Using forbearance agreements in the ‘new normal’
Among the victims claimed by the global coronavirus pandemic was the record-long U.S. economic expansion. While the effects of COVID-19-related business interruptions have been more or less severe depending on industry and location, most enterprises will see operational impacts that will affect revenue.
The banking industry moved quickly in March and April to provide relief to borrowers affected by the economic downturn. Many, if not all, of these actions were short term and aimed at stabilizing the financial system and “Main Street” economy. As the crisis has evolved, however, it is becoming clear that these actions, while helpful, will not save many businesses from financial distress over the longer term. Servicing debt and staying in compliance with loan agreements will be a challenge, and a further restructuring of debt may not be a realistic option.
The role of forbearance agreements
It is helpful to think of forbearance as a process covering a specific time period where both a lender and borrower have something to gain. Forbearance often involves lender/borrower relationships that are long-standing or where the borrower has a reasonable chance of emerging from financial distress and being able to service its debt in the not-so-distant future.
Regardless of which party requests a forbearance period, the starting point is an acknowledgement by the borrower of a default, which then should initiate a discussion about the terms of the forbearance period. A forbearance fundamentally changes the old credit relationship and should be seen as an essentially new legal relationship that requires new documentation.
For borrowers, this process is mainly to provide time for the business to return to health. For lenders, there are many goals a forbearance can address, such as:
- Remedying deficient documents concerning the loan at risk
- Addressing intercreditor issues that may have arisen since the loan was first extended
- Maintaining the customer relationship and contributing meaningfully to the customer’s ability to operate its business
Establishing common ground
In restaging the lending relationship, it is important to establish common ground between lender and borrower.
From the outset, the agreement should contain an acknowledgement and affirmation of the outstanding debt. This should be itemized, displaying both principal and interest, as well as the applicable post-default rate of interest and applicable fees. Lenders will also want borrowers to acknowledge the lenders’ legal rights relating to the default. Any dispute regarding monies owed should be clarified in detail.
Lenders almost never intend to waive rights and remedies when entering the forbearance process. Forbearance agreements should explicitly state that the lender retains all rights, that no amount of debt is being waived, and that any new loans in no way alters this basic understanding.
It is also important to use forbearance agreements as a tool to clarify issues of priority. A lender will often seek the borrower’s acknowledgement and affirmation of the liens and security interests implicated by the loan agreement.
Common terms and conditions
While every forbearance agreement documents a unique situation and should be customized based on the specifics of the lender/borrower relationship, some issues should be addressed in all agreements. This list includes:
- Setting forth a specific period of time for the forbearance to establish a solid framework around which performance expectations can be communicated and managed
- Stating explicitly that the lender will forbear remedies regarding only the defaults listed and described in the agreement
- Reassessing existing loan terms and covenants, especially maturity dates, payment dates, amortization levels and financial reporting frequency and processes
- Making sure the borrower has the authority to enter into the agreement and/or amend existing loan documentation
- Reassessing whether the loan is properly collateralized or if the loan requires a greater security interest
Thinking ahead to possible bankruptcy
While no lender wants to see its borrowers go bankrupt, it is almost a certainty that we will experience a significant increase in filings during 2020. When entering the forbearance process, there are steps lenders can take – even if only at the strategic level – to improve their position in the event of a borrower bankruptcy.
First and foremost, consider the implications of potential preference claims and think through the timing and circumstances around loan payments and/or default remedies, given the 90-day period prior to bankruptcy filings where such payments could become the subject of a claw-back action.
Additionally, lenders might consider including an exclusion to the automatic stay within the forbearance agreement. This provision would ultimately have to be approved by the bankruptcy court, but it can’t hurt to establish such a provision as a part of the agreement and the common understanding of the lender and borrower.