We Can Work It Out: When Bad Things Happen to Good Borrowers

By Jorium Jones, Associate Attorney, Smith Pauley LLP

                                                              We Can Work It Out:

When Bad Things Happen to Good Borrowers 

            “We Can Work It Out” is not only a hit song performed by The Beatles, but this collaborative concept, which is manifested as a workout agreement, is also a strategic tool utilized by financial institutions to formally restructure the terms of a loan agreement and in turn, maximize a lender’s recovery and create a sustainable path forward for a good borrower facing a bad financial situation. This article will provide an overview of the commercial real estate loan workout process and discuss why workout agreements are necessary and beneficial for both a lender and a borrower.

Regulatory Guidance for Financial Institutions

            In alignment with safe and prudent lending practices, financial institutions should offer loan accommodations that are appropriate for the borrower’s unique circumstances and that comply with applicable laws and regulations. For instance, pursuant to the final policy statement issued by the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and National Credit Union Administration, financial institutions are encouraged to “work prudently and constructively with creditworthy borrowers during times of financial stress.” Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts, 88 Fed. Reg. 43,115 (July 6, 2023).

What is a Workout Agreement?

            In the context of commercial real estate and banking and finance, a workout agreement is a negotiated agreement, accommodating a borrower, who is experiencing financial hardship and is therefore unable to satisfy the original loan repayment terms. Such agreements differ from a standard refinance, and the purpose is to avoid a default, bankruptcy, or foreclosure and ultimately provide financial relief to the borrower and minimize loss for the lender.

Additionally, the goal of a workout agreement is to restructure the existing loan terms by creating a mutually agreeable and sustainable short-term or long-term structure that allows the borrower to avoid adverse action and the lender to maximize its recovery. Examples of restructuring the existing loan terms include revising the payment schedule, extending the loan maturity date, creating new terms for what constitutes a default under the new workout agreement, a waiver of defenses by a borrower, and collateral stipulations. A borrower waives defenses by acknowledging the remaining balance of the loan and forgoing any claims or defenses against the lender related to the loan agreement. Collateral stipulations confirm the lender’s security interest in the collateral and could take the form of a new pledge or guarantee by the borrower to further secure the new loan.

Why Enter a Workout Agreement?

To foreclose or to workout? That is the question…that many lenders contemplate. Rather than pursuing a foreclosure, a lender should enter a workout agreement to maximize its recovery because lenders often recover more financially through a negotiated workout than through a lengthy and costly foreclosure. Further, a workout agreement assists in maintaining and retaining customer relationships, as a valued customer may eventually recover financially and become a reliable borrower again and pursue other transactions with the lender. From a borrower’s perspective, the objective is to retain ownership and equity in the real estate and to avoid a default, bankruptcy, or foreclosure, which in turn, protects the borrower’s credit and could minimize their personal liability.

The Workout Process at a High Level

Ideally, the workout process begins when a borrower notifies its lender before a default occurs and fully discloses their financial situation, as well as the cause of the imminent default. The lender then conducts a thorough financial analysis and reviews the borrower’s income, expenses, and assets to assess the borrower’s ability to repay the loan under new, modified terms. During the negotiation stage, the lender and the borrower, or their legal counsel, propose and negotiate specific terms that result in a new workout agreement memorialized in a formal, legally binding contract. If an agreement is executed, the borrower must strictly adhere to the new terms under the workout agreement, and the lender must diligently monitor the borrower’s compliance.

Before deciding to work out an agreement with a borrower, lenders should proactively conduct due diligence and perform a preliminary investigation of the specific facts and cause for the problem loan. After the cause is determined, then a lender should be able to make a reasonable, informed decision on whether to attempt a workout agreement or if other enforcement options should be pursued.

Common Workout Options

In general, there are three common workout options for a commercial real estate loan: Reservation of Rights; Forbearance Agreement; and Deed-in-Lieu of Foreclosure. First, by reserving its rights, a lender agrees to pause enforcement actions related to the original loan. However, the new workout agreement will explicitly provide that the lender does not waive its existing rights or remedies to enforce the original loan. If the workout fails, the lender’s reservation of rights provides protection by still allowing the lender to maintain its right to accelerate the loan or foreclose.

Second, a forbearance agreement is a temporary reduction or suspension of loan payments or a lender’s legal remedies that allows the borrower time to recover and cure the default. However, the loan’s interest generally still accrues.

Third, a deed-in-lieu of foreclosure essentially allows the lender to step into the borrower’s shoes as the owner of the real estate, which means the borrower voluntarily surrenders and transfers the real estate to the lender in satisfaction of the loan and to prevent the foreclosure. However, under this option, the lender becomes subject to all existing liens and interests against the real estate without the benefit of its original security interest’s priority over all subordinate liens or interests.

Conclusion and Best Practices for Lenders

In conclusion, a successful workout is only feasible after a lender performs its due diligence of the facts and circumstances, and then assesses its legal alternatives and corresponding consequences. As such, lenders should be proactive and contact their legal counsel early on in the workout process to ensure compliance with applicable laws and regulations and to determine the most appropriate workout option for the specific economic factors. Being flexible and accommodating with creditworthy borrowers is a policy that is strongly encouraged by many federal agencies. Although workout agreements will often require lenders to grant concessions that would generally not be considered acceptable during the initial loan origination stage, workout agreements are proven to be a win-win solution for both lenders and borrowers…who can work it out.

Jorium P. Jones is an attorney licensed in Nebraska and Texas at Smith Pauley, practicing in the areas of banking and finance, real estate, and corporate law.