Distress in U.S. commercial real estate industry persists and is unlikely to go away any time soon.

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.

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 this first of a two-part client alert, the Morrison Foerster Distressed Real Estate Group provides some helpful tips for lenders to avoid lender liability claims while dealing with distressed commercial real estate loans.

Tip #1: Build a record.

During the period leading up to the decision to exercise remedies, it is important to create a record that documents the facts, so that they can be used later as evidence, if need be. Keep records and communications as factual as possible and seek to include two representatives on calls and meetings with borrowers/guarantors/other lenders to enhance credibility of future testimony.

Tip #2: Avoid confrontational communications.

Do not send emails, texts, or other communications to the borrower containing inflammatory, defamatory, derogatory, or confrontational comments or threats. Keep your communications (and files) clean and neat and avoid a “lender liability” roadmap. Control all of your communications, always keeping a good paper trail. Recall that all communications could be subject to disclosure in a future litigation, so best to follow the “Wall Street Journal” test and avoid saying anything that you would not feel comfortable appearing on the front page of the Journal. Consider signing up a well-drafted pre-negotiation agreement (more on this in part 2).

Tip #3: Exercise consistency in decision-making.

You should exercise approval rights consistently with your status as a lender, taking into account any applicable standards in the loan documents when granting or withholding approvals or consents. Avoid taking inconsistent positions and precipitous actions that could be viewed as “pulling the rug out from under” the Borrower. When you make changes that affect the course of dealing in a material way, make sure to provide reasonable time and notice, e.g., canceling a line of credit, to provide the borrower reasonable time to arrange alternatives. Bottom line is to observe the Golden Rule, namely, always be fair and treat the borrower as you would expect to be treated if you were in the borrower’s situation.

Tip #4: Do not take actions that unreasonably harm the borrower.

Only take drastic actions under the loan documents as a last resort. Do not make decisions or exercise remedies in a manner that harms the borrower without reasonable justification, even if technically within your contractual rights. For example, you should not commence a foreclosure or refuse to disburse the balance of a construction loan or future advance for immaterial or technical defaults. Do not declare construction loans to be out of balance without adequate substantiation. You should also avoid being careless or unreasonably slow in processing disbursement requests. Overall, strive for quick, thoughtful replies and actions. Avoid overreacting and appearing arrogant. Before denying borrower requests in regard to major leases or other material business decisions, consider consulting with counsel regarding applicable legal principles. While it’s best to always take actions within the four walls of your loan documents, be aware that doing so does not always absolve you from potential future liability claims. Be familiar with lender’s credit and other policies with respect to distressed real estate loans and adhere to them.

Tip #5: Be truthful.

Be honest in regard to the lender’s intent with respect to renewing a loan or enforcing the lender’s rights under the loan documents. Do not threaten to take actions that have not yet been authorized or actually contemplated. Do not give oral assurances that “soften” the strict language of a loan agreement and then turn around and attempt to enforce the documents as written. Avoid giving rise to false hopes. Do not give the borrower any cause to complain that it took actions in reliance on words or conduct by the lender that was [CG1] less than candid and forthright.

Stay tuned for part 2 of this Client Alert for some more helpful tips for lenders to avoid lender liability claims.

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