not as a “deed absolute.” Thus, the lender should structure this type of workout as a contractual promise to deliver the deed, the keys, and ancillary transfer documents, to the lender’s designee or nominee on a future date certain. But what if the market, or borrower’s hopes and dreams for the asset, change during that marketing period, and borrower seeks to extricate itself from that promise. The lender should collateralize the promise and ameliorate the risk by triggering (or “springing”) full recourse for the debt on the part of an existing or new creditworthy guarantor. Lenders have done this, with success and execution certainty. This is a powerful workout tool.
Consent Judgment of Foreclosure and Sale
An often overlooked legal enhancement is the imposition of a menu of “litigation” remedies in favor of the lender should borrower subsequently default under the workout agreement. There is a wide range of these remedies with varying potency; several may be “tickets for admission” to the workout. Others may be more difficult to secure, but are available and enforceable, and should be considered for the longer-term, more substantive or concession-laden workout agreement. This, too, may become an art form.
The gold standard remedy is the consent (in a judicial foreclosure state like New York) to the entry of a judgment of foreclosure (the judgment includes a computation of the indebtedness and the waiver of a referee to compute) with a stay of execution (the foreclosure auction) until the earlier of the occurrence of a default or the forbearance expiration date. This powerful remedy—which lenders have observed works very well and can be orchestrated in a number of ways—should not be granted, or even sought, in exchange, for example, for three months’ deferral of debt service due to Covid-19. That’s an unfair overreach.
By contrast, if the forbearance period is nine-to-twelve months with deferred payments, waived covenants and a discounted repayment option, then the consent judgment of foreclosure and a public auction of the property on a negotiated date certain may, subject to the laws of the jurisdiction where the mortgaged property is located, be an appropriate remedy. Because the judgment of foreclosure is consensual, the lender can bypass many of the time-consuming, cumbersome and unpredictable steps required in a judicial foreclosure action. The lender achieves litigation finality up front.
And if the consent judgment of foreclosure is coupled with a promise to deliver a deed in lieu of foreclosure, collateralized by springing guarantor recourse for failure to perform—the lender has achieved, at least from a legal perspective, workout royalty. With that workout royalty comes the enthusiasm to make greater, more economically meaningful, concessions to the borrower. All parties benefit; the property and its occupants benefit; the parties have orchestrated a workout that works.
Consensual Receiver or Property Manager
The workout works better still from a lender’s perspective with additional, reasonable, enhancements. The borrower should consent, in any subsequent (or pending) foreclosure action, to the appointment of a receiver (an “officer of the court”) for the mortgaged property as identified and recommended by the lender, without further notice or challenge. A sometimes preferable alternative is a consensual property manager, designated by the lender but engaged by the borrower, to collect rent and revenue, enter into new leases, make essential repairs and otherwise manage, protect and preserve the lender’s collateral. One might even envision a workout scenario where the consensual property manager (or receiver) markets the mortgaged property for sale, with minimum sales pricing parameters to be set by the parties.
Lock Box or Cash Management Account
In lieu of the formality of receivership (which requires the pendency of a foreclosure action) or a consensual property manager (which does not), the lender may recognize that management of the property is better served, and should remain, in the hands of borrower (as a going distress-free concern), or its property manager. In such a case, the enhancement should consist of a “hard” lock box, or cash management account maintained by lender (or its designee bank), into which borrower will, and will direct tenants to, deposit rent or other revenue (such as hotel receipts). The proceeds in the account will be additional security for the loan. The lender will disburse sums for controlled pre-approved expenditures (including debt service), as evidenced by an updated monthly (or quarterly) approved budget. Excess cash flow will either be “swept” monthly (or less frequently) by the lender and applied in reduction of the principal balance of the loan or to unscheduled property expenses, or retained in the account, or a bit of both.
General Release
Another enhancement is a general release in favor of the lender, and “lender parties,” of all defenses, claims and counterclaims. In exchange for concessions, the lender wants, and should receive, unfettered immunity from any lender liability-type claims or defenses, a clean slate and the legal certainty that at least through the date of the workout agreement, the lender did nothing wrong. No claims or defenses, whether feigned or real, should be asserted. The releases should not be mutual or reciprocal. Borrower should not be entitled to a release—at least until the indebtedness is repaid.
Limitation on Distributions
The lender also should limit distributions—other than for payment by borrower or its investors of federal and local income tax—out of the property’s cash flow to borrower’s investors (even if there is no hard lock box, approved budget or cash flow sweep). After all, a borrower should be hard-pressed to exact debt relief on the ground revenue is insufficient, and then turn around and distribute “excess” cash flow to its principals or investors. That limitation on distributions should last for the duration of the workout (or at least until the deferred debt service installments have been repaid).
Consent to Vacate Automatic Stay in Bankruptcy
An important, sometimes expanded and often negotiated, enhancement is the consent by the borrower to vacate the automatic stay provisions of the Bankruptcy Code. The borrower parties waive all protections and benefits of the automatic stay and agree not to take any action further to stay, prevent, delay, hinder or enjoin the lender from enforcing its remedies. While not binding on the Court, the trustee in bankruptcy, or on other creditors, the consent to vacate the stay is generally binding on the debtor if given as part of the meaningful loan workout or debt restructure. (The consent to vacate the stay may be treated differently in different jurisdictions.)
There are certain more fulsome bankruptcy waivers and consents that the lender may seek. These include: (i) “adequate protection” payments during any automatic stay; (ii) the requirement for filing a plan of reorganization within 90 days that leaves the interests of the lender unimpaired; (iii) the prohibition on incurring senior priority debt secured by the mortgaged property; and (iv) the prohibition on supporting any plan of reorganization that abridges the lender’s rights or senior lien. The borrower should also acknowledge that these bankruptcy protections are material inducements to the lender in exchange for concessions, on which the lender relies to its detriment.
Conclusion
The distressed real estate loan workout is a business deal filled with mutual compromise that right-sizes the asset and resets the loan obligations and the parties’ expectations. Any lender making material economic concessions has bargained for, and should acquire, legal enhancements of the type described above. By doing so, the lender may maximize its ability to achieve the just and uneventful realization on its collateral and its state court remedies upon a subsequent default. This is the “secret sauce” that paves the way for a successful, fair and lasting loan workout, in troubled times, or not.
Richard S. Fries is a partner at Sidley, Austin and the co-chair of the Real Estate Finance Committee of the Real Property Law Section of the New York State Bar Association and a fellow of the American College of Real Estate Lawyers. The content of this article does not reflect the views of the firm.
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