Workouts 101: Mindsets and Prenegotiation Agreements

It’s no secret that default rates in commercial real estate loans have been increasing and are continuing to grow. Bloomberg reports that “the default rate on commercial mortgages held by U.S. banks may rise to the highest in 17 years in the fourth quarter as debt for refinancing remains scarce and the recession drags down rents.”

Across our firm’s nationwide real estate practice, we are seeing increasing defaults and resulting workout and foreclosure activity.   Some projects fail for reasons that are too difficult to resolve: for example, they may be too far underwater to be saved.   But many other distressed loans that result in foreclosures could be worked out if certain simple, and seemingly obvious, steps are taken by both sides, lender and borrower/developer, so that they can cooperatively work out a consensual resolution.

Often both the lender and the borrower/developer could obtain better results if they thought through the other party’s motivations and constraints.   So, at the risk of stating the obvious, here’s a brief overview of issues often overlooked by both sides in working out problem loans.   (I’ll go into more detail about some of the specific points of leverage in later posts.)

Borrower Mindset.   Borrowers want to get their projects built and make a profit.  And they usually come to a deal as optimists – they have to be, in order to get projects developed.   Fundamentally, they also are creative: they like designing and doing the work, and are used to keeping control of it.   One downside of this, in a downturn, is that some borrowers aren’t quick to see themselves as in trouble, when a financed property starts to fall short of its covenants or cash flow.   And even many of those who know that they are in trouble are hesitant to approach their lenders early, when trouble is foreseen but not yet happening, to seek a workout or forbearance.   Instead, they may be tempted to act only after the trouble hits and their rents dry up; and then sometimes only by trying to obscure or shut down the flow of information to their lenders.   This strategy generally does not work well.

Lender Mindset.   Unsurprisingly, lenders want to get their loans repaid.   Their mindset is, “you borrowed the money and said you’d repay it; now it’s time to pay it or surrender the collateral.”

But most lenders don’t really want to take over the development of the financed real estate.   They typically don’t have the skills needed to develop, lease up or manage property, nor do they want the liability of an active developer.   They also know that if they foreclose, rather than doing a workout, they likely will recover less.

So, if they can see a reasonable plan for doing so and have enough flexibility, lenders usually would rather extend or modify their loans.   This can leave the borrower/developer in charge, operating the property, as long as there is some realistic possibility of a repayment over time.   If a workout or extension is done early enough, some types of lenders may be able to avoid having to reclassify the loan as a bad loan, which often costs them extra, as they must reserve additional capital against the potential loss.   (Whether the lender is a portfolio lender, who originated and holds its own loan, or a CMBS lender, where the originator sold off all or most of the interests in the loan, and the loan is being serviced by a servicer, may to a large extent determine the flexibility the lender has to modify the loan.)   However, while most lenders would rather complete a consensual workout than a foreclosure, they typically don’t want to loan more money into a troubled project, unless they can see a clear exit that will result in a full repayment of the loan.
Most lenders will typically assess fairly early on whether a distressed loan can be repaid in a reasonable time and what the current value of the project is.   If the project is not salvageable, the lender typically will foreclose on and sell the collateral to collect as much of the outstanding amount as possible.  

In deciding whether to negotiate a workout or to foreclose, many lenders assess whether a borrower falls one of two informal categories: first, the borrowers that are straightforward about the project and that add hard-to-replace value to the collateral (for example, by working hard to increase the project’s income, or by providing more equity or more collateral); or, second, borrowers that are not likely to add value or are not playing straight with their lender. In the current market, lenders’ distressed loan departments are often overworked and understaffed; so these “good or bad” decisions sometimes will be made quickly and cursorily, not after careful study.   In seeking a workout in a downturn, first impressions count. A borrower that falls into the “bad” category will typically not be able to negotiate a workout – the lender’s representative will make triage decisions to spend time negotiating only the workouts that are likely to lead to a deal.

Leverage.   Once a borrower defaults or is in danger of defaulting on its loan, the lender has more leverage: if the borrower won’t or can’t pay back the loan, the lender can and will foreclose on the project.   And there is usually no obligation on the part of a lender to work out a loan – a lender typically has the right to enforce its loan documents by foreclosing on the collateral and may also have the right to pursue additional repayments from borrowers or guarantors.

A borrower who knows its project is having cash flow or other problems should analyze its cash position, when it is likely to default on its loans and what would be needed to get the project cash flowing again.   This should be done as early as possible.   It is usually advisable to bring in experts, such as asset managers, to help evaluate the financial position of the project, and lawyers, to help evaluate the borrower’s legal position and develop a strategy.   This analysis will help determine if the borrower has any leverage it can use to negotiate a deal with its lender, and what the lender’s position is likely to be.

Finding Common Ground.   As early as possible, but only after a careful analysis of the parties’ positions and potential leverage, a borrower with a salvageable project should approach its lender and open discussions about working out the loan, confirming any oral requests in writing.   If the lender is not responsive, the borrower should resend its request for workout discussions in writing, with a brief summary of its proposed workout plan, until it gets a response.   (Using a lawyer can help – the borrower’s lawyer can chase the lender’s representative until a response results.) 

Most lenders won’t enter into workout discussions with a borrower unless the borrower signs a “prenegotiation agreement” or similar form.  Usually these agreements provide that, although the parties agree to talk about modifying the loan, there will be no change to the loan terms until they both agree to and sign formal loan modification documentation.   Lenders require such letters to avoid any misunderstanding that they have agreed to some deal unofficially.  Signing a short, reasonable prenegotiation agreement should not be a problem for borrowers.   On the other hand, some lenders try to materially improve their positions by including waivers of claims and defenses, full releases, and similar concessions in these agreements, so such agreements should always be carefully reviewed by legal counsel before they are signed.

Once it gets the lender’s attention, a borrower should consider proposing a plan likely to work over a reasonable time that, if possible, does not require the lender to put more money into the project.   In exchange for a loan modification and more time to pay off the loan, borrowers might consider offering any or all of the following concessions, or any others specifically tailored to the project:

• borrower or its principals may put in more equity;
• borrower or its principals may sell shares in the project to investors, giving up some upside;
• borrower may agree to defer any payments to itself or any affiliates;
• borrower may provide the lender with other collateral;
• borrower may scale back the quality and expense of the tenant improvements it wants to put into the project;
• borrower may agree to sell other properties to raise cash to put into the troubled project.

The point of such concessions is to limit the lender’s loss exposure and thereby incentivize the lender to extend and modify the loan. While such concessions may be painful to consider, a rational borrower will almost always be better off starting with its own list of suggested scaling-down changes, rather than a less-informed list that its lender might confect.

A lender may or may not provide detailed comments on a borrower’s workout proposal – generally, lenders are not willing to tell the borrowers what to do, as they are usually concerned about not incurring lender liability for taking over a project.   But a rational lender ought to be able to let its borrower know what about the borrower’s proposal will work for the lender, and what doesn’t.   Then, if the parties find common ground, they and their lawyers can negotiate a modification and extension that puts the loan and the project back on track.

What not to do.   My next post will talk more about the parties’ tactical and business options. For now, here’s a summary of obvious missteps to avoid in an early stage workout.

1. Lie to the other side, or be so unreliable that they can’t put trust in you. (This includes making inaccurate statements or unfulfilled promises through your lawyer.)
2. Become silent and unresponsive.
3. Ask for something before analyzing your real economic position (you may be asking for the wrong thing).
4. Start the conversation too late to have any viable options for returning the deal to a performing, healthy one.
5. Ask the other side to do your work for you.
6. Be rude (or allow your lawyer to be rude) to the other side’s people and other representatives.

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15 Responses to “Workouts 101: Mindsets and Prenegotiation Agreements”


  1. 1 Tim June 10, 2009 at 4:42 pm

    Very good summary—great balance in not over explaning–but also not assuming too much.

    Looking forward to your follow up article.

    • 2 mauraboconnor June 20, 2009 at 1:27 am

      Many thanks for the kind words, Tim; it’s great to get feedback so quickly. Next post should be up tonight.

  2. 3 Dan Rosenberg June 10, 2009 at 6:23 pm

    Maura: It’s true that banks don’t have the mindset, knowledge, experience or understand market value to sell development/investment real estate. However, despite these shortcomings, banks still feel they can sell distressed assets. My experience with lending institutions is that they do one of two things: 1. they don’t acknowledge they have distressed assets. 2. they think it’s easy to sell distressed assets. What has your experience been with banks getting these assets off their books?

    • 4 mauraboconnor June 20, 2009 at 2:15 am

      Dan:

      Sorry that this reply is so late. I’m still figuring out the tech/computer end of blogging, and my first several attempts to reply earlier this week did not save. It will get better.

      You raise some interesting points, but I don’t completely agree with them. I think the truth is a bit more nuanced. As to your first point, there seem to be several factors that may be contributing to the current lack of distressed asset deals:

      (1) At the beginning of a downward cycle in commercial real estate, it seems to take a while for all participants in the market to adjust to the new reality — that they can’t sell their CRE for what they expected.

      (2) In the current cycle, no one appears to be in a rush to recognize losses unless they have to, which is not unusual in a downward trending market. (This applies not only to lenders but also to sellers.) I’m hearing that there’s still a big gap between what price lenders or other sellers are willing to take to sell distressed assets, and what price buyers will buy.

      (3) Many lenders don’t have lots of skilled workouts/distressed assets personnel on staff, because there’s been relatively little call for those skill sets since 2002, and those capacity issues limit the number of distressed asset sales that get done. Many of them are now retraining loan originators to handle this work.

      (4) Also, sales of the real estate collateral (as opposed to troubled loans) generally require that the lender first foreclose on the real estate collateral — and that process takes some time after a default, which time period is frequently extended due to attempts to work out or restructure the loan consensually and/or by litigation, sometimes including bankruptcy filings by borrowers.

      (5) The massive infusions of governmental monies have made it possible for some lenders to “pretend and extend” — to modify and extend loans to, in effect, put off dealing with the issues in hopes the market for real estate and CRE loans will improve in the near term. In my opinion, the fact that the federal government keeps coming up with new programs to put more money into the system (with the well-intentioned goal of forestalling a systematic financial system crash) may also encourage lenders to hope for a quick economic revival that reinvigorates the CRE market. (Personally, I don’t think that’s a likely outcome, but I’d love to be wrong on that.)

      (6) Finally, some lenders face regulatory challenges if they recognize too many losses at once, as they have to increase their capital reserves for each such loss. Some may worry about their own solvency, and about the possibility of being taken over by the FDIC, if too many losses hit their books in too short a time.

      As to your second comment, In my experience over 3 CRE cycles, some lending institutions do a good job — usually by hiring good outside brokers who really know the market and asset class to assist their inhouse personnel. Some don’t do such a great job. To be fair, you could probably say that about any set of companies or firms — or professionals. I think it’s important to have a great team to close good deals in a down market: it’s harder than closing deals in an up market. In a down market, a seller needs the most creative, skilled, persistent and practical broker and lawyer and other service providers possible, because buyers get cold feet more easily. Nursing a deal along and solving whatever problems arise is tough in this sort of market, but it’s a good professional challenge and strengthens the survivors (because what doesn’t kill you makes you stronger, to mangle Nietzsche). I also think that one needs a good sense of humor to weather this sort of market and that attribute can also help jolly along the participants in a rough deal.

      So let me know if you agree. And thanks again for your comment.

      Best regards,

      Maura

  3. 5 Brad T June 11, 2009 at 12:27 pm

    Maura … good blog. I look forward to future posts.

    • 6 mauraboconnor June 20, 2009 at 2:18 am

      Thanks, Brad; as with any readers, please let me know if there are any real estate related topics you think would be good fodder — and please feel free to chat back. I have written a fair amount of legal articles over the years, and obviously am still learning about how to blog (though I’ve been reading blogs for a long time) — it is great fun, and a huge incentive to write, to receive comments from you.

      All the best,

      Maura

  4. 7 Richard Friedman June 12, 2009 at 4:32 pm

    Maura:
    You briefly touched on the distinction between portfolio loans and securitized loans but didn’t really address the difficulty and frustration of trying to deal with a servicer who is not motivated (and probably is not authorized) to engage in pre-default restructuring negotiations, and typically will not do anything (including transferring the loan to a special servicer) until the loan is in default for at least 60 days. Any thoughts on how to get the servicer to respond before the “barn has burned down”?

    • 8 mauraboconnor June 23, 2009 at 3:43 am

      Richard:

      You are correct that the master servicer typically won’t engage in pre-default restructuring negotiations, and typically won’t transfer a loan to a special servicer prior to default. The main (and highly simplified) reason is that the legal rules applicable to REMICs provide that modifications of loans generally cannot be made unless such loans are in default or there is a “reasonably foreseeable default”. The pooling and servicing agreement may also specify that certain events must take place to trigger a transfer to the special servicer. (Some have also suggested that master servicers don’t want to reduce their fees by prematurely transferring loans to special servicers.)

      So, in order to trigger a file transfer from the master to the special servicer, a borrower or its counsel should request such a transfer in writing (to the master servicer), and should spell out that a default is “reasonably foreseeable” and imminent, and explain why. (However, I do not think it is a good idea to default in order to trigger a servicing transfer!)

      If the servicer is not responsive, I suggest the polite but persistent approach: first communicate your request in writing (sent return receipt requested). If that doesn’t work, then start calling. Increase the number of calls over time (first weekly, then every couple of days, then daily, twice daily up to hourly). Follow up with more letters and calls. The key is to be *very polite* and very persistent. Eventually the squeaky wheel will get the grease — as long as the squeaky wheel is decent to the servicer’s people. (The lack of politeness is unfortunately too common. When I was doing a lot of work for a large national servicer a couple of years ago, I was frequently surprised by how many borrowers and borrowers’ counsel thought they’d get a better result by berating the servicer’s staff or outside counsel. All I can say is, that antagonistic approach does not work well.)

      Best regards,

      Maura

  5. 9 Selina Parelskin June 17, 2009 at 10:35 pm

    Maura: Thank you for an insightful article into the mindset of both parties. We are experiencing a greater volume each month in commercial filings of Notice of Default’s (NOD’s). The lenders are pulling the trigger for various reasons: 1) filing the NOD is like playing chess, it is a strategy used to make the borrower pay attention and it forces a move; 2) the property is clearly underwater/over leveraged, and by the lender filing a judicial foreclosure, they are able to appoint a receiver which allows the lender to collect rents and maintain tenant relationships. The filing of a judicial foreclosure is usually undertaken in conjunction with a non-judicial foreclosure running on a parallel track. The non-judicial foreclosure provides a more expeditious timeline in the foreclosure process (approximately 120 days).

    We are currently experiencing about 50/50 ratio as to whether the property goes to sale or various stages of a work-out go into play.

    In the month of June, we received our first requests for the filing of NOD’s from the CMBS world of special servicers, ranging across many property types and sizes.

    • 10 mauraboconnor June 20, 2009 at 3:04 am

      Selina:

      Welcome to the blog, and thanks for commenting.

      You are in California, as I am, and you’re right about the judicial vs. nonjudicial process. I am planning to do a blog entry that is more detailed about this later, but the bottom line in deals secured by California real estate is that the lender can elect to *start* either or both a nonjudicial foreclosure sale (aka a trustee’s sale), or a judicial foreclosure (usually so that it can get a receiver in place to manage the property pending foreclosure, or because there’s some problem with the loan or collateral) — although it is allowed to finish only one. But here’s a quick and dirty overview.

      A CA nonjudicial foreclosure sale takes a minimum of 3 months and 21 days (but as you correctly state usually takes about 4 months to complete). If the lender completes this sale of the property (which is generally done outside of a court process unless the validity of the sale is challenged or the borrower files bankruptcy), the lender is often the only bidder, so it usually gets back the property. (If another bidder is willing to pay more than the lender’s bid, the lender gets the money up to the amount owed, and any overage is allocated per statute.) The lender gives up any claim to a “deficiency” — the amount still owed in excess of the purchase price for the property paid at the nonjudicial foreclosure sale — against the borrower. (The lender may be able to pursue any guarantors to pay the deficiency if it has a guaranty with appropriate, highly technical waivers in it.) The borrower has no right to “redeem” — buy back — the property.

      A CA judicial foreclosure often takes longer — it can take a year or even two. This is a litigation in front of a court. Again, provided that the borrower doesn’t file for bankruptcy, the lender will ultimately be authorized to have the property sold, and again usually the lender is the successful bidder. If the loan is of a type where a deficiency judgement is allowed (there are some loans where a lender can’t get a deficiency), then the lender can seek a deficiency against the borrower. However, first there’s a fair value hearing before the court, where the court determines the fair value of the property (its intrinsic value). The lender can then get a deficiency judgment against the borrower in the amount of the loan less the greater of the sales price actually paid at the judicial foreclosure or the fair value of the property. The tradeoffs for being able to get a deficiency judgment are (1) it takes a lot longer than nonjudicial foreclosure; (2) it’s a lot more expensive; and (3) the borrower has the right to redeem the property by paying the lender what the lender paid for it at the sale (for a period of 3 months if the proceeds of the sale are sufficient to satisfy the debt, or for a period of 12 months if the proceeds of the sale were not sufficient to satisfy the debt). This makes it very difficult to market the property, so most lenders complete their nonjudicial foreclosure sales instead.

      In California, this area of law is very difficult and very technical, and provides lots of protections (notably the “antideficiency” and “one-action” rules) to borrowers. Any lender thinking about foreclosing on CA real property needs to bring in highly experienced CA real estate counsel to avoid inadvertently taking risks that it may not be aware of. If the borrower protections are violated, a lender can end up losing its lien on the real property collateral. And unfortunately, a lot of lawyers pretend to understand this area of law, but don’t. For example, I know a litigator who was approached in the 1990’s to handle a foreclosure, and did not bother to bring in real estate counsel. This particular litigator went forward with a judicial foreclosure on a loan financed by the seller, in order to get a deficiency judgment against the wealthy borrower, only to find out very publicly in court that deficiency judgments for such loans are expressly forbidden by CA Code of Civil Procedure 580b. This led to an ugly, but unfortunately deserved, legal malpractice case which cost the litigator’s firm a lot of money.

      So on that cheery note, thanks for commenting. Let us know how your CMBS Notices of Default go. I expect you’ll see a lot more as CMBS loans mature and can’t find replacement financing.

      Best regards,

      Maura

  6. 11 Robert Smith June 25, 2009 at 5:33 pm

    when a loan is in default and not cured is it possible to call on a guaranty without going through the foreclosure procedures?

    • 12 mauraboconnor June 25, 2009 at 8:39 pm

      Robert:

      That depends on the law of the state, and how the guaranty is worded. In California, for example, that is possible provided that (1) the guaranty is enforceable and not a “sham guaranty” (as defined under some complex case law); (2) the guaranty contain all of the required waivers of “one action”, “antideficiency” and suretyship protection; and (3) the guaranty is not secured by real property collateral.

      I’d welcome any answers to this question from other lawyers who practice in other states: is such a guaranty separately enforceable in your state?

      Best regards,

      Maura

  7. 13 Mary K March 2, 2010 at 1:05 am

    Very interesting and insightful article. I would agree that the borrowers mindset is usually creative. Also that many are reluctant to contact the lender at the first sign of financial difficulties. This of course can be due to sheer embarrasment that their plans are not working out as they desired.

    Also, it can be very difficult to meet with lenders who have rigid mindsets and may also be governed by the laws in their particular state/province.

    I agree that, if the problem is dealt with quickly, there is a greater chance of it being resolved in a mutually beneficial manner.

    • 14 mauraboconnor March 14, 2010 at 10:31 pm

      Agreed, Mary; it seems to me that polite persistence works best whether on the lender or borrower side. That said, contractually and legally, lenders not only have the right to be repaid the money they lent (including the right to foreclose on the property and perhaps to pursue any deficiency owed above the amount the property is worth against the guarantors and borrower — if the lender conforms to the applicable legal rules, including in CA, the antideficiency and one-action rules) and frequently I see borrowers expect that lenders will bear all the costs of any workout. That usually won’t fly. Usually, a lender will assess whether the problems are caused by (a) the general downturn in the economy, (b) some specific verifiable problem (e.g., a dominant anchor tenant of a shopping center goes out of business), or (c) the borrower/operator is doing a bad job. Then the lender will evaluate the value of the real estate collateral. To the extent that the real estate collateral is not worth the amount owed, the lender is likely to pursue the guarantor if the guarantor has assets. Bottom line, most lenders will consider working out a deal with borrowers who are good operators, but usually expect the borrower to propose a deal that is better for the lender than what the lender would get if it just foreclosed. I’m frequently surprised by the optimism of certain borrowers and guarantors — and their unwillingness to kick in some money to to a workout and to get out of a much bigger potential liability under a guaranty — until it’s too late. In workout negotiations, it’s important not only to figure out one’s leverage (whether lender or borrower side) but also for a borrower to move quickly to recognize it may be in a situation where triage is required, and where the only question is will it cost more or less money, NOT will it cost some money or none.

      Thanks for writing!

      Best regards,

      Maura


  1. 1 what are the Upside Down Mortgage Options Trackback on September 4, 2009 at 10:12 pm

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Attorney Advertising. This blog is a periodical publication of Maura O'Connor, a partner of Seyfarth Shaw LLP and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. You are urged to consult a lawyer concerning any specific legal questions you may have. The contents are intended for general information purposes only and represent the individual views of Maura O'Connor only. Any tax information or advice contained herein is not intended to be and cannot be used by any taxpayer to avoid tax penalties that may be imposed on the taxpayer.

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