Despite the improvement in the economy since the advent of the “Great Recession,” many businesses nevertheless continue to struggle. Accordingly, lenders are well advised to stay up to date on  “best practices” when facing a potential restructure of a troubled loan. In a series of posts, we will address a number of considerations in dealing with a post default loan situation.

Part 1. Good Faith Obligations

Every contract, whether consumer or commercial, has an implied obligation of good faith and fair dealing. The obligation stems from two sections in the Uniform Commercial Code (“UCC”), section 1-304 and section 1-201, as well as from case law.

Court decisions that address, in the context of a loan workout, the issue of whether there was a breach of the implied covenant of good faith tend to focus on whether the lender’s acts or failures to act deprived the borrower of the benefit of its contractual bargain.

In this regard, courts have typically found that good faith obligations do not, without more, supersede the express terms of the loan documents, and courts tend to allow lenders to exercise sole discretion and similar rights set forth in their loan agreements.  For example, the imposition in the sole discretion of an asset-based lender of a reserve on the availability to borrow under a borrowing base in circumstances relating to collateral value or other tangible financial concerns (such as an account debtor being in financial extremis) would likely be upheld. But imposing a reserve for no particular reason, or in an indirect attempt to “squeeze” the borrower to induce it to leave the bank may raise red flags.

Thus, generally lenders may rely on the express terms included in the loan documents when exercising remedies.  For instance, the Court in Farm Credit Services of America v. Dougan held that the mortgagee did not breach the implied covenant when it denied the mortgagors an extension, opining “[w]hen the express provisions of the loan documents required timely installment payments and no provision entitled the borrowers to extensions as a matter of right, there can be no breach of the implied covenant.” Yet, some courts have ruled unfavorably in cases where the lender’s conduct exacerbated the borrower’s situation, such as the lender failing to respond to the borrower’s inquires or delaying the borrower’s ability to pursue its rights.

As a general proposition, a lender is not required to negotiate with a defaulting borrower. “Courts have consistently recognized that unless the loan agreements themselves require the lender to restructure a loan, a lender has no legal duty to negotiate a restructure and hence does not violate its duty of good faith and fair dealing by refusing to negotiate at all and to instead enforce the remedies available to it upon the borrower’s default.”

However, a prudent lender will want to base its post-default strategy solely on the economics of the situation. The lender should take into account matters such as the nature and severity of the default, the likelihood of a successful negotiation, and the prospects for successful rehabilitation of the borrower; and generally should be willing to at least engage in discussions with the borrower.

If the lender does decide to negotiate with the borrower, while there are cases to the contrary, there is also case law that suggests that there is likely no obligation on behalf of the parties to reach an agreement. Nevertheless, the lender should avoid negotiating without actually intending to reach a resolution, and should avoid delays in responding to the borrower or being unresponsive to the borrower’s questions.

Additionally, depending on the circumstances and unless it agrees otherwise, a lender would likely be permitted to pursue the exercise of its contractual remedies while concurrently engaging in meaningful workout conversations with its borrower  (ie., the lender ordinarily should not be required to entirely forbear from pursing its rights and remedies in a default situation simply because it is amenable to participating in workout discussions). Notwithstanding, a lender could potentially create exposure if it exercises its remedies during discussions with the borrower but without genuinely intending to consummate a restructuring.

In any case, we believe that a prudent lender should insist on a pre-negotiation and/or forbearance agreement with the borrower prior to entering into substantive workout discussions. These agreements—and what we believe to be the lender’s reasonable expectations regarding their terms—will be discussed in our next post.