If you are a mortgage lender who followed the recommendations in the first article in this series, then you should have a solid grasp of your mortgage portfolio. You have identified the relevant players and their respective rights and obligations. You have taken inventory of the collateral, assessed its condition, confirmed the priority of your security interests and its future prospects. You have evaluated the financial condition of the borrower and guarantors as well as creditors who may have rights ahead of you.
The next step is to evaluate your options.
Once a mortgage loan default occurs, the mortgage lender typically has the right to pursue most or all of the following actions (the facts and applicable law may eliminate some of the options):
- Ignore the Problem
- Accelerate the Loan
- Take the Cash
- Sell the Note (probably at a discount)
- Accept a Discounted Payoff
- Workout/Modify the Loan
- Seek Appointment of a Receiver
- Take the Property Back
- Deed in Lieu of Foreclosure
- Judicial Foreclosure
- Non-Judicial Foreclosure (deed of trust states)
- Sue the Borrower and/or the Guarantors
- Set up a Prepackaged Bankruptcy
Ignore the problem
While monetary defaults are hard to ignore, especially for banks and other regulated lenders, it is surprising how many mortgage lenders think ignoring a non-monetary default is a viable option. At the risk of violating a lawyer’s standard “never say never” rule, ignoring a material default is never the answer.
There are people who know that they have a health issue but choose not to go to the doctor because they are afraid of what the doctor will say. While the doctor may tell them that they have cancer, the problem is not the doctor’s pronouncement of cancer but the cancer itself. Since cancer usually gets worse if left untreated, the ill individual would have benefited from confronting the problem and seeking treatment sooner. So it is with a non-monetary default. Acknowledge it and develop a plan for addressing it.
Additionally, if you ignore a default, you run the risk that your borrower will argue you have waived the default and/or established a course of conduct of ignoring defaults. Even if the loan documents say a waiver must be in writing, in many jurisdictions an established course of conduct may be used to prove the existence of an agreement outside of the loan documents. There is no reason for you to take that risk.
In the mortgage loan world, a forbearance is a decision by a lender to temporarily postpone its exercise of remedies following a default by a borrower. The forbearance may be short (e.g., a matter of days) or it may last for years. Typically a lender’s agreement to forbear is conditioned upon the continued satisfaction of certain conditions and will terminate automatically if any of those conditions are not satisfied (e.g., monthly payments are not made, new events of default occur, and borrower and guarantors fail to provide financial information about themselves and the property).
While forbearance agreements benefit a borrower, they may provide advantages to a lender as well. Unlike the situation in which a lender ignores a default and is susceptible to a waiver argument, a forbearance agreement generally requires that the borrower and guarantors expressly acknowledge and agree that the default has occurred and has not been waived. It should also toll all applicable time periods.
A forbearance agreement is often appropriate in situations in which the defaults are expected to be temporary. For example, if the property is operating at a deficit (e.g., as a result of COVID 19 closures), but you and the borrower expect the cash flow will turn positive in the foreseeable future, it might not make sense for you to aggressively pursue remedies. A forbearance agreement could be used as a “band-aid” to protect the interests of both borrower and lender until the problem heals itself. And, if the problem does not resolve itself, you can explore your other options.
Forbearance agreements may also be beneficial in the instance of a material non-monetary default that cannot be cured easily but does not materially affect the loan collateral. For example, if the borrower puts a construction mortgage on the property and builds improvements without your consent, it may be a default under your loan documents; however, if the property has increased in value as a result of the improvements, and your lien remains in first position, you may not want to create major problems for your borrower and the property by foreclosing or exercising other remedies. Once again, a forbearance agreement could be used to preserve your position.
Accelerate the loan
Loan acceleration results in all outstanding amounts under a loan becoming immediately due and payable, effectively moving up the maturity date. While some loan documents provide that the loan will accelerate automatically upon the occurrence of a default, most give a lender the option to decide whether to accelerate the loan (except that acceleration should always occur automatically when a borrower files for bankruptcy).
Loan acceleration is a very big weapon in a lender’s arsenal. Once a loan is accelerated, most loan documents provide that interest accrues thereafter on the entire outstanding principal balance of the loan (not just on a missed payment). The amount of default interest varies from loan to loan, but it is typically at least 3 percent in excess of the non-default interest rate, and often much higher.
As a general rule, you will want to accelerate the loan if you think your borrower is on the verge of bankruptcy. You will also want to accelerate before commencing a foreclosure. By doing so in the foregoing instances, you ensure that your claim is for the entire outstanding amounts under the loan and not just the amount of any missed payments.
You may want to consider accelerating a loan if you feel that the borrower is not taking the default seriously. Demanding immediate repayment of the loan can be an effective mechanism for getting the borrower’s attention.
Accelerating a loan is a powerful remedy, but it is not suited to every situation. It certainly increases the pressure on a borrower to pay off the loan if it is able, but it can also change the tone of discussions. It may derail productive discussions between borrower and lender or force the borrower into a more aggressive mode.
Take the cash
One of the options you should explore after a default is whether you have the right to take control of some or all of the borrower’s cash and future rents. If a hard lockbox was put in place at loan origination, then you should already control the cash; however, check with counsel before running the cash management waterfall because the post-default application of funds to the loan may be problematic in some jurisdictions (e.g., California).
If a springing lockbox or cash management system was put into place at loan origination, a default is likely to give you the right to convert the lockbox into a hard lockbox (i.e., one in which you have sole control over the funds). If you do trigger the hard lockbox, you should work with your borrower and/or the property manager to gain a firm understanding of the property expenses and necessary maintenance obligations.
Even if the loan documents do not provide for a lockbox or other cash management system, your loan documents probably contain an assignment of rents by the borrower in your favor. The enforcement mechanism varies dramatically among jurisdictions, but there should be a means for you to start receiving cash from the property directly. Before exercising this remedy, make sure you understand any legal requirements applicable to your receipt and use of the cash.
In some loans, a letter of credit is provided as additional collateral for the loan. It is not always beneficial for a lender to make a full draw under the letter of credit (unless it is about to expire). For example, if the borrower under the loan is also the applicant under the letter of credit, a draw under the letter of credit could complicate the situation by bringing the issuing bank into the mix as another creditor. Another example is that if a lender draws more money under the letter of credit than is owed to the lender, and the borrower files for bankruptcy, the excess cash could become an asset of the bankruptcy estate. If you are holding a letter of credit, think before you draw.
Sell the note
Another option available to you to resolve a non-performing loan is to sell the note to a third party. This option often appeals to lenders who do not have the resources (human and/or financial) to engage in a fight with the borrower, invest the capital necessary to complete/stabilize the project and/or carry a defaulted loan on its books. It also appeals to lenders who anticipate that their position will worsen over time as well as to lenders who have no desire to own the property.
If the loan is non-performing, then there is a high likelihood that the note will be sold at a discount (i.e., less than par). The size of the discount will vary depending upon the specific situation and a variety of factors (e.g., condition of the property and likelihood of a bankruptcy filing by the borrower).
Many lenders are reluctant to pursue a note sale because they do not want to definitively recognize a loss. Many lenders may have to reflect the estimated loss on their books, but it is only an estimate. There is always a possibility that the situation will improve and the amount of the loss will decrease or evaporate entirely. In contrast, once a note sale is complete, the amount of the loss (assuming it was a discounted sale) is final and must be recognized on the lender’s books.
If there are other creditors involved in the transaction (e.g., mezzanine lender or preferred equity), these parties may be interested in buying the note rather than losing their investment. If they are not interested, reach the intercreditor agreement carefully because it may contain restrictions on the parties to whom you can sell the note.
From a lender’s perspective, a discounted payoff is similar to a note sale in that the lender receives a sum of money to be done with the loan. The primary difference is that the buyer is the borrower (or an affiliate), and the loan is treated as fully repaid. In many situations, a discounted payoff is not viable because the borrower (and its investors) do not have the financial resources to payoff of the lender.
If there are other lenders involved in the situation (e.g., mezzanine lender), you will need to review the intercreditor agreement. Intercreditor agreements frequently restrict any lender from selling the loan to a borrower or an affiliate.
Workout/modify the loan
The term “workout” references a consensual resolution to a non-performing asset. Most often this involves some type of modification to the loan that takes the loan from a non-performing to a performing status.
While loan modifications often involve a change in payment terms and an extension of the maturity date, there are many other ways in which a loan may be modified. Put your imagination to work and think creatively about modifications that could benefit both lender and borrower. Among the loan modifications worth considering (but not suited to every situation) are the following: change the term of the loan; reduce the interest rate and/or restructure interest into “current pay” and “deferred”; reduce the amount of the monthly payments; take additional collateral; increase recourse to the borrower and guarantors; provide an incentive for the borrower to stay involved in the project rather than walking away; institute greater financial controls; replace the property manager or franchisor; implement a lockbox/cash management program; or add an equity kicker or participation component to the note.
Seek the appointment of a receiver
Many loan documents permit a lender to seek the appointment of a receiver following the occurrence of a default. A receiver is an agent of the court (not the lender) who takes control of the borrower and all of its assets. The scope of a receiver’s work is often far more extensive than that of a property manager, so its fees may be high. A receiver will also have its own counsel whose fees need to be paid. Typically, the party that seeks the appointment of a receiver is responsible for payment of the receiver’s (and its counsel’s) fees if property revenues are insufficient. Accordingly, a receiver is not the solution to every problem situation.
Some circumstances in which you might benefit from the appointment of a receiver include the following: (a) the property is generating large amounts of cash (e.g., cannabis dispensary) that are difficult to track; (b) you are concerned that the borrower will use rents from the property to establish a bankruptcy fund or otherwise use them in a manner inconsistent with the requirements of the loan documents; (c) the borrower is materially mismanaging the property and is thwarting your efforts to put in a third-party property manager; (d) the property is under construction (new development or major redevelopment), and you want construction to be completed but do not want the responsibility of doing it yourself; and (e) the property is more like an operating business (e.g., a full-service hotel) than a real estate asset, and putting a receiver in place would facilitate a transition when you foreclose.
You should be aware that courts in some jurisdictions are reluctant to appoint a receiver even if it is authorized by the loan documents. Receivers have a wide range of skill sets and their cost can vary tremendously. Therefore, you would be wise to evaluate multiple receiver candidates before making a final selection.
Get the property back
One choice available to a lender, though generally not the first choice, is to acquire title to the property. Before deciding whether to take a property back, you should consider the potential risks and liabilities associated with ownership of the property, including environmental matters, unsafe conditions, deferred maintenance and operational liabilities. If you decide that you want the property, then your options are to acquire it with the cooperation of the borrower through a deed in lieu of foreclosure, or to force a sale of the property pursuant to a judicial foreclosure or, in jurisdictions where it is available, non-judicial foreclosure.
Deed in Lieu of Foreclosure
A deed in lieu of foreclosure is similar to a property sale. A lender acquires the property from a borrower in exchange for a release of borrower’s obligation to repay the debt (or a portion thereof). If you and your borrower can reach a consensual agreement for the transfer of the property, it is generally a better and more effective (but not necessarily less expensive) way for you to take title than a foreclosure.
The primary disadvantage to a deed in lieu of foreclosure is that a lender will acquire title to the property subject to existing liens. If you know that there are a lot of liens against the property and that you will need to foreclose in order to extinguish those liens, it may not make sense for you to spend time and money on both a deed in lieu of foreclosure and a foreclosure. If you do not believe that there are any liens and you do take title to the property pursuant to a deed in lieu of foreclosure, then you should keep the mortgage in place for some period of time to be sure that no liens materialize. If they do, then you still have the foreclosure option.
Judicial foreclosure is a remedy available to a lender in all states. As the name implies, it enables a lender to foreclose on property by proceeding through the judicial system. The actual foreclosure procedure differs among jurisdictions.
Since a judicial foreclosure is a court proceeding, the process is often costly and may take a significant amount of time to complete. In some situations, it may make sense for a lender to seek appointment of a receiver to manage and protect the property during the foreclosure period. The time and expense of a judicial foreclosure often puts pressure on the parties to find an alternative resolution.
A non-judicial foreclosure, as its name implies, is a foreclosure that is accomplished outside of the court system. It is only available in some states. As a general matter, a non-judicial foreclosure takes less time and is less expensive than a judicial foreclosure.
A non-judicial foreclosure may not make sense in all instances. For example, if there are material disputes between a lender and a borrower over the existence of a default, then the dispute may need to be resolved by a court, in which case judicial foreclosure may be a better option. Also, some states restrict the remedies available to a lender who completes a non-judicial foreclosure. For example, in California, a lender may not sue a borrower for a deficiency under the note following a non-judicial foreclosure.
Sue the borrower and guarantors
Depending upon the terms of the loan documents (e.g., the loan is recourse to the borrower and the guarantors have provided a payment guaranty) and applicable law, you may have the right to sue a borrower and guarantors to recover the debt. If you do have the right to bring a lawsuit, some jurisdictions will permit you to do so prior to, or concurrently with a foreclosure. Others will require that you complete a judicial foreclosure prior to obtaining a deficiency judgment against a borrower.
Litigation is typically expensive and time consuming. Some lenders believe that the threat of litigation will elicit more cooperation from a borrower and guarantors, and in some instances it might. If you are giving serious consideration to a lawsuit, you should confirm first that the borrower and/or guarantors have enough assets to satisfy any judgment that you obtain.
Additionally, before commencing litigation, you should be aware that many jurisdictions provide a guarantor with defenses that are not available to a borrower. Review the guaranty to determine whether these defenses have been validly waived. If not, while the guaranty might still be enforceable, depending upon the facts, these defenses could impair your ability to prevail in litigation against a guarantor, making litigation a less desirable option.
Set up a prepackaged bankruptcy
Last, but certainly not least, a prepackaged bankruptcy may provide you with your best opportunity to reach a satisfactory resolution. In a prepackaged bankruptcy, the debtor and creditors agree upon the reorganization plan before the debtor files for bankruptcy. By filing for bankruptcy, the debtor is able to take advantage of some of the bankruptcy rules and is able to effectuate a reorganization plan without the consent of all of its creditors.
A prepackaged bankruptcy is most commonly used when a borrower has multiple assets and creditors. A prepackaged bankruptcy is not likely to provide much benefit to a lender when its borrower is a single-asset debtor whose only liabilities are the mortgage loan and a handful of trade payables.
Part one of the series can be found here. The next article in this series will address issues for a lender to consider in developing a workout strategy for a mortgage loan.
Susan J. Booth is a partner at Holland & Knight and leader of the firm’s West Coast Real Estate Group. She is based in Los Angeles with a national practice focused primarily on purchase, sale and capital market transactions involving data centers, hotels, office buildings, multifamily developments, shopping centers, industrial parks, senior-living centers and mixed-use projects.