Commercial Loan Forbearance Agreements: Striking a Fair Balance from the Borrower’s Perspective
By Stephen M. Kindseth
A Borrower has defaulted on its obligations with its Lender. The Borrower’s vulnerability is compounded by its dependence upon its credit facility with its Lender to meet its working capital needs. The Borrower’s principals (who guaranteed the indebtedness) recognize that the Lender may at any moment enforce its remedies and so they live in fear of having their business abruptly shut down through the Lender’s decision to cease advancing funds or otherwise compel the termination of operations.
The Borrower needs the Lender to agree to refrain from exercising its remedies. Such restraint would come in the form of a Forbearance Agreement. But its negotiation requires the parties to strike a delicate balance.
The Lender’s perspective on the loan has shifted dramatically. Its greatest concern is the risk of non-payment. To minimize this risk, the Lender typically will seek to improve its position vis-à-vis the Borrower and the Guarantors, and their respective assets.
The Borrower seeks to secure a meaningful opportunity to rehabilitate its business, and needs the Lender’s cooperation. Despite perceptions, the Borrower and its principals hold substantial leverage. They are in possession and control of the business and all of its related assets — the most likely source of payment for the Lender. They also have options: from engaging in a workout, to defending (or prosecuting) litigation or filing for bankruptcy protection under Chapter 11 to accomplish a reorganization.
The Lender may agree to forbear from enforcing its collection remedies for a fixed period of time, but only in exchange for certain additional protections granted by the Borrower, the Guarantors and perhaps others. For the Borrower, compromising or relinquishing these rights and interests must be in direct proportion to the committed economic accommodations and other benefits provided by the Lender. Most importantly, the Forbearance Agreement should afford the Borrower a reasonable prospect for turning around its business.
Although the Lender’s counsel may kick off the process by declaring that, “this is the bank’s form and it’s not negotiable,” this, in most instances, simply isn’t true. Many terms are negotiable, and a Borrower should walk away and look to other avenues if ultimately the best the Lender can propose, after extensive negotiations, fails to afford the Borrower a reasonable opportunity to accomplish its objectives.
For these negotiations — and to protect and advance its interests through these financial and legal challenges — the Borrower should retain an attorney who specializes in commercial insolvencies and, in particular, who primarily represents borrowers. The following is a summary of the typical provisions each side should expect to negotiate in the context of a Forbearance Agreement.
What are the Borrower’s Asks?
- Forbearance for a Defined Period of Time
The Lender’s forbearance is the cornerstone of the agreement. The Borrower is in default and faces the imminent threat of the Lender’s enforcement of its collection remedies. Postponing this right through the Lender’s agreement to forbear enables the Borrower to move forward with its plans to turn its business around.
The Forbearance Agreement typically will provide for the Lender’s forbearance obligation to extend for a defined period of time. Once again, many factors will influence the parties’ agreement on its duration. What are the Borrower and Guarantors giving up? How much financial and other support is the Lender providing? When does the Borrower expect to get to the next stage of its recovery?
How to address the present and potential future defaults complicates matters significantly. The Lender normally insists upon the Borrower identifying all present defaults (monetary and non-monetary) and agreeing that any other default arising from the original loan documents or the Forbearance Agreement terminates the Lender’s agreement to forbear. The original events of default (including any non-compliance with the many representations and warranties) may not have been concerning at the time of the loan when the Borrower’s business and finances looked so promising. Now they are minefield.
Borrower’s counsel must review them thoroughly to ensure that all defaults (and even potential existing defaults) are disclosed and included in the Forbearance Agreement. The Forbearance Agreement should also include provisions that make clear that only a truly new and material default can permit the Lender to terminate the forbearance period. Similarly, the Borrower should try to avoid including as an event of default in the Forbearance Agreement things such as the Borrower’s “insolvency” or a “material adverse change in the Borrower’s financial condition or ability to repay their obligations to the Lender.” The Lender should, at this point, be fully aware of the Borrower’s financial challenges so such existing circumstances should not confer upon the Lender the ability to terminate the forbearance period (especially while retaining the benefits conferred by the Forbearance Agreement).
Another difficult provision to negotiate is the Lender’s continuing obligation to fund the Borrower during the forbearance period. This is, perhaps, what the Borrower needs the most. Unfortunately, the Lender may seek to make such funding “at its sole and complete discretion.” Of course, this is no commitment at all.
Why provide some assortment of additional acknowledgments, releases, mortgages, guarantees, and remedies (as discussed below) and not receive the certainly of continued financing in return? Ideally, the Borrower’s counsel will instead negotiate a defined set of parameters which, if met, will obligate the Lender to fund during the forbearance period. The specific pre-conditions should provide the Lender the comfort it needs. This is no easy task and a lot depends upon whether the Lender trusts the Borrower and its principals, their counsel, and their prospect for successfully turning the business around.
There needs to be trust on both sides. If the Lender, while expressing optimism, refuses to commit formally in the document to fund during the forbearance period, the Borrower and its counsel must, at the very least, ensure that they have had a candid conversation with the Lender about the Borrower’s needs and expectations regarding continued financing. The goal would be to attain the degree of confidence necessary to justify surrendering what the Lender demands in exchange.
- Adjustments in Payments, Interest Rates and Fees
A critical component of the Borrower’s rehabilitation is its financial projections and, more specifically, its plan to meet its essential operating expenses in the near term and, thereafter, to return to being cash flow positive. Adjustments to the Borrower’s payment obligations due the Lender normally facilitate this process.
The Borrower should first develop its financial projections. The Borrower would then provide them to the Lender along with its request for adjustments to its payment obligations consistent with the Borrower’s forecast. Everything is on the table: reducing or suspending periodic payments, adjusting interest rates, or waiving or deferring the payment of fees. The flip side is that the Lender may demand additional fees, paid monthly or at the end of the forbearance period. These should, obviously, be resisted.
- Permanent Loan Modifications
As part of the Forbearance Agreement, the original loan documents may be modified in ways that provide the Borrower with substantial relief and, perhaps, even an exit. These revisions would follow from circumstances very specific to the Borrower. For example, if the Borrower contemplated a refinance, sale of assets or its business entirely, or other substantial transaction, the Lender may agree to material adjustments to the overall economics (e.g., discount of principal) as an additional incentive.
What are the Lender’s Asks?
- Acknowledgements and General Release
In return for forbearance, the Lender will, first and foremost, seek to establish through a series of acknowledgments by the Borrower and Guarantors, the enforceability of the loan documents and, in particular, the most critical obligations set forth therein. Typically, they will be asked to acknowledge and, as appropriate, ratify, confirm and agree to the following: (1) the existing debt including the outstanding principal balance together will all accrued interest, legal fees and other amounts due under the loan documents; (2) the validity and binding nature of the loan documents; (3) the extent, validity and priority of all security provided; (4) the defaults that have occurred; (5) the representations and warranties set forth in the loan documents (other than those relating to the disclosed default); (6) the Lender’s reservation of all rights and remedies; and (7) the absence of any defense, offset or counterclaim. The Lender will also request a general release from the Borrower and Guarantors from any claims, causes of action, liabilities or damages whatsoever.
Generally, the Borrower should not have an issue with any of these … provided that there is no issue in any of these regards. The Borrower and its counsel should evaluate each component to determine what, if anything, may be given up. If the Lender has “done right” by the Borrower to date and all the loan documents and security interests are in order, there would be no basis to object to acknowledging as much. If, on the other hand, the Lender has engaged in questionable actions—such as taking unjustified positions with respect to the terms of the loan documents or interfering with the Borrower’s business—then, once again, the Borrower must strike a balance between what it relinquishes versus what it receives from the Forbearance Agreement.
Of particular note, though, is the reaffirmation of the original representations and warranties. Circumstances with the Borrower have presumably changed dramatically. Consequently, and like determining all existing defaults, the Borrower and its counsel will need to go through each representation and warranty contained in the loan documents to evaluate the Borrower’s present compliance, and disclose and exclude from the reaffirmation any non-compliance.
The Lender will seek through the Forbearance Agreement to tighten up the Borrower’s performance obligations under the original loan documents. The Lender’s forbearance will be conditioned upon, among other things, the Borrower and Guarantors strictly observing and performing all of their obligations under the loan documents (other than the identified defaults). The disclosed defaults may be required to be cured by certain dates. The Lender may also insist upon adjustments to the financial covenants. Before committing, the Borrower should take a long, hard look at its plan and prospects going forward, and conclude that it realistically will be able to satisfy these additional conditions.
- Additional Collateral or Guarantees
In the face of insecurity, a Lender will seek more security. Part of this will depend upon the existing collateral base and other sources of recovery, and the extent to which the Lender is secured. Part of it will depend upon the Lender’s tolerance for risk. Regardless, the Lender will want to improve its position. This can come in a variety of forms, such as: (1) a mortgage against a related party’s real estate, like a principal’s residence; (2) additional guarantees from related parties or converting a limited guarantee to full recourse; (3) a lock box for all accounts receivables or some other account-control arrangement; or (4) a pledge of equity interests, tax refunds, litigation proceeds or other specific assets.
- Enhanced Collection Remedies
The Lender could also improve the likelihood of enforcement and full payment by enhancing its collection remedies. Items objectionable at the original loan closing are now back in play. The Borrower may be asked to consent to, in the event of a subsequent default: prejudgment remedies without notice or a hearing, a confession of judgment, the appointment of a receiver, the surrender of possession, the waiver of UCC Article 9 sale notices, or the Lender’s relief from the automatic stay in the event of a bankruptcy filing. Each of these should be evaluated by the Borrower with its counsel to determine, and better understand the risks posed.
- Chief Restructuring Officer / Financial Advisor
Finally, the Lender may insist upon the Borrower’s retention of a Chief Restructuring Officer (“CRO”) or Financial Advisor (“FA”) to assist the Borrower in its turnaround. In many instances, such employment is in the Borrower’s best interest and may have already been suggested by its counsel.
However, conflicts may arise because the Lender seeks through the CRO or FA far greater transparency and control. The Lender may even suggest individuals for the Borrower to choose from. These proposed individuals will frequently have an extensive pre-existing relationship with the Lender. Compounding matters, the Lender will insist the that CRO or FA be permitted to fully disclose to the Lender “all aspects of the financial operations of the Borrower” and be directed to respond to inquiries of the Lender regarding such “financial operations.”
To avoid the potential conflict of interest, the Borrower should decline (politely) the recommendations of the Lender and look to its counsel to recommend a CRO or FA. A seasoned insolvency attorney will almost certainly have established relationships with turnaround specialists who may serve as a CRO or FA, and who will be acceptable to the Lender. These professionals will also be better able to balance the Borrower’s contractual obligation to share with the Lender information concerning the “financial operations” of the Borrower while fully honoring their fiduciary obligations (including the duty of loyalty) to the Borrower.
Undoubtedly, much may be gained by the Borrower and the Lender through a Forbearance Agreement. They both certainly hope that it will facilitate the Borrower’s rehabilitation of its business and financial affairs, and lead to future prosperity. This will, in turn, ensure that the Lender receives the benefits of the bargain it made at the time of the loan. But, from the Borrower’s perspective, what it gives up must balance fairly against the benefits received through forbearance, continued funding and otherwise, and correspond to its true prospect for success. Otherwise, the Forbearance Agreement may ultimately serve to undermine the Borrower’s efforts to turn its business around.
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