How to handle defaulted commercial loans, part 1: Transaction workouts

Thought Leadership on Banking and Commercial Transactions presented by Weinstock, Friedman & Friedman P.A.

This article is the first of a two-part series on basic legal issues lenders face in handling defaulted commercial loans. Although bankruptcy is fairly prevalent in the world of commercial loan workouts, it is outside the scope of this article. This series will focus on two aspects: (1) transactional workouts via documentation and (2) court-related intervention. Please also note that this presentation is not jurisdiction-specific or detailed. Each state will have specific practices and procedures that you should research and review before taking any action.

Amending loan documentation can be complex, and there is a wide variety of actions you can take. However, at a more basic level, there are essentially two main strategies you can use to work out a commercial loan via documentation: (1) Loan amendment/modification of terms, or (2) change or release in collateral.

  1. Amendment/Modification of terms

How you can amend or modify a loan can vary widely, from simple changes in terms (such as the extension of the maturity date, changing the interest rate, changing the payment schedule, curtailing principal or forbearing) all the way to more complex modifications such as consolidation and restatement of loans, cross-collateralization of debt, or adding and releasing borrowers or guarantors.  Any or several of those tactics can be used to either rehabilitate the loan or bring it to closure in order to exit your portfolio.

You can also use this opportunity to improve your lending position. For example, if your underlying loan instrument does not contain such provisions, the Amendment to Loan Documents should contain a confession of judgment provisions, if applicable, as well as a waiver of jury trial provisions and language releasing the lender from liability. But be aware that making any of those kinds of adjustments may require changes to other loan documents or the drafting of supporting documents. For example, if the bank is adding borrowers, an amended and restated note may need to be entered into by all the borrowers to bind everyone to those new provisions. Or, if you have a corporate borrower, it should also provide a unanimous written consent or resolution to provide evidence of the entity’s ability and approval to enter into such modifications. This documentation is especially important when a new entity is joining the transaction and pledging collateral. In that case, you will also want to see organizational documents and a corporate resolution authorizing the entity’s actions.

  1. Changes in collateral

As a lender, you may decide that the best way to secure the debt is to change the collateral. But what you draft will depend on the type of change being made. If you are making collateral changes involving real estate, a real estate loan document modification agreement should be executed and must be recorded in the land records. If you are taking new collateral for a modification of a loan, such as an account of deposits or other financial accounts, the lender may need several documents executed, which may include a  pledge and security agreement (which pledges the collateral to the lender), a UCC financing statement (which should be recorded in the Secretary of State’s or a similar office) and a control agreement that perfects the security interest given to the lender. If you are taking new collateral for a modification of a loan, such as a membership interest in an entity approved by the lender, the lender may need a membership pledge and security agreement, and a UCC financing statement filed in the records of the Secretary of State or similar office.

If there are multiple loans, the lender may want to consolidate, amend and restate the loans  to simplify and streamline the transaction. If the notes are consolidated, amended and restated, any document securing the notes will also need to be consolidated, amended and restated.

Tips to remember

When handling a loan workout via transactional documentation, it is critical to make sure all details are handled properly. Any missed items could result in difficulty collecting if the loan defaults again. Here are some things you should remember to do, which are commonly overlooked:

  • The documents should always be witnessed by a third party, and if a document requires a notary, the notary blocks must be properly completed. Until all parties, including the lender, have properly executed the required documentation, the document will not be deemed ratified.
  • Have a flood certificate ready for your counsel (if real property is involved).
  • Make sure the UCC statements are recorded properly and timely (if business assets are involved) or that the trust/security documents are recorded properly and timely (if real property is involved). Please remember that there will be recording fees, and possibly recordation taxes, associated with a document filing and that the originals must be recorded to properly secure the collateral.
  • Check the lien history to make sure you know the position and priority of your loan. Be prepared to obtain subordination agreements where necessary.
  • Make sure you comply with all provisions of the Anti-Money Laundering/Bank Secrecy Act, and the Foreign Corrupt Practices Act.

These strategies can help you improve the performance of your loan portfolio by either rehabilitating the otherwise good credits, or working the bad credits out of your portfolio. If documentation fails or is otherwise not a viable strategy, the legal system provides court-related strategies you can use. Those strategies will be covered in the next article.

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