Q & A: How to Prepare for and Respond to a Loan Default
By: MARY S. RANUM & CARRIE L. SEELE
June 2009
Although lenders have always needed to monitor loans for warning signs that a borrower may default or that the collateral value has diminished, in these uncertain times monitoring is critical. Lenders should prepare to respond to defaults by understanding their loan documents, collateral and borrowers’ businesses. This preparation will put lenders in the best position possible if they have to negotiate with a defaulted borrower or exercise their remedies.
Q: What can lenders do prior to a default to avoid problems in a workout or default situation?
A: Lenders should know and understand their borrowers and collateral. They should confirm that they have the right documentation and filings in place to evidence and secure their loan. This documentation should include agreements with third parties necessary to perfect security interests (e.g., deposit account control agreements for accounts at other financial institutions) and realize on collateral (e.g., landlord’s waivers and consents to permit entry to a leased premises to obtain collateral). Lenders should keep loan files current and maintain agreements with borrowers and complete notes of conversations. Lenders should carefully monitor covenant compliance by comparing financial covenants to borrowers’ periodic financial statements and should pay attention to borrowers’ actions or inactions that could adversely affect the collateral or a borrower’s ability to repay the loan. Examples of such actions or inactions include transferring property to subsidiaries, forming joint ventures, failing to maintain insurance, and changing a borrower’s name. Additionally, lenders should perform periodic inspections or audits of borrowers to the extent permitted by the loan documents. For instance, site visits help lenders determine if a borrower moved collateral to a location owned or controlled by a third party that would require a collateral access agreement to realize on the collateral. Lenders should obtain updated appraisals prior to extending loans to determine if the collateral value is sufficient. Lenders should also have a tickler system to track financing statement expirations and should file all necessary continuation statements.
Q: What are some common examples of “warning signs” that a borrower’s business and its ability to meet its obligations under its loan documents may be in trouble?
A: Common warning signs that a borrower may default include:
- missed or late payments of interest, principal or fees (especially if prior months’ payments were made on time)
- notice of tax liens
- late and/or inaccurate financial reporting
- violations of financial covenants
- overdrafts
- notice of mechanic’s liens
- changes in senior management or the board of directors
- changes in accounting firms
- draws on letters of credit securing obligations
Q: What are some things lenders should do to prepare to respond to a default?
A: Lenders should review the loan documents to confirm all documents were properly prepared and executed. Additionally, lenders should analyze the documents to understand the events of default, determine what notices are required, and evaluate the available rights and remedies, including whether there are any rights to income (e.g., assignment of rents or a right to a receiver). Lenders should also review collateral status by running the Uniform Commercial Code (UCC), tax lien, judgment and bankruptcy searches against all appropriate names and in all relevant jurisdictions to determine if there are any additional liens or if any adverse events have occurred. As part of this process, lenders should consider whether there are any additional documents or reports needed based on the borrower’s circumstances or the collateral. For instance, lenders should get updated title searches and environmental reports on real property to determine if there are any title or environmental issues that may impact how to proceed. The diligence lenders do in preparation for responding to a default should be similar to diligence performed when considering making a loan, such as determining whether the collateral exists, whether any third party has rights in any collateral, whether the lender is perfected, and whether the lender has access to the collateral. Part of the analysis should also include identifying and analyzing any potential defenses a borrower may raise, which could include defects or gaps in the documentation or issues relating to the lender’s conduct.
Q: What are some options available to lenders in a default situation?
A: One option available to lenders is to negotiate a workout or loan restructure with the borrower, which may include such things as a principal reduction, additional collateral, new guarantors or other credit enhancements. Lenders may also pursue remedies under the loan documents including (1) self-help remedies such as set-off against deposit accounts, noticing account debtors to pay lenders directly, notifying tenants that rents should be paid directly to lender, and pursuing other credit enhancements; (2) foreclosing a mortgage; (3) appointment of a receiver; (4) using UCC and other security interest enforcement actions; and (5) taking action on guaranties or other credit enhancements. A loan secured by real estate could be resolved with a deed in lieu of foreclosure or a voluntary foreclosure agreement.
Q: What are some common terms in workout agreements?
A: As part of the workout agreement, a lender needs to determine whether to waive defaults or to forbear from exercising its remedies. A waiver is an agreement that the known defaults are “excused” and no action will be taken. A forbearance is an agreement not to exercise default remedies for a specified period of time to permit the borrower to cure the default. Workout agreements should include such things as recitals reflecting the facts, including the known defaults, an acknowledgment of the debt and collateral security, a recitation of the consideration given by the lender, an acknowledgment of the lender’s good faith, a provision stating that, except as modified, the current documents remain in full force and effect, an acknowledgment that the agreement was drafted by both parties, and a requirement that the borrower and its principals indemnify and hold harmless the lender. Lenders should also consider including waivers in the document as permitted by the UCC, and a waiver of the borrower’s ability to contest a motion for relief from automatic stay should there be a bankruptcy involving the borrower. A waiver of the automatic stay is not enforceable in all jurisdictions, but should be included in the event it is enforceable. Lenders should require all guarantors to join the agreement so there is no doubt that the guarantors’ obligations continue, and should avoid exercising too much control over the borrower to limit the possibility of lender liability claims. The agreement should also include an acknowledgment that it addresses only known defaults and that the lender reserves the right to take action if new defaults occur or become known.
Takeaway
A well-prepared lender will be able to achieve the best results in the event of a borrower default. In today’s economic climate, it is critical to enter into a default situation having made a comprehensive analysis of the loan and the borrower.