Publications: Understanding and Using Forbearance Agreements

It is no secret that economic conditions have forced real estate lenders to critically assess their portfolios and begin dealing with many nonperforming and under-performing loans. One tool to deal with such loans is a forbearance agreement. A forbearance agreement is typically a temporary measure where lender agrees to refrain from exercising its remedies with respect to specific defaults for a certain period of time to either allow the lender more time to determine whether a permanent loan modification is feasible, or to give borrower time to arrange a sale or a refinancing of the property. Although lenders and borrowers sometimes confuse the two, forbearance agreements are usually not permanent loan modifications. Permanent loan modifications are used where there is a change to substantive terms of the loan, such as a change to the interest rate or maturity date of the loan, adding new collateral or equity, affirmative waivers of certain defaults or adjustment of financial covenants. While forbearance agreements may touch on some of these issues, they are usually not intended to permanently modify the loan documents.

Initial considerations

Much like evaluating a permanent modification proposal, a lender considering a forbearance proposal for a troubled loan should first ask the important question: Why? Why is a forbearance agreement the best option for this particular loan? What is the borrower’s strategy? What is the borrower going to do to improve the cash flow of the property? Alternatively, what is the borrower’s exit strategy? Is the strategy itself realistic? For rental properties, where does the borrower stand in negotiations with potential tenants and renewing current tenants? What is the credit strength of the tenant(s)? To what extent can property operating expenses be reduced without compromising service to tenants? If the borrower is attempting to sell the property, how realistic is the asking price? Is the lender willing to do a short sale? Essentially, a lender should ask the borrower to present a revised business plan for the project before agreeing to discuss a forbearance arrangement.

Pre-negotiation letters

Before engaging in forbearance discussions, a lender may want to require the borrower to sign a pre-negotiation letter setting forth the parties understanding about the legal effect of workout negotiations. It may not be necessary for situations where one or two simple monetary defaults have occurred. However, in situations where the defaults are numerous and negotiations over material terms are expected to be extensive, a pre-negotiation letter should at least be considered by a lender to make clear that lender is not waiving any defaults, lender is preserving all of its rights and remedies under the loan documents and that lender may pursue such rights and remedies at any time, notwithstanding the negotiations.

Key provisions of forbearance agreements

Once a lender decides to forbear and how long the forbearance will last, a basic forbearance agreement will contain the following essential terms:

• Acknowledgement of defaults – The borrower and all guarantors should acknowledge all defaults that have occurred under the loan documents to date. Lenders should perform a full audit of both the borrower and property as part of forbearance negotiations, as some defaults, such as nonpayment of real estate taxes and the recording of mechanic’s liens against the property, may be less apparent than the breach of a financial covenant or a missed payment.
• Grant of forbearance - The lender agrees to refrain from exercising its remedies as to the specified defaults (but not any other unknown defaults) for a specified period of time, subject to the continued satisfaction of certain conditions. Forbearance periods will vary in length depending on borrower’s plan of action for correcting the defaults or exiting the transaction.
• Conditions of forbearance – In exchange for lender’s continued forbearance, the borrower is usually required to continuously satisfy certain conditions. These conditions are usually tailored to the particulars of the specified defaults and corrective actions to be taken by the borrower. However, there are some common conditions included in almost all agreements, such as: no bankruptcy or other insolvency proceedings are instituted against borrowers or guarantors, no assignments for the benefit of creditors by borrowers or guarantors, no further default under the loan documents, no default under the forbearance agreement itself, for multiple draw loans, no further advances, and no further material adverse change in the condition of the borrower, guarantors or the property.
• Borrower’s obligations during forbearance period – Here is where the lender will set out how the borrower’s revised plan for the project will be implemented. Depending on the strategy, it may include provisions setting forth a timeline for a sale or lease of all or a portion of the property, and what intermediate steps have to be taken to accomplish that objective. Or, the borrower may covenant to take certain concrete actions approved by the lender to reduce the operating expenses of the property or otherwise improve the property’s cash flow. Finally, lender may want the borrower to continue to make certain reduced debt service payments (to the extent there is available cash to do so), with the lender reserving its full rights against the deferred portions of such reduced payments. Again, these obligations will be very transaction-specific.
• Waiver of defenses – Borrower and guarantors should be required to waive all defenses as to claims based on the specified defaults and agree not to contest any enforcement of lender’s remedies with respect thereto, including, without limitation, any rights of redemption and reinstatement. Lender should also require borrower to release lender from all claims and actions based on the loan documents, the workout negotiations or the agreement itself. If the borrower has no equity in the property, lender should require the borrower to acknowledge that fact.
• Effect on loan documents – The agreement should confirm that none of the loan documents are modified by the forbearance agreement.
• Monitoring and reporting – The lender may want to require more frequent monitoring and reporting by borrower. Depending on the type of property and the severity of the default, weekly, even daily, reporting of financial information and property operations may be appropriate. The lender may also want to the ability to conduct audits or inspections with increased frequency.
• Representations and warranties – The borrower should re-certify as to the truth and accuracy of all of the representations and warranties made in the loan documents. The lender should also obtain an acknowledgement from the borrower of the outstanding principal balance of the loan, all accrued interest, and the per diem interest accruing during the forbearance period at the default interest rate. Borrower should also represent and warrant that there are no other defaults except for the specified defaults.
• Re-affirmation of guaranties – If applicable, the guarantors should re-affirm their respective guaranties.

Forbearance agreements can be useful tools to allow a borrower a short period of time to either exit the project entirely or refinance or allow the lender further time to evaluate. However, at the conclusion of a forbearance period, there should either be a payoff of the lender’s loan or a more permanent modification of the loan structure. Anything less than that is really just “pretend and extend.”