Today's distressed real estate loan is a complicated affair, with many diverse parties pursuing objectives and interests quite different and more complex from those just a few years ago. Layer upon layer of debt—real estate, mezzanine, preferred equity—have become the norm; lenders and investors have competing interests and remedies; relationships among lenders (some “in the money” and some not) have become as important, contentious and sophisticated as relationships between mortgage lenders and borrowers of real estate down cycles past.

Today's capital stack is filled with national and international hedge or private equity funds, or opportunistic or strategic lenders, which may have purchased a debt position at a discount, or even originated the loan with the intention (or hope) of becoming the owner of the collateral through foreclosure. These lenders often provide financing with interest rates and covenants that increase the prospects of default in a rising interest rate environment or, as now, at the tail end of the real estate cycle. These (often unregulated) lenders may have increased litigation staying power as a result of: (1) a greater ability to own, hold, manage, and liquidate the collateral at a profit; (2) their low basis in the underlying obligation; and (3) far less regulatory scrutiny of their capital structure, loan-loss reserves, or financial condition.

By the same token, borrowers and their investors are litigating vigorously, invoking a plethora of challenges, tactics and strategic delays throughout the judicial process. This may induce “lender fatigue”—the phenomenon by which a lender, “exhausted” from the costs and unpredictability of litigation, maintaining the collateral and regulatory oversight, will offer a borrower a favorable workout structure, or even a discounted repayment, in order to “stop the bleeding.”

Loans may be current; the borrower may have never defaulted on a loan obligation in the past and its project may be well maintained. Nonetheless the project may fall victim to the cycle, a softer market or unforeseen capital events. These circumstances cry out for a balanced and workable forbearance agreement. This article (in two parts) sets forth a primer on what such a forbearance agreement—perhaps the most common commercial loan workout device—should look like.

Strategies, Techniques and Objectives

The forbearance agreement adheres to the following principle: In exchange for economic and legal concessions, the lender obtains certain credit or collateral enhancements and/or remedies.

“Concessions” include: (1) restraint or forbearance from accelerating the loan and/or pursuing foreclosure and other legal remedies; (2) extension of the maturity date; (3) waiver of economic or covenant defaults; (4) suspension of principal amortization or interest payments; (5) reduction of the interest rate; (6) partial release of collateral; (7) release of guarantors or reduction of their obligations; (8) the opportunity to repay the indebtedness at a discount; (9) modification or waiver of covenants or capital requirements; (10) additional loan advances; or (11) an exchange of debt for equity.

“Enhancements” in favor of the lender include: (1) the cure of legal, document or perfection deficiencies; (2) concessions or contributions from other lenders in the capital stack; (3) additional collateral from a sponsor, guarantor or equity investor; (4) an additional guaranty of a previously non-recourse loan, debt service, project completion or other financial obligations; (5) an increase in the scope of guaranteed obligations, or new “recourse” events; (6) more loan covenants, financial reporting or monitoring rights; (7) control of the project revenue (cash collateral) through a cash management agreement; (8) a cash flow sweep tied to an approved budget, controlled expenditures, or a new or improved revenue stream; (9) a capital infusion to stabilize the project or reduce the indebtedness; (10) ratification of the loan documents and lien priority; (11) waiver and release of defenses and counterclaims; and (12) consent to remedies.

Negotiating the trade-off of concessions for enhancements—framed against the backdrop of uncertain market conditions or asset classes (such as retail, hospitality or high-end condominium construction), rising interest rates, densification of real estate, e-commerce, scarcity of institutional replacement financing, suffocating regulation and risk retention rules, backlogged courts, crafty lender liability defenses and judicial and legislative sympathy—has become an art form like never before.

Essential Provisions

The “state of the art” commercial real estate loan forbearance agreement should include the following essential provisions:

Acknowledgment of Indebtedness: The lender's “ticket for admission” for forbearance is the unequivocal acknowledgment by borrower and all guarantors (including “bad boy” guarantors) that defaults have occurred and the entire debt is immediately due and payable in full without defense, offset, or counterclaim. (In certain circumstances, the borrower may resist waiving defenses to the indebtedness; these are rare, limited and if granted must be fact specific.)

Ratification of Loan Documents: The lender wants to cure any and all loan or document defects, oversights, incomplete signatures or failures to perfect its security interests in its collateral. The borrower and guarantors will ratify and confirm the validity, enforceability and binding nature, both at the time of delivery and on the date of the forbearance agreement, of all loan documents. Borrower and guarantors will acknowledge that all of their financial obligations are duly and properly secured by mortgages and all other security or collateral instruments and the priority of the lender's lien.

Waiver of Defenses and General Release: No one likes to release defenses or claims. However, the prudent lender will not make any significant economic concessions or grant meaningful forbearance unless the lender is assured of a clean slate when the forbearance period has expired. The borrower—looking for forbearance, economic concessions or an avoidance of foreclosure, receivership or springing recourse—should suppress its “creative word processing” and acquiesce. The forbearance agreement should provide that borrower, guarantors and their affiliates unconditionally waive and release all defenses to repayment and all claims against lender relating to the loan documents, the obligations, the mortgaged property and the dealings between the parties.

The negotiation of the release can be arduous. Invariably, borrowers will—and should—give in on this point. In complex, multi-tranche, multiple collateral transactions, the parties may carve out from the release specific facts, claims, defenses or a limited course of dealing. Duration of the forbearance plays a role, as does the quality of the lender's economic concessions. For example, for a one-year forbearance, a suspension of debt service or a discounted repayment option, the borrower is far more willing to release its “claims” than it would be for lender's agreement to forbear enforcement for a few weeks.

Forbearance Expiration Date: The lender agrees to forbear acceleration of the indebtedness (unless that has already occurred) and/or the exercise of its legal remedies until a negotiated date certain (the “forbearance expiration date”), which may be extended. The forbearance lasts as long as borrower and guarantors fully and timely satisfy all obligations set forth in the forbearance agreement. Subsequent defaults end the lender's forbearance obligation.

Built-in options to extend the forbearance expiration date if economic milestones are met or “good news events” transpire (or to shorten the term if milestones—such as receipt of a refinancing term sheet—are not met) make for an enduring, lively and closely watched period of forbearance.

Payment Modification: A key economic component is the modification or suspension—for the term of the forbearance, or longer—of the contractual debt service payments. These are pure business points, based on cash flow, capital improvements and deferred maintenance needs, recourse, reputation or the parties' leverage in the workout. Principal and interest rate relief or deferral generates needed cash flow. Even in a low interest rate environment, “debt service relief” for large, distressed, projects, adds up. The “ask” is an easy one to make; the “give,” more nuanced.

Here's the structure: monthly principal installment payments are suspended (or reduced); interest is modified into a “note rate/pay rate” model whereby interest will continue to accrue at the contract, or note, rate but borrower pays interest monthly at a lower “pay rate.” The difference (the “contract interest shortfall”) is accrued and either paid on the forbearance expiration date or other date certain, or forgiven once borrower has performed its obligations and repaid the indebtedness (as such may be reduced) when due.

Lender should also accrue interest at the default rate and the difference between the default and pay rates (which erodes equity remarkably quickly) will be forgiven when the remaining indebtedness has been repaid or certain benchmarks (such as reaching certain stabilization levels) have been achieved. This “default rate” accrual—particularly if there is recourse—creates additional leverage for the lender and economic motivation for the borrower to perform. From the lender's perspective, the forgiveness should occur only after the other contractual obligations have been met—never when the forbearance agreement is first executed.

Part two of this article will explore certain creative economic solutions for a loan in distress and the type of remedies the lender can implement in exchange.

Richard S. Fries is a partner at Sidley Austin and co-leader of its global real estate practice. He is the co-chair of the Real Estate Financing Committee of the Real Property Law Section of the New York State Bar Association.

Today's distressed real estate loan is a complicated affair, with many diverse parties pursuing objectives and interests quite different and more complex from those just a few years ago. Layer upon layer of debt—real estate, mezzanine, preferred equity—have become the norm; lenders and investors have competing interests and remedies; relationships among lenders (some “in the money” and some not) have become as important, contentious and sophisticated as relationships between mortgage lenders and borrowers of real estate down cycles past.

Today's capital stack is filled with national and international hedge or private equity funds, or opportunistic or strategic lenders, which may have purchased a debt position at a discount, or even originated the loan with the intention (or hope) of becoming the owner of the collateral through foreclosure. These lenders often provide financing with interest rates and covenants that increase the prospects of default in a rising interest rate environment or, as now, at the tail end of the real estate cycle. These (often unregulated) lenders may have increased litigation staying power as a result of: (1) a greater ability to own, hold, manage, and liquidate the collateral at a profit; (2) their low basis in the underlying obligation; and (3) far less regulatory scrutiny of their capital structure, loan-loss reserves, or financial condition.

By the same token, borrowers and their investors are litigating vigorously, invoking a plethora of challenges, tactics and strategic delays throughout the judicial process. This may induce “lender fatigue”—the phenomenon by which a lender, “exhausted” from the costs and unpredictability of litigation, maintaining the collateral and regulatory oversight, will offer a borrower a favorable workout structure, or even a discounted repayment, in order to “stop the bleeding.”

Loans may be current; the borrower may have never defaulted on a loan obligation in the past and its project may be well maintained. Nonetheless the project may fall victim to the cycle, a softer market or unforeseen capital events. These circumstances cry out for a balanced and workable forbearance agreement. This article (in two parts) sets forth a primer on what such a forbearance agreement—perhaps the most common commercial loan workout device—should look like.

Strategies, Techniques and Objectives

The forbearance agreement adheres to the following principle: In exchange for economic and legal concessions, the lender obtains certain credit or collateral enhancements and/or remedies.

“Concessions” include: (1) restraint or forbearance from accelerating the loan and/or pursuing foreclosure and other legal remedies; (2) extension of the maturity date; (3) waiver of economic or covenant defaults; (4) suspension of principal amortization or interest payments; (5) reduction of the interest rate; (6) partial release of collateral; (7) release of guarantors or reduction of their obligations; (8) the opportunity to repay the indebtedness at a discount; (9) modification or waiver of covenants or capital requirements; (10) additional loan advances; or (11) an exchange of debt for equity.

“Enhancements” in favor of the lender include: (1) the cure of legal, document or perfection deficiencies; (2) concessions or contributions from other lenders in the capital stack; (3) additional collateral from a sponsor, guarantor or equity investor; (4) an additional guaranty of a previously non-recourse loan, debt service, project completion or other financial obligations; (5) an increase in the scope of guaranteed obligations, or new “recourse” events; (6) more loan covenants, financial reporting or monitoring rights; (7) control of the project revenue (cash collateral) through a cash management agreement; (8) a cash flow sweep tied to an approved budget, controlled expenditures, or a new or improved revenue stream; (9) a capital infusion to stabilize the project or reduce the indebtedness; (10) ratification of the loan documents and lien priority; (11) waiver and release of defenses and counterclaims; and (12) consent to remedies.

Negotiating the trade-off of concessions for enhancements—framed against the backdrop of uncertain market conditions or asset classes (such as retail, hospitality or high-end condominium construction), rising interest rates, densification of real estate, e-commerce, scarcity of institutional replacement financing, suffocating regulation and risk retention rules, backlogged courts, crafty lender liability defenses and judicial and legislative sympathy—has become an art form like never before.

Essential Provisions

The “state of the art” commercial real estate loan forbearance agreement should include the following essential provisions:

Acknowledgment of Indebtedness: The lender's “ticket for admission” for forbearance is the unequivocal acknowledgment by borrower and all guarantors (including “bad boy” guarantors) that defaults have occurred and the entire debt is immediately due and payable in full without defense, offset, or counterclaim. (In certain circumstances, the borrower may resist waiving defenses to the indebtedness; these are rare, limited and if granted must be fact specific.)

Ratification of Loan Documents: The lender wants to cure any and all loan or document defects, oversights, incomplete signatures or failures to perfect its security interests in its collateral. The borrower and guarantors will ratify and confirm the validity, enforceability and binding nature, both at the time of delivery and on the date of the forbearance agreement, of all loan documents. Borrower and guarantors will acknowledge that all of their financial obligations are duly and properly secured by mortgages and all other security or collateral instruments and the priority of the lender's lien.

Waiver of Defenses and General Release: No one likes to release defenses or claims. However, the prudent lender will not make any significant economic concessions or grant meaningful forbearance unless the lender is assured of a clean slate when the forbearance period has expired. The borrower—looking for forbearance, economic concessions or an avoidance of foreclosure, receivership or springing recourse—should suppress its “creative word processing” and acquiesce. The forbearance agreement should provide that borrower, guarantors and their affiliates unconditionally waive and release all defenses to repayment and all claims against lender relating to the loan documents, the obligations, the mortgaged property and the dealings between the parties.

The negotiation of the release can be arduous. Invariably, borrowers will—and should—give in on this point. In complex, multi-tranche, multiple collateral transactions, the parties may carve out from the release specific facts, claims, defenses or a limited course of dealing. Duration of the forbearance plays a role, as does the quality of the lender's economic concessions. For example, for a one-year forbearance, a suspension of debt service or a discounted repayment option, the borrower is far more willing to release its “claims” than it would be for lender's agreement to forbear enforcement for a few weeks.

Forbearance Expiration Date: The lender agrees to forbear acceleration of the indebtedness (unless that has already occurred) and/or the exercise of its legal remedies until a negotiated date certain (the “forbearance expiration date”), which may be extended. The forbearance lasts as long as borrower and guarantors fully and timely satisfy all obligations set forth in the forbearance agreement. Subsequent defaults end the lender's forbearance obligation.

Built-in options to extend the forbearance expiration date if economic milestones are met or “good news events” transpire (or to shorten the term if milestones—such as receipt of a refinancing term sheet—are not met) make for an enduring, lively and closely watched period of forbearance.

Payment Modification: A key economic component is the modification or suspension—for the term of the forbearance, or longer—of the contractual debt service payments. These are pure business points, based on cash flow, capital improvements and deferred maintenance needs, recourse, reputation or the parties' leverage in the workout. Principal and interest rate relief or deferral generates needed cash flow. Even in a low interest rate environment, “debt service relief” for large, distressed, projects, adds up. The “ask” is an easy one to make; the “give,” more nuanced.

Here's the structure: monthly principal installment payments are suspended (or reduced); interest is modified into a “note rate/pay rate” model whereby interest will continue to accrue at the contract, or note, rate but borrower pays interest monthly at a lower “pay rate.” The difference (the “contract interest shortfall”) is accrued and either paid on the forbearance expiration date or other date certain, or forgiven once borrower has performed its obligations and repaid the indebtedness (as such may be reduced) when due.

Lender should also accrue interest at the default rate and the difference between the default and pay rates (which erodes equity remarkably quickly) will be forgiven when the remaining indebtedness has been repaid or certain benchmarks (such as reaching certain stabilization levels) have been achieved. This “default rate” accrual—particularly if there is recourse—creates additional leverage for the lender and economic motivation for the borrower to perform. From the lender's perspective, the forgiveness should occur only after the other contractual obligations have been met—never when the forbearance agreement is first executed.

Part two of this article will explore certain creative economic solutions for a loan in distress and the type of remedies the lender can implement in exchange.

Richard S. Fries is a partner at Sidley Austin and co-leader of its global real estate practice. He is the co-chair of the Real Estate Financing Committee of the Real Property Law Section of the New York State Bar Association.