Making Lemonade from Lemons: A Mortgage Lender's Guide to Successful Loan Workouts, Part 4

The first three articles in this series took you through the steps for developing a workout strategy. If you have followed those recommendations, you understand where you are and where you want to be. You have also developed a plan to get you there. This article will address the purpose and components of some of the key legal documentation that a mortgage lender needs for a workout.

Default Notice

Typically, the first critical document you will need to prepare in the workout process is a default notice. A default notice is a formal notification to your borrower (and any guarantor) that a breach of the loan documents has occurred. Even if you want to keep matters "friendly" with your borrower, it is important that you deliver a default notice once you become aware of the existence of a default. Otherwise, you are at risk of a claim by the borrower that you have waived the default by failing to act on it. You can soften the tone of the letter if you have a good working relationship with your borrower, but the substantive content of a default letter should generally be the same regardless of the level of animosity between you and your borrower.

It is essential that you prepare the default notice carefully. If litigation or other legal proceedings arise between you and your borrower, your borrower is likely to make the default notice Exhibit "A" in the litigation and attack the sufficiency of the notice.

The default notice should comply fully with the terms of the loan documents. It should be addressed to the borrower, guarantor and any other loan parties, and copy all persons who are required by the loan documents to be copied on notices (e.g., attorneys). Depending upon the nature of the default and your developed plan of action, you may also want to provide notice of the default to persons unrelated to your borrower (e.g., general contractor or property manager) who have entered into one or more loan documents. Notifying these third parties is necessary in some instances (e.g., if you want the property manager to send rent directly to you), but it is likely to increase tensions between you and your borrower. It may also have material consequences for your borrower (e.g., a default notice from a lender may give a general contractor additional rights or remedies under its construction contract). Accordingly, before giving notice to persons other than the loan parties and anyone required to be copied on notices to the loan parties, consider the likely consequences of giving (or not giving) that notice and proceed in the manner that will best serve you.

It is essential that any default notice be sent to the addresses set forth in the loan documents unless you have received formal notice of a change of address that complies with the terms of the loan documents. For example, assume that the loan documents provide for a notice to be sent to the borrower at 1 Main Street, and the borrower subsequently sent your assistant an email stating its new address is 300 Main Street. If your assistant is not a formal notice party and/or email is not a permitted method of sending notice set forth in the loan documents, then the borrower has not validly changed its address, and you must send the notice to the borrower at 1 Main Street to provide valid notice to your borrower. However, you should also send the notice to the borrower at 300 Main Street because that is where the borrower is likely to receive it. If you are in doubt as to where a notice should be sent, then unless there is a reason not to do so, you should send the notice to all possible addresses. You do not want the borrower to have a viable legal claim that it never received the notice.

The default notice should be sent in a manner required by the loan documents. For example, if the loan documents provide that notice may be sent by FedEx (as opposed to another national overnight courier), then use FedEx. You want to be able to prove that the borrower (and guarantor) actually received the default notice. Even if the loan documents allow you to send an email notice, you should follow it up with a method that requires a signature (or formal rejection) from the borrower. 

The substance of the default notice is the information that you provide regarding the default, and it should identify all known defaults regardless of whether any applicable notice or cure periods have expired. In most instances, you will be well served to provide detailed information regarding the default, including the facts supporting the default assertion, outstanding amounts and applicable loan document provisions (including section references). A detailed notice, if accurate, reduces the likelihood that your borrower may successfully claim it did not have adequate notice or knowledge of the default. A detailed notice may also stop your borrower from raising issues in the future (e.g., question the amount of the default) if it did not raise them in response to the initial default notice.

Additionally, your default notice should be clear as to whether or not the notice is being sent to a) notify your borrower that all cure periods have run, an Event of Default has occurred, and you are entitled to exercise remedies, or b) trigger the start of your borrower's cure period. If it is the former, you want to be clear that all applicable notices and cure periods (if any existed) have expired and that you have the right to exercise remedies, including (if applicable), collecting default interest, accelerating the loan and commencing foreclosure. It is important that you list the primary remedies you have the right to exercise pursuant to the loan documents even if you ultimately decide against pursuing such remedies or ultimately decide to waive them. You should support your statements with references to the applicable provisions of the loan documents whenever possible. 

If the purpose of the default notice is to start a cure period, you want to be sure that your default notice sets forth the length of the cure period (including references to the applicable sections of the loan documents) and expressly makes a demand upon the borrower to cure the default within the relevant period. It should also clearly state the consequences to your borrower if the default is not cured within the applicable period.

If the loan has a guarantor, then you should review the documents to determine whether the guarantor could have liability under its guaranty. If such liability exists, then your default notice should also make a demand for payment upon the guarantor, including citations to the applicable guaranty sections.

Finally, the default notice should include a reservation of all your rights and remedies, including with respect to defaults that are not specifically identified in the default notice.

Notice of Acceleration

A notice of acceleration is a formal notice from the lender to the borrower stating that the loan has been accelerated. To the extent permitted by the loan documents, you can include notice of acceleration in a default notice, and if you do, a separate notice of acceleration is not required. It is not necessary to send a notice of acceleration if a loan has already matured because there is nothing to accelerate.

Preparing a notice of acceleration is similar to preparing a default notice. You should pay attention to the addressees and their respective addresses. A notice of acceleration only needs to include a simple statement that the loan is being accelerated, but you should also include a reference to the specific loan document provision(s) that grant you the right to accelerate and provide a detailed breakdown of all amounts that are owed to you as a result of the acceleration (e.g., principal, interest, late fees, unpaid expenses, etc.). The notice should include a demand for immediate payment and make it clear that if you are not fully repaid by a certain date (e.g., 10 days after the date of the notice), you reserve the right to commence exercising your remedies.

If you are planning to commence foreclosure proceedings, before doing so, you will probably want to accelerate the loan. Once the loan has been accelerated, you can seek to recover all outstanding amounts under the loan rather than just the amounts then due. However, acceleration does not ensure that you will be able to recover all outstanding amounts because some states (e.g., California) provide a borrower with the right to cure missed payments rather than repay the entire loan, even if the loan has been accelerated.

Be aware that sending a notice of acceleration after a notice of default is likely to increase the pressure on the borrower and may escalate tensions between you and your borrower. Depending upon the situation, this may be your desired result. If it is not a result that you believe would increase the likelihood of achieving your objective, then you may want to wait longer to see how the workout discussions progress before sending a notice of acceleration.

If a forbearance agreement (discussed below) is in place at the time that you send the notice of acceleration, the forbearance should be terminated expressly. Depending upon what you hope to achieve by sending the notice of acceleration, you may also want to terminate any ongoing settlement discussions.

Once a notice of acceleration has been sent, it is critical that you act in a manner that is consistent with the notice. For example, you should not bill for, or collect, any regular (e.g., monthly) payments. If your borrower does make a partial payment following acceleration, it is important for you to send a separate written notice to your borrower which makes it clear that your acceptance of a partial payment does not extend or modify the loan or otherwise impact your acceleration of the loan.

Pre-Negotiation Agreement

Before engaging in any discussions with your borrower regarding any change in any of the terms of the loan documents (e.g., loan modification or forbearance), you must make sure that you, your borrower and your guarantor execute a "pre-negotiation agreement" or "pre-workout agreement." The purpose of a pre-negotiation agreement is to provide a set of ground rules for discussions among you, your borrower and the guarantor that will enable the parties to freely discuss matters related to the loan without altering anyone's rights, remedies or obligations. 

Pre-negotiation agreements come in a variety of forms but typically contain the following key elements:

• A provision stating that all discussions will be treated as "settlement discussions" and will be inadmissible in any legal proceeding, and a related provision stating that the discussions are confidential.
  • It is essential to include this provision. If the parties are unable to agree on a resolution, and instead end up in court, you do not want your ability to exercise your remedies to be impeded by any comments made during the course of the discussions, including any suggestion that you could be satisfied with a resolution other than foreclosure.
  • Without limiting the generality of the provision, it is advisable that you include express references to Rule 408 of the Federal Rules of Evidence as well as to the applicable state law evidence rules.
• The negotiations do not create a waiver of any rights or obligations of any party under the loan documents.
  • The purpose of this provision is to ensure that the pre-discussion positions of the parties remain unchanged by the discussions. You want to be sure that all of your rights and remedies are preserved.
• The existence of the pre-negotiation agreement does not obligate any party to negotiate.
  • A pre-negotiation agreement is put in place to protect the parties. It is not intended to create additional liability for either party (e.g., claim of bad faith because of failed negotiations). Accordingly, neither party should be compelled to negotiate if it does not believe that the negotiations will be advantageous to its position.
• No loan modification will be binding unless and until a written agreement is executed by the parties.
  • Requiring a written agreement provides an objective measurement regarding whether an agreement has been reached. This provision protects both parties by allowing them to discuss a broad range of options while minimizing the risk that the other side will claim falsely that an agreement was reached.
• Any party may terminate the agreement at any time for any reason or no reason whatsoever.
  • While ostensibly for the benefit of both parties, this provision is more likely to protect the mortgage lender. If you feel that your borrower is playing games, using the discussions as a stall tactic or failing to make viable proposals, then you can end the discussions promptly and without explanation.
• There can be no assurances that a deal will be reached between the parties so the borrower should not expect nor rely on a loan modification and should pursue other alternatives that may be available to it.
  • If the discussions do not result in a consensual resolution, your borrower may look for ways to defend against your exercise of remedies. This provision is intended to protect you from a claim that your borrower relied on reaching a deal with you, and, as a result, chose not to pursue other opportunities (e.g., third-party equity infusion) that could have cured the defaults or otherwise better protected the borrower's positions.
• The lender has the right to pursue its remedies at any time.
  • If you feel that your borrower is cooperative and the discussions are productive, you may not want to exercise remedies concurrently, but you should not waive your right to do so, particularly if the discussions stall. You may also enter into a pre-negotiation agreement with little confidence that the discussions will result in a consensual resolution, and if that is the case, you do not want the discussions to interfere with your ability to exercise your remedies concurrently.

While the foregoing elements form the core of a pre-negotiation agreement, some lenders choose to expand the scope of the pre-negotiation agreement to gain an advantage over the borrower and guarantor. Being overly aggressive on a pre-negotiation agreement may be appropriate in some circumstances (e.g., you do not believe that a consensual resolution is feasible, and you have a litigious borrower) but not in all circumstances. For example, if your objective is to turn the loan into a performing loan, and you believe that there is a good chance that the parties can agree upon a loan modification, then you may not want to risk scaring off your borrower by taking a hardline position on the pre-negotiation letter.

If you do want to strengthen the pre-negotiation agreement from a lender's perspective, additional elements you may consider including are the following:

• An acknowledgment by the borrower and the guarantor that (a) an Event of Default has occurred under the loan documents, (b) the lender has provided all notices required by the loan documents, (c) the lender has not made any promise or commitment or undertaken any obligation to the borrower and guarantor other than those that are outlined in the loan documents, (d) the loan documents are binding and enforceable against the borrower and the guarantor and (e) the lender has the right to immediately exercise any of its remedies under the loan documents.
• The borrower and guarantor remake all of their representations and warranties and reaffirm all of their respective obligations under the loan documents.
• The borrower and guarantor (a) represent that they have no offsets or defenses against any of their respective payment or performance obligations under the loan documents, and (b) release the lender from all known and unknown claims.
• The borrower and the guarantor authorize the lender to communicate with third parties regarding the loan, the borrower and the guarantor.
  • This provision may not be necessary if the loan documents already authorize the lender to have such conversations or if there are no third parties involved in the loan.
  • If there are third parties integrally involved in the loan (e.g., a mezzanine lender), then you will want to have the right to discuss the situation with those third parties. To the extent that discussions with third parties are authorized (whether in the loan documents or the pre-negotiation agreement), be sure that these discussions are excluded from the confidentiality restrictions contained in the pre-negotiation letter.

Forbearance Agreement

The last document that is commonly used during workout negotiations is a forbearance agreement. Under a forbearance agreement, a lender agrees to forbear from the exercise of certain of its rights and remedies as long as certain conditions are satisfied. Forbearance agreements may be of short or long duration. Forbearance agreements are often, but not necessarily, combined with loan modifications.

There is a misconception that forbearance agreements are solely for the benefit of a borrower. They do benefit a borrower but can benefit a lender as well. If you have declared a default under a loan, do not exercise remedies for a period of time, and then commence the exercise of remedies, your borrower may try to prevent you from doing so by claiming (a) you waited so long to exercise your remedies that you are prevented from doing so because of laches, (b) you are estopped from doing so because you waited too long, (c) you have waived your right to do so, and/or (d) you have altered the terms of the loan documents through course of conduct. A forbearance agreement provides lenders with some protection against these types of claims.

A forbearance agreement is often helpful to a lender when a loan has matured, and the borrower does not have sufficient funds to repay the loan in its entirety. You may want to take some time to explore alternatives with your borrower. By entering into a forbearance agreement, you can take extra time to assess the situation.   

The key elements of a forbearance agreement are the following:

• The lender agrees not to pursue remedies against the borrower and guarantor for a specified period of time.
  • Even though a lender may agree to forbear from the exercise of its remedies for a significant period of time (e.g., years), a forbearance should be a temporary arrangement. If you are agreeing to permanently forbear from the exercise of its remedies as a result of a default, then you should do so pursuant to a loan modification rather than a forbearance agreement.
  • A lender's agreement to forbear is typically conditioned upon the borrower's satisfaction of certain requirements (e.g., no new defaults, all rents deposited directly into a lockbox account, borrower continuing to make the monthly payments due under the loan as if the loan had not matured, etc.).
• A forbearance agreement tolls all time periods applicable to a lender's exercise of remedies. It does not (as a matter of right) extend a borrower's cure periods under the loan documents.
  • This provision is key to protecting a lender from claims of laches and should always be included.
• The forbearance agreement does not waive the rights or obligations of any party except to the extent expressly set forth therein.
  • A forbearance agreement reflects certain agreements of the parties that are outside of the scope of the loan documents. However, a lender wants to be sure that it is not opening itself up to additional arguments by the borrower that other terms of the loan documents have been modified. Thus, a forbearance agreement should clearly state that the loan documents remain in effect except to the extent that the forbearance agreement expressly provides otherwise.

A forbearance agreement often includes additional lender-friendly provisions. It is to your advantage to obtain these concessions when possible. However, if the forbearance agreement is going to benefit you as much as it is going to benefit the borrower, then you need to be careful not to overreach if doing so means that the forbearance agreement will never be executed.

The most common lender-friendly forbearance provisions are the following (even if these provisions are included in a pre-negotiation letter, they should be included in a forbearance agreement as well):

• An acknowledgment by the borrower and the guarantor that (a) an Event of Default has occurred, (b) the lender has provided all notices required by the loan documents, (c) the lender has not made any promise or commitment or undertaken any obligation to the borrower and guarantor other than those which are set forth in the loan documents, and (d) the loan documents are binding and enforceable against the borrower and the guarantor.
• The borrower and guarantor remake all of their representations and warranties and reaffirm all of their respective obligations under the loan documents.
• The borrower and guarantor (a) represent that they have no offsets or defenses against any of their respective payment and performance obligations under the loan documents, (b) waive their right to contest any defaults described in the forbearance agreement, and (c) release the lender from all known and unknown claims.

Congratulations. You are now armed with the knowledge you need to complete a mortgage loan workout successfully.

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

Part 3: Steps a Mortgage Lender Can Take to Develop a Solid Strategy, May 28, 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.