Loan Modifications and Forbearance Agreements in the Age of COVID-19

Although the COVID-19 pandemic will continue to impact the economy, numerous commercial borrowers have begun contacting their lenders about either actual or anticipated defaults on their loans, seeking payment deferrals, interest-only periods on amortizing loans, temporary or permanent modification of lending formulas and covenants, and waivers of defaults. 

Loan modification and forbearance agreements are two methods most commonly used by lenders to provide breathing room to a defaulting (or soon-to-be defaulting) borrower. Lenders and borrowers need to have a comprehensive understanding of the best practices in the negotiation and structuring of loan modification and forbearance agreements. 

Loan Modification Agreements

A loan modification agreement permanently restructures or modifies the existing terms of a potentially defaulted loan to restore it to a performing status for the foreseeable future.  Although many loan modification agreements may provide for a long-term restructuring of loan terms, a loan modification also may be appropriate to provide short-term relief, such as a payment deferment, changes in the amortization structure or a temporary change to financial covenants. Regardless of its specific terms, a modification agreement is typically the preferred form of accommodation from the borrower’s perspective because it eliminates any prior defaults as if they never occurred. In the event the lender has accelerated the loan, a modification agreement will reverse the effect of such acceleration.

When negotiating a loan modification, the borrower will typically ask for one or more of the following accommodations:

• Deferment or reduction of regular loan payments
• Changes in the existing amortization structure, such as an interest-only period, reduced amortization payments and/or an extension of the maturity date
• Reduced interest rate
• Waiver of any prepayment premium (make-whole provisions) in the event of refinancing
• Changes to financial covenants
• In construction loans, an increase of the interest reserve funded from the loan proceeds, an extension of the timetable for completion of the project, and an addition of various force majeure provisions excusing the borrower’s failure of performance resulting from a pandemic, government shutdown order or other events similar to the ongoing COVID-19 pandemic
• Ability to bring in new equity investors or incur other debt
• Changes in provisions regarding guarantors

Even if the lender agrees to the accommodations requested by the borrower, the lender should use the loan modification agreement as an opportunity to review the loan file and consider how it might strengthen its position. For example, over the course of a loan, the lender may find that it wishes some provisions had been drafted differently. The lender can therefore use the loan modification agreement as an opportunity to “clean up” any inconsistencies or shortcomings in the existing documents. 

Additionally, the lender’s  “wish list” may include:

• Additional collateral
• Cross-collateralization and cross-default with other loans to the buyer or the buyer’s affiliates
• If the loan is unsecured, added security provisions
• If a loan does not have guarantees, added guarantors or the change of a limited or springing guaranty to an unlimited, unconditional guarantee  or added recourse to a non-recourse loan
• Establishment of a cash management “lockbox” or other method of dominion over cash that controls cash flow from tenants or account debtors, to be sure it is applied first to the loan, as appropriate
• Additional financial covenants and financial reporting
• A release by the borrower and guarantors of any existing claims, defenses and setoff rights against the lender
• A modification fee to compensate the lender for the expenses incurred with the preparation of the modification agreement 
• Added monitoring fees if the lender will be called upon to increase its oversight of the loan

Forbearance Agreements

While there may be some overlap between debt modification and forbearance agreements, they differ in how the lender views the borrower’s long-term outlook. A forbearance agreement is used in default situations when the lender may not believe the borrower’s ability to turn its business around justifies a longer-term or permanent loan restructuring. Instead, in a forbearance agreement, the lender will temporarily agree not exercise its legal rights and remedies against the borrower, solely if the borrower complies with the terms of the forbearance agreement. Unlike a modification of the existing credit documents, it preserves the existing defaults. 

A forbearance agreement does not restore the defaulted loan to a performing status, which may have implications for a regulated lender. However, the defaulting borrower can still gain significant benefits from the “breathing room” provided by a forbearance agreement. A short-term forbearance agreement can provide the borrower with a temporary deferral or reduction of loan payments. It also can allow the borrower some time to resolve disputes with third parties (such as taxing authorities or vendors), and explore potential avenues for repayment of the loan, such as a refinancing, sale of some or all of the borrower’s assets or the attraction of new capital or subordinated debt.

In situations where the lender deems the borrower capable of a successful turnaround, the forbearance agreement may modify or temporarily waive some of the loan terms to allow the borrower to potentially reinstate the loan. A forbearance agreement may help the borrower restructure its business without the expense or loss of control associated with a bankruptcy filing.  

A forbearance agreement may provide several significant benefits to the lender as well. In many instances, a forbearance agreement allows the lender to minimize, if not eliminate, the expense and delays associated with enforcing its rights and remedies while preserving the existing defaults in the event future enforcement is necessary. The parties may agree to a “friendly foreclosure,” whereby the borrower agrees to peacefully surrender the collateral. This allows the lender to obtain a judgment against the borrower and schedule a foreclosure sale without opposition while allowing the borrower to market its assets more effectively.

Similar to a modification agreement, a forbearance agreement also provides the lender with an opportunity to review the existing credit documentation and, if necessary, to correct any documentation flaws and to potentially enhance its collateral position.  However, if the borrower grants additional collateral to secure an otherwise unsecured or undersecured loan, in the event of the borrower’s subsequent bankruptcy filing, such collateral may be subject to a preference attack under §547 of the Bankruptcy Code. Finally, a forbearance agreement allows the lender to potentially maximize its recovery by structuring a going-concern sale of the borrower’s business or an orderly liquidation of the its assets.

Some terms typically requested by the borrower in a forbearance agreement include:

• Deferral or reduction of monthly loan payments
• Longer forbearance period (12 months or longer)
• Reinstatement of the loan at the end of the forbearance period
• Ability to market the business or collateral without the lender’s oversight
• Lender’s agreement not to accelerate the loan
• If the loan has already been accelerated, a waiver of any prepayment premium (make-whole provision) in the event of refinancing or repayment from the sale of the borrower’s assets
• Additional time to pay off the loan if it has matured already

The lender should approach drafting a forbearance agreement as a blueprint for its exit strategy, and should consider including the following terms:

• Requirement that the borrower make improvements to its business, the necessity for which may have become clear during its distress.  These may include improving its collections and inventory turns, seeking improved vendor credit terms or reducing expenses.  
• Confirmation of the existing defaults, including an acknowledgement that the lender has not waived the defaults, that the borrower has no valid defenses to the defaults and a reservation of the lender’s rights, except as specifically provided under the forbearance agreement
• Reaffirmation of the lender’s collateral position
• Short-term forbearance period (90 to 180 days), subject to early termination if the borrower fails to comply with the forbearance terms
• Some periodic payments during the forbearance period
• Payment of the outstanding loan balance, with all accrued interest, costs and charges, upon termination of the forbearance agreement
• Additional collateral and guaranties
• Time frame for a sale of the borrower’s assets or refinancing of the loan
• Engagement of a turnaround advisor or manager who should be reasonably acceptable to the lender and whose agreements, analyses and reports should be available to the lender
• Additional reporting requirements, particularly with respect to the borrower’s efforts to refinance the loan or sell the assets, and, if the borrower engages an investment bank or other intermediary, access to such intermediary and its materials for the lender borrower’s and guarantors’ consent to entry of judgments in favor of the lender, and to the lender’s foreclosure on the assets at sheriff’s sale or non-judicial sale
• Release of the borrower’s and guarantors’ claims, defenses and any setoff rights against the lender
• Forbearance fee to compensate the lender for the delay in the exercise of its rights and remedies, the preparation of the forbearance agreement and additional monitoring
• Waiver of the automatic stay protection with respect to the lender’s collateral in the event of the borrower’s bankruptcy filing. Both lenders and borrowers should be aware that courts are divided on the issue of the enforceability of such bankruptcy protection waivers. Some courts will enforce these provisions, provided certain factors are present. 
• Also, when dealing with a larger borrower, lenders should consider requiring the borrower to improve its corporate governance, e.g., appointing one or more truly independent board members where none have been present, and providing reports of board meetings to the lender

While the full impact of the COVID-19 pandemic on the economy remains to be seen, one thing is clear: lenders will need to negotiate agreements that provide struggling borrowers with much-needed accommodations while preserving lenders’ rights and maximizing their opportunities for recovery. Both sides will need experienced counsel and other professionals at all stages of the restructuring, from preliminary discussions through the negotiation and preparation of loan modification agreements or forbearance agreements.