Workouts 101, Part 3: More Points of Borrowers’ Leverage

Continuing from last week, here are more points of potential leverage for borrowers facing potential workouts or foreclosures.  A borrower should figure out its position and points of leverage before proposing a workout to its lender.

Review the loan documents (including guaranties and correspondence)Or have new counsel do so.  It’s a good idea to bring in new counsel to look at the deal documents, because new counsel will bring in fresh eyes, and will be able to see what’s actually written in the loan documents, rather than what counsel that did the original deal thinkswas done.  (It’s simply human instinct to see what one thinks is there.)  Obviously the new counsel should be experienced in real estate workouts in the state where the property is located, as there are lots of subtle legal issues that are state-specific in this area.  (See my response to Selina Parelskin’s letter on the first week’s post for some of the California issues and a war story — the names have been omitted to protect the guilty.  In the current market, we’re unfortunately seeing a lot of real estate and other transactional lawyers — even former municipal law lawyers — reinventing themselves as workouts lawyers.  While it is certainly possible to learn a new area, in many states including California, the law about how to enforce loans secured by real estate is technically very complex and quite difficult, and we’re  frequently dismayed by the low caliber of advice given by some lawyers to their borrower or lender clients in this arena — it is very common to see basic issues simply missed altogether.)

It is not uncommon for loan documents to contain flaws that could affect their enforceability — or could at least give the borrower some leverage in a workout.   About 1 out of every 2 or 3 deals we see has had at least one major documentation problem that could be used by a borrower to increase its leverage.  For example, a few problems I’ve seen over and over in 20 years of practice are the failure to attach the proper legal description; inadequate or ineffective guaranty waivers (there’s one of 3 needed waivers that is frequently missed in California); and incorrect UCC filings (very important in loans secured by certain asset types:  you can’t run a hotel after foreclosure without its beds, furniture, etc.).

Also, sometimes correspondence with the lender will disclose that the lender agreed to do certain things, and has not done so; this can provide leverage to the borrower.

Basically, a business and legal review of the property and the loan documents should be done to fix any potential defaults or similar problems the borrower can fix (such as a failure to deliver required information that could trigger a default) and to develop leverage.  That allows the borrower to make a proposal reflecting a practical solution to the problems facing the property that is likely to be accepted by the lender. 

Maintenance and waste.  Early in a workout, a key issue for borrower/owners will be to make sure that the property is not wasting (generally having its value significantly diminished by lack of care).  

Specifically, borrowers should assess and confirm that the condition of the property doesn’t deteriorate to where it triggers covenant breaches that make it more likely the lender will foreclose rather than doing a workout. 

Also, it’s fairly common for “non-recourse” loans to have a carve-out, reimposing personal liability, for some grave defaults often including significant waste.  In such cases, it’s in the borrower’s  interest not to risk personal liability by letting the improvements start to fall apart. 

 Insurance coverages.  Financed owners should check their casualty and liability insurance coverage for the property, to confirm that adequate coverage is in place; premiums are paid;  and all needed policies are up to date, in force, and sufficient to satisfy any loan covenants about mandatory minimum coverage.   

 Other areas of personal or pass-through liability.  Another set of issues, where the borrower should analyze the situation and try to get ahead of the game, is any other loan document clauses that give the lender direct right against assets beyond the property itself … like the borrower’s principal (if the borrower is a corporation, LLC or other entity) or any guarantors.   

 At the outset of a possible workout, a borrower should carefully check whether:

  • There is an unfulfilled capital contribution obligation, a possibility of future mandatory capital calls.
  • There is an argument that the property’s ownership vehicle is undercapitalized and can be ignored (sometimes called “veil-piercing”), and liabilities passed through to the next level of ownership.
  • There is personal liability for real estate taxes.
  • There is a guaranty (or arrangement that amounts to a guaranty) that can be called.
  • The legal fees incurred by one party in a default or workout must be reimbursed by, or can be demanded from, the other side.
  • If an investor and developer are in partnership (or similar arrangement), what further calls or liability can be placed on the investor.
  • Officers, directors or partners have personal liability for actions taken or not taken … and whether there is directors and officers insurance in place to address those risks.
  • What exactly has been granted as collateral for the loan?  There may be omissions that the lender will wish to see corrected.  A borrower can sometimes agree to correct such omissions in order to negotiate for concessions it needs to work out the loan and return the project to profitability.

Only a thorough legal review up front by experienced local real estate workouts counsel will give the borrower the understanding of its situation and potential liability that will allow it to do a thorough business review and to then understand what the best possible outcome is — and negotiate a workout that moves as much in that direction as possible under the circumstances.

More on workouts from the lender side to follow, and a new thread shortly.  If you have ideas for topics to be addressed, questions, concerns, agreement/disagreement or other comments, just let me know.

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12 Responses to “Workouts 101, Part 3: More Points of Borrowers’ Leverage”


  1. 1 bobgreenfest June 25, 2009 at 8:12 pm

    I like your thought process Maura; look for the technical flaws and to the wind with the moral obligation of having actually borrowed money with a promise to repay. Clients would be smart to retain you. For additional insight into this, and other financial matters, see http://www.bobgreenfest.wordpress.com.

    • 2 mauraboconnor June 25, 2009 at 9:03 pm

      Bob:

      Actually, I believe that if one borrows money, one should repay it. Even if it means retaining less money yourself, and accepting a lower lifestyle, etc.

      If the bargained-for loan was a loan to an entity, and was personally guaranteed by a principal of that entity, for example, then the entity borrower and guarantor should each be liable for repayment. After all, they borrowed the money and had the use of it.

      But I’ve also seen cases where the borrower was intended to be a limited-assets entity, and an unscrupulous lender agreed to limiting its recourse on the loan, but slipped into the loan documents, and later tried to enforce, language that was designed to create a guaranty to make principals other than the borrowing entity liable for the loan, even though that was not the deal either side contemplated when the loan was made.

      And, in addition to honoring the principle of paying one’s debts, I think it is also very important to honor the contract made by the parties when the loan was made. That means that when making the loan, both the borrower and the lender need to bargain for, and carefully document in writing, what they agree to do if the deal works, and if the deal doesn’t. (Typically, in commercial real estate deals this requires a competent real estate lawyer; often, both sides assume all will be well, and don’t want to think through what happens if there’s a problem.) But when the market goes down, or other problems occur, many borrowers and many lenders try inappropriately to change the deal to shift their risks to the other party.

      The best borrowers and lenders tend to try to work out their differences reasonably. Typically that means the borrower pays up or if it can’t, gives up the collateral; the guarantor pays a significant portion if not all of its guaranty, and the lender does not try to bankrupt the guarantor.

      Unfortunately, it’s not a perfect world. Both borrowers and lenders can be overreaching, unscrupulous or even fraudulent. As a lawyer, while I will not represent anyone whom I believe is taking a fraudulent position, I have a professional obligation to advocate for my clients’ best interest. None of the clients I’ve had the privilege to serve, to my knowledge, have committed fraud; and most are fairly reasonable. However, when there’s a grey area, and the other side in a dispute is using all the leverage it can muster, it is important to understand what leverage is there. Then the client ultimately decides what actions it will take.

      One of my objectives in writing this blog is to demystify some of how law and lawyers work. Fundamentally, we provide advice and counsel to our clients, but they get to drive the car. We don’t control their morals or their actions. We are, essentially, their servants. And once a lawyer is representing a client, if the lawyer disagrees with a client’s actions, the lawyer’s only remedy is to withdraw from representing that client — and various ethical constraints limit how we do that — we’re typically barred from doing so in a way that hurts the client. Later blog entries will explore this more thoroughly.

      Best regards,

      Maura

  2. 3 Bruce Newman June 26, 2009 at 2:02 pm

    Maura,

    I have enoyed reading your series of articles – Workouts 101.

    In part three you mentioned a borrower should consider wether there are any unfilled capital call requirements.

    My question is this, if an LLC can not pay it mortgage obligation, and the LLC operating agreement provides for capital calls from the members, can a lender force the capital call provision?

    Thank You

    Bruce Newman

    • 4 mauraboconnor June 26, 2009 at 9:17 pm

      Bruce:

      Great to hear from you! Thanks for the kind words about the workouts pieces. Shortly we’ll move into lender side issues.

      The answer to your question would vary considerably depending on the facts surrounding the specific loan. Of necessity, my answer will have to be rather general.

      You’re asking whether a lender can force a capital call when the LLC borrower can’t service the loan. Of course, generally the management is in charge, not the lender. So unless the lender has some special rights, either by negotiating for them in the LLC agreement or in some pledge or similar arrangement where the equity serves as security for the loan, a lender is not going to have the intrinsic ability to force a capital call. It’s possible, but not routine, for commercial real estate lenders to bargain for that kind of special ability to get their fingers into the equity’s pockets.

      If things get really bad, the lender might be able to do something. As a secured creditor, it might be able to take possession of the LLC interests as collateral, and depending on what rights a pledgeholder had, might be able to enforce some of the company’s rights against the equity holders. Even as an unsecured creditor, a lender might seek to get distributions made to the members returned, by pursuing a fraudulent conveyance argument.

      To assess a lender’s options here, one would need to analyze (1) what rights, if any, the lender had been given against the LLC or its members as part of the loan collateral (which might require analysis under the UCC as enacted in that state); (2) the provisions of the LLC agreement; (3) state law applicable to LLCs and (4) state law applicable to enforcement of commercial real estate loans.

      Some states put strong limits on how aggressively a lender can control a borrower, and may stick the lender with more liability than it wants if it directs the borrower’s activities, such as capital calls.

      It’s probably useful to remember that, unlike corporations, LLCs are deliberately designed to be highly variable and flexible structures, so there could be all kinds of special rights, and there’s really no substitute for carefully reading the applicable agreement word for word.

      Best regards,

      Maura

  3. 5 Paul June 26, 2009 at 3:23 pm

    How many hits did you get on your blog, Bob? A little self righteous for one so self promoting.

    I think Maura is dead on and above-board with her explanation and the reasons for giving it.

    When you get out of the armchair and into the field it becomes apparent that you must act ethically AND be prepared to defend yourself in the event that there is a misunderstanding or things are not clear.

  4. 6 Leo Varley June 30, 2009 at 10:25 pm

    Maura,

    Great article! Many very practical and impactful points to pay attention to. The very things that can hit one in the pocketbook as well.
    Thanks and looking forward to reading more of your work.

    Leo Varley

  5. 8 Philip Higgins PC July 4, 2009 at 12:41 pm

    Maura,

    Many thanks for for your posts – myself and my team negotiate workouts and loan acquisitions daily, and this was a refreshing set of articles to point the un-informed and curious towards.

    All my best from (sunny & warm, but don’t tell any one!) Portland Oregon

    Philip Higgins PC

    Bluestone & Hockley Real Estate Services
    REO Asset Management / Investment Sales / Advisory Services

    Empire Capital Advisory
    Director of Capital Markets, Private Capital / Equity Placements

    • 9 mauraboconnor July 7, 2009 at 2:41 am

      Dear Philip:

      Thanks for the kind words. I appreciate them, and hope you’ll come back for more! Now that I’m back from Upnorth, Minnesota, and no longer on the Moosenet (name changed to protect the guilty) network, you can expect more posts shortly.

      Best regards,

      Maura

  6. 10 David August 19, 2009 at 3:11 am

    Maura:
    Your posts are very informative, practical and to the point. I just wish more lawyers were like you.

    Question: What is the 1 waiver in the guaranties that you typically find missing in most cases during your loan document audit that you reference in your blog?

    Keep up the good work. Thanks.

    • 11 mauraboconnor August 19, 2009 at 4:31 am

      Dear David:

      Thanks for the compliment, David.

      California Civil Code Section 2856(a)(1) allows guarantors to waive several rights, including the guarantor’s (or other surety’s) rights of subrogation, reimbursement, indemnification, and contribution and any other rights and defenses that are or may become available to the guarantor or other surety by reason of Sections 2787 to 2855, inclusive. Cal. Civil Code Section 2856(a)(2) – (3) allow guarantors to waive certain other rights, then Section 2856(c) – (d) provide safe harbor language for those waivers — but NOT for the waivers referred to in 2856(a)(1). We are frequently seeing guaranties that do not include the waivers allowed under Cal. Civil Code Section 2856 (a)(1). It looks like a lot of guaranty drafters (particularly during 2004 – 2007) just copied the safe harbor language out of the statute and did not make sure the other waivers of subrogation, etc., were included in their guaranties.

      Hope this is helpful.

      Best regards,

      Maura O’Connor


  1. 1 Workouts 101, Part 3: More Points of Borrowers' Leverage … | Distressed Marketplace Trackback on June 25, 2009 at 7:54 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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