The Workout Journey: Seven Rules for the Road (Lender’s Perspective)

If the current coronavirus (COVID-19) situation persists, real estate lenders increasingly will be faced with the need to restructure loans in their portfolios. Lenders that held non-performing real estate loans during prior real estate downturns (e.g., 2008, 1990s) have no doubt embarked on the real estate workout process countless times before. However, with the passage of time, the lessons learned by real estate lenders of earlier eras may have faded from memory. Moreover, many of the lenders active in real estate finance today were not even on the scene during prior recessions. Accordingly, it may be best to go back to the basics – to return to general guidelines on how best to approach a problem real estate loan.

For those without prior experience, and even for those who have survived the workout wars of earlier generations but who have not yet drawn up a general roadmap for handling their troubled real estate loans today, here are seven rules on how to minimize the bumps in the road on the next real estate workout journey.

Rule 1: Lender Due Diligence

At the outset of the workout, and before sitting down to negotiate with a borrower, the lender must conduct comprehensive due diligence surrounding the troubled loan. It would be ill-advised to meet with the borrower without as full an understanding of the loan, the project, and the borrower as possible under the circumstances. If, for no other reason, such expansive due diligence is advised to determine the leverage brought to the table. The cards dealt in each real estate workout are different, and it is incumbent on the lender to determine up front the strength of its hand.

Lender diligence can be broken down into four distinct categories:

1. A review of the relevant loan documents;

2. An evaluation of the physical condition of the underlying property;

3. An investigation into the financial condition of the borrower and any loan guarantors; and

4. A detailed analysis of litigation risk.

The first three categories should be standard operating procedure for every real estate loan workout; the need for the fourth will depend on the unique set of facts and circumstances surrounding each loan.

Documents

Document review consists of three steps, namely, (1) collecting and reviewing the relevant material, (2) comparing the contents of this material with the lender’s various internal “approval” memoranda, and (3) identifying actual or potential problems. All too often, lenders launch into discussions with borrowers without conducting these three simple steps, a failure that can lead to unforeseen and unfortunate results.

Document collection sounds obvious, but it often is conducted in a self-defeating manner – in stages, over time, and in a disorganized way. The time to collect documents is when a problem loan is first identified. The materials collected should include all files, including closing files, credit files, document files, desk files, correspondence files, personal files, appraisal files, and the like (and in today’s technological era, lenders should not overlook materials contained in email, on computers and computer systems, on flash drives, in cloud storage, and the like). Depending on the lender (and/or servicer), these files are likely located in a variety of locations and offices, so appropriate time and resources must be allocated to this task.

The scope of the information gathered should be comprehensive in nature – it should cover not just the borrower, but all guarantors and indemnitors of or relating to the problem loan, as well as all relevant data relating to other loans and extensions of credit to the same borrower and to its affiliates. It is helpful to collect all of the information in a single actual or virtual location, such as a conference room, at the lender’s counsel’s office, or on a site like Intralinks or SyndTrak, and to catalog all of the materials so that information can readily be retrieved and reviewed whenever needed.

After collecting all documents needed for review, the lender should verify that the information contained in the files corresponds to the internal reports, appraisal data, and other internal memoranda written or approved by senior officers, the credit department, and the in-house appraisal group, if any. All significant discrepancies must be identified and noted. For example, if the mortgage loan was underwritten on the basis of a guarantee or letter of credit backing up all or a portion of the debt, and the files do not show the existence of such third-party support, or they show that a loan officer no longer with the lender returned or canceled such support without the knowledge of his or her superiors, this critical discrepancy should be noted.

Identifying documentary problems is an undertaking to be conducted jointly with counsel. One of the goals of any workout is to correct any defects in the applicable loan documents. Fixing documents can run the spectrum from merely “tightening” loose documents negotiated at a time when the borrower had greater leverage over the lender, to correcting gaffes that may have been inherent in the loan and mortgage forms used by the lender, to remedying the all too common “egregious” errors found in the underlying structure or documentation of a particular transaction or that arose through the misuse of otherwise acceptable forms.

Examples of document tightening include items such as: reducing or eliminating default grace periods; revamping financial covenants; increasing reporting requirements; preventing dividends or partnership distributions; eliminating exceptions or carve-outs to the due-on-sale clause; strengthening provisions contained in non-recourse carve-out guaranties; creating tax or other escrows, impounds or cash management or lockbox accounts where none existed before; requiring tenant security deposits to be held with the lender; including real estate tax refunds as collateral for the loan; adding bankruptcy reinstatement or spring back language to loan guarantees; and cross-collateralizing or cross-defaulting related or distinct loan facilities.

It would be a near-impossible task to catalog the almost infinite array of documentary gaffes that are inherent in the various loan and mortgage forms on the market today. As is well known, some forms are better than others, and none are perfect. It would be even more difficult to itemize the vast multitude of egregious documentary, structural, and lien perfection errors that have arisen in real estate transactions of the past. Suffice it to say that some errors are obvious on a one-time read of the documents, while others are far more insidious. What follows is a brief smattering of some of the more common mistakes:

• Not all documents have been signed
• Some documents (often the note) are missing
• UCC financing statements contain inaccurate descriptions, were never properly filed, are filed in the wrong place, or have lapsed
• Letters of credit have expired
• Guarantees were not properly confirmed when loan documents were amended
• Lender has not taken the action necessary to enforce cash management or rent assignment before bankruptcy, or to gain “cash collateral” protection after bankruptcy (i.e., failure to record a mortgage or deed of trust)
• Usury issues were not adequately addressed when financing originally closed
• Property insurance documents do not have a loss-payee clause
• Borrower did not have authority or did not take the appropriate corporate/partnership action to borrow/guarantee the loan
• Loan documents not executed by appropriate parties
• Documents include “springing liens” or unrecorded mortgages
• Lender improperly perfected in hotel revenues by recording assignment of rents, and not by filing appropriate UCC financing statements
• Pledged instruments (such as stocks, bonds, treasury bills, and pledged notes) are not, to the extent necessary, in lender’s possession
• Third-party consents were not obtained (such as failure to get the consent of all partners to a pledge of partnership interests)

Property

Concurrently with its review of the loan documents, the lender should embark on a detailed property review. This type of review requires the lender to obtain and analyze all available information, which should include, among other things, environmental and engineering reports, market studies, feasibility analyses, title updates, architectural drawings, plans and specifications, UCC and docket searches, and appraisals.

Just as important, the lender should conduct one or more physical inspections of the site, review all ground and space leases, and determine whether the property is in compliance with all regulatory requirements. For example, are the improvements built on the site in compliance with local building codes, applicable zoning laws, and the property’s certificate of occupancy; or is the condominium or cooperative in compliance with local, state, and federal securities laws; or does the project have adequate access or accessibility to utilities and roads? What is the current physical state of the property, and are any material repairs needed? Numerous problems can be identified by a simple site visit that lenders frequently overlook.

The importance of “walking the property” should never be underestimated. Such a walk through should include a meeting with the property manager to, among other things, learn of problems at the property, identify the status of proposed and existing leases, and the like.

Borrower/Guarantors

A review of the financial condition of the borrower, and any related guarantor, indemnitor, subsidiary, or other affiliate typically is what lenders are best prepared to do. This is not to say that loan workouts do not require a more detailed analysis than the original loan, or that all the necessary information will be made available to the lender for an adequate analysis. Lenders should be aware of the different types of available information and should not be shy to ask for any additional data reasonably needed to perform an appropriate analysis. This information, among other things, can include:

• Financial statements (audited, reviewed, pro forma, or otherwise)
• Tax records and returns
• UCC searches
• Title bring-downs
• Reviews of the general execution docket
• Cash flow projections
• Business plans and projections
• Leasing reports

Litigation Analysis

Although lenders with troubled real estate loans should always be sensitive to the possibility of litigation, some situations are more likely to end up in court than others. A lender liability litigation review would prove helpful in most loan workout situations, but the price for such an undertaking may be unwarranted under certain circumstances. Accordingly, lenders must weigh the benefits against the costs involved and select loans with the highest litigation risk for review.

A detailed litigation review overlaps, to some degree, with the more common documentary review, but a litigation review goes much further in detecting and analyzing litigation risks and suggests appropriate measures to protect the lender. This level of review typically requires the trained eye of an experienced litigator.

In a litigation review, all documents and related files and materials are examined, but the focus is somewhat different from a standard document review. For example, in a litigation review, more time will be spent analyzing jury trial waivers and arbitration clauses, submission to jurisdiction provisions, choice of law elections, management change clauses, equity kickers, overreaching defaults, available remedies, and the quantity and level of controls over the borrower contained in the loan documents. Further, after reviewing the files, the team conducting the audit will interview all loan and other officers of the lender (to the extent that they have remained in the lender’s employ) to determine, among other things, what actually occurred between the borrower and guarantors (if applicable) and lender, whether certain provisions of the loan documents were routinely ignored, whether oral promises or agreements were entered into with the borrower, or guarantors, whether the loan officers acted in ways contrary to the lender’s internal policies or the norms established by the courts, whether courses of conduct between the borrower or guarantors and lender arose, and the like.

During a litigation review, it is common for the lender’s policy and procedure manuals and general credit policies to be reviewed, for the files to be separated into those items protected by attorney-client privilege and those that are not, and for close scrutiny to be made of actions taken by the lender in connection with a default (including decisions to cease funding or accelerate the debt). Moreover, the manner in which the borrower was treated, the method and tone of negotiations, the existence of any threats and perceived threats made by the lender, and any actions inconsistent with a creditor-debtor relationship will be closely scrutinized.

A key goal of the litigation review is to minimize surprise by uncovering all material that will be turned over to a litigating plaintiff through the discovery process and to reduce the lender’s exposure if a lawsuit were brought. Although the cost of such a review may be high, in appropriate circumstances, the savings could be enormous.

Rule 2: Identify Appropriate Parties

Although it is true that all real estate workouts will involve discussions between the lender and its borrower, for a restructuring to be successful, it is also likely true that additional parties will need to become involved. The need to identify necessary third parties typically arises during each of three stages to a workout: the discussion (i.e., negotiation) stage, the document stage, and the post-execution consent and approval stage. Generally, the number of parties involved grows as the lender moves from one stage to the next.

Selecting the parties needed to commence negotiations during the discussion stage of a workout is an art, not a science. There is no magical formula that will tell in each case who to bring to the negotiation table. Generally, the more experienced the lender, the more likely that the correct parties will be present.

Obviously, if only the lender and borrower are present, to the exclusion of other relevant parties, the workout is unlikely to succeed. On the other hand, if the lender invites every possible interested party to the table, the meetings quickly will become too cumbersome and little will be accomplished. Accordingly, a happy medium must be reached. Each workout and the parties needed to be present will differ. At the discussion and document execution stage, the lender should consider including, among others, the following parties:

• Partners
• Equity investors
• Major contractors and trade creditors
• Principal tenants
• Municipalities
• Senior lenders
• Subordinate lenders
• Mezzanine lenders
• Federal and state taxing authorities
• Local ad valorem real estate tax authorities
• Environmental protection agencies (federal and similar state or municipal agencies)
• Franchisors
• Property managers
• Members of the lending syndicate (co-lenders)
• Unsecured creditors

In addition, when the time to close the deal arises, thought should be given to the approvals and consents necessary to consummate the transaction. Among others, these parties can include:

• Guarantors
• Indemnitors
• Senior lenders
• Subordinate lenders
• Mezzanine lenders
• Loan participants
• Members of the lending syndicate (co-lenders)
• Tenants
• Sureties
• Title companies
• Permanent or take-out lenders
• Contractors and other mechanics lienors and suppliers
• Governmental agencies, such as the state attorney general, the industrial development agency, the state housing commission, and the like
• Surveyors
• Architects

Rule 3: Default/Acceleration Notices

To minimize the risk of liability during a workout, it is best for lenders to adhere to the following general rules of thumb: exercise drastic remedies under the loan documents only as a last resort; do not make false threats (especially if the action threatened is not contemplated); do not overreact; do not take precipitous or inconsistent actions with respect to the borrower; and do not make any sudden change in treatment of the borrower without notice to provide the borrower time to arrange for alternatives. Accordingly, the sending of default and acceleration notices should be treated seriously.

Having said this, it is nonetheless important to act swiftly and decisively in a workout. The lender should have internal policies regarding sending default notices, and should take great effort to comply with them. Lenders should not wait too long in sending out default notices or risk facing waiver and estoppel arguments by the borrower. Before sending out any such notice, however, the loan documents should be scrutinized to determine exactly what is required. Some documents call for but a single notice, while others call for several. For example, some forms may require one notice to commence the running of a grace period after default, a second at the end of the grace period to ripen the default into an “event of default,” a third to accelerate the debt, and a fourth to exercise remedies. The exact requirements of the documents should be carefully adhered to, including notice parties, addresses, and methods of delivery.

In addition, the contents of and risks attendant to sending out a default notice should be analyzed by counsel. For example, will such a notice have an unanticipated side effect, such as causing a cross-default with another credit facility of the borrower, or be deemed an election of remedies under state law precluding other remedies? Is the borrower a public company, and will the default notice be a reportable event? Could it also affect the borrower’s share price or bond rating?

Moreover, counsel should be sought to determine that the default requirements contained in the various loan documents are internally consistent. For example, do each of the loan agreement, the mortgage, the note, and the security agreement contain separate default provisions? Are the notice requirements the same? Do they provide for identical or different grace periods? Are these grace periods coterminous or consecutive? Do they require separate notices? These and similar questions will need to be analyzed before a default letter can go out.

Rule 4: Pre-Workout Agreements

In earlier cycles, pre-workout agreements (also referred to as “pre-negotiation” or “negotiation” agreements) were more the exception than the rule. Today, these agreements have gained widespread acceptance and often seem to be the rule rather than the exception. In appropriate situations, these agreements can be helpful to both the lender and borrower and, therefore, should be considered whenever a troubled real estate loan is identified.

Pre-workout agreements run the gamut from simple, one- or two-page letter agreements, to more elaborate ten- or eleven-page documents. The form to be used in any particular transaction will vary depending upon the parties, their counsel, and the circumstances surrounding the workout. What should be remembered is that, no matter what form is used, these agreements are merely a means to an end, and not an end in themselves.

The purpose of a pre-workout agreement is to permit the parties to sit down together to discuss the viability and, perhaps, terms of a workout. This agreement is intended to set the framework for discussions. All too often, however, weeks and even months pass in negotiating these very agreements. All the while, however, the underlying problem – a defaulted loan secured by a lien on a deteriorating asset – goes unaddressed. Spending long periods of time in essence arguing over the “shape” of the negotiating table is not in the lender’s best interest. Accordingly, an excessive amount of time should not be wasted bickering over the terms of this agreement.

To save time in negotiating this agreement, it is best to understand that its provisions generally fall into one of three broad categories:

1. The first category, that each party reserves its rights against the others, that nothing is binding on the parties until final and definitive documentation is entered into among all parties covering all issues of concern, and that any party can terminate discussions at any time without liability to the others, generally is not controversial, and can be drafted to protect all parties.

2. The second category, consisting of estoppels and waivers to be agreed to by the borrower, may include a confirmation of the debt, the loan documents, and the existence of a default. In addition, this category may include a litigation release in favor of the lender, a waiver of future notice or grace periods, and a confirmation that the borrower has no offsets, claims, defenses, or counterclaims against the lender. This set of provisions usually is the most controversial and creates the greatest level of angst in borrowers. Although some lenders will not enter into workout negotiations without these estoppels and waivers, others are content to forego such provisions and accept only the category one provisions. There is no rule of thumb as to which approach is best, but two points should be made. First, lenders should be wary of entering into negotiations with a borrower clearly in default who is unwilling to confirm the fact of its default. If a lender spends an excessive amount of time negotiating this point with a borrower, the chances of a successful restructuring reduce. In any event, it is a sign that future negotiations will be difficult. Second, lenders with inflexible attitudes toward receiving pre-workout agreements only in their “pre-approved” forms should be sensitive to later arguments by borrowers of coercion and duress.

3. The third category of provisions can be classified as miscellaneous agreements. These provisions include everything from specifying interim loan payments to be made by the borrower during the discussion period, to identifying the exclusive representatives authorized by the borrower to negotiate on its behalf, to acknowledging that the borrower was adequately represented by counsel and freely, knowingly, and without duress entered into the agreement, to requiring that disputes between the parties be handled by arbitration. This category of provisions, although often negotiated, is generally resolved quickly to the satisfaction of all parties.

Rule 5: Independent Specialists

In workouts, lenders should not be bashful in using and hiring independent specialists. These specialists can include workout specialists, both inside and outside of the lender, and others. Use of independent specialists frequently ensures a better result for the lender than leaving the matter to the original credit relationship team.

The general reason for having troubled loans handled by specially trained workout specialists, as opposed to the loan officers who originated the underlying loans, is intuitive. Independent workout specialists tend to be more objective and instill a greater sense of reality on the borrower. In addition, a workout specialist will not have a past relationship or other business with the borrower that would cloud the lender’s ability to deal firmly with the borrower. The workout specialist will not be inclined to cover up for mistakes of prior loan officers, if any, and will not have developed a course of conduct with the borrower that can later be misconstrued. Moreover a new face on the scene can eliminate personality conflicts that might have arisen with the original loan officer as the real estate loan started to deteriorate.

Many lenders have special in-house workout or special loan units that deal only with troubled situations. Others have officers within their real estate departments who are specially trained to deal with, or have prior experience in handling, loan workouts. Still, other lending institutions do not have sufficient staff to deal only with loan workouts. These latter institutions are often best served by hiring outside workout experts, or by shifting problem loans to new officers so as to gain some of the freshness and benefit of having a workout specialist involved.

Other types of specialists also should be considered by lenders involved in real estate workouts. First, the lender may not have sufficient experience to deal with the variety of difficult and complex issues that must be handled during the course of a workout. Expert advice is often needed. Second, outside specialists often provide a layer of protection to the lender, especially in syndicated or participated deals. For example, if a loan syndicate member or participant or a group of shareholders bring suit for actions taken by the lender, it is helpful for the lender to be able to rely on the advice of acknowledged experts. Independent specialists often retained on real estate workouts include, among others:

• Industry specialists, such as those experienced in hotels and motels
• Appraisers
• Construction inspectors
• Accountants
• Architects
• Environmental experts
• Special or local counsel, such as those specializing in local zoning or land-marking matters

Rule 6: Identify Specific Problems of Loan & Workout Goals

The causes of and goals to be achieved in each workout are different. In order for a lender to determine its desired course of action, it must have a handle on what went wrong. The variety and combination of causes underlying real estate loan workouts would take a treatise to summarize. Some troubled loans are the result of one catastrophic event, such as a global pandemic; others are brought down by a domino effect of multiple problems. Suffice it to say that some of the common causes might include:

• Borrower’s deteriorating financial condition
• Location of project
• Anchor tenant failing to materialize
• Environmental problem
• Poorly underwritten loan
• Bad management of the project
• Depressed local or national market conditions
• Project poorly conceived and never should have been built
• State of construction, such as cost overruns and time delays
• Bankruptcy of major tenant or subcontractor
• Inadequate level of financing
• Physical casualty, such as fire or flood
• Design, architectural, or engineering defects
• Condemnation by state or local government
• Takeout financing unavailable
• Dispute among partners
• Labor or union dispute
• Death of developer
• Diversion of funds to pay unrelated indebtedness

Obviously, the lender’s goals can be as diverse as the problems causing the troubled loan. After evaluating the cause or causes of the problem, the lender will desire to develop an objective and plan. The objective can range from protecting its upside if the project were to rebound at some time in the future, to foreclosing on the asset and liquidating the property promptly, to obtaining ownership of the project to rehabilitate the asset for subsequent disposition, to minimizing lender liability risk, to restructuring the loan in a manner that enhances its value or suitability for sale as a free-standing loan or as part of a bulk sale or some form of securitization. Whatever the initial plan of the lender, it is important to remember that the lender must remain flexible and develop multiple and backup contingencies. The workout process is not static, but evolves as time passes and information is developed. What made sense three months ago based on scant information might make little sense later after detailed financial information, appraisals, and pro forma cash flows have been prepared. Further, the lender should revisit objectives as material new information or developments arise.

In addition, the transfer, recording, stamp, intangible, and other similar local taxes and charges must be considered for each plan and contingency. Often there are various alternative methods of obtaining comparable results, with certain methods giving rise to significant local tax liabilities, while other methods can be performed at nominal cost. Each should be assessed by the lender.

Rule 7: Understand Non-Economic Motivations

The most effective workout officers are the ones who understand the non-economic motivations on the other side of the table. Borrowers and their counsel often seem better versed in the motivations of lenders than the other way around. Motivational “hot buttons” of some borrowers include the need to eliminate personal guarantee and other recourse obligations, the need to minimize significant tax liabilities that can be associated with a restructure – such as tax recapture for limited partners if the lender forgives debt or takes back a project – and the need to avoid adverse publicity. Understanding, being sensitive to, and working with these non-economic motivations can be as significant to the success of a workout as economic issues such as interest rate and maturity date.

In addition to understanding the borrower’s non-economic motivations, the lender must be sure to structure any workout in a way that provides the borrower with adequate “motivational” equity, even if that means accepting a lower recovery potential for lenders. This is especially true if the lender intends to keep the borrower involved with the future operations, management, leasing, or sale of the property. The borrower will not desire to work for 20 years working off its debts to the lender without any potential upside. If forced to do so, the level of talent and enthusiasm required by the lender will never be attained. The trick is to develop a plan with appropriate incentives to keep the borrower interested and yet help repay the lender’s loan (or at least help minimize its losses). If properly structured, the success of the borrower will be mutually beneficial to both borrower and lender.

Conclusion

A systematic approach to dealing with real estate loan restructurings will likely yield the best result for lenders. The seven rules set out here should help these lenders develop the right approach for themselves.