Making Lemonade from Lemons: A Mortgage Lender's Guide to Successful Loan Workouts, Part 3

If you are a mortgage lender who followed the recommendations in the first two articles in this series, then you have performed due diligence on your mortgage portfolio and have taken note of the many options that are potentially available to you to move forward with your workout, understanding that not all options are available in all circumstances. The next step, and by far the most challenging, is to develop a workout strategy for your mortgage loan.

A good strategy is one that takes into account all of the pertinent facts. There is no established set of rules, and each situation is unique. The "perfect" strategy in one situation could lead to disastrous consequences in another. This is why it is so challenging to develop a successful strategy.

The first step in developing your strategy is to identify your objectives as well as those of the borrower. One of the biggest mistakes a lender often makes is focusing entirely on its own objectives and disregarding those of the borrower. It is an understandable mistake, but hopefully not one you will make. You may be frustrated that the borrower has not honored its obligations, and, on principle, it seems wrong that you should have to consider the desires of a borrower in default. You will be better served by setting aside your principles on this point and recognizing that the borrower's desires may affect the ultimate outcome. Certainly, you cannot achieve a consensual resolution to a nonperforming asset without the borrower's consent. Even if you want to take back the property rather than achieve a consensual workout, if the borrower's primary objective is to retain the property, it will thwart you every step of the way to foreclosure. You need to be prepared for that. 

Borrower's Objectives

You will never know with certainty what the borrower's objectives are because you cannot get inside the borrower's head. Even if the borrower tells you its objectives, the information may not be accurate. The best you can do is to make an educated guess about the borrower's objectives based upon its actions, not its words.

Since each situation is unique, there is an endless list of objectives the borrower could have, but the most common include the following:

• Keep Ownership of the Property. This is often driven by a desire to preserve its equity or have additional time to recover its equity.
• Maintain Control of the Cash from the Property. The borrower may want to establish a "war chest" with which to fight you.
• Reduce Its Payment Obligations Under the Loan. This can be done on a permanent or temporary basis.
• Extend the Maturity Date of the Loan. The length of the extension will depend upon the borrower's plan to repay the loan.
• Minimize Personal Liability of the Principals. This is true particularly if there is a repayment guaranty or known problems (e.g., violation of environmental laws or construction defect) for which the principals are liable.
• Avoid/Minimize Additional Equity Contributions. The borrower may not want to contribute additional equity regardless of whether it has the ability to do so.
• Avoid/Defer Tax Consequences. Certain workout resolutions (e.g., loan forgiveness) may have negative tax consequences to the borrower, which would require it to make a fairly immediate income tax payment.
• Avoid Domino Effect on Other Assets/Obligations. The borrower or guarantor may have unrelated obligations that could be triggered if you exercise your remedies (e.g., the guarantor might fail to satisfy financial covenants under other loans if it makes a payment to you).
• Keep Current Management in Place. Even when a borrower has abandoned its expectations of recovering equity, if the property is being managed by the borrower or an affiliate, then the borrower may try to hold on to its revenue stream.
• Resolve Mechanic's Lien Claims So Sales Can Close. Mechanic's liens are always problematic, but the borrower may believe that if it could resolve mechanic's lien issues, it would be able to generate sufficient cash flow to repay your loan (e.g., condo units, improved lots).
• Avoid Foreclosure by Creditors Other Than the Mortgage Lender. A borrower may be less focused on preventing your foreclosure than it is on avoiding other foreclosures (e.g., association assessment liens and mechanic's liens) and, depending upon the priority of the mortgage lien, it may be in the lender's interest to avoid these as well.
• Avoid Reputational Damage. This is more common among institutional borrowers who recognize that engaging in a nasty fight with their lender may have negative consequences on their ability to borrow from other lenders in the future.
• Use the Property as a Bargaining Chip in the Context of a Larger Workout. If the mortgage loan is just one element of a borrower's overall relationship with you, the borrower may use the property and the loan as a means to achieve an overall resolution of the entire credit.

The foregoing list is not comprehensive but is a good starting point as you try to identify the objectives you think are important to the borrower in structuring a workout. Consider all objectives that are theoretically possible for the borrower to achieve and discard the ones that are not. For example, the borrower may want control of the cash, but legal requirements may prohibit you from giving the borrower control (e.g., an intercreditor agreement that requires the mortgage lender to retain control of the cash). If that is the case, then control of the cash is an objective that the borrower cannot achieve and is different from an objective that can be achieved, but you don't want to give (e.g., turning excess cash flow over to the borrower).

In addition to identifying the borrower's objectives, you should try to determine what you believe to be the order of priority and importance of each of the borrower's objectives. For example, if a borrower wants to keep the property primarily so it can continue receiving management fees, then its main objective would be the retention of management fees. If your goal is to take back the property, the borrower may willingly give you a deed in lieu if there is a way for the borrower to be compensated for its lost management revenue (and as much as you may resist making a payment to the borrower, this option could be much cheaper than litigation). It is essential that you keep an open mind to all possibilities throughout the process. 

Lender's Objectives

Once you believe that you have identified your borrower's objectives, it's time to identify your own. As with the borrower's objectives, your objectives will vary based upon the specific facts. Some of the more common lender objectives are the following:

• Get Repaid in Full. You may need to be repaid in full right away because you have issues with your liquidity or capital reserves. Alternatively, it might be more important to you that you get repaid in full, even at a future date, than collecting a lesser amount today.
• Create a Performing Loan for Reporting Purposes/Increase Liquidity. If this loan is just one of many troubled loans in your portfolio, you may be experiencing issues with liquidity and capital reserves, and your priority may be on modifying the loan in such a way that it can quickly be reclassified as a performing loan.
• Complete Construction of the Project/Preserve the Value of the Collateral. If the project is only partially constructed, or you are concerned that deferred maintenance items may become structural or life-safety concerns, this may be your objective.
• Get Control of the Cash from the Project. This is applicable if the property is generating cash flow (even if it does not exceed the amount necessary to pay operating expenses) and you do not already have a cash management arrangement in place.
• Maximize Personal Liability of the Principals. If you think that the value of the property is worth less than you are owed on the loan, you may want to find ways to recover from the principals rather than (or in addition to) the real property.
• Minimize Lender Liability Claims. If you have concerns about actions that your employees may have taken (e.g., providing detailed directions to the borrower regarding minute details of property management), then you may put a higher priority on avoiding big payouts to the borrower than you do on maximizing your recovery on the loan.
• Replace or Keep Existing Management. If you think that some of the property's problems are attributable to poor management or marketing, then one of your first goals may be to replace existing management. In contrast, you may want the manager to remain in place because it brings a unique set of skills and related assets (e.g., hotel or data center).
• Resolve Mechanic's Lien Claims So Unit Sales Can Close. There is nothing that prevents you and the borrower from having the same objective.
• Obtain Additional Security for the Loan. If you think the borrower, guarantor or sponsor has additional collateral (including cash) that could provide additional support for the loan, you may want to tap into that (e.g., obtaining a letter of credit in exchange for a maturity date extension).
• Minimize Construction Defect Liability. If your loan collateral consists of residential condominium units, even if they have been fully constructed, you may be reluctant to take over the project because of potential construction defect claims.
• Minimize Losses in Overall Relationship with Principals. If you have a relationship with the borrower/sponsor that extends well beyond a single loan, it may be more important to you to protect the overall relationship and assets than it is to maximize your recovery on a single real estate loan.
• Limit Exposure with Respect to a Particular Region/Product Type/Principal. If you feel that you have too much exposure to a particular product type or market (e.g., condos in Miami), then you may be willing to take a loss today to avoid the risk of a larger loss tomorrow.

Since it is impossible to put together a comprehensive list of lender objectives, do not limit your thinking to the objectives listed above. You may have different objectives. It is important only that you identify and prioritize all of them.

Evaluating Strengths and Weaknesses

Developing a strategy requires you to understand what strengths and weaknesses you and the borrower possess. There are many facts that can affect the strength of your position, but in most cases, what works to your benefit (i.e., a strength) hurts the borrower's position (i.e., a weakness) and vice versa. Some of the most common factors that affect a party's negotiating strength and leverage are the following:

• Nature of the Default. If a borrower's default is monetary, particularly a maturity date default, the borrower will have less leverage in a fight against you than if you have called a "technical default" (e.g., failure to timely renew an elevator permit). In some jurisdictions, you may not be able to foreclose for a nonmonetary default unless it is technical, which would have the effect of removing foreclosure as a meaningful threat.
• Threat of Bankruptcy. The power of this threat will depend in part upon whether you believe that if the borrower files for bankruptcy, you will be able to take advantage of the single-asset provisions of the bankruptcy code (if the borrower owns multiple assets or if you think there is a legitimate risk of a consolidated bankruptcy, this threat gives the borrower leverage).
• Nature of the Project. If the collateral is complex (e.g., a resort hotel or stadium), it may be difficult for you to take effective control of the asset without the borrower's cooperation. Foreclosing might also damage the reputation of the asset (e.g., a five-star hotel).
• Important Expertise. If the principals bring something that increases the value of the collateral (e.g., a patented method for farming agricultural land) that you cannot replicate easily, that will give a borrower an advantage in negotiations.
• Partially Completed Project. Many lenders are not in a position to complete a construction project, either themselves or through the appointment of a receiver. If the borrower is the general contractor of the project, it would be even more difficult for you or a receiver to step in midstream. Another consideration is if entitlements for the project are at risk of expiring, in which case ensuring completion of the project would become far more important.
• Financial Condition and Obligations of the Guarantors. If there are guarantors (or other principals) willing to invest additional equity in the project, this could give a borrower leverage in the negotiations. In contrast, if a guarantor has executed a full repayment guaranty, then your ability to leverage the guaranty will depend upon whether the guarantor has assets to satisfy it.
• Nature of the Loan Documents. The completeness and accuracy of the loan documents will dictate leverage (e.g., if the note was never signed or the guaranty identifies the wrong party, it will reduce your leverage).
• Legitimate Potential Lender Liability Claims. If there are legitimate lender liability claims, you should be prepared for the borrower to use them against you.

Develop a Strategy

If you have taken the steps described in the first two articles in this series as well as the ones listed above, you are ready to develop your strategy. Article 2 of this series focused on the options that are available to you when facing a nonperforming real estate asset. Review that list in conjunction with the parties' respective objectives, strengths and weaknesses you have identified in an effort to narrow your list of options. If there are options that will not further your objectives or cannot be obtained for another reason (e.g., guarantor has no assets), remove those options from the list. You have now identified the range of options that you can use (even though you may not want to do so) to achieve your objectives.

The next step is to compare the lists you put together of the borrower's objectives and your objectives and their respective priorities. If there is overlap, that is good news because it means that both you and the borrower are rowing in the same direction and appear to want the same result. It doesn't mean that there won't be challenges because you may want to follow a different path than the borrower to achieve those results, but you have a reasonable chance of reaching a consensual resolution that suits your shared objectives. Put together your plan for resolving the situation based on the foregoing and talk to the borrower about potential resolutions. Do not present a plan to the borrower. As a lender, you need to be sensitive and tread lightly to avoid creating liability for yourself by directing the actions of the borrower. Instead, use the plan to direct your receptivity to ideas proposed by the borrower (e.g., encouraging those ideas that would be beneficial to achieving your desired result).

If you and the borrower have diametrically opposed objectives (e.g., your top priority is to take title to the property and you believe the borrower's top priority is to keep the property), you may have a long road ahead. It does not mean that you cannot get what you want; only that you will need to be more thoughtful and determined in your approach because the goals of the parties are not aligned. Determine your tolerance for a big fight as well as the resources (human and financial) that you are willing to expend on a fight and make a similar determination with respect to the borrower. If you know that you are not willing or able to devote resources to a fight, but this is the borrower's key asset and it will probably fight to the bitter end, reevaluate your objectives and see where there might be some common ground.

One final factor to consider in developing your workout strategy is the personal motivation of the people involved in the workout. As is frequently the case, individuals have their own reasons for doing things that are not always aligned with the goals of the company that they represent. If you sense a divergence between the ambitions of the individuals representing the borrower or guarantor and the goals of the organizations that they represent (e.g., an individual may lose their job if the lender forecloses), then you may be able to use the divergence of interests for your own benefit.

The next article in this series will discuss the purposes and fundamental components of the basic legal documentation involved in a workout, including default letters, pre-negotiation agreements and forbearance agreements.

The Series

Part 1: Steps a Mortgage Lender Should Take Before the Workout Starts, April 30, 2024

Part 2: Steps a Mortgage Lender Should Take Once a Default Occurs, May 14, 2024

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.