The commercial real estate market has been in the longest period—10 years or so—of sustained growth and activity in recent memory. Industry experts have been anticipating, and predicting, a real estate downturn for the past few years. Investment sales have slowed, the retail apocalypse has continued, foreign investment has halted, the interest rate environment (and the cost of funds) has changed, institutional lenders are skittish (especially regarding ground-up construction) and federal and local regulations are impacting lending, property values and the real estate market as a whole. And, real estate, as the saying goes, is "cyclical." The time is ripe—indeed some would say, long overdue—for the correction to take hold, for real estate to right size, for loans to fall into default and distress.

In this cycle, the loans (not to mention the underlying assets, ownership and investment structures) are more complicated than in downturns past; the parties—lenders, co-lenders, participants, debt funds, opportunity funds, sponsors, joint venture partners, developers, tenants, contractors, investors—their relationships and the economic stakes are far more complex, internecine and clandestine than ever before.

The parties to the distressed loan workout are armed with a decade of judicial pronouncements in the "lender liability" arena borne of the financial crisis, the impact of non-recourse carveout guaranties, competing economic interests and other factors. "Judicial sympathy"—real property is unique and equity abhors a forfeiture—gives rise to "judicial scrutiny," as the courts have explained and cautioned time and again.

Lender liability is a legitimate concern in protracted workout negotiations, especially if there is no deal and the multi-faceted parties (and their representatives), some scorned, some frustrated, others resigned, hear what they want, report what they want and face personal liability if they do not prevail. The successful, fair and enduring loan workout is vital and, for all concerned, far preferable to the cost, uncertainty, delay and risk of litigation. Negotiations should be encouraged.

This article will describe the "pre-workout" or "pre-negotiation" agreement which the parties to the loan workout should execute prior to engaging in substantive negotiations among them.

The pre-workout agreement should make clear that (1) by entering into negotiations, neither party waives any rights or remedies, (2) there shall be no agreements based on oral communications, (3) no negotiations shall be binding on either party until the parties document and execute an agreement fully memorializing the product of their negotiations, and (4) either party may terminate discussions at any time for any reason (or for no reason).

While there is some artistry to the pre-workout agreement, the standard (even-handed and party neutral) form has become widely-accepted. Typically, neither party achieves an advantage over the other—such as an acknowledgement of the debt, or that the debt is immediately due and payable without defense, offset, or counterclaim.

The agreement preserves the status quo. It gives the parties the contractual comfort that nothing in their negotiations will create a binding agreement, or a liability, or a duty to act or refrain from acting. The pre-workout agreement allows the parties to negotiate freely and openly without fear of triggering liability, sacrificing a litigation position, delaying or subverting loan or guaranty enforcement or inviting defenses thereto, whether feigned or real. This should be the borrower's "ticket for admission" to workout discussions.

Essential Terms

The standard pre-workout agreement contains the following features; when taken as a whole—mindful of leverage, deal nuances, objectives, the status and severity of the defaults (if any has yet occurred), the quality, nature and situs of the real estate asset (stabilized, income producing, industrial, retail, hospitality, construction, vacant land), the number of parties and the size and complexity of the loan—the following should provide a blueprint for the fair, protective and easy-to-implement pre-workout agreement that "works" for all concerned.

Negotiations. The parties plan to discuss various courses of action which might be in their respective interests. Crucially, there shall be no obligation to engage in discussions, or to continue negotiations, and there shall be no liability by reason of any party's failure or refusal to negotiate. There is no obligation to negotiate in good faith or to use any sort of best efforts to effect a workout deal. Indeed, either party, in its sole and absolute discretion, may terminate discussions at any time and for any reason, without liability of any kind. Thus, discussions may end abruptly, on a moment's notice and for no good reason. Upon such termination of discussions, the parties' respective obligations to one another, other than as set forth in the loan documents, shall be only as set forth in fully executed written agreements, if any.

Lender achieves peace of mind that there will be no legal or economic consequences (i.e., "lender liability") should lender decide (1) discussions will not be fruitful or (2) to pursue, even concurrently, other alternatives (including foreclosure, guaranty enforcement, a sale of the loan, or utter silence (e.g., "special servicer paralysis")) no matter how consequential or harmful to borrower they may turn out to be. Lender need not forbear from exercising its rights and remedies under the loan documents; borrower should agree not to claim in any legal proceeding or otherwise that any discussions have resulted in an agreement unless such agreement has been reduced to writing, approved by the parties, executed and delivered. Discussions are not discoverable or admissible for any purpose (such as proof of admissions of any obligations or liabilities) in any litigation, dispute or proceeding (including any pending or future action by the lender to foreclose its mortgage).

Rights and Remedies. Lender may pursue its legal rights and remedies. That much is unassailable. Sometimes, however, lender tries to exact (or extract) an "acknowledgement" by borrower that borrower is in default under the loan documents, the indebtedness is immediately due and payable in full, without defense, offset or counterclaim and lender may enforce (rather than merely "pursue") its rights and remedies by virtue thereof. From borrower's perspective, that's unfair. That's tantamount to a consent by borrower to summary judgment in favor of lender. That's not a fair trade, or a fair concession, merely for the privilege of having workout discussions that may be terminated at any time. Notwithstanding the seeming inequity, some lenders insist on an acknowledgement like this, lest they will not negotiate.

This does not mean that borrower, upon receipt of a draft agreement to such effect, should deem futile the prospects of a loan restructure. Nor should borrower acquiesce and sign the draft submitted by lender. Most of the time, absent a matured loan, or conceded long-standing monetary defaults, or a recalcitrant, steadfast, lender (all of which may occasionally be the case), acquiescence would be likely unnecessary.

So here's the suggestion—borrower should cross out "borrower acknowledges" its defaults, or that the indebtedness is immediately due, and substitute "lender alleges." That's neutral; that's fair; and, most times, lender will (or should) agree because lender is still protected against lender liability and protracted foreclosure defenses. That's the benefit of the parties' bargain at this juncture—preserving the status quo and engaging in meaningful negotiations—and nothing more.

Only Written Agreements and Amendments. The parties' discussions may be lengthy, complex and inconclusive. While they may reach temporary verbal understandings on one or more preliminary issues, the pre-workout agreement should provide that neither party—not just the lender; this needs to be mutual—shall be bound by any agreement, verbal or written, on individual issues, and no rights or liabilities shall arise unless (1) an understanding is reached on all issues, and (2) such understanding on all issues has been reduced to a written, fully executed agreement. Nor shall any term sheet or discussion memorandum be considered an offer, a commitment or binding on any party in any respect. Lender may also want borrower to recognize that the individuals signing the agreement do not have the authority to bind lender to any modification of the loan or the loan documents. Only after receipt of credit approval and the preparation and execution of definitive agreements will any modification or restructure be binding. This is an obligatory feature of every pre-workout agreement.

Reaffirmation of Loan Documents. Borrower should acknowledge and reaffirm: (1) all of its obligations as set forth in the loan documents, (2) that the loan documents were all properly and duly executed and delivered, (3) that the loan documents are now, and at all times have been, in full force and effect, and are binding and enforceable in accordance with their terms, (4) that lender maintains valid, properly perfected, fully enforceable security interests in and liens on the collateral and (5) there are no amendments, waivers or modifications of the loan documents, except for those made in writing and executed by the parties.

No Waiver of Rights. The parties agree that the pre-workout agreement, their discussions, any term sheet and any other actions or statements shall not constitute any waiver, estoppel, release, modification, limitation or forbearance with respect to the parties' legal rights or remedies or a waiver of any breach or default by borrower under the loan documents. The parties' rights and remedies are expressly reserved.

Here's the "hot tip" to borrowers' counsel: Should lender's draft say that nothing impairs lender's rights or prevents lender from exercising its rights, borrower should bargain for and try to achieve mutuality. Ergo, cross out "lender" and substitute "the parties." This mutuality is fair and should be acceptable to lender, though some may balk, and some may have the institutional predisposition or the deal leverage to resist this requested change.

No Fiduciary Relationship. The pre-workout agreement should provide that nothing contained therein or in the discussions shall constitute or contemplate a joint venture or partnership or otherwise create a fiduciary, trust or agency relationship between any of the parties. In fact, there is no fiduciary relationship between lender and borrower under the law, the loan documents or by reason of workout discussions. Lender wants this assurance and borrower should agree.

Waiver and Release of Certain Future Claims Related to the Discussions. The parties should agree to a blanket release of future claims arising out of their workout discussions. That's the fundamental precept of the pre-workout agreement, upon which the parties rely. This waiver and release is inviolate, sacrosanct—and mutual. Thus, each party irrevocably waives and releases any and all claims, actions, damages and defenses which such party might have or might thereafter have by reason of any statement or utterance (whether oral or in writing) made during the course of the discussions.

This waiver and release does not (1) release any party from any of its obligations under the pre-workout agreement (including confidentiality), any loan document or any definitive written agreement executed after the pre-workout agreement, or (2) waive, release, limit, restrict or affect in any way (a) any legal rights or remedies of any party (as applicable) under any loan document or any definitive written agreement or (b) any notices given or actions taken in connection with the enforcement of such party's legal rights and remedies.

No Lender Liability. Lender often tries to secure an acknowledgement by borrower that there are no lender liability claims. This could be negotiated and/or resisted. Part of the art here may be for borrower to preserve its defenses, if any, to foreclosure of the collateral, but, if there's absolutely no choice, to forego affirmative recovery against lender for claims for damages.

The standard provision might read substantially as follows: "Borrower acknowledges that (1) lender is not in default of any of its obligations under the loan documents and, as of the date of the pre-workout agreement, lender has fully performed all of its obligations under the loan documents, (2) lender has no obligation to make any additional advances of any kind under the loan documents [if in fact there are any potential future funding obligations], and (3) no event has occurred that would in any way render lender liable to borrower under the loan documents."

Alternative Opportunities. As negotiations may not produce a written agreement, lender wants borrower (and all related or interested parties) to agree that, during the course of discussions (which may be protracted and inconclusive), borrower will pursue a parallel track—such as, seeking alternative financing, a partnership, joint venture or equity investment, preferred equity financing or asset disposition opportunities. Borrower should not forgo, defer or delay any opportunity to protect its property, rights or interests or take or fail to take any action during the course of discussions. Borrower should expressly so agree.

Confidentiality. All borrower parties must agree to keep all discussions and their respective terms, conditions and status (including that discussions are taking place) confidential. The confidentiality provision follows the customary form found in commercial non-disclosure agreements. The confidentiality terms and provisions should survive the termination of discussions.

Conclusion

Today's distressed real estate loan is a complicated affair, with many diverse parties pursuing objectives and interests more complex and elusive than those just a few years ago. Layers of debt 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 and contentious as relationships between mortgage lenders and borrowers of real estate down cycles past.

The parties to the distressed loan workout will be well-served to put in place, on day one, a pre-workout agreement along the lines outlined above. This will enable them to proceed with discussions free, vigorous and substantive; nothing therein will expose them to liabilities, damages, litigation delay or unexpected consequences. They can focus on the risks, rewards and wrinkles of the workout; the reactions and sympathies of the courts; the complexities and intricacies of various types of collateral (including market forces, revenue streams, regulatory, financial and business changes), and the latest workout structures and remedies available in the contemporary legal marketplace.

By putting their fear of negotiation reprisal behind them, the parties will ultimately be in the best position to implement a workout of the distressed real estate loan that is fair, efficient, and that works. That's their goal.

Richard S. Fries is a partner at Sidley Austin and one of the leaders 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.