Publications & Resources
January/February 2010
Managing Troubled Assets
Building a Solid Forbearance Arrangement
By Pamela J. Martinson
The typical first step of a borrower confronted with a default is to ask for more time, but time alone may not be the answer to the problems the borrower faces in repaying the loan. Lenders should not agree to an extension of time alone without a thoughtful analysis of the borrower’s situation and the lender’s goals. A forbearance is the first step in a workout of a troubled credit and not a mere delay in the exercise of remedies. Building a solid forbearance arrangement requires effort from both borrower and lender to realistically address the facts and circumstances preventing repayment.
The forbearance agreement is the written record of the relationship reflecting what has happened, what will change, and when and how the intended result will occur. The first step to a successful workout begins with an analysis of the lender’s ultimate goal for the credit. If the lender wishes to exit the credit, the forbearance will set a time for this to be accomplished, and the specific steps (e.g. a term sheet and then a commitment letter from another lender) required. If the lender needs more information to decide whether to pursue a strategy of workout or foreclosure, the forbearance will focus on improving reporting, creating financial models, and perhaps require hiring a financial advisor or accounting firm. If the lender believes that a bankruptcy of the borrower is inevitable, the forbearance may focus on obtaining the borrower’s advance cooperation in a liquidation or foreclosure.
The lender is under no obligation to offer a forbearance or workout proposal to the borrower. The loan documents should give the lender the right to foreclose on the collateral and pursue all rights and remedies available at law or equity. However, voluntary repayment is preferable to a forced sale of collateral. Updated appraisals of collateral will be obtained to establish potential recovery if existing valuations are dated, or circumstances affecting collateral value have changed in any significant way. Representations made at origination concerning the type and location of collateral will be updated to allow consideration of adding previously unencumbered assets, deposit account control agreements, landlord or bailee waivers or guarantors. If the lender’s best chance of full recovery is through continued operation of the business rather than liquidation, it will be amenable to working with the borrower for some additional time.
A complete file review assesses and corrects any lapses in documentation, including controls, covenants and reporting that may have been overlooked or not considered necessary at origination. In exchange for the agreement to forbear from exercise of remedies and to modify terms of the loan, the lender may be able to get back some of the points it gave to the borrower in the original negotiation, which are helpful if the borrower’s issues are not resolved during the forbearance period, and a foreclosure or other exercise of remedies becomes necessary.
A well-drafted forbearance agreement includes an acknowledgement of all existing defaults. The borrower should admit to the defaults and the rights and remedies of the lender under the loan documents so that consideration is established for changes in security and loan terms. Further, the default listing highlights the problems that led to the forbearance, opening the door to a discussion of solutions. If the borrower is chronically late delivering the required financial reports, or unable to provide them at all, the forbearance might include a requirement to engage a financial advisor or systems consultant. If cash shortages are common, the possibility of additional equity might be addressed. Covenants restricting the flow of funds to shareholders, partners or sponsors for a period may be included also. A history of misapplication of funds may be solved with a lockbox or blocked account arrangement where collections are applied immediately to the outstanding balance of the loan. The structure of the forbearance is driven by what is required to give assurance to the lender that a delay in exercising its remedies will not alter the status quo, except for the better.
The borrower must present, or be helped to create, a viable plan for repayment to serve as the foundation of the forbearance. Without this, any forbearance would be, at best, nothing more than a delay of the inevitable, and at worst, a delay that results in loss due to wasting of assets or lost opportunities. If the borrower cannot articulate the steps it will take to meet its obligations to the lender, it is unlikely that the forbearance will offer any real solution. A forbearance is not just a time-out, but a tool to improve the lender’s recovery.
Pamela J. Martinson is a partner in the Silicon Valley office of Bingham McCutchen LLP. She can be reached at pam.martinson@bingham.com.
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