New Jersey Law Journal: ‘Delay and Pray’: Short- and Long-Term Loan Accommodations and Workout Arrangements

As we enter the second quarter of 2024, borrowers and lenders alike find themselves mired in a continuing field of uncertainty. Market dynamics influenced by a myriad of known and unknown dynamics, particularly interest rate uncertainty, have caused consternation among borrowers facing looming maturities and diminishing refinancing opportunities. Conversely, lenders managing non-performing and maturing loan portfolios are caught navigating a minefield of competing internal and external pressures and regulatory scrutiny. To wit, the Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (Board), Federal Deposit Insurance Corporation (FDIC) (amongst other federal regulators and agencies) have “encouraged” financial institutions to “work prudently and constructively with creditworthy borrowers during times of financial stress” in implementing short-term loan accommodations and long-term loan workout arrangements to improve a lender’s prospect for repayment while mitigating “long-term adverse effects on borrowers by allowing them to address the issues affecting repayment ability and are often in the best interest of financial institutions and their borrowers.” (See June 29, 2023, “Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts”—referred to herein as the Policy Statement.) As stated in the Policy Statement, lenders should “employ prudent risk management practices and appropriate internal controls over such accommodations” while contemporaneously implementing consistent sound banking and accounting practices in accordance with applicable laws and regulations. (Id. at page 20.) At first glance, such a goal seems quite attainable; however, without a crystal ball, no one knows when, how or if borrowers facing such financial stress will return to a position refinancability.

Operating under such regulatory edicts, lenders remain under pressure to triage underperforming and/or unrefinanceable loans without employing harsh enforcement mechanisms. This most often leads to the ubiquitous and inevitable loan extension (colloquially known as “extend and pretend” or “delay and pray”). Obviously, any lender (and borrower for that matter) is keenly aware the prospects for repayment diminish with each day of underperformance. Accordingly, consistent with a lender’s sound practices, such an accommodation is likely the last opportunity a lender will have to ensure its interests are protected while still having a borrower’s, sponsor’s and guarantor’s (amicable) attention. A lender that finds themselves managing an underperforming loan when executing an “extend and pretend” strategy should hope for the best but expect the worst. As such, lenders should consider implementing the following business practices in connection with any such loan accommodation or workout arrangement:

  1. Document Review: Lenders should endeavor to ensure all the loan documents are accurate, correct and complete. Lenders and, if applicable, its counsel, should review all loan documents to confirm, among other things: (1) loan amounts are correct, (2) documents have been duly executed and properly dated, (3) if the loan had been assigned, all necessary assignments have been properly executed and delivered, (4) lender is in possession of all original documentation necessary to enforce them, and (5) any typos or incorrect information is updated and/or corrected accordingly.
  2. Collateral Review: Lenders should undertake a careful review of its collateral pool. This includes, running lien searches and title updates to confirm there are no prohibited encumbrances (for instance mechanics liens, unknown or undisclosed security interests, etc.) and that lender’s lien remains in the required priority position. Performing this exercise will avoid surprises if an enforcement action ensues.
  3. Due Diligence Review: Problems beget problems. Often times, if a borrower is experiencing financial distress and, consequently, having trouble paying its lender, they will also experience issues with other contractual relationships and/or fighting among sponsors of the borrower. Thus, lenders should consider performing due diligence searches on not only the borrower, but the guarantors and sponsors of the borrower. Having an understanding of any adverse events affecting the business affairs of the borrower and its owners (including any adverse consequences thereof), will allow a lender to properly structure any extension in order to mitigate further deterioration of the loan and the credit. Such searches should include, at a minimum, UCC searches, tax lien and judgment searches and litigation searches.
  4. Right-Size the Loan: As values and operating income fall off, many lenders have found that collateral valuations are, expectedly, falling off (particularly in the office sector) well below underwriting guidelines and metrics in place at origination. This presents a fundamental issue for a lender, particularly federally regulated institutions that are subject to hefty capital reserve requirements with respect to under-collateralized loans. In order to mitigate potential capital reserve requirements and ensure compliance with internally mandated “sound policies,” lenders should require borrowers to either pay down the loan or pledge additional collateral to re-margin the loan from a loan-to-value perspective.
  5. Additional Recourse/Guarantor Financial Covenants: In addition to or in lieu of requiring a loan paydown (whether as a consequence of a relationship or feasibility issue), lenders should consider increasing the “personal” recourse to any guarantors when dealing with limited or non-recourse loans. Having more “skin in the game” will increase a lender’s leverage if (or, more likely, when) the loan enters a remedial or enforcement phase.
  6. Implementation of Loan Reserves: A lender should require a borrower who is cash flowing at an insufficient level to establish various reserves to fund debt service payments, taxes, and insurance to mitigate monetary defaults during an extension/workout period.
  7. Extension Documentation: Depending on the nature of the loan modification and extension, the lender should consider including the following provisions in the extension documentation:
    1. Waivers and Covenant Breaches: If the existing loan documents contain financial covenants, for instance, debt service coverage ratios, debt yield, etc., that the borrower is not reasonably likely to meet, the lender should consider modifying the applicable covenants to avoid an immediate default post accommodation. Additionally, if any events of default have occurred, consider including appropriate one-time limited covenant waiver language.
    2. Release Language: To mitigate the risk that a displeased defaulting borrower raises claims against lender for prior actions, the extension and modification documents should contain language releasing lender parties from any claims arising from events prior to the extension/modification.
    3. No Course of Dealing: The extension documents should make clear that the agreements of the lender and any accommodative measures (i.e., extensions of maturity, waivers of defaults, loan modifications) are a one-time occurrence and the mere fact that lender agreed to such measures once does not mean the lender will agree to any such accommodations in the future.

One last consideration: extension or forbearance? Stripped down, an extension and forbearance are essentially the same thing—time to perform. But each has a notably different tenor and tone. In the event there is an active on-going and uncured default (be it a maturity default, payment default or covenant default), lenders should consider structuring the modification as a “workout” and implement a forbearance concept. Utilization of a forbearance agreement has distinct advantages to a loan extension. For instance, borrowers will acknowledge the existence of a default and, consequently, recognize that lenders have a full and unfettered right to foreclose and/or exercise their respective remedies. In turn, such acknowledgements and consents may carry strong probative value during any subsequent enforcement action should a borrower assert that a lender is not entitled to exercise its remedies.

The facts and circumstances surrounding each loan accommodation and/or workout will vary greatly and often evolve day to day. As such, lenders are cautioned to ensure that any such proposed accommodative measures align with their likewise evolving credit and risk policies before implementing same.

Reprinted with permission from the April 16, 2024 issue of the New Jersey Law Journal. © 2024. ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

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