Anticipating a Workout?

Commercial real estate loan defaults are on the rise. If you, a mortgage lender, find yourself in this situation, and a payoff is not forthcoming, your basic options are to: (a) agree to a loan modification with the borrower, (b) forbear from exercising remedies and “wait and see,” (c) sell the note, or (d) foreclose on the collateral. You will probably begin by discussing a possible workout with your borrower regardless of the path you ultimately select. Although each situation is unique, the following is a brief summary of 10 important tasks you should undertake prior to commencing workout discussions.

1. Physical Condition
Physically inspect the property. Is construction complete? Is there material damage? Is there deferred maintenance, and, if so, could it affect the revenue stream (e.g., inhibit future leasing or constitute a default under a franchise agreement or lease)? Does occupancy appear to be consistent with your expectations? 

2. Title Condition
Real Property: Confirm that you have the complete original title policy. Obtain an updated title report. Does it state that your borrower owns the property subject to your lien? Are there other liens? Even if you are in a first position, taxes have priority over your lien, and junior lienholders can challenge the priority of your lien and play a role in the borrower’s bankruptcy proceeding. Does the title report identify any exceptions that are not reflected in your title policy (whether before or after your lien was recorded)? Are there any exceptions (pre-existing or new) that could affect your decision-making (e.g., unperformed covenants with a governmental authority)? 

Personal Property: Confirm that all of the personal property is owned by the borrower. Order UCC searches and verify your lien. Are there any equipment leases that cover property which is material to the project’s operations (e.g., HVAC system)? 

3. Environmental Condition
Order an updated Phase I and (if applicable) Phase II environmental site assessment. Have any new environmental issues arisen since loan origination? Has the borrower performed any remediation required by the loan documents? Is there any ongoing remediation or monitoring? 

4. Operating Statements
Obtain current property operating statements. Do the statements present a detailed picture, prepared in accordance with a recognized accounting method, or is there the potential for gamesmanship (e.g., combining cash and accrual)? Are the statements consistent with your expectations? Is it clear what is happening to the cash? Is the cash controlled by the borrower or a third-party manager? 

5. Financial Statements
Request financial statements for the borrower and the guarantors. Do the financial statements of any individual include assets other than the individual’s assets (e.g., community property or trust assets)? How much liquidity do the principals have? Do they have unencumbered assets? Does it appear that the principals’ financial difficulties are property-specific or global? 

6. Litigation Searches
Obtain litigation, judgment and bankruptcy searches on the borrower and the guarantors. Is there any litigation that could materially and adversely affect the collateral? Are there any creditors threatening to attach assets of the principals? 

7. Loan File
Confirm that you have all original loan documents and amendments, fully executed with exhibits as well as any original letters of credit. Review the loan documents and remaining loan file. What are your rights when the borrower defaults? Are there any matters that could give rise to a legitimate lender liability claim? Do you have an assignment of the material third-party agreements (e.g., franchise agreement or construction contracts)? What actions do you need to take to preserve your rights under each of the material agreements (e.g., copy on default notices)? 

8. Lender Agreements
Identify all of the loan-related agreements to which you are a party (e.g., participation agreement or intercreditor agreement). What are your obligations to the other party with respect to the existing default (e.g., copy on default notices or obtain consent to loan acceleration)? What cure rights does the other party have and what happens if the cure rights are not timely exercised? What approval rights does the other party have? What are your obligations to the other party in connection with a workout? 

9. Default Notice
Send the borrower (with a copy to all applicable parties) a notice identifying all defaults. Depending upon your loan documents, you may have the right to accelerate the loan. Determine whether acceleration is appropriate at this time. 

10. Pre-Workout Agreement
Enter into a short agreement with the borrower and any guarantors that outlines the terms of your discussions, including that (a) the discussions are settlement discussions within the meaning of Rule 408 of the Federal Rules of Evidence, (b) no loan modification is binding unless and until an agreement is executed by all parties, (c) any party may terminate the agreement at any time, and (d) the negotiations do not create a waiver of any rights or obligations of any party under the loan documents.