When commercial real estate loans go into default, workouts are often pursued to resolve the default by agreement. What are the common forms of workout agreements?

For commercial real estate borrowers in default, it’s important to understand that the lender will likely continue to evaluate its options even while negotiating with the borrower. The lender could decide to:

• Prepare for foreclosure or other litigation, including appointment of a receiver
• Sell the loan
• Agree to a discounted payoff (unlikely)
• Propose a deed in lieu of foreclosure
• Do nothing (unlikely)
• Pursue a workout with the borrower

In choosing a course of action, lenders typically evaluate, among other factors:

• The seriousness of the default
• The borrower’s future ability to perform
• The value of the collateral
• The cost of foreclosing
• The time it will take to foreclose
• How difficult it would be for the lender to manage the property until it can be resold
• Whether any guarantor(s) have assets that can be reached
• The likelihood of the borrower and any guarantor(s) making a bankruptcy filing
• The lender’s internal issues and regulatory concerns

To start the workout process, a lender may require a pre-negotiation letter agreement with the borrower, which is typically non-binding until a final workout agreement is made, similar to a letter of intent. However, some pre-negotiation letter agreements have binding provisions. Binding covenants might include: covenants to cooperate with the lender to provide financial information and property access during negotiations; covenants not to dispose of assets outside the normal course of business; and most important to the lender, an estoppel representation that the loan and loan documents are in effect, the loan is in default, and the borrower has no defenses or counterclaims.

Common forms of workout agreements are forbearance agreements, reinstatement agreements, and loan modification agreements. All options will likely require the borrower to pay a fee and the lender’s legal fees and expenses in connection with the default and negotiating the workout agreement.

In a forbearance agreement, in its simplest form, the lender agrees to forbear from exercising its rights and remedies for the existing default(s) for a stated period of time or until another default occurs (either under the loan documents or the forbearance agreement). A forbearance agreement will include covenant and estoppel terms similar to those in a pre-negotiation letter agreement. If the forbearance is being given to allow the lender more time to consider its options or for the borrower to prove that it and the property can be brought into loan compliance, the forbearance agreement may require the borrower to obtain an updated appraisal or correct the factual situation that led to the loan default.

In a reinstatement agreement, the borrower and lender agree that the loan defaults are resolved and the loan reinstated to “performing” status. This typically requires the borrower to have corrected the factual situation that led to the default (such as paying missed payments and bringing financial and operational results into conformance with loan covenants) so the lender either withdraws its default notices, or agrees they are no longer in effect.

In a loan modification agreement, the borrower and lender agree to changes in the loan documents, such as: extending the loan term (“extend & pretend”); covenant relief (such as reducing debt service coverage ratios or leasing or occupancy covenants); or changing payment terms (such as changing monthly payments of principal and interest to payments of interest only for a time period, or re-amortizing the payment schedule if the loan term has been extended). In addition to the borrower paying the lender’s fees and legal costs, it’s also common for a lender to require a partial paydown of the loan principal or additional collateral (such as new or increased cash reserves held by the lender) or a new guarantor. A loan modification agreement might also require the borrower to refinance or sell the property by a deadline, to pay the loan off prior to its original due date.

In practice, workout agreements often combine forbearance, reinstatement, and loan modification, conditioned on the borrower’s compliance with the modified loan terms. A borrower’s ability to negotiate the terms of a workout agreement depends a great deal on each party’s relative leverage and appetite for risk, but borrowers can often negotiate better terms than the lender’s first offer. Sometimes the lender holds all the cards and dictates the terms; other times a borrower that is willing to consider a bankruptcy filing or who believes the lender is unlikely to foreclose might negotiate aggressively for better terms. In any event, a commercial real estate borrower in default should consult with a lawyer experienced in loan workouts before signing any workout agreement.