Lenders: 4 Critical Steps To Prepare For Impending Commercial Borrower Defaults

As interest rates continue to rise in an effort to rein in inflation, many economic experts predict that a recessionary period is likely to occur in 2023. Commercial borrowers whose creditworthiness was unimpeachable a few years ago may now be struggling with labor, supply, or cash flow issues.

As a lender, it is critical to review your portfolio before borrower defaults begin to make sure you are in the most favorable position possible with respect to collateral, documentation issues, and intercreditor issues. This will help maximize recovery and minimize risk if a borrower does, in fact, default.

The checklist below is provided to help you assess your position and plan for potential defaults—as well as control a workout if a default occurs.

1. ASSESS

• Assess the state of the deal by asking the following questions:
• What types of defaults exist (payment, covenants, other liens, taxes)?
• What type of collateral secures the obligation or loan (accounts, inventory, equipment, real estate, improvements, fixtures, developed property, rental property, owner occupied)?
• What is the value of the collateral? How recent is the last valuation? Is there insurance on the collateral?
• What is your lien priority? Consider statutory (superpriority) liens in addition to consensual liens. Are there any competing interests that may have rights to or possession of your collateral (e.g., landlords, warehousemen, consignors, etc.)?
• What is the status of the loan and/or collateral documentation? Has it recently been reviewed for deficiencies, needed updates, continuation of liens?
• Are existing financial covenants properly structured/defined? Are they measuring the correct financial metrics of the borrower?
• What sources of recovery exist other than the collateral, such as a guaranty or co-borrower? Have such entities been recently evaluated in terms of creditworthiness?
• Does the borrower's business plan make sense, or do they have an alternative plan to alleviate the default?

2. ENGAGE

• Where do you want the deal to go? Lender control over a deal begins with a notice of default and enforcement of remedies. Consider including the following in a default notice:
• Statement of relevant defaults and timeframe to cure such defaults
• Acceleration of debt, if necessary
• Implementation of a default rate, if available
• Advising the borrower of remedies available to lender and potential for lender to recover fees (late fees, court fees, legal fees for collection)
• Request for information needed to assess situation and extent of defaults (updated financial information, information on litigation, etc.)
• Reservation of rights: indicate that lender is not waiving any remedy by simply providing notice of all currently known defaults and that delay in prosecuting other defaults and remedies does not constitute a waiver of either

3. RECORD

• Create a clear document trail with borrower regarding default and workout agreements. A forbearance agreement can be a strong start and should contain at least the following:
• Acknowledgments by borrower (amount of debt; enforceability of security interest; existence of defaults; no defenses, setoffs or counterclaims; lender's right to enforce; and that documents are still in effect)
• Release of claims against lender and related entities
• Provisions for payments and related deadlines, along with acknowledgment that time is of the essence
• Provisions providing credit enhancements (adding collateral, guarantors, or other signatories)
• Provisions related to additional lender's rights (access to collateral, inspection of books and records, audits, budgets, etc.)
• Consider charging a forbearance fee or adding new affirmative or negative covenants of the borrower or guarantors that are not in the loan documents
• Termination of forbearance agreement upon forbearance defaults
• Acknowledgment by borrower that they were represented by counsel in negotiation of forbearance and waiver of jury trial

4. REVIEW

• If workout negotiations fail, consider the following other remedies:
• UCC Article 9 public/private foreclosure sale
• UCC Article 9 partial/full satisfaction of debt agreement
• State court receivership/assignment for benefit of creditors (ABC)
• Deed in lieu of foreclosure
• Deed in escrow
• Sale of loan
• Replevin or foreclosure proceedings/self-help repossession
• Composition agreements/contract with creditors to accept pro rata settlement

Maslon's Financial Services team continually monitors economic developments impacting commercial borrower defaults and can assist with any of the foregoing, including initial reviews of loan files for potential pitfalls.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.