In the current cycle, asset quality remains strong at most institutions. There are occasional exceptions — a poorly managed business, a hurricane or other unexpected event, etc. — but for the most part, banks and other lenders have strong portfolios.

This, of course, will not last forever. Interest rates have risen in the last few years. Certain sectors, including office and retail, have faced headwinds as technology has fueled a rise in remote work and remote shopping.

It is prudent to plan for the next downturn. The following are some key considerations in dealing with troubled assets.

1. AN ENFORCEABLE WORKOUT IS A GOOD SOLUTION

As in most areas of the law, a settlement is better than litigation. If it is possible to structure a forbearance agreement to allow the borrower to come back into compliance with the loan obligations, that often is the best solution.

It is best to build in some protections for the lender, if possible under the circumstances. A forbearance agreement without some “teeth” often results in simply kicking the can down the road — delaying the default rather than remedying the situation.

If possible, the borrower should concede, in the forbearance agreement, the necessary elements the lender otherwise would have to prove in a court case to enforce its loan documents. In exchange for the lender’s forbearance, the borrower should concede that the loan is in default, the specific payments missed or other violations, the amount due, and that the borrower has no defense to payment. The borrower should concede that if it fails to abide by the terms of the forbearance agreement, the lender is entitled to a judgment against it in court in a specified amount. The borrower should concede that if it files for bankruptcy protection, it will, within the bounds of applicable bankruptcy law, cooperate with the lender’s efforts to lift any bankruptcy stay to pursue collateral. 

2. DO YOU WANT THE COLLATERAL?

Another key consideration is the quality of the collateral. Real estate or other collateral for which there is a ready market at a good price of course is best, but not all loans have such collateral. Some real estate and other collateral can be difficult to manage and dispose.

The lender is not required to pursue the collateral, absent unusual provisions rarely contained in standard loan documents. A serious consideration whether to pursue the collateral, and what the lender intends to do with it if it forecloses, should be made at the outset.

Many loan documents provide for the appointment of a receiver as one of the lender’s remedies. A receiver is an officer appointed by a court to manage property until the lender is able to foreclose on it or the borrower is able to settle. For certain properties — office, retail, and multifamily in particular — a receiver can be a good option in some circumstances. The receiver takes control of the property, books, and records; pays the bills and operates the property; and in some circumstances is able to market it and bring potential buyers to the court for approval. A receiver can be a good option when a lender needs to have collateral managed and marketed appropriately without having to take title itself. The lender should bear in mind that while the receiver has control of the property, the lender will likely incur expenses. The receiver’s fee will have to be paid, as will the property’s operating expenses. To the extent that the property does not generate sufficient income to do this, the shortfall often must be covered by the lender until the property is sold. While any such advances usually can be added to the loan balance, they may not ultimately be recoverable. 

3. IF YOU GET A MONETARY JUDGMENT, WHAT THEN?

The usual remedy to recover on a defaulted loan, of course, is to sue the borrower for the amount owed. Most such cases are straightforward. Assuming the lender can prove that it owns the loan, that the loan is in default, and what amount is due, the cases usually result in a judgment for the lender. While, in some circumstances, there can be lender liability issues to consider, most often the resolution is in the lender’s favor.

This, however, is only the beginning. A judgment is simply a piece of paper stating that the borrower owes a certain sum to the lender. It does not guarantee collection.

A survey of the borrower’s assets, beyond any pledged collateral, is an important first step. Does the borrower own real estate in its own name? A lender’s monetary judgment can become a lien on that property. Are there other liens that would be senior in time to the lender’s judgment? Is there enough remaining equity to make a levy upon the real estate worth it? The same analysis would apply with respect to personal property.

OTHER CONSIDERATIONS

Be ready for bankruptcy. Good bankruptcy counsel can guide a lender to the best resolution if a debtor files a bankruptcy petition.

Remember that there can be a market for your loan documents and for your monetary judgments. Private equity funds exist that will purchase your paper. An important protection to build into any sale of your paper is that the purchaser indemnifies and holds the lender harmless from any lender liability claims.