When a loan goes into default, a secured lender usually has a number of choices of remedies to exercise. Many professionals mistakenly think of lender remedies in terms of the two ends of the spectrum. At one end is a simple forbearance, in which a lender agrees not to exercise its remedies. At the other is a notice of foreclosure, under which a lender sells all of the collateral on the courthouse steps.
The reality is much different: lenders can take many interim steps between those two extremes. These range from mild to extreme leverage, depending on the message the lender is attempting to send, its perceived risk, and the severity of the default. Borrowers need to be familiar with these remedies to understand what message their lenders are trying to communicate and to decide how to respond appropriately to preserve their businesses. Distressed debt buyers need to be familiar with these remedies because remedies should be the subject of due diligence in a loan purchase and because the remedies also provide them with opportunities to recognize on their investments after buying loans.
Looking at remedies in order of ascending leverage by stages, what follows are typical remedies among which a lender could choose under its loan documents.
Early Stage Remedies
Early stage remedies are generally intended to get a borrower to take a default seriously, to apply pressure so that the default does not get worse, and to buy time for the lender to evaluate its options. The borrower is incentivized to find replacement financing or to work out a go-forward deal that is palatable to the lender.
Default and Reservation of Rights Letter. Many events of default ripen into full defaults without the necessity of notice. These are usually payment defaults; breaches of financial ratio covenants, such as the debt service coverage ratio; or similar breaches. Other defaults require that a lender give notice so that a borrower has an opportunity to cure them. These include nonpayment of taxes, the removal of construction liens on collateralized real estate, and the like.
It is standard practice for lenders to send a default letter outlining defaults, whether or not a notice obligation exists. Much of the time, lenders also include “reservation of rights” language in their default letter, stating that the decision not to exercise certain remedies immediately or the failure to name certain defaults is not a waiver related to those remedies or defaults.
Most loan documents contain “non-waiver” language to begin with, but in an abundance of caution, lenders also generally include such language in a default letter and make clear that no agreement or forbearance is in place. Regardless of how matter of fact a default and reservation of rights letter may be, it usually sends a strong message to the borrower’s team that the game has now changed.
Default Interest. Well-drafted loan documents usually provide that upon default, a loan’s interest rate jumps several points to a default interest rate. Lenders sometimes exercise this right to charge additional interest immediately, but at other times will reserve their right to seek payment at a default rate interest that may already be accruing. The decision is often based on whether the demand for default interest will redirect money from a borrower’s operations where it is sorely needed and, as a result, potentially impair the value of the collateral. As a practical matter, default interest usually becomes the subject of negotiation in a forbearance agreement if the parties reach a negotiated resolution.
Prohibiting Distributions to Equity, Management Affiliates, and Subordinated Debt. Many loan documents provide limitations on the ability of a borrower to make payments to equity, affiliates, and subordinated debt. When a loan goes into default, a lender often has the right to prohibit payments altogether or to review and approve such payments in advance. This creates internal pressure at the borrower because it cuts off access to potential cash needed in affiliate management agreements and to pay insiders (often for real services being provided, not just distributions). Further, subordinated debt (and especially insider debt) begins to feel the pressure as well, which helps to push the situation forward to a resolution.
Forbearance Agreement or Waiver.
Lenders generally dislike having unresolved defaulted loans on their books, and if a lender is not moving to exercise late stage remedies, then it may be amenable to a forbearance or waiver agreement that provides the borrower with an extension. The cost of such an extension to the borrower can vary but often includes a forbearance fee and a waiver of any claims against the lender. It also sometimes includes a grant of additional collateral or an agreement to a modified interest rate.
Middle Stage Remedies
Middle stage remedies apply intense pressure on borrowers and are used to send a message that problems are acute and require immediate action to appease the lender. At the same time, middle stage remedies are not necessarily end-game strategies like late stage remedies, and room for a negotiated resolution may still remain. Middle stage remedies also allow a lender to begin recovering on its loan and protecting its collateral value without having to spend significant funds and attempting to take over title to a property or business.
Acceleration of the Debt. After a default, lenders usually have the right to accelerate the debt so that all principal and interest is immediately due, instead of just the current payment on the amortization schedule. This gives a lender the right to sue for the entire debt, rather than just past-due payments. It may also entitle a lender to collect an exit fee under the loan; even though the borrower is not making a voluntary pre-payment, the loan documents provide for collection of an exit fee upon default and a decision to accelerate. Some real property leases also provide for the right to accelerate the amount owed under the lease, rather than simply to sue for each past-due payment.
Acceleration of a loan or real property lease can have a ripple effect on borrowers because such actions may result in cross-defaults on other loans with other parties or the failure to meet regulatory requirements, resulting in the loss of licenses, permits, and the like.
Filing Suit. If a lender does not want to institute foreclosure, it sometimes files a collection suit against a borrower instead. And if the loan is guaranteed, lenders — especially recently — have been opting to file suit against the guarantors instead of pursuing foreclosure in a bad real estate market. Such lawsuits pressure a company and insiders to find an exit from the credit and to comply with other demands related to repayment. A lawsuit brings additional pressure because it establishes deadlines by which the company and guarantor must respond.
Decreasing Availability. For revolving loans or lines of credit, a lender can decrease the line amount so that the borrower cannot draw as much money. This is commonly referred to as “ratcheting down” a line of credit. Post-default, most loan documents allow a lender to terminate a loan and cease funding without affecting its right to recover its collateral. In addition, lenders often have a discretionary right to determine the amount of reserves to be held in calculating availability under a line of credit. After a default, the lender may simply increase its reserve requirement, which effectively reduces the amount of the loan.
Requiring Engagement of a Financial Advisor. A common remedy lenders use is requiring a borrower to hire a professional turnaround advisor. An advisor assesses a company and recommends how management can maximize the business’ value for all stakeholders, usually by looking for ways to turn around the company to return it to profitability.
While a lender cannot force a borrower to hire a financial advisor, it often requires such a move as a condition for providing additional forbearance. To avoid allegations that it is controlling a debtor, a lender usually provides a list of three or more acceptable financial advisors from which the borrower can choose.
Sending in Auditors. Most loan documents provide lenders the right to inspect their collateral and to review the books and records of borrowers. When a default becomes acute, a lender usually sends in its own financial team to review a borrower’s financials to get a handle on the difficulties with the credit.
This team is much more substantial than the bank’s inside auditors, who typically have come in for a day or two in past years for a check-up. These auditors are usually lender employees and outside professionals, and the borrower bears the cost of their work. Such a team often produces a full report for the lender on the company’s value and the most likely way for the lender to recover its money using late stage remedies. The borrower does not receive a copy of the report.
Late Stage/Extreme Remedies
Late stage remedies are generally end-game strategies exercised by lenders and distressed debt buyers to collect on collateral. They make clear that the lender is playing for keeps and that the time for lesser solutions has passed. Negotiations may still be a possibility, but the process has accelerated so that a borrower must respond immediately with countermeasures, often Chapter 11.
Foreclosing the Collateral. Almost all secured loan documents allow the lender to sell the collateral at foreclosure to the highest bidder, including the lender exercising its option to credit bid using its debt. The procedure for foreclosure depends on the state in which the property is located and whether the property is real estate or personal property.
If a state is a “judicial foreclosure” state and the property at issue is real property, the foreclosure on the collateral must be handled through a lawsuit, which usually takes months or even years. In a “power of sale” state or if the collateral is simply personal property, a lender publishes and sends out notices of sale, and, in some jurisdictions, a foreclosure sale of real and personal property may occur 10 to 20 days later.
Seeking Appointment of a Receiver. In cases in which a lender is concerned about the cash flow from its borrower’s operation disappearing or about the quality of its borrower’s ongoing operations, a lender often files a lawsuit to have a receiver appointed for the borrower’s operations and real estate. The receiver is an independent party appointed by the court to take control and preserve the borrower’s business and operations.
The appointment also buys time for the lender so that it is not forced to foreclose on its collateral in a bad market. Instead, the lender can use the receivership to maintain the “status quo” while it waits for the market to return so the property can be sold at a higher price. The lender also can advance additional money to the receiver if necessary to protect the value of the collateral.
Setting Off Funds. If a lender holds funds owned by the borrower, such as a reserve account or certificate of deposit, or if a lender has control over bank accounts of the borrower, the lender may decide to set off the funds and apply them against the debt. This results in immediate reduction of the debt, which is helpful to the lender but strips the borrower of cash that otherwise might be used to fund operations and may very quickly force the borrower to shut down or file bankruptcy. Unless it handles a setoff carefully, a lender may damage the value of its own collateral, transforming it from a going concern to a closed institution.
Intercepting Accounts and Rents. If a lender’s collateral includes a borrower’s accounts receivable or rents produced by property, the lender usually has the right to intercept those payments by having them paid directly to the lender after default. This protects the accounts and rents to make sure that they don’t disappear. Again, however, this is an extreme remedy that may end up shutting down the borrower. A lender is more likely to seek a receiver to preserve the going concern value of the borrower’s business.
Exercising Stock Pledges. In the last 10 to 15 years, stock pledges have become a common form of credit-enhancing collateral. The borrower’s owner(s) pledge their equity, whether stock, partnership interests, or limited liability company (LLC) interests, and if the borrower defaults, the lender has the right to foreclose the equity interest and take over the ownership position in the borrower.
This is one means of disincentivizing a borrower from filing bankruptcy, because the lender can take control of the bankruptcy process by exercising the stock pledges to control the bankrupt entity (unless the owners of the stock also file bankruptcy). In addition, many equity pledges allow the lender to exercise the equity holder’s voting rights after a default, even before the lender has foreclosed the pledge. While enforceability is sometimes an issue in such cases, if it is successful, a lender may be able to prevent the owners from voting in favor of a bankruptcy filing.
Repossessing Collateral. Secured creditors (and equipment lessors) usually have the right to repossess their collateral — especially personal property — often in advance of a foreclosure sale. This is done either through self-help, when a lender requests that the borrower assemble the collateral for pick-up (assuming the borrower complies), or by judicial fiat after the lender files a lawsuit seeking possession of its collateral. Such requests are usually heard on an expedited basis within a few weeks.
Entering and Taking Control. Most secured loan documents provide that a lender can enter the borrower’s property and take control of the borrower’s operations. As a practical matter, lenders rarely exercise this self-help remedy for two reasons: borrowers are not compliant, and, more importantly, the lender would take huge risks involving lender liability, especially to third parties, if it decided to run the operations.
Involuntary Bankruptcy. Creditors have the right to put a company that is not paying its debts when due into an involuntary bankruptcy proceeding. This right belongs to unsecured creditors or secured creditors whose collateral is worth significantly less than their debt. Practically speaking, the usual purpose of an involuntary bankruptcy is to prevent and/or recover preferences paid by the borrower to some parties and not others. As a result, the “have-nots” usually initiate involuntary bankruptcy filings. Because they are rarely “have-nots,” secured creditors are much more likely to pursue receivership than an involuntary bankruptcy.
Selling the Loan.
Especially in the current economic climate, lenders often simply say “enough” and, rather than work out the loan, sell it to a fund at a discount. Distressed debt buyers, having expended significant money to purchase an underperforming loan, usually have little patience for long-term repayment. Instead, the buyer expects a quick return on investment and therefore demands that the borrower to pay the face amount of the note or turn over the collateral. As a result, the sale of a loan to a distressed debt buyer is a third-stage extreme remedy that borrowers often fear greatly.
Delay Can Be Costly
When it comes to default remedies under secured loan documents, it is important for borrowers to focus on the message that their lenders are sending by the choice of remedies they choose to employ. Early intervention is the key to a successful exit and return to profitability. A borrower that delays is likely to see a lender’s response move quickly from early to middle to late stage remedies—with increasingly severe impacts.
 Note that this is slightly different from a lender reviewing and approving all payments made by a borrower in its business, which is often a basis of lender liability claims. Here, the lender is reviewing and approving insider payments for legitimacy and prohibiting payments that are specifically outlined in the loan documents, such as to subordinated debt.