Byline: Robert Willner, Esq. and Shadi Enos, Esq.
While a lender typically enters into a loan transaction with the expectation the borrower is financially sound and capable of repaying its debt, the lender must be prepared for the scenario where the borrower materially defaults on its loan obligations. There is no question lenders are aware of the risk of default and take great care when drafting loan documents to ensure they will be positioned to exercise rights and remedies against a defaulting borrower. There is a question, however, of whether the lender is sufficiently protected by the loan documents if the lender opts not to exercise these rights against a defaulting borrower and instead opts to modify or “workout” the troubled loan. Under the latter scenario, lenders may be vulnerable since some loan and security documents do not contemplate the precautions needed to preserve a lender’s rights in workout negotiations, thereby exposing it to additional risk or liability.
In workout negotiations, a lender is exposed to a variety of risks, including the claim the lender has exercised undue control over the borrower and the claim that a new agreement has been reached even if such purported agreement is not signed by the lender. These risks can be mitigated by entering into a “pre-workout agreement” (also known as a pre-negotiation agreement) with the defaulting borrower prior to the commencement of workout negotiations to establish the ground rules for negotiations and key provisions to preserve the lender’s enforcement rights should those negotiations fail. Pre-workout agreements are useful tools to assist the lender in engaging in frank and fruitful discussions with the borrower to modify a problematic loan.
The purpose of this article is to provide lenders and counsel with a practical guide to preparing a pre-workout agreement. First, the article will explain the benefits of such an agreement and the circumstances under which they are preferable. Next the article will lay out the due diligence steps to be taken prior to drafting a pre-workout agreement. The article will also enumerate the provisions and concepts a lender should incorporate in the agreement. Finally, the article will address the enforceability of pre-workout agreements.
B. The Loan is in Material Default
What is “material”?
The first step in determining whether a loan workout (and consequently, a pre-workout agreement) is appropriate is to assess the extent and materiality of the defaults. Often there is no bright line that delineates a material default from a non-material default. Rather, materiality is subjective and requires the consideration of a variety of factors, which may include the frequency and gravity of the borrower’s defaults. For example, a single non-payment default may be immaterial; but, if the same default is repeated or left uncured for a substantial amount of time it may be a material default. Alternatively, a single payment default, breach of a financial covenant or breach of a covenant relating to the financial condition of the borrower, typically is deemed material because the underlying covenants or representations are viewed as fundamental to the loan transaction.
2. Why does “materiality” matter?
A lender must assess the materiality of a borrower’s defaults before enforcing its rights under any loan document because lenders have a general duty to act in good faith. The Uniform Commercial Code (the “U.C.C.”) states that “every contract or duty within [the U.C.C.] imposes an obligation of good faith in its performance or enforcement” where good faith is defined as “honesty in fact in the conduct or transaction concerned.” U.C.C. §§ 1-203 and 1-201(19) (amended 2001). Restatement of Contracts 2nd (the “Restatement”) imposes an even broader obligation “of good faith and fair dealing in . . . performance and enforcement” of contracts. Restatement (Second) of Contracts § 205 (1981) (emphasis added). While this general duty of good faith was established by the U.C.C. and the Restatements, courts have consistently applied the concept in the lender-borrower context. See e.g., Brown v Avemco Inv. Corp., 603 F.2d 1367 (9th Cir. 1979), Tolander v. Farmers Nat’l Bank, 452 N.W.2d 422 (Iowa 1990), Mann Farms Inc. v. Traders State Bank, 801 P.2d 73 (Mont. 1990), and United States Nat’l Bank v Boge, 814 P.2d 1082 (Or. 1991). Courts will consider whether a lender’s enforcement of its rights and remedies would be deemed to be in “observance of reasonable commercial standards of fair dealing in the trade.” U.C.C. §§ 2-103(b) and 1-201(19); see also U.C.C. § 3-103 (As it relates to negotiable instruments, “‘good faith’ means honesty in fact and observance of reasonable commercial standards.”). Accordingly, lenders cannot freely enforce contractual remedies without considering the context of the borrower’s breach and the harm the lender may cause by such enforcement. A lender seeking to enforce a remedy for a non-material breach will likely find itself being admonished by the court. Consequently, prudent lenders will conduct a thoughtful evaluation of the materiality of the borrower’s breach before commencing any enforcement against a borrower.
C. What Do You Do Next?
1. Identify and list all defaults
The next step is for the lender to identify and enumerate all of the borrower’s defaults. Creating a table, like Table C.1 below, provides a framework for evaluating the collective set of defaults in its totality. The table should list (i) all known defaults, including payment and non-payment defaults, (ii) the actions the borrower was required to take under the terms of the existing loan documents, (iii) an assessment of the materiality of the corresponding breaches and (iv) an assessment of the borrower’s intent to cure.
Table C.1: Sample Table of Defaults
||Loan Document Reference
||Loan Document Required Action
||Borrower’s Intent to Cure
||Pay all immaterial taxes.
|Borrower has not paid state franchise tax board tax assessment of $270.
||Per Borrower’s correspondence on 11/1/12, Borrower will pay FTB tax in two days.
||Pay interest on 15th of Month
||Borrower has not paid interest
||Per phone conversation with Borrower on 11/16/12, Borrower hopes to be make payment in 5 days.
For each breach, the lender must make an assessment of materiality, which as previously discussed, is subjective and requires considering a variety of factors. Next, the lender should assess whether the borrower is capable of curing its defaults. To the extent the borrower is unable to cure a material default, despite its desire to do so, further negotiations will prove futile. If, however, the breach may be cured, the lender must determine whether the borrower intends to cure.
In assessing intent, one factor the lender should evaluate is the borrower’s general course of conduct. For example, the lender should consider whether the borrower has previously been in default and if so, further consider the frequency of those defaults. Occasional and isolated instances may be excusable; whereas, a pattern of borrower negligence or financial instability should give the lender pause. Ultimately, the outcome of this factor hinges on the soundness of not only the borrower’s financials but also of its relationship with the lender.
2. Engage counsel to conduct a file review
After preparing the default table, the lender should have a comprehensive understanding of the breadth and gravity of the breaches and will have three courses of action from which to choose. If the borrower intends to cure and the lender is sufficiently assured it can and will do so, the lender should consider waiving the existing defaults and reinstating the loan on its terms.
Alternatively, however, if the borrower indicates either expressly or impliedly through its conduct, that it cannot or will not cure, the lender may determine that workout negotiations would be fruitless. In such case, the lender may proceed to enforcing its rights and remedies, including accelerating the loan and foreclosing on the collateral. In such case, a loan workout (and consequently a pre-workout agreement) has no relevance.
If, on the other hand, it appears the borrower is acting in good faith and is capable of achieving compliance with the loan documents over time, but will require certain interim modifications to the loan documents, the lender may well determine that a forbearance and restructure of the loan is the best course of action. Specifically, the lender should believe the borrower’s non-compliance is temporary and there may be some resolution through, for example, the passage of time or the injection of new cash. In such case, a pre-workout agreement entered into prior to the first negotiations is appropriate.
Regardless of whether the lender decides to exercise its remedies against the borrower or continue on the path of a potential workout, it is critical that the lender conduct a thorough review of the transaction file. The purpose of the file review is to identify any documentation problems that may inhibit enforcement and ensure the lender is perfected in all collateral. If there is a problem, now is the time to correct it and the default provides the leverage and the consideration to do so. Generally this task is assigned to experienced counsel. To do this, the reviewing counsel should take the following steps:
(a) Compile and list all loan documents and all amendments
Reviewing counsel should compile a list of all loan and security agreements, including all amendments and supplements. It is important to review all correspondence (including email) with the borrower, any guarantors or subordinated creditors, as the courts may include both formal and informal communication as evidence of an amendment or modification to the loan documents. Reviewing counsel must then compare the loan documents against the credit approval memoranda to confirm consistency or identify any deviations. They must also ensure all loan documents have been properly executed, filed and recorded, as applicable.
(b) Confirm perfection of security interests
Reviewing counsel should also list all collateral by type and confirm the lender’s security interest in each is properly perfected. For example, for all accounts, inventory, and equipment, the lender should have a properly recorded U.C.C.-1 financing statement for each loan party. There should also be evidence the lender has “control” (as defined in Article 9 of the U.C.C.) of the applicable deposit accounts and securities accounts. See U.C.C. §§ 9-104(a) (control of a deposit account) and 9-106 (control of investment property) (amended 2001). If there are any vehicles, reviewing counsel should confirm the security interest has been perfected with the DMV for the applicable jurisdiction. For registered copyrights, reviewing counsel will need confirmation the security interest in each copyright evidenced by a security agreement/copyright mortgage was properly filed with the United States Copyright Office.
(c) Update lien searches
We recommend that reviewing counsel obtain and review new U.C.C. lien searches for each borrower and secured guarantor to identify any intervening or subsequent liens and to confirm the priority of the lender’s filings. It is also advisable that the scope of such lien searches be broadened to include searches for non-consensual liens such as federal tax liens, state tax liens, judgment liens, filed litigation, bankruptcies filings, fixture filings, ERISA liens (less commonly ordered), and agricultural liens (if applicable). While the rules to determine the jurisdictions and debtor’s name(s) under which these searches should be ordered are not the subject of this article, it is important to note the lender may want to err on the side of being over-exhaustive if there are large dollars at stake.
For example, the lender should consider obtaining a copy of the borrower’s (and any guarantor’s) tax return to determine the name under which such entity filed its taxes. To the extent the loan party filed taxes under a name spelled differently than the name of such entity as reflected on its certified formation documents, the lender should obtain additional searches under the names of the loan party as spelled on the tax return. In the heartburn inducing case, United States v. Crestmark Bank (In re Spearing Tool & Mfg. Co.), 412 F.3d 653 (6th Cir. Mich. 2005), the 6th Circuit held that the U.C.C. rules of perfection and filing did not apply to the IRS, and permitted the IRS to file a tax lien against an entity using the entity’s name as stated on its tax return even though that name was not its legal name as shown on its organizational documents. The Spearing Tool court further ruled the IRS had priority over a perfected lender who filed a U.C.C. financing statement using the borrower’s correct legal name. Id. at 657. Accordingly, to identify all federal tax liens, searches should be conducted under the obligor’s tax return name in addition to the obligor’s proper legal name.
While the list of recommended searches may appear excessive, the lender needs to do a cost benefit analysis, weighing the cost of the searches against the possible loss if it turns out the priority of its lien may be junior to any potential unsubordinated creditors.
(d) Obtain current good standing certificates and certified articles
Good standing certificates for the jurisdiction of organization or incorporation as well as for each foreign qualification jurisdiction should be ordered and reviewed to confirm obligors are in good standing and qualified to do business in the applicable jurisdictions. Additionally, since certain post-closing changes to the borrower’s status can cause the lender’s security interest to be unperfected (e.g., if a borrower changes its name or jurisdiction of organization), certified articles of incorporation or formation should be ordered.
(e) Landlord Waivers and/or Warehouse Agreements
Reviewing counsel need also ensure the necessary landlord waivers or warehouse agreements have been obtained for all locations where any material tangible collateral (including books and records) is stored.
3. Send notice of default to the borrower and all guarantors
After completing the due diligence review and evaluating the table of breaches, the lender should send a notice of default to the relevant parties enumerating the defaults listed in the table. This notice should include all defaults, material and non-material, to avoid establishing a course of dealing which may imply a waiver of the lender’s rights and remedies with respect to any default. At a minimum, the notice will need to be sent to the borrower and any guarantors. There may be, however, additional parties who must or should also be notified. Accordingly, in conducting their file review, lender’s counsel should determine whether any third parties require notice of defaults (e.g., landlords, subordinated creditors, mezzanine lenders or other parties to an intercreditor agreement). In addition to providing a subordinated creditor notice, if required, the lender should also consider blocking borrower payments to the subordinated creditor, assuming the subordination agreement permits such blockage.
4. Determine whether to accelerate or attempt a workout
Next, the lender should consider which available remedies, if any, it should exercise. While the lender may have the right to accelerate the loan or foreclose on the collateral, it will likely decline this option if it intends to successfully negotiate a workout with the borrower. The lender may, however, find it prudent to impose the default interest rate, cease making advances to the borrower, impose reserves, implement a lockbox, send notices to the account debtors to pay the lender directly, exercise control over the borrower’s deposit and securities accounts, and/or send blockage notices to subordinated creditors. Determining which remedies to exercise requires care. The lender must balance the gain of incremental financial security against the potential loss of goodwill in exercising its rights. A lender that is too harsh prior to commencing workout negotiations may establish an inhospitable environment for such discussions.
D. Preparation for Loan Restructure
1. Parties to involve in discussions
Assuming the lender deems it appropriate to commence workout negotiations, the lender must then determine which parties should be involved. This determination is done on a case-by-case basis, but the general rule of thumb is to keep the group to a small and manageable size. Certainly the borrowers, the lenders, and the inside guarantors will need to be included. Beyond these parties, the decision to include third party subordinated creditors or guarantors should be made subject to a review of the documents governing their interests. For example, determining whether institutional subordinated debt providers need to be included requires a review of the intercreditor agreement to understand what modifications can be made to the senior loan documents without the consent of the junior creditors. Typically, it is market for the subordinated debt documents or intercreditor agreements to require the junior lien lenders to consent to changes in the senior documents that would be material or adverse to the junior lenders.
2. Document all contact with the parties
Once all relevant parties have been identified, the lender should document correspondence and keep contemporaneous notes of all telephone calls and in-person meetings with each party. This is a critical step to preventing allegations of misrepresentation and misconduct and to help establish evidence the lender acted in a commercially reasonable manner during the enforcement and administration of the loan documents.
E. The Pre-Workout (or Pre-Negotiation) Agreement
Although the decision has been made to consider a workout and the parties have been identified, the lender must take caution not to jump directly into substantive negotiations at this stage. Rather, the lender should enter into a pre-workout agreement with the borrower.
1. When do you want a pre-workout agreement?
Most importantly, pre-workout agreements should be entered into prior to the first substantive discussion with the borrower concerning a possible loan restructure. These agreements are best entered into when the parties desire to document their intent to work in good faith to resolve the defaults and restructure the loan documents. The lender must believe the borrower’s non-performance of the loan requirements is temporary and the borrower is capable of performing its obligations going forward.
2. Why do you need a pre-workout agreement?
There are numerous benefits to pre-workout agreements, but the most notable is the lender’s ability to reduce its exposure to lender liability claims. Lender liability is a blanket term describing various contract and tort theories under which borrowers have sued lenders. Generally, the claim is that the lender has exercised undue control over the borrower, thereby making the lender responsible for the borrower’s losses. Borrowers have also argued breach of implied covenant of good faith and fair dealing, fraud, negligence and conversion, and breach of fiduciary duties owed to the borrower. See generally E. Allan Farnsworth, Precontractual Liability and Preliminary Agreements: Fair Dealing and Failed Negotiations, 87 Col.L.Rev. 217 (1987). Borrowers successful under lender liability claims may be able to recover not only compensatory damages but also substantial punitive damages. See, e.g., Crystal Springs Trout Co. v. First State Bank, 732 P.2d 819, on reh’g, 736 P.2d 95 (Mont. 1987); Robinson v. McAllen State Bank, 48 BNA Banking Rptr. 1004 (Tex. Dist. Ct. 1987).
Lenders are often most vulnerable to lender liability claims when negotiating a loan workout or restructuring. If negotiations between the parties fail, a borrower may claim the lender agreed, either expressly or impliedly by its conduct, to some course of action or granted some concession when it did not. Borrowers may also claim, as the court held in Markov v. ABC Transfer & Storage Co. 76 Wash.2d 388, 457 P.2d 535 (1969) that “[i]mplicit in the act of negotiating is a representation of a serious intent to reach agreement with the other party.” Thus, liability may be imposed on a lender that “enters into negotiations without serious intent to reach agreement . . . .” E. Allan Farnsworth, Precontractual Liability and Preliminary Agreements: Fair Dealing and Failed Negotiations, 87 Col.L.Rev. 217, 233 (1987).
While this article is not intended to provide a comprehensive discussion of the grounds for lender liability, the above sample of claims borrowers may bring is presented to highlight the perils that befall an unprotected lender. Lenders can reduce exposure to liability claims by entering into a pre-workout agreement that, among other things, (i) obtains a general release of liability from the borrower and insider guarantors and subordinated creditors, (ii) makes clear that no agreement is final unless it is in writing and duly executed by persons authorized to sign, and (iii) obtains an acknowledgement that the lender is under no duty to restructure the loan or grant any concessions.
Pre-workout agreements can also be beneficial in establishing ground rules for negotiations and identifying the individuals that are authorized to negotiate on behalf of each party. Establishing this framework can help keep the discussions focused and more productive. These agreements are also useful to obtain estoppels from the borrower which prevent the borrower from asserting certain defenses in the event of litigation. For example, the lender can obtain a written acknowledgement by the borrower of the events of default under the loan documents, and their materiality, in order to estop the borrower from later disputing the same. Lenders can also obtain an acknowledgement by the borrower that the loan documents are in full force and effect, preventing any later argument the agreements are not enforceable. Finally, if workout discussions prove unproductive, the pre-workout agreement can set forth a plan to terminate the discussions in an orderly fashion.
3. Who should be party to the pre-workout agreement?
The borrower, all guarantors and the lender should be party to the pre-workout agreement. If a borrower is initially resistant to executing a pre-workout agreement, the lender should first inform the borrower that without such agreement, the lender may decide the more prudent alternative is to enforce its rights and remedies under the loan documents. If the borrower continues to resist, the lender may either decide that the borrower is not acting in good faith and proceed with exercising its rights and remedies or it may proceed with negotiations without the pre-workout agreement and forgo the added protections afforded by such agreements. Lenders adopting the latter path must be cautious to document every discussion with the loan parties/subordinated creditors and to refrain from using language on which the borrower may detrimentally rely.
4. Key Provisions of a Pre-Workout Agreement
When drafting pre-workout agreements, lenders are advised to include the following provisions:
- A schedule of all loan documents, with an acknowledgment from the borrower that all are in full force and effect, and will remain in full force and effect during the negotiations. The schedule should include a comprehensive list of all loan documents found during the file review and a catch-all provision to ensure no agreements are inadvertently omitted.
- A schedule of defaults, listing both required performance and actual performance.
- An acknowledgement by the borrower [and guarantors] of the existence of the defaults.
- An acknowledgement by the borrower [and guarantors] that the lender has not waived the existing defaults.
- An acknowledgment by the borrower [and guarantors] of the debt owed to the lender.
- An acknowledgement by the borrower [and guarantors] that any extensions of credit or acceptance of partial payments during the negotiations do not constitute a waiver of the defaults.
- A provision stating that during negotiations, the lender will forbear from exercising remedies with respect to known defaults, i.e., those enumerated in the Pre-Workout Agreement.
- An acknowledgment by the borrower that the lender is not obligated to negotiate or modify the loan documents.
- A provision stating that the workout discussions are not binding until reduced to a written agreement signed by authorized signatories, and the identity of those authorized.
- A provision stating that any restructure is subject to formal credit approval.
- A provision stating that the borrower pays the lender’s expenses, including attorneys’ fees for negotiations, documentation, etc. Drafting note: some lenders require a deposit before workout discussions. The deposit serves to not only protect the lender financially, but may also serve as an early indication of the borrower’s sincerity and interest in negotiating a workout.
- A provision stating there will be an end to discussions and negotiations if an agreement is not reached by a date certain. Such a deadline can keep the borrower motivated to progress discussions. The lender can agree to extend the deadline if needed.
- A general release by the borrowers and guarantors.
- A provision stating that the negotiations are to be kept confidential.
- A provision stating that negotiations are to be deemed settlement discussions and therefore are not inadmissible in state or federal court (See Cal. Evid. Code 1152; Fed. R. Evid. 408).
- A bring-down of the borrower’s representations and warranties in the loan documents.
The above listed provisions ensure the lender is guarded against the typical issues that arise from failed workout negotiations. However, additional provisions may be needed to address unique or more complex circumstances.
5. Enforceability of Pre-Workout Agreements
The article thus far has posited the merits of pre-workout agreements and provided the steps to preparing a well-drafted agreement. There is, however, one last word of caution that must be provided to lenders regarding the enforceability of a pre-workout agreement.
While pre-workout agreements are generally enforceable, lenders are cautioned to ensure that such agreements comply with general principals of contract formation, including consideration. The court in German American Capital Corporation v. Moosup Road Limited Partnership, 1998 WL 405090 (Sup.Ct. Conn. 1998) held that a pre-workout agreement was unenforceable for lack of consideration, reasoning that the “agreement imposes no obligation on the [lender]” and that “[a] bilateral contract demands ‘mutuality of obligation.’” The court went on to state that “the pre-negotiation agreement [was] so lacking in mutuality as to be unenforceable as a bilateral contract.” The lack of mutuality, the court held, could be “avoided if there was partial performance by the lender, such as forbearance or the negotiations themselves.” Accordingly, lender’s counsel should ensure the drafted pre-workout agreement adheres to the general rules of contract formation.
Assuming a pre-workout agreement complies with the rules of contract formation, courts have generally found such agreements to be enforceable. In fact, they typically assume the enforceability of such agreements without so much as providing an explanation for their holding. For example, in Travelers Ins. Co. v. Corporex Properties, Inc., 798 F. Supp. 423 (E.D. Ky. 1992) a borrower entered into a pre-workout agreement with Travelers but later claimed Travelers waived its foreclosure rights when it accepted partial payments of interest. The court found Travelers had not waived its rights by accepting partial payments citing, as its authority, the express language of the pre-workout agreement that there was no waiver. In doing so, the court assumed the enforceability of the pre-workout agreement without discussion. See also, Federal Home Loan Mortgage Corp. v. Drofan Realty Corp., 1996 U.S. App. LEXIS 345 (S.D.N.Y 1996).
While pre-workout agreements have been used by lenders for several decades, today’s challenging economic conditions have given them renewed importance. With more borrowers struggling financially, an increasing number of loans have proven problematic. Lenders who attempt to salvage these problematic loans by entering into workout negotiations find themselves at risk of facing a variety of lender liability claims if an agreement cannot be reached. These risks can be mitigated, however, by entering into pre-workout agreements. Pre-workout agreements also provide the benefit of establishing both a framework for productive discussions and a plan to terminate unfruitful negotiations in an orderly fashion. Lenders desiring to achieve these objectives can follow the steps enumerated in this article to prepare a favorably drafted and enforceable pre-workout agreement.