By Mark A. Costello, Esq.
When a loan goes into default a lender, for any number of reasons, may determine that pursuing or continuing a foreclosure against its security is not its best option. Concomitantly, a borrower may wish to attempt to bring a loan current or to obtain takeout financing to make a lender whole, but may require additional time in which to do that. Permitting a borrower a grace period—a forbearance period—in which to restructure, refinance, rebuild, or do whatever it is the borrower may wish to do, might, after weighing the variables, make more economic sense to a lender than foreclosing. When a lender decides to refrain from foreclosing to allow a borrower additional time to work out its issues, the parties will need to memorialize their understanding in what generically is referred to as a “forbearance agreement”.
The terms of a forbearance agreement vary from case to case, because they address a seemingly infinite variety of variables, but the core concept in each remains the same: In exchange for actions or promises, or both, from a defaulting borrower, a lender agrees to refrain from pursuing certain remedies unless the borrower defaults under the terms of the forbearance agreement. The goal of a forbearance agreement can be to allow a borrower time to sell the property secured by a mortgage so that the borrower can repay the lender, to permit the borrower to find take out financing to repay the lender, to permit a reinstatement of a loan upon repayment of the outstanding arrearage, or to accomplish other things unique to the facts of a particular dispute. A lender should view a forbearance agreement as an opportunity—an opportunity to shorten the foreclosure timeline , to get paid, to get releases of outstanding claims, and to eliminate uncertainties. For example, there may be poor or incomplete loan documentation that will be exposed if a lender is required to bring suit. A lender may use the forbearance agreement as an opportunity to fix that documentation problem. Since forbearance agreements by their nature are negotiated at a time when a borrower is in a compromised position, problems with loan documentation can be remedied without the borrower ever knowing they existed and promises and waivers can be more easily extracted from a borrower.
The Purpose of the Forbearance Agreement
All forbearance agreements have one of two mutually exclusive goals:
- Reinstatement. The goal is for the borrower to bring the loan current. If the goal is reinstatement, the agreement will allow the borrower time to make payments to repay the arrearage. There may be a new equilibrium at the end of the process (e.g., a modified loan, additional security, new business partners, etc.), but the ultimate goal is for the lender to keep the loan, in some form, as part of its stable of investments.
- Terminating the Loan Agreement. The goal is for the borrower and lender to end their relationship as borrower and lender. If the goal is payoff, it might be a short payoff (the lender is to receive less than what is owed) or a full payoff. In either event, the borrower will be allowed time to do something (e.g. to sell the property, obtain takeout financing, win the lottery) to obtain financing to pay off the loan in whatever amount agreed.
The Variables
The variables in a forbearance agreement seemingly are infinite, so it is important to know the facts unique to the loan, the borrower, the property and the needs of the lender, before one commences drafting. That said, the following are some of the more common points to consider when drafting a forbearance agreement:
- Foreclosure. The lender may wish to complete (or commence) a foreclosure action, short of selling the property during the forbearance, so that if there is a default at the end of the forbearance the lender will be in a position to sell the property. This is particularly useful in judicial foreclosure states. Some ancillary issues in connection with the foreclosure that a lender may also wish to address are as follows:
- Default. Have the borrower admit its default.
- Amount due. Have the borrower admit the amount owed and the per diem interest accruing going forward.
- Defenses. Have the borrower withdraw its Answer (if one has been interposed), and waive any defenses to its default. (This applies even if there is no foreclosure.)
- Counterclaims. Have the borrower waive all counterclaims. (This applies even if there is no foreclosure.)
- Value of the Property. In the event there is a deficiency issue, have the borrower admit the value of the property securing the loan. Borrowers typically will want a deficiency waived if they give up the property, but a lender may even try to get a stipulation or confession of judgment for a deficiency.
- Deed in Lieu. The lender may require the borrower to give a deed in lieu of foreclosure as security for payments under the forbearance agreement. If there are subordinate liens, however, the lender may still have to foreclose its mortgage interest in order to clear the title.
- Confession of Judgment. The lender may require the borrower to secure the forbearance agreement with a confession of judgment.
- Interim Payments. The lender may require funds upon signing the forbearance agreement or may require periodic payments during the term of the forbearance, or both.
- Taxes. To avoid a tax foreclosure real property taxes should be addressed. (E.g., the borrower should be required to pay them or a lender may agree to pay them.) Know the status of the taxes and be familiar with the local tax foreclosure procedures to know when the property might be coming to foreclosure.
- Assignment of Rents. Related to receipt of payments, a lender may require a borrower to direct all rents be paid to the lender.
- Property Management. A lender may insist that a borrower hire (or replace) a property manager for a commercial project. A lender, however, must be careful not to become involved with the management of the property (or business), otherwise the lender could unwittingly assume unwanted liability.
- Property Improvement. A lender may afford the borrower time to complete construction or rehab of a property so that the property can generate rental income sufficient to keep the loan current or can be utilized by the borrower’s business (which will make money to keep the loan current or will improve the value of the property so the borrower may sell it at a reasonable price). In either case, the goal is property improvement to generate more money. When the property is going to be improved, the lender should include some method of oversight to monitor the improvement. In some instances a lender might wish to establish a minimum amount that the borrower must expend on improvements and a method of verifying what the borrower has spent on the improvements.
- Increasing Rental Income. The lender may afford a borrower time to increase rental income (e.g., time to market the property to prospective tenants), with a goal of repaying arrearages or improving the value of the property so it may be sold.
- Selling the Property. The lender may afford the borrower time to sell the property (and pay off the lender). The lender might require that the borrower present good faith evidence that the borrower has hired a reputable real estate agent or broker and listed the property at a fair market price.
- Business Restructuring. A forbearance period may provide the borrower time to bring its business back to profitability and to reinstate the loan. The lender may require borrower to hire a turnaround company to assist in improving a business borrower’s profitability but, again, the lender should careful not to become involved in decisions about running the borrower’s business.
- Admission of Enforceability. In all situations a lender will want to have a borrower admit that the loan documents are enforceable.
- New Security. In some instances, (e.g., there is an expired UCC lien) a lender may wish to have a borrower renew some of the security documents, may acquire additional security or may secure a previously unsecured loan.
- Time. Afford a borrower time but not too much time. Terms running five months to nine months are fairly common. Shorter terms are sometimes used; longer terms are less common. A borrower in financial trouble will be less likely to maintain its property, pay taxes, so care should be taken to make certain the value of the security is not diminished during a period of forbearance.
- Impairment of an Inferior Security Interest. Be sure to adhere to local rules in connection with mortgage modifications. In some instances, the terms of a forbearance agreement may be deemed to be a modification that impairs the rights of an inferior lien holder and, for that reason, it is not valid without that inferior lien holder’s consent to subordinate its interest.
Conclusion
A borrower in default and confronted with certain loss of collateral or a money judgment for failure to pay a monetary obligation often is optimistic about its chances to cure a loan default and, as a result, may be willing to enter into a forbearance agreement. A lender may choose to exploit a borrower’s vulnerability to its advantage, extracting waivers, admissions and other concessions that will simplify litigation and enhance a lender’s position. Before drafting a forbearance agreement, know the variables unique to your case, seize the moment, and aim for the moon.
