Part I of this article provided an overview of the commercial loan workout landscape and began a discussion of essential provisions to include in a “state of the art” commercial real estate loan forbearance agreement, including acknowledgement of indebtedness, ratification of loan documents, waiver of defenses and general release, forbearance expiration date and payment modification. Part II of this article will cover economic concessions, additional collateral, recourse and remedies.

Discounted Repayment Model: Property owners have little incentive to act merely as “brokers” for their lenders if the asset is worth less than the debt. They strive to create the equity that the marketplace or changes in the asset class have taken away since the loan was originated. The borrower brings to the lender its primary objective—payment on a date certain. This objective comes at a price if the property is worth less than the debt—the loan discount. The lender's collateral (and the scope of borrower and guarantor recourse) is no longer sufficient to secure repayment of the entire outstanding indebtedness; as such the parties would be better off negotiating a one-time cash payment in settlement of that obligation. Real estate has “right sized.”

The discounted repayment model (a DPO, or discounted pay-off) allows the lender to receive consensually and predictably the financial equivalent of the successful foreclosure (i.e., fair market value of the collateral), but allows the borrower to retain ownership and achieve the potential upside of an improved marketplace, investment or capital event. The DPO works well in a non-recourse setting and in circumstances in which the borrower has proceeded honorably (i.e., the loan default is the result of market forces, such as increased construction costs, declining tenancies or revenue, and not fraud or misappropriation of revenue). The lender equates a discounted repayment to “victory, at the outset, in the foreclosure litigation.”

Once the parties make a handshake “deal” on the discounted repayment amount, reality sets in—borrower needs time to “scour the market” for this discounted payoff. The forbearance agreement should deal with this as follows. Let's say the loan is $50 million and the “discounted repayment amount” is $38 million. Borrower has the right to repay and lender has the obligation to accept payment of the indebtedness at this discount provided borrower and guarantors have not otherwise defaulted under the forbearance agreement and such payment has been received by lender by the forbearance expiration date.

Typically, borrower asks the lender to modify and reduce the loan to the discounted repayment amount at inception—requesting, on these facts, an immediate forgiveness of $12 million, before the lender has any assurance that the $38 million is forthcoming. Lenders should not fall prey to this tactic. Instead, the $50 million note should be split into two notes—Note A for $38 million, with interest at a modified pay rate, and Note B for $12 million, with interest paid (if at all) based on available cash flow. Note B will be forgiven only after Note A has been timely repaid in full. The discounted repayment option could be staged during the forbearance term with declines in the discount (increases in the repayment amount) for payments made at later dates. The business deal could vary, or complicate, this repayment scheme.

A common lender concern (the embarrassing “quick flip”) can be avoided with the “equity sliver.” The lender obtains a portion (or sliver) of the equity in the property (secured by a lien without remedies) to protect against a quick flip of the property to a third party at a profit mere moments after the borrower has repaid the debt at a discount. The “sliver” could burn away over time if the “quick flip” has not materialized.

Right-Sizing Obligations: Note A/Note B/Note C: Another workout strategy—“Note A/Note B/Note C”— involves slicing the underlying loan obligation to reflect current or revised economic realities and projections. The obligation is split into several sub-obligations. The primary obligation, represented by “Note A,” is performed by borrower for the balance of the forbearance term. Note A reflects a more accurate valuation of the underlying collateral, the borrower's ability to make periodic payments, or the discounted repayment amount (if applicable). Interest on Note A is tied to the market.

Note B evidences a negotiated portion of the underlying obligation, which continues to accrue interest at a contract, default or some other modified rate. Interest on Note B is paid out of cash flow or another “good news” capital event if business or cash flow improves. Note B could either: (1) be a component of the discounted repayment amount, (2) represent debt that must be repaid if the forbearance period is extended into a “second term” if the project's economics improve or identified “good news” events occur or (3) be forgiven (at the end) if that is the parties' business deal.

Note C represents a “deferral” obligation, comprising the remaining indebtedness, with no debt service installments, payable—in full—only upon a subsequent default, non-payment of the discounted repayment amount, or other agreed-upon acts.

The obligation to repay the principal balances of Notes B and C is deferred, with forgiveness of Notes B and/or C (depending on the deal) to occur only upon the borrower's timely repayment of Note A in full. The overhang of Notes B and C provides significant financial incentives for the borrower and guarantors to repay Note A and perform the other terms of the restructured obligation. Like the equity sliver, Notes B and C also can be configured to prevent the borrower from capitalizing on a dramatic increase in the value of the collateral or an undisclosed, premeditated plan by the borrower to sell the collateral or bring in an investor at a profit.

Additional Collateral: In any workout, the lender is likely to request additional collateral. Borrower's initial response is that there is none. However, in exchange for meaningful economic concessions (including the option to repay at a discount), borrowers somehow find additional collateral. This collateral could consist of subordinate interests in other real property owned by the sponsor, membership interests in related projects, marketable securities, tax refunds, litigation recoveries, condemnation awards or preferred equity, among other assets. The lender's willingness to forbear or make economic concessions constitutes good, valuable, and sufficient consideration for the pledge of additional collateral.

Additional Guaranties; Expanded Non-Recourse Carve-Outs: Lenders will also seek new or enhanced recourse—in whole or in part (e.g., a portion of principal; debt service carry; “bad acts”)—against borrower's principals or new investors. If previously absent, the guaranty covers state of the market and workout specific “bad boy” non-recourse carveouts such as bankruptcy, impermissible transfer of the property, interference with remedies, failure to deliver a deed in lieu of foreclosure, misappropriation of revenue or fraud. The guarantor should acknowledge the sufficiency of the consideration (forbearance, concessions) for this “credit enhancement.”

Consent to Remedies: The effective forbearance agreement should, to some vigorously negotiated extent, contain the consent by borrower and guarantors to remedies. The nuances, immediacy, enforceability and implications of such remedies and the extent of borrower's consent thereto should be mastered by counsel before the workout discussions begin. The remedies include: (1) acceleration (bringing forward the entire debt); (2) consent to the appointment of a specific receiver and/or third party property manager; (3) consent to lender's computation of the indebtedness; (4) consent to entry of a judgment of foreclosure; (5) confessions of judgment; (6) tolling of the statute of limitations; (7) consent to jurisdiction (including federal court); (8) consent to an order of seizure of non-real estate collateral; (9) enforcement of “bad boy” guaranties; (10) implementation of the (hard) lock box for project revenue; and (11) consent to vacate the automatic stay in bankruptcy. Borrower (and guarantors) should acknowledge that their consent to these remedies is a material inducement to the lender for its grant of forbearance privileges and other economic concessions, on which lender relies to its detriment.

Because the judgment of foreclosure is consensual, the lender can bypass many of the time-consuming steps required in a judicial foreclosure action (such as the appointment of a referee to compute) and proceed (upon a default) to judgment and auction in a fraction of the time and cost—and with predictability. Courts typically react favorably where the lender secures the borrower's consent to foreclosure in exchange for forbearance or settlement with respect to a defaulted loan. Finality and judicial economy are achieved—consensually.

* * *

In any loan workout, the parties need to reconcile, amicably, their contrary objectives. The forbearance agreement can be used effectively to realize that goal. Workout specialists need to evaluate the risks attendant to today's judicial processes and the reactions and sympathies of the courts. They should understand the complexities and intricacies of various types of collateral and the disparate objectives of the holders of several tranches of debt (including market forces, changes, intercreditor arrangements, regulatory constraints and risks of loss), and master the dispute resolution mechanisms available to them. By doing so, the parties should be in a position to craft a forbearance agreement that is fair, efficient, and that works.

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.

Part I of this article provided an overview of the commercial loan workout landscape and began a discussion of essential provisions to include in a “state of the art” commercial real estate loan forbearance agreement, including acknowledgement of indebtedness, ratification of loan documents, waiver of defenses and general release, forbearance expiration date and payment modification. Part II of this article will cover economic concessions, additional collateral, recourse and remedies.

Discounted Repayment Model: Property owners have little incentive to act merely as “brokers” for their lenders if the asset is worth less than the debt. They strive to create the equity that the marketplace or changes in the asset class have taken away since the loan was originated. The borrower brings to the lender its primary objective—payment on a date certain. This objective comes at a price if the property is worth less than the debt—the loan discount. The lender's collateral (and the scope of borrower and guarantor recourse) is no longer sufficient to secure repayment of the entire outstanding indebtedness; as such the parties would be better off negotiating a one-time cash payment in settlement of that obligation. Real estate has “right sized.”

The discounted repayment model (a DPO, or discounted pay-off) allows the lender to receive consensually and predictably the financial equivalent of the successful foreclosure (i.e., fair market value of the collateral), but allows the borrower to retain ownership and achieve the potential upside of an improved marketplace, investment or capital event. The DPO works well in a non-recourse setting and in circumstances in which the borrower has proceeded honorably (i.e., the loan default is the result of market forces, such as increased construction costs, declining tenancies or revenue, and not fraud or misappropriation of revenue). The lender equates a discounted repayment to “victory, at the outset, in the foreclosure litigation.”

Once the parties make a handshake “deal” on the discounted repayment amount, reality sets in—borrower needs time to “scour the market” for this discounted payoff. The forbearance agreement should deal with this as follows. Let's say the loan is $50 million and the “discounted repayment amount” is $38 million. Borrower has the right to repay and lender has the obligation to accept payment of the indebtedness at this discount provided borrower and guarantors have not otherwise defaulted under the forbearance agreement and such payment has been received by lender by the forbearance expiration date.

Typically, borrower asks the lender to modify and reduce the loan to the discounted repayment amount at inception—requesting, on these facts, an immediate forgiveness of $12 million, before the lender has any assurance that the $38 million is forthcoming. Lenders should not fall prey to this tactic. Instead, the $50 million note should be split into two notes—Note A for $38 million, with interest at a modified pay rate, and Note B for $12 million, with interest paid (if at all) based on available cash flow. Note B will be forgiven only after Note A has been timely repaid in full. The discounted repayment option could be staged during the forbearance term with declines in the discount (increases in the repayment amount) for payments made at later dates. The business deal could vary, or complicate, this repayment scheme.

A common lender concern (the embarrassing “quick flip”) can be avoided with the “equity sliver.” The lender obtains a portion (or sliver) of the equity in the property (secured by a lien without remedies) to protect against a quick flip of the property to a third party at a profit mere moments after the borrower has repaid the debt at a discount. The “sliver” could burn away over time if the “quick flip” has not materialized.

Right-Sizing Obligations: Note A/Note B/Note C: Another workout strategy—“Note A/Note B/Note C”— involves slicing the underlying loan obligation to reflect current or revised economic realities and projections. The obligation is split into several sub-obligations. The primary obligation, represented by “Note A,” is performed by borrower for the balance of the forbearance term. Note A reflects a more accurate valuation of the underlying collateral, the borrower's ability to make periodic payments, or the discounted repayment amount (if applicable). Interest on Note A is tied to the market.

Note B evidences a negotiated portion of the underlying obligation, which continues to accrue interest at a contract, default or some other modified rate. Interest on Note B is paid out of cash flow or another “good news” capital event if business or cash flow improves. Note B could either: (1) be a component of the discounted repayment amount, (2) represent debt that must be repaid if the forbearance period is extended into a “second term” if the project's economics improve or identified “good news” events occur or (3) be forgiven (at the end) if that is the parties' business deal.

Note C represents a “deferral” obligation, comprising the remaining indebtedness, with no debt service installments, payable—in full—only upon a subsequent default, non-payment of the discounted repayment amount, or other agreed-upon acts.

The obligation to repay the principal balances of Notes B and C is deferred, with forgiveness of Notes B and/or C (depending on the deal) to occur only upon the borrower's timely repayment of Note A in full. The overhang of Notes B and C provides significant financial incentives for the borrower and guarantors to repay Note A and perform the other terms of the restructured obligation. Like the equity sliver, Notes B and C also can be configured to prevent the borrower from capitalizing on a dramatic increase in the value of the collateral or an undisclosed, premeditated plan by the borrower to sell the collateral or bring in an investor at a profit.

Additional Collateral: In any workout, the lender is likely to request additional collateral. Borrower's initial response is that there is none. However, in exchange for meaningful economic concessions (including the option to repay at a discount), borrowers somehow find additional collateral. This collateral could consist of subordinate interests in other real property owned by the sponsor, membership interests in related projects, marketable securities, tax refunds, litigation recoveries, condemnation awards or preferred equity, among other assets. The lender's willingness to forbear or make economic concessions constitutes good, valuable, and sufficient consideration for the pledge of additional collateral.

Additional Guaranties; Expanded Non-Recourse Carve-Outs: Lenders will also seek new or enhanced recourse—in whole or in part (e.g., a portion of principal; debt service carry; “bad acts”)—against borrower's principals or new investors. If previously absent, the guaranty covers state of the market and workout specific “bad boy” non-recourse carveouts such as bankruptcy, impermissible transfer of the property, interference with remedies, failure to deliver a deed in lieu of foreclosure, misappropriation of revenue or fraud. The guarantor should acknowledge the sufficiency of the consideration (forbearance, concessions) for this “credit enhancement.”

Consent to Remedies: The effective forbearance agreement should, to some vigorously negotiated extent, contain the consent by borrower and guarantors to remedies. The nuances, immediacy, enforceability and implications of such remedies and the extent of borrower's consent thereto should be mastered by counsel before the workout discussions begin. The remedies include: (1) acceleration (bringing forward the entire debt); (2) consent to the appointment of a specific receiver and/or third party property manager; (3) consent to lender's computation of the indebtedness; (4) consent to entry of a judgment of foreclosure; (5) confessions of judgment; (6) tolling of the statute of limitations; (7) consent to jurisdiction (including federal court); (8) consent to an order of seizure of non-real estate collateral; (9) enforcement of “bad boy” guaranties; (10) implementation of the (hard) lock box for project revenue; and (11) consent to vacate the automatic stay in bankruptcy. Borrower (and guarantors) should acknowledge that their consent to these remedies is a material inducement to the lender for its grant of forbearance privileges and other economic concessions, on which lender relies to its detriment.

Because the judgment of foreclosure is consensual, the lender can bypass many of the time-consuming steps required in a judicial foreclosure action (such as the appointment of a referee to compute) and proceed (upon a default) to judgment and auction in a fraction of the time and cost—and with predictability. Courts typically react favorably where the lender secures the borrower's consent to foreclosure in exchange for forbearance or settlement with respect to a defaulted loan. Finality and judicial economy are achieved—consensually.

* * *

In any loan workout, the parties need to reconcile, amicably, their contrary objectives. The forbearance agreement can be used effectively to realize that goal. Workout specialists need to evaluate the risks attendant to today's judicial processes and the reactions and sympathies of the courts. They should understand the complexities and intricacies of various types of collateral and the disparate objectives of the holders of several tranches of debt (including market forces, changes, intercreditor arrangements, regulatory constraints and risks of loss), and master the dispute resolution mechanisms available to them. By doing so, the parties should be in a position to craft a forbearance agreement that is fair, efficient, and that works.

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.