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In Default: Forbearance Agreements Can Be a Valuable Tool

July 20, 2016, 07:00 AM
Related: LeClair Ryan

Secured lenders can pursue a number of non-litigation alternatives when dealing with a defaulting borrower, including forbearance agreements, loan modifications, debt restructures and workouts, voluntary surrender of collateral, self-help repossession, and business liquidation, to name a few. The particular facts and circumstances, as well as lender goals and objectives will help determine which path to follow. Forbearance agreements sit at one end of this spectrum. They are not useful in dire situations that require immediate judicial intervention or when delay would prejudice the lender. However, forbearance agreements may be the best option in situations involving one or more of the following factors:

  • The circumstances are not yet ripe for an exit strategy or other permanent or long-term solution or the parties cannot yet determine what the appropriate strategy or solution is,
  • The results of certain actions or future circumstances may improve the situation, or clarify the selection of a solution or strategy, or
  • There is a need to temporarily preserve the status quo.

Sometimes in these situations, lenders may be inclined to simply wait and see. However, forbearance agreements offer lenders a number of benefits that can make them the best option, including improving the ability to collect loans after the expiration of the waiting period, avoiding borrower claims of waiver or laches, and memorializing exactly what the obligated parties have proposed to do. By contrast, the informal “wait and see” option can have the effect of giving borrowers all the benefits of forbearance agreements without the usual corresponding benefits enjoyed by lenders in a contractual arrangement.

A forbearance agreement, at its core, is a temporary agreement by the lender to refrain from exercising its post default rights and remedies. The defaults are not waived -- the borrower still remains in default. This preserves the status quo and allows lenders to pursue their remedies once the forbearance period ends. It also facilitates the waiver of certain debtor rights that can only be waived after default.

General Considerations. In a forbearance arrangement, regardless of the situation, all obligated parties generally reaffirm the debt, acknowledge the defaults and waive and release all claims against the lender. This is considered the minimum quid pro quo for the lender’s agreement to refrain from immediately enforcing collection, and benefits the lender by streamlining the collection process after the forbearance period is over. Depending on the length of the forbearance, an agreement to toll the statute of limitations may also be advisable.

In addition to a specific description of the nature, extent and length of the forbearance period, these agreements address the events and circumstances that will cause an early termination of the forbearance period (so that the lender is not obligated to sit on its hands if the borrower fails to perform or the situation deteriorates); and a description of what happens when the forbearance ends (often dependent on the actions to be taken during the forbearance period and the results of those actions).

The arrangement should also address financial and other reporting, in addition to what is required under the loan documents. Since the borrower is in financial distress, more frequent and/or more detailed financial reporting may be needed. Reports and updates tied to the purpose of the forbearance and the borrower’s required actions should also be included. The agreement also provides an opportunity for the lender to obtain more detailed information about the borrower’s assets to facilitate collection of the debt, if necessary, after the forbearance expires.

Since the loan is in default, the agreement should address whether the default interest rate is being implemented and describe what payments are required during the forbearance period. A forbearance fee and payment of the lender’s expenses are also customary.

Situation-Specific Considerations. These agreements also include more situation specific terms tailored to reflect the reason for entering into the arrangement as well as the goals to be accomplished. Many times the purpose of the forbearance agreement is to allow the borrower to take certain actions or implement changes to its business. The overall purpose should be spelled out and the actions to be taken -- often broken down into components or steps -- must be requirements under the arrangement. Frequent reporting and disclosure regarding these steps will also help the lender monitor progress, even before deadlines are reached.

Forbearance arrangements may be beneficial in wide variety of situations (too many to be fully enumerated here). Below are some simple examples based on actual situations that should shed light of the general utility of these arrangements.

  • In one situation, the borrower suffered a significant, and likely long term, reduction in sales. The company was able to adjust its operations to maintain profitability (positive EBITDA) but could no longer service its debt in full. The borrower’s plan was to sell boot real estate collateral not needed for the operation of the business. A forbearance arrangement was put in place under which the real property was to be sold. The arrangement included interim targets and deadlines such as the retention of a broker and execution of a purchase contract, and reporting tied to those steps. A market sale of the real property generated a significant loan paydown, and the remaining balance was modified to match the new business size.
  • In another case, a borrower seeking to address financial problems restructured its business operations rendering several large capital assets surplus to the business. A forbearance arrangement was put in place under which the assets were to be marketed to pay down the loan and minimum collateral release prices were agreed to. Marketing and selling the assets in a non-distress situation resulted in significantly higher prices/loan pay downs. Although, for other reasons, the borrower’s turnaround plan did not ultimately succeed, the lender’s exposure was decreased significantly and the remaining balance was still fully secured.
  • In another situation, a borrower proposed a turnaround plan acceptable to the lender but needed time to implement it. The parties entered into a short term forbearance arrangement, subject to extensions if certain benchmarks were met. The major action steps in the turnaround plan were incorporated as covenants under the arrangement.
  • Finally, we’ve seen numerous cases where an exit strategy, such as a refinance or sale of the company, is already being pursued, and only needs time to see if it can be carried out. In those situations, the forbearance arrangement would include interim steps and disclosure and periodic reporting tied to consummation of the exit strategy.

Under the right circumstances, forbearance agreements can allow time for situations to stabilize or for parties to take corrective action. Extra time can help clarify the proper, longer-term course of action while simultaneously helping to both protect lenders’ rights and, ideally, improve their position.

Robert M. Wonneberger
Shareholder | LeClair Ryan
Robert M. Wonneberger is a shareholder at LeClairRyan. He focuses his practice on commercial law and financing including loan origination, debt restructures and workouts, and real estate.

Wonneberger regularly represents financial institutions and borrowers in originating commercial and asset based loans involving numerous businesses and industries, loans to high net worth individuals, mortgage loans secured by various types of real estate, leasehold mortgages, and equipment leases. He has extensive experience in problem loan resolution including debt restructures and workouts, loan sales, Article 9 sales and voluntary and involuntary liquidations. He also represents owners and tenants in acquisition, sale, leasing and other real estate transactions.
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