19 April 20207 minute read

The lender’s playbook in the time of COVID-19 (US)

The impact of coronavirus disease 2019 (COVID-19) on society as a whole is like nothing we have ever seen.  Not only is almost everything we are used to different today, but we wonder how long will this last and what the lasting ramifications will be.    As one of our clients recently said, “isn’t it unbelievable how an entire portfolio of loans could have changed in two weeks?”
In these times, how should secured real estate lenders be approaching their loan portfolios?  As with any market downturn, real estate lenders are bracing themselves for their borrowers’ requests.   If the lender has a secured lien, the lender could simply reject a borrower’s restructuring proposal and proceed to enforce its remedies (which, unless the remedies do not require judicial action, may have to wait until courts reopen).  However, most of the time a lender does not want to own the asset and will work with its borrower to achieve a mutually acceptable result.

Step one
After the borrower approaches the lender with a proposal, the first thing a lender can do is require the borrower to execute a pre-negotiation letter. A pre-negotiation letter will, among other matters, state that all negotiations and discussions are non-binding and any final agreements must be in writing.  This will allow the lender to negotiate in good faith without worry that it might unintentionally impair its position. It is wise to keep the letter short and to the point so as to avoid unnecessary cost and expense in negotiating this agreement, which is really just the appetizer. 

Step two
If the borrower is not in default, the lender can proceed to prepare a modification agreement. However, if the borrower has defaulted (or if the borrower defaults in the midst of negotiating a modification agreement) the lender may deliver to the borrower a default notice with a reservation of rights included in the default letter. It is important for the lender to preserve its rights with respect to the specific default while trying to negotiate a modification.  The notice can establish leverage for the lender during negotiations, and it can be essential in the event that the lender is not able to reach an agreeable resolution with the borrower.

Step three
A modification agreement should address the immediate needs of the parties and attempt to address mid-term needs so that the parties do not have to repeat the dance in the near future.  There is no need to address longer term issues that are not well-defined. Given the uncertainties that surround the current crisis it may be better to sit back down at the bargaining table in four to six months with fresh facts then to guess at what the world will look like. Many of the modification agreements that we are currently seeing include one or more of the following as it pertains to the next three-month period:
  • A deferral of principal and/or interest, required to be repaid within a year.
  • A waiver of the cash trap period.
  • Permission to close down operations of a hotel or mall.
  • Waiver of certain reserve deposits (however, we have not yet seen a waiver of tax deposits)
  • A loosening of standards relative to negotiating with tenants for lease modifications.
  • Confirmation that any loan obtained from a governmental program will not violate the prohibition on additional borrower debt (of course, confirm that said debt may not be secured by the mortgaged property).
It is important to remember when modifying the loans not to permit the borrower to do something that will result in a default under a third-party agreement. For example, a lender may not wish to permit a borrower to close a hotel if that would result in a default under a franchise agreement. Likewise, a lender may not want to waive an FF&E deposit if said deposit is required under a hotel management agreement.

The modification agreement need not be one-sided. The lender will want to make sure that the modification agreement not only accomplishes the borrower’s goals but also satisfies the lender’s needs.  For example, the modification agreement could:
  • Capitalize deferred interest.
  • Obtain an exit fee.
  • Confirm that during any “waiver period” the borrower is not permitted to disburse any funds to its equity owners. That prohibition may include not only income generated directly from operations but also any business interruption insurance and any funds obtained through any of the government grants/loans.
  • In certain instances, require that the borrower make a claim under its property insurance policy relating to the current COVID-19 health crises.
  • In certain instances, require that the borrower seek to obtain any available government grants/loans.
  • Obtain interim financial reporting on both the borrower and guarantor.
  • Obtain additional recourse.
  • Add an interest rate floor.
  • Provide a waiver of the automatic stay in bankruptcy. (Courts have not taken a uniform approach when determining whether pre-bankruptcy waivers of the automatic stay are enforceable; however, courts are more likely to enforce pre-bankruptcy stay waivers that are included as part of forbearance agreements as opposed to the original loan documentation.  See, eg, In re Bryan Road, LLC, 382 B.R. 844, 849 (Bankr. S.D. Fla. 2008); In re DB Capital Holdings, LLC,454 B.R. 804, 816 (Bankr. D. Colo. 2011)).
Step four
The borrower may need to confirm that the modification does not yield unwanted tax consequences.  For example, if the modification includes a reduction of principal, that reduction could result in cancellation of indebtedness income unless the transaction falls under certain enumerated exceptions under Section 108 of the Internal Revenue Code (eg, insolvency, bankruptcy and qualified real property indebtedness exceptions). In addition, if the modification is deemed to be a “significant modification” under Section 1001 of the Internal Revenue Code, the transaction  will be treated as an exchange of debt instruments which could result in a taxable transaction.  Furthermore, if as part of a “significant modification” the interest rate is reduced below the Applicable Federal Rate there may be deemed to be a reduction in principal resulting in the cancellation of indebtedness (and thus, taxable income) under Code Sections 1271 through 1275 (the Code Sections governing original issue discount).
Step five
Repeat. We really do not know how long the market disruption will last. Accordingly, the above steps may have to be repeated.  We “extended and pretended” our way out of the 2008 recession. We may have to do that again here.  Maintaining a decent relationship with the borrowers will prove important because climbing out of this may not be easy and the more we keep lines of communication open, the better off the outcomes will be in the long run. 

One aspect of this downturn different from prior downturns is that there is actually a lot of capital on the sidelines.  Selling loans to debt funds and/or opportunity funds (many currently exist, others are being formed as we type) may afford lenders an exit out of troubled loans if they are not willing or able to ride it out.
If you have any questions regarding these new requirements and their implications, please contact any member of DLA Piper’s Real Estate group or your DLA Piper relationship attorney.

Please visit our Coronavirus Resource Center and subscribe to our mailing list to receive alerts, webinar invitations and other publications to help you navigate this challenging time.

This information does not, and is not intended to, constitute legal advice.  All information, content, and materials are for general informational purposes only.  No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.