1. Prevention. Prevention is the
first step in a well planned approach to troubled loans. Proper underwriting,
documentation and provisions for access to information may help a lender
facing a troubled loan. In the event the loan does get into trouble, the
lender will be in a stronger position to protect its interests. Prevention
includes careful underwriting of the collateral and the borrower. In underwriting
the borrower, the lender should obviously look to the usual credit report
and financial statements, but should often go beyond them to get a better
feel for the borrower's reputation, character, fortitude, expertise, consistency
and creativity. The lender should ask: Has this borrower built or managed
this kind of project before? Are the market and feasibility studies realistic?
Are the projections consistent with these factors and do they provide adequately
for a "worst case scenario"?
Once the credit decision has been made, the transaction
should be fully and carefully documented with prevention in mind. Use the
checklist approach to be sure nothing is overlooked. (See for example,
JMBM's HIT list, the acronym for Hospitality Investment Task list). Be
sure all desired title and liability insurance is in place, with endorsements
to cover the lender's interests. Particularly with construction loans,
negotiate all necessary controls for the project - to cover both the ordinary
course of building and the possibility of default. A lender will never
have a better opportunity to protect its interests than the period before
it has disbursed the loan proceeds.
2. Monitoring and Early Warning. Information
control is paramount. A lender must carefully monitor its loans until they
are paid off. Early warning systems should be established to alert the
lender to problems with the borrower, the collateral, or the project's
feasibility. Is the construction or marketing of the project being delayed?
Is the property being wasted? Are materials disappearing from the job site?
Have the demographics and economics of the market changed adversely? If
trouble signs appear, the special asset group should be consulted at an
early stage, even if the project stays in the hands of the loan servicing
3. Use a Special Assets Group for Troubled
Assets. The CMBS world figured this out and locked it down with special
servicing. But other lenders should remember that, whatever the name and
acronym, a specialized group should be used for handling troubled assets.
A specialized division for working on troubled assets (for convenience
we will refer to this group as a specialized asset group or "SAG") brings
greater objectivity in dealing with troubled loan issues, thereby minimizing
the peril of an approach drawn from past dealings with the borrower that
may be either too sympathetic or too harsh and raise lender liability issues.
The SAG should also bring (or will develop) specialized
expertise in handling the unique problems of troubled assets. It should
be provided with expedited access to senior management for policy decisions
and allocation of resources. It should also have authority to implement
crucial procedures and policies such as settling customer complaints, bringing
in special counsel, hiring consultants, executing pre-workout documents
and documenting negotiations to avoid liability for unsuccessful workouts.
Bringing the SAG into the situation also provides notice to the borrower
that the lender is serious about collecting the debt and that this is not
"business as usual."
4. Comprehensive Situation Analysis -- Information
Update. The Special Asset Group with its experienced, detached personnel,
should gather, analyze and summarize all relevant information on the loan,
the borrower, the collateral and relevant documentation and history. Update
the borrower's financial statements, tax returns, litigation history and
credit rating. In addition to gathering all loan documents, promissory
notes, guaranties, evidences of advances, notices, a complete written history
of the loan should be prepared. When the history is compiled, care should
be taken to protect as much as possible from discovery so that any candid
descriptions of problems and proposed solutions to such problems will not
be a part of the evidence at trial, should you choose litigation. This
can be done by engaging outside counsel or involving the bank's in-house
legal department. Loan service personnel should be interviewed, and waiver
and estoppel issues must be evaluated. Consider interviewing witnesses
with counsel present, to protect sensitive information obtained from disclosure
later on if litigation is filed. The impact of conversations, correspondence,
and course of conduct must be given careful consideration. Appraisals,
projections and feasibility studies should be updated as necessary.
Two final cautions on information updates. First,
the update of collateral information should include a physical inspection
of the premises. Walk the project! Don't settle for "drive-by" or borrower's
guided tour. The physical inspection may suggest problems to be dealt with
or new approaches to the project.
Second, the information, documents and summaries
gathered by the Special Assets Group should be reviewed by counsel experienced
in troubled loan matters and lender liability. This review should analyze
the validity of the notes, security interests, guaranties and other important
documents with an eye toward identifying defects that might be cured or
curable. From this review lenders should also be able to determine the
potential of any borrower defenses or counter claims. Counsel should find
out from the lender if there are any potential tort or strict liability
claims that may go along with any transfers of ownership in real property,
such as an apartment owner's duty to pay for tenant injuries or a landowner's
duty to pay the costs of cleaning up contaminated property.
5. Evaluate the Information and Alternatives.
All the gathered information needs to be evaluated by appropriate business
and legal personnel. Fully armed with this information and evaluation,
the lender can then assess whether to do nothing, commence a workout or
restructure of the loan, seek a receiver, initiate foreclosure or initiate
involuntary bankruptcy proceedings.
6. Develop a "Game Plan" and Stick to it! Once
an alternative course of action has been selected, the lender should develop
a game plan or blueprint for executing its course of action. There may
be valid reasons to wait until specified events have occurred or time periods
have elapsed. However, in general, once the course of action has been decided,
delay is ill-advised. The most successful lenders are those who stick with
their game plan, except as changed circumstances may warrant.
7. Pre-Workout Agreement. Before commencing
workout negotiations, a pre-workout agreement should be executed. Such
an agreement offers the advantage of protecting the lender from liability
from claims arising from the workout process itself.
Many institutions have been "bitten" by their
good faith efforts in a workout situation. They report that desperate debtors
or their unscrupulous representatives have either misunderstood statements
made in workout negotiations, or intentionally misrepresented positions
taken. Whatever the motivation or cause of the problems, these institutions
find themselves the victim of claims that oral agreements, representations,
or waivers made in the course of a workout entitle the borrower to rights
or damages never contemplated by the lender upon entering workout negotiations.
The pre-workout agreement is designed to minimize these risks.
The pre-workout agreement typically recites that
the parties are about the commence workout negotiations and that the agreement
is a material inducement for the lender to participate. Loan documents
can be attached as exhibits and acknowledged to be legally binding on the
parties. It is usually agreed that the loan documents continue in full
force, unless modified in the specific manner permitted by the pre-workout
agreement. Sometimes, egregious problems which exist in the lender's loan
documentation can be corrected in a pre-workout agreement, when the borrower
is usually in a very cooperative mood. The confirmation of the loan document's
binding effect, recital of loan history and acknowledgment of defaults
may greatly simplify collection efforts later if the negotiations fail
or the workout falls apart. Consider inserting a confidentiality provision
in the pre-workout agreement, to try to prevent the borrower from using
the media to increase its negotiating leverage, especially if the borrower
is in a business that may attract media attention.
The key provision of the pre-workout agreement
recites that discussions and negotiations between the parties may be lengthy
and complex, however, no discussions or oral agreement have any effect
whatsoever unless all parties execute a written agreement. This critical
provision helps prevent a party from claiming a binding agreement was reached
on certain issues in the absence of satisfactory resolution of all disputes
in the workout process.
The agreement should provide that only amendments
in writing have any effect, should state that the pre-workout agreement
is the entire agreement of the parties on the subject matter, specify the
governing law and provide for attorneys' fees to the prevailing party in
the event of any dispute. The agreement should also provide that no negotiations
or other acts taken in the workout process constitute any waivers by the
lender of its rights except to the extent specifically identified in writing.
The pre-workout agreement should also confirm that the attorneys' fees
to be incurred by the lender in the workout will be reimbursed by the borrower.
The most controversial issues on pre-workout agreements
usually involve whether to include a mandatory arbitration provision for
any disputes concerning the credit (with corresponding waiver of jury trial
and court process) and any release provisions. Some lenders say they would
rather proceed with the "main event" if they cannot obtain an arbitration
provision and release for any action up to that date. Others would rather
engage in the workout process to cure defects in the loan documentation
in exchange for concessions to the borrower and are less concerned with
the benefits of arbitration or waivers.
8. Document the Transaction Completely.
It goes without saying that once negotiations have resulted in a restructuring
or workout, all aspects of the agreement should be thoroughly and fully