Workouts of Commercial Real Estate Loans by Steven D. Collier

Posted on 12-14-2016 by

Get (financially) fit before the holidays with Workout Wednesday! Learn how to avoid the doom and gloom of bankruptcy and foreclosure by initiating a commercial real estate loan workout. 

Bankruptcy and foreclosure are not the only possible outcomes when a commercial real estate mortgage loan goes into default. A workout allows the lender and the borrower to negotiate a solution to a defaulted or otherwise distressed commercial real estate mortgage loan.  Read on to learn when and how to approach a workout discussion.

Workout discussions most commonly begin after the occurrence, or in anticipation, of a loan default. There are two categories of loan defaults: monetary and non-monetary.

  • Monetary Defaults. A monetary default occurs when a borrower fails to timely pay interest, principal, or other sums payable under the loan documents, which could be at maturity.
  • Non-Monetary Defaults. In addition to monetary obligations, the loan documents typically impose numerous other borrower obligations. Examples include (i) insurance and property maintenance covenants, (ii) financial reporting covenants, (iii) special purpose entity covenants, (iv) requirements to obtain the lender’s prior written consent for specified leasing activity, property transfers, and other material actions, and (v) financial covenants (e.g., covenant to maintain a minimum debt service coverage ratio). A non-monetary default occurs when a borrower fails to satisfy any of those other obligations.

Once a default continues beyond any applicable notice and grace or cure periods provided in the loan documents, the default becomes an “event of default,” and the loan documents typically provide the lender the right to exercise remedies (e.g., accelerate the loan balance, charge default interest, and commence foreclosure proceedings).

When to Begin Workout Discussions

When Representing the Borrower

  • If a borrower is aware of circumstances likely to put its loan into default in the future (e.g., if a borrower thinks that it will be difficult to refinance the property in question), in most cases, the borrower should approach the lender with a reasonable and realistic workout proposal as early as possible (i.e., the borrower does not need to, and should not, wait for the default to occur). A proactive approach makes sense for a few reasons:
  • A lender is more likely to consider a workout when the borrower is competent and trustworthy. By proactively addressing potential loan defaults, the borrower demonstrates competence and trustworthiness.
  • A lender’s leverage increases substantially post-default — absent an agreement from the lender to the contrary, the lender retains the ability to exercise foreclosure and other remedies throughout the workout discussions.
  • Subject to certain exceptions (e.g., a securitized loan), a lender may have more flexibility in structuring a workout pre-default.

In some cases, a borrower may decide a wait and see approach is best (i.e., wait for the lender to declare the applicable default (if and when it occurs)). Consider the following example: A borrower receives notice from a major tenant exercising an option to terminate its lease. The borrower is concerned that it will be unable to make future monthly debt service payments once the lease terminates. The loan is non-recourse, but under the loan documents, the loan becomes fully recourse to the borrower and the guarantor if the borrower admits its inability to pay its debts as they become due (a fairly common full recourse provision). If the borrower does not have a good working relationship with its lender and/or is uncertain the lender would seriously consider a workout, providing the lender advance notice of the potential debt service default may be too risky — the lender may argue that a literal interpretation of the recourse provision requires that the loan automatically becomes full recourse because the notice constitutes an admission of the borrower’s inability to pay a debt when due. An analysis of whether such a recourse agreement would be likely to succeed if litigated in the applicable jurisdiction is beyond the scope of this practice note.

While a proactive approach is often best, that is not always the case, and the best time for a borrower to commence workout discussions varies from deal to deal. The important takeaway is that a borrower should only follow a wait and see approach if it determines (after reviewing the loan documents and considering all relevant facts and circumstances) that the risks of a proactive approach outweigh the benefits.

In some cases, lenders may not be willing or able to enter into substantive workout discussions with the borrower prior to an event of default. For example, “securitized” loans that have been sold into the secondary commercial mortgage-backed security (CMBS) market are serviced by master servicers prior to default. Master servicers typically do not have authority to enter into other than the most routine workouts. Until the loan is transferred to a special servicer, it may not be possible to have substantive workout discussions.

When Representing the Lender

If a default is likely to occur in the foreseeable future, most lenders (other than master servicers as noted above) prefer to begin workout discussions well before the potential default date if the borrower is willing. Even if a lender believes a successful workout is likely, once a default occurs, the lender should promptly declare the default and exercise at least some remedies (unless there are compelling reasons for delay and the lender timely sends a reservation of rights letter). The lender should not begin any discussions (whether pre-default or post-default) until the parties have entered into a pre-negotiation agreement.

Steven D. Collier is Counsel in the Atlanta office of Alston & Bird LLP.

Lexis Practice Advisor:  For comprehensive coverage of a host of transactional law topics, including more practical guidance and forms related to commercial real estate loan workouts, visit Lexis Practice Advisor. Click this link for a free 14-day trial.


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