Interestingly, given the hangover from Covid-19, the work-at-home dynamic, the spike in inflation and the upward move in interest rates, commercial mortgage delinquency rates remain at relatively low levels.
As a means of comparison and using the Trepp CMBS delinquency rate index as a guide (https://www.trepp.com/trepptalk/cmbs-delinquency-rate-falls-sharply-may-2022), in April 2022 the delinquency rate was 3.5%, 22 basis points lower than March. The high in this indicator of course occurred during the financial crisis, reaching 10.3% in July 2012.
Similarly, the chart above from the Federal Reserve also shows the commercial mortgage loan delinquency rate sitting at very low levels.
But, what if the situation were to change and delinquency rates moved higher, ultimately to the point that attempted commercial mortgage restructurings, workouts, defaults and foreclosures became more of the norm?
What’s a lender and borrower to do?
An article from Arren Goldman, Partner with Seyfarth Shaw LLP, looks at some of the methodology to be aware of…
‘Early stages of commercial loans: pre-negotiation agreements and other key considerations‘
- Identifying defaults and strategising on both sides – is a workout feasible?
- Default letters
- Importance of file review
- Key considerations for pre-negotiation agreements
- Key considerations after execution
Identifying defaults and strategising on both sides – is a workout feasible?
In the early stages of a commercial loan, the parties should consider, among other things, these questions:
- What are the short and long-term goals and strategies?
- What is the nature of the default?
- Will there be a new exit plan?
When drafting default letters, the wording is particularly important. Default letters often include common lender protections, such as the lender’s ability to accept partial payments without waiving rights and language which makes it clear that defaults not specified in the letter (whether known or unknown) are not being waived. Lenders will often need to specify precisely what they expect their borrower and/or guarantor to do, as well as specify a precise deadline.
Importance of file review
File review is especially important for lenders early on in the workout process. The lender should review the file for matters such as whether:
- there are executed copies of all loan documents, executed by appropriate parties;
- they have the original executed promissory note;
- mortgages or deeds of trust were recorded and whether there is a recorded copy of it;
- they received the final title policy reflecting the recorded mortgage or deed of trust;
- they have a filed copy of the Uniform Commercial Code financing statements, properly filed, including accurate collateral descriptions;
- any letter of credit has expired;
- the personal guarantor is still alive;
- the entity guarantor still exists;
- guarantees were reaffirmed when the loan documents were amended;
- any pledged instruments (eg, original limited liability company membership interest certificates) are in the lender’s possession;
- there is evidence of current insurance on file; and
- they obtained all required consents from third parties.
Key considerations for pre-negotiation agreements
Pre-negotiation agreements are crucial to ensure that both sides protect themselves. The goal of a pre-negotiation agreement is to facilitate the sharing of current and accurate information without any such communications being used in court.
The standard provisions should make it clear that a pre-negotiation agreement:
- has non-binding quality until the definitive agreement is reached;
- may be terminated at any time for any reason;
- does not create any obligations to enter into a definitive agreement;
- does not waive existing rights;
- all communications are inadmissible as evidence in court;
- must state governing law;
- specify who is responsible for fees and expenses; and
- can serve as an estoppel.
A lender may also want to:
- confirm any existing debt;
- obtain an acknowledgment of existing default(s); and
- state that there are no defences available to the borrower and/or guarantor.
A borrower may attempt to add the following provisions:
- a standstill regarding the lender’s exercise of rights during the open discussions;
- access to property receipts; and
- the way communication should take place with third parties, as well as when and how information can be shared with third parties.
Key considerations after execution
After a pre-negotiation agreement is executed, the key aspects to consider are:
- a forbearance agreement;
- loan modifications;
- collateral enhancement; and
- the enforcement of the agreement.
After a pre-negotiation agreement is executed, the key aspects to consider are the following:
- whether the parties enter into a forbearance agreement with a specified forbearance period to address defaults or whether they enter into a loan modification agreement;
- whether there will be collateral enhancements in connection with the foregoing; and
- what steps the lender should take in order to enforce the loan documents if all else fails.
Arren Goldman concentrates his practice in commercial real estate transactions. He is co-lead of Seyfarth’s Distressed Situations team and the pro bono chair of the firm’s Charlotte office. His profile can be found here, https://www.seyfarth.com/people/arren-goldman.html, and Arren can be emailed here, email@example.com.