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Troubled
Real Estate
Loans

by Frances E. Komoroske

This article explores some of the issues that borrowers' counsel often encounter in the workout of a problem real estate loan, suggests some alternatives to negotiating a workout, and takes you through the negotiation process.

When a borrower defaults on a real estate loan, the lender generally has two choices: (1) call the loan due and commence exercise of remedies, including the right to foreclose the property, or (2) negotiate a loan modification with the borrower. It is the job of the borrower and his or her counsel to convince the lender to choose the second option.

Workouts can benefit both the lender and the borrower. More favorable payment terms make it more likely the borrower will repay the loan and thereby avoid a foreclosure or an adverse judgment, both of which stigmatize the borrower and result in costs and delays to the lender. In short, a successful workout can be a win-win situation for both sides to the transaction.

Unfortunately for borrowers, there is no duty on the part of lenders to "work out" a troubled loan or arguably even to exercise good faith during workout negotiations. It is therefore critical for borrower's counsel to convince the lender that there will be some benefit to the lender in modifying the loan so that it can be repaid, either partially or in full.

The trick is to negotiate a workout that does, in fact, "work out;" one that sets realistic terms and conditions which the borrower can meet and the lender can accept. If both parties ultimately cannot reach an agreement, all borrower's counsel has accomplished is a postponement of the day of reckoning for the client after having charged the client fees that might have better been used to cure the default or reduce the loan balance.

The inquiry

To get a handle on the client's needs, counsel should first determine:

1. Who is the client? If the borrower is an individual and there are no guarantors or co-makers, the answer is simple. However, in almost every situation, questions can arise about who is the client, and conflicts of interest may also be presented. These issues must be resolved before representation is formally undertaken:

• Is the borrower a corporation?
• Is the borrower a partnership?

2. Who is the lender? This is critical to determining what strategy to employ during the negotiations because different lenders have drastically different philosophies concerning their troubled loans. For example:

• Is the lender the original lender on the loan, or is the lender a successor institution that has either purchased the loan or obtained it as part of a governmental takeover of a failed financial institution?
• Is the lender a financial institution on the brink of a takeover?
• Is the lender a large bank, a local savings and loan, a "hard-money" lender, or a "vulture fund?"

3. What is the status of the loan? The next inquiry of borrower's counsel should center on the background and nature of the loan, as well as any procedural or substantive irregularities that the borrower can use as leverage during the workout negotiations. The client should provide counsel with the following:

• All loan documents, including the promissory note, deed of trust, security agreements, financing statements and guarantees.
• Any ancillary agreements, correspondence between the lender and borrower and any loan modifications or amendments.
• Information concerning the underlying loan transaction. Were there any procedural irregularities?
• Information concerning any relevant events during the life of the loan.
• Complete information and documentation regarding legal action taken by the lender.
• Full and accurate details of any initial negotiations or discussions between the lender and the borrower.

The analysis

After obtaining the foregoing information, borrower's counsel should analyze it for answers to the following questions:

• Is the loan recourse or nonrecourse?
• Has the lender complied with all relevant procedural requirements?
• Are there any substantive irregularities in the underlying transaction or in the lender's conduct?
• Are there any violations of the anti-deficiency protections or the one-action rule?
• If the lender has mixed collateral (both real and personal property), is it foreclosing in the proper order and manner?
• Has the lender wrongfully accelerated the loan?
• Does the borrower have any common law lender liability claims, such as breach of contract, fraud or interference?
• Has the lender violated any federal or state law protecting borrowers?

Alternatives to a workout

Throughout the initial analysis period, borrower's counsel should keep in perspective, and discuss with his or her client, the alternatives available if a workout cannot be negotiated with the lender or if those negotiations break down. These other options include:

1. Bankruptcy. Filing a bankruptcy petition gives the borrower some breathing room by virtue of the automatic stay. It also provides a temporary respite against any pending foreclosures, and allows the borrower time to regroup and reorganize his or her business affairs.

Counsel should not, however, be too quick to push the client into bankruptcy court. The client should be advised that such a move is not a panacea, that it means loss of control over the client's business, that by lifting the automatic stay, any pending foreclosure can proceed, and that bankruptcy can be extremely expensive.

2. Deed in lieu of foreclosure. Another option is to allow the lender to take the property in exchange for an agreement not to pursue the borrower for a deficiency judgment. This provides a number of benefits for the borrower. A foreclosure will not appear on the borrower's credit report, the debt will be discharged and the borrower does not have to worry about being sued for a deficiency.

3. Litigation. The decision to engage in litigation is a function of many factors. If the lender knows the borrower's claims are weak or meritless and that the borrower is able to pay off the loan in full, it is unlikely the lender will be persuaded to provide any concessions, even under threat of litigation.

However, initiating litigation by filing for a temporary restraining order or an injunction to stop a trustee's sale is often a much cheaper and less burdensome way to stop the sale than is filing a bankruptcy petition.

Pre-negotiation agreements

One final concern for the borrower before entering into a workout is what type of agreement the lender will ask the borrower to sign before negotiations begin. In their eagerness to start negotiations, some counsel may gloss over the fine print in the pre-negotiation, forbearance or standstill agreement. As in all areas of practice, the failure to review adequately, and advise the client of the effect of, such terms may raise legal malpractice concerns if the workout does not in fact work out.

Although it is usually the lender that requests a pre-negotiation agreement to protect its interests, a borrower also may benefit from a well-drafted agreement. Such an agreement provides the borrower with written assurance that the lender will not pursue its post-default remedies during the negotiations.

Lenders generally insist on certain noncontroversial language in these agreements, such as confirmation that there is no binding agreement until the parties execute final documents or that the negotiations will be confidential. Some lenders, however, also may attempt to improve their legal positions by inserting provisions in the agreement such as:

• Affirmation of seemingly innocuous facts;
• Admissions of damaging facts; and
• Releases of claims, jury trial waivers or arbitration clauses.

Borrower's proposal to lender

After the decision has been made to attempt a workout, counsel should meet with the borrower, the borrower's financial advisors and any management or other key personnel to formulate a workout proposal. The borrower's team should prepare:

• Reliable, professionally produced analyses and projections that show the lender that the borrower has fully analyzed the situation and is offering a reasonable solution that will ultimately benefit both the lender and the borrower.
• Short-term cash flow projections.
• A workable business plan under the borrower's proposed loan terms that enables the borrower to meet all financial obligations.
• New management methods, marketing efforts or other planned changes to increase operational efficiency, generate income or reduce costs.

Next is the question of whether the borrower should first approach the lender to request a workout or wait until the lender moves against the borrower. Most lenders do not like surprises; they appreciate borrowers who keep them informed, even when having problems. Such candor enhances the borrower's credibility and the chances of a successful workout.

Similar concerns dictate when and how the borrower should raise potential claims or defenses against the lender. What to do in any given situation is a function of how strong the claims are, how aggressive the lender is and what tone has already been set.

In virtually every case where the lender is represented by competent counsel, a well-grounded threat of liability will get the lender to the negotiating table fairly quickly. The same is true of a lender that knows its wrongful conduct has caused the borrower substantial damage and that the borrower has the wherewithal to pursue his claims.

Borrower's counsel should discuss with the client and the client's team the financial resources required to repay the loan and whether the client can realistically be expected to pay these amounts.

Culmination of negotiations

Negotiations should focus on creating new loan terms that provide both concessions to the lender and relief to the client. For example, neither the lender's nor the borrower's interests would be served by an agreement that restricts the use of net operating income to property-related uses if that prevents the borrower from paying necessary expenses. The lender needs to be shown that using some of those funds to pay the borrower's expenses, such as taxes and attorney's fees, will ultimately benefit the lender by keeping the project operating and the loan performing.

Counsel also should resist any efforts by the lender to control decisions about the project or to insist on approving every business decision. Such actions greatly increase the lender's risk of liability for undue control, including liability to third parties such as the borrower's creditors.

Assuming that the negotiations are successful, borrower's counsel should consider the tax ramifications of any agreement. Discounted payoffs and deeds in lieu of foreclosure can have significant tax repercussions to the borrower.

The agreement usually will be documented by either a new set of loan documents or amendments to the existing documents. Lenders generally charge borrowers renewal or rollover fees, and they expect the borrower to pay the lender's attorney's fees for both the negotiation and documentation of the transaction.

Lenders virtually always insist on releases in the final loan documents. Signing a release means the borrower is forever forfeiting the right to pursue any claims, whether known or unknown, based on the lender's misconduct up until the date the final documents are signed. This is not a decision to be made lightly -- a release should be given only if the lender is providing substantial concessions and the borrower and his or her counsel are virtually certain that the workout will work out. If the workout fails, the client may look to the lawyer for compensation for the loss of any claims the lawyer advised the client to release.

If the parties cannot reach agreement on the terms of a workout, then it is safe to assume the lender will pursue its legal remedies through either a trustee's sale (if the amount of the debt is close to the value of the property) or a judicial foreclosure (if the loan is recourse and the property is worth less than the debt). If a judicial foreclosure is pursued, the borrower should be prepared to face not only the loss of the property, but also payment of a judgment for the deficiency remaining after the sale of the property.

Frances E. Komoroske, a partner in Santa Barbara-based Foley, Bezek & Komoroske, wrote the first book on lender liability (Butterworth Legal Publishers 2d ed. 1995).