Tips for Reducing Lender Liability Risk When Dealing with Distressed Commercial Real Estate Loans (Part 2)

A number of factors have combined to cause an almost “perfect storm” for commercial real estate distress. The COVID-19 pandemic led to a rise in remote and hybrid work, increasing vacancy rates and decreasing property values. Rising interest rates and inflated operating and maintenance costs made the properties more expensive to maintain, further depressing values. The collapse of several regional banks and greater regulatory scrutiny caused the credit markets to tighten, making financing and refinancing extremely difficult. And difficulties in maintaining existing tenants, and finding replacement ones, have further deflated value. All in all, commercial real estate values in various sectors have plummeted, causing some owners to choose to default or even “hand over the keys” to the mortgage lender.

As a result, lenders have faced increased numbers of troubled commercial mortgage loans and are spending more and more time on workouts, short sales, debt sales, DPOs, and foreclosures and other enforcement remedies. It is in those situations that lenders are most vulnerable to facing lender liability claims from borrowers and third parties.

In part one of this two-part client alert, the Morrison Foerster Distressed Real Estate Group provided five helpful tips for lenders to avoid lender liability claims while dealing with distressed commercial real estate loans. In this part two, we provide six additional helpful tips.

Tip #6: Do not attempt to control a borrower’s day-to-day operations.

Viable lender liability claims have arisen in circumstances where a lender exercises control over a business or its management to the extent that the lender is viewed to have taken on fiduciary duties to the borrower or to have exercised undue coercion on the borrower’s business. As a lender, you should not be dictating a borrower’s day-to-day business decisions, such as which trade creditors to pay, when to pay them, or what personnel to hire. You should not make payments to contractors or subcontractors that the borrower has not authorized. You should not be interacting with third parties in a manner that causes confusion as to who is in control of the borrower. You should not make threats that the lender does not intend to carry out in order to induce the borrower to follow a course of action suggested by the lender. Generally, steer clear of any form of intimidation tactics. Do not coerce the borrower to accept a third party or an employee of the lender to operate the borrower’s business, especially to the exclusion of the borrower’s own officers and employees. Overall, do not run your borrower’s business.

Tip #7: Give informed advice.

If you choose to take on a role of “financial advising” regarding lease terms, marketing strategies, contractor selection, etc., make sure to give informed and sound advice.  It’s alright to monitor the borrower’s business and financial affairs, and/or to insist upon detailed information, but limit your “financial advising” to advice and consultation on discrete business matters. In the end, it’s “borrower’s call.”

Tip #8: Be aware of litigious borrowers and personality conflicts.

Try to identify litigious borrowers early and avoid making loans to them. If you find yourself with a litigious borrower on your hands, take additional care with following all of these tips. If a personality conflict develops between the borrower and the loan officer, consider changing the loan officer to avoid escalation of the situation.

Tip #9: Consider involving outside counsel at an early stage.

When ordering an appraisal, environmental report, property condition report, or other consultant’s report in connection with a distressed loan, consult with the lender’s legal staff to determine whether your outside counsel should engage those consultants directly.  Doing so may possibly enable such work product to be treated as attorney work product protected from disclosure in a subsequent litigation.

Tip #10: Be conscious of information and documents covered by attorney-client privilege.

When counsel has been involved in providing advice in connection with a distressed loan, exercise care not to waive attorney-client or attorney work-product privileges that might otherwise apply to documents and communications by sharing them with third parties. Any time attorney-client communications or work product is shared outside of the lender, any applicable privilege may be deemed to be waived. Extreme care should be used before sharing documents or advice externally, including with third-party consultants providing financial or public relations advice.  Even sharing work product and communications with co-lenders, mezzanine lenders, and subordinate lenders can be problematic. Seek out advice of your counsel in these situations.

Tip #11: Consider entering into a pre-negotiation agreement (PNA).

A PNA—also referred to as a “pre-workout agreement” or a “negotiation agreement”—is essentially intended to set the framework for discussions among the parties.  It permits the borrower and lender (and perhaps other parties) to sit down together to discuss the viability and terms of a workout or other resolution.  The essential terms of a PNA are that each party reserves its rights against the others, that nothing is binding until final and definitive documentation is entered into among all parties covering all issues of concern, that nothing said is admissible in court, and that any party can terminate the discussions at any time without liability to the others.  Signing a PNA is a means to an end, namely a successful resolution. It’s best, if such an agreement is deemed helpful, to work to negotiate and execute it expeditiously, because while the PNA is being negotiated, the lender is likely not dealing with its underlying problem, namely a defaulted loan secured by a lien on a likely deteriorating asset.  PNAs come in various shapes and sizes and often seek some “controversial” provisions, such as releases, waivers, estoppels, document and lien confirmations, and the like, which can slow a PNA’s final execution.  It’s best to discuss with inside or outside counsel the lender’s internal policies regarding the use of PNAs, and what is best for any given credit and in each specific factual situation.

Should you have any questions regarding lender liability or seek further understanding or clarification regarding any of these “tips” to reduce lender liability risk, please do not hesitate to contact any member of MoFo’s Distressed Real Estate Group.