Despite their best intentions, borrowers sometimes experience financial issues that impact their ability to meet all of the terms and conditions of their loans. Defaults happen. Whether a borrower is unable to comply with a financial covenant or fails to make timely payments when due, a lender will require that the default be addressed and any agreed-upon resolution be documented in writing. We are often asked, however, whether the documentation should be achieved by means of a forbearance agreement or a loan modification agreement. In this article, we will address the appropriate circumstances to use each instrument and the differences between them.
The key question we ask our lenders in determining whether we should document the deal as a forbearance or loan modification is whether the lender has classified (or intends to classify) the loan as a performing or non-performing asset. Our suggested approach will differ for a performing asset compared to a non-performing asset. If the loan has become a non-performing asset on the lender’s books or there is some doubt that the parties will be able to fix or salvage the credit, then we typically document the deal between the parties using a form of forbearance agreement. The primary function of a forbearance agreement is to provide a defaulted borrower with additional time to “right the ship,” before the lender starts to exercise remedies. In a forbearance agreement, the parties will acknowledge that certain defaults have occurred under the loan without the lender waiving them, the lender will reserve its rights under the applicable loan documents with respect to such defaults, and the borrower (and potentially a guarantor) will attempt to resolve the financial or other issues that caused the loan to default. In return, the lender will provide a specified amount of time for the borrower to resolve such issues before the lender takes any action or exercises any remedy against the borrower, guarantors, or their assets with respect to such defaults.
A forbearance agreement may contain specific financial targets the borrower must meet during the term of the agreement so that a lender can track a borrower’s progress toward the desired goals, and may temporarily impose additional obligations on the borrower that are not already required in the loan documents. For example, the lender may require that the borrower retain a financial consultant (a so-called “turn-around consultant”) to assist the borrower in its efforts. It is important to note that a lender cannot require a borrower to retain a specific consultant but will typically suggest three or four consultants that the lender has worked with previously. As part of a forbearance, the lender may also permit a borrower to defer making principal or interest payments for a certain period of time and set forth the terms for repayment of such deferred payments at a later date. Most importantly, a forbearance agreement should not extend the maturity date of the defaulted loan (although it may provide a borrower with more time to repay it) and thus the loan remains a non-performing asset on the lender’s books.
In a defaulted loan situation, a lender will likely choose the loan modification approach if the lender wants to keep the loan classified as a performing asset and believes that there is a reasonable likelihood that a one-time change or a temporary waiver of certain covenants will solve the defaults going forward. If the borrower has continued making scheduled loan payments but there has been a non-monetary default (e.g., a failure to satisfy financial covenants), a loan modification agreement may be the right tool. A loan modification agreement will also typically provide that the lender will waive the existing default(s). This is often required to permit the borrower’s accountants to finalize the borrower’s financial statements without a negative footnote or qualification. A loan modification agreement may sometimes suspend the calculation of existing financial covenants for a specific period of time (perhaps due to seasonality issues in a borrower’s business or the occurrence of unusual events) and may impose more easily attainable covenants such as minimum EBITDA or liquidity guardrails.
The goal in a loan modification is to set a borrower up for future success by adjusting financial covenant requirements in situations where it may take more than one testing period for the borrower to resolve or overcome its financial issues. This approach was utilized frequently by lenders after the pandemic where many borrowers in businesses involving the sale of goods found themselves with too much inventory and simply needed time to work through the imbalance. We anticipate that this situation may also occur more frequently in commercial real estate office loan portfolios where a borrower may need more time to find ways to restore revenue after the loss of a significant tenant or due to a declining rental rate environment.
It is important to note that a loan modification should always include language limiting the lender’s waiver of defaults to only the existing defaults stated in the agreement. In addition, the loan modification agreement should expressly state that any waiver of covenant defaults shall not (i) be deemed to be a waiver of such covenants or any other covenants for any other period, (ii) constitute an agreement by the lender to waive compliance with any other covenant contained in the loan documents, (iii) be deemed to create a course of dealing between the lender and the borrower, and (iv) an agreement by the lender to waive future compliance with the applicable covenants or any other covenant or undertaking contained in the loan documents. A loan modification agreement makes permanent changes to the terms of the loan documents (except to the extent they are expressly intended to be temporary) and is considered an amendment to the specific loan documents being modified.
In spite of the different purposes for the use of a forbearance agreement or a loan modification agreement, both types of agreements can be used in response to a borrower’s troubled loan situation where the borrower will need some type of accommodation from the lender. Importantly, in both cases, the lender may be taking on some additional risk. As such, there are provisions that should be considered in both types of agreements, such as the following: (i) any language necessary to clarify existing loan document provisions which may appear ambiguous or may not have been properly drafted to accurately reflect the lender’s original credit approval, (ii) the correction of any collateral or perfection issues, (iii) requirements for additional financial reporting such as regular 13-week cash flow reports so that the lender can better track a borrower’s performance, or (iv) a requirement that a borrower work with a consultant to create a plan to improve the borrower’s financial situation or achieve additional equity contributions or the sale of the business. Both types of agreements could also include a forbearance or modification fee (as applicable) payable to the lender. Lenders spend an inordinate amount of time on troubled credits and often want to be compensated (at least in part) for the additional work and risk. Finally, both types of agreements should contain well-drafted and robust release language in which the borrower releases the lender from any and all claims or other causes of action which the borrower may have against the lender with respect to the loan.
This article reviews when loan modification agreements and forbearance agreements are customarily used in troubled loan situations. Of course, loan modification agreements are often used to modify, amend, renew, increase, or extend existing loans in non-troubled loan situations as well. Additionally, forbearance agreements may be the tool of choice in a loan situation where the lender has reason to hope that a borrower may recover from its financial issues and the troubled loan can be reclassified at some point in the future from a non-performing to a performing asset. Despite the guidelines provided in this article, it is our experience that troubled loans (and the recommended approach by a lender for their resolution) are quite nuanced and thus usually require additional analysis and consideration by experienced work-out counsel as to the proper documentation to effectively achieve the lender’s goals.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances. In addition, the firm undertakes no obligation to update the information discussed in the foregoing article.
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