by Beverly Weiss Manne, Michael A. Shiner
A business faces many challenges when a restructuring is necessary. Even in the absence of payment or other loan covenant defaults, a business’s lender may increase scrutiny of a credit if it sees negative trends for an industry, a downturn in earnings, an increase in expenses, or other negative financial events.
In such instances, a lender and borrower usually negotiate and execute a forbearance agreement. This article addresses these agreements from a lender’s perspective.
A forbearance agreement, also known as a “standstill agreement” or an “agreement regarding loans,” is a contract that obligates a lender to refrain from enforcing existing or anticipated defaults for a short time period in consideration of new agreements by a borrower. During a forbearance or standstill period, the borrower cures defaults, improves performance, or exits its relationship with the lender. The lender does not waive defaults during the standstill and may enforce them and its rights and remedies at the conclusion of the forbearance term.
A number of considerations determine whether a forbearance agreement is necessary or appropriate:
Defaults. The severity and type of default are critical. Also at issue is whether defaults evidence a continued decline in the credit or are one in a string of defaults. Some defaults can be addressed through an amendment to the loan documents and waiver. However, if a monetary default is involved, a lender is unlikely to agree to a waiver and amendment.
Ongoing and repeat financial covenant defaults that have been the subject of prior waivers are likely to trigger stronger action. Covenant breaches likely to precipitate lender action include fixed-charge coverage ratio violations, tax liens, and collateral coverage issues.
Lender Confidence. In the absence of a default, the pending maturity of a line of credit may be the impetus for a forbearance agreement that clearly sets forth that a borrower is to seek financing elsewhere. In that case, a lender that lacks confidence in the borrower and is interested in exiting the credit but not in liquidating assets to achieve repayment will view a forbearance agreement as the cleanest path to exit.
A forbearance agreement is often a more attractive option for a lender than obtaining judgment and liquidating because:
- Assets securing the indebtedness are relatively illiquid and enforcement of the loan through liquidation of the assets would create a loss.
- Deficiencies in loan documentation or collateral coverage exist that can be corrected while giving the borrower time to effectuate a turnaround or obtain alternative financing.
- A lender can preserve defaults if a borrower continues on a downward trend and cannot exit in a timely manner.
- The “doctrine of merger” impairs the ability to amend and restructure the indebtedness. Under this doctrine the underlying note obligation merges into the judgment and the judgment becomes the evidence of the obligation.
- A lender can obtain extra fee income.
However, complications arise to entering a forbearance agreement versus amending loan documents. These include:
- No event of default has yet occurred.
- A lender may want to retain the relationship but needs for the borrower to reverse negative trends.
- A borrower needs continued advances, often for amounts in excess of the existing borrowing base formulas.
- The timeframe for repayment or exit may require a long-term strategy (more than one year).
- The credit has lending participants, some of which have different agendas than that of agent lender.
Negotiating the Agreement
Once it is agreed that a forbearance agreement is appropriate, the parties can proceed in different ways. First, they simply may negotiate terms, document the deal, and sign the agreement. If the parties cannot reach an agreement, they may proceed to litigation and liquidation or bankruptcy.
In such instances, however, a lender will want written acknowledgement before drafting begins that until a written agreement is reached, it is under no obligation to forbear and the mere entry into forbearance negotiations is not a waiver of rights, remedies, or defaults. Alternatively, a lender and borrower might execute a pre-negotiation agreement setting out:
- The parties’ identities.
- The nature of the default.
- An agreement to negotiate in good faith.
- A good faith fee to be paid in advance of execution of the forbearance agreement.
- Likely terms to be included in the agreement.
- Maintenance of the status quo — i.e., a de facto forbearance, pending conclusion of negotiations.
- Acknowledgement that all loan documents are unchanged and no defaults are waived, and the parties mutually reserve all rights (i.e., defaults and defenses).
- A reminder that the negotiation letter is not an agreement to forbear and that notwithstanding any discussions or the reaching of any unwritten or preliminary understandings, the lender may determine not to undertake further discussions or may terminate discussions at any time and for any reason whatsoever without prior notice to any obligor and without liability.
While an agreement must be tailored to the specifics of the transaction, the following is a non-exhaustive list of terms to include:
Recitals. These provide a good place to summarize the transactions between a lender and borrower and:
- Identify all obligors (borrowers, guarantors, pledgors of collateral).
- Identify loan documents and security documents.
- Describe existing collateral.
- List judgments and any material litigation.
- List defaults.
- Detail the amount of bank debt, including fees and professional fees.
Standstill Period, Termination Date. The standstill period and a termination or expiration date, until which the lender will forbear from enforcing the defaults, should be specified. The termination date provision can provide for an automatic extension upon the occurrence of a particular event, such as an executed commitment letter or asset purchase agreement. The period typically is less than a year.
Forbearance Fee. A forbearance fee generally amounts to 0.25 to 2 percent of balances. This may seem counterintuitive when a borrower is already facing cash shortages, but it constitutes consideration for the lender not to enforce its rights and remedies immediately. The fee should be reasonable relative to the transaction so that it is not be viewed as a penalty or as “unconscionable.”1 The fee, even if paid in installments or on the termination date, will be “fully earned” as of the execution of the agreement. If a borrower performs at certain levels or repays the obligations early or prepays at specified times and levels, a lender may waive all or any part of the fee, which can be a powerful incentive for a borrower to get its refinancing finalized.2
Confirm Collateralization, Fix Deficiencies. Obligors should ratify their obligations under the various loan and collateral documents and confirm the validity and extent of their obligations to lender. If a deficiency exists in the documents or collateral, provisions should be included for new or additional documents to be executed or collateral to be pledged. A borrower may not realize the documentation or collateral deficiencies exist. When a “collateral fix” is included, the termination date should be at least 90 days out — the time required to “preference-proof” the “fixed” liens.
Language should be included to reaffirm, re-grant, or grant new liens and mortgages, as well as an authorization for the lender to file one or more initial financing statements and amendments. If it is not already included in the loan documents, a power of attorney should be added to authorize the lender to take actions as agent and attorney in fact for the borrower to effectuate the purposes of the forbearance and loan agreements.
Scope of Forbearance by the Lender. Exactly what the lender will not do during the standstill period should be specified: accelerate, discontinue lending, notify account debtors to pay, enter judgment, or execute on any judgment. Similarly, what a lender may do also should be detailed: act to perfect or protect collateral, defend against actions by third parties, and pursue non-party obligors.
Interest Rates. A forbearance agreement is a good a time to increase the interest rate. Again, the issue of the borrower’s ability to afford additional interest when it is facing a cash crunch may arise. However, if the goal is to require the borrower to exit the relationship, it behooves the lender not to make it too comfortable or inexpensive for the borrower to encourage the borrower to obtain financing elsewhere. Due to borrower’s financial deterioration, such financing is likely to be at a higher cost.
Tying the interest rate to financial covenant performance levels is also a fairly common practice. Because most notes authorize the implementation of default interest, a lender may elect to increase the interest rate to a level below the default rate as an accommodation to the borrower. The agreement will specify that upon the occurrence of a standstill or forbearance default, the default rate will apply immediately.
Payments During Standstill Period. Depending on the borrower’s circumstances, there may be a need for deferral of scheduled principal payments or for over-line advances. Installment payments that will be due during the forbearance period should be stated specifically. Rarely will a lender agree to a deferral or forgiveness of interest payments. In a multi-lender credit, all of the participants must agree to payment forgiveness or deferrals, which will complicate and possibly delay finalization of an agreement.
If the purpose of the forbearance is to enable the lender to exit the credit, it should specify that payment in full is due upon the termination date. If a line of credit is accompanied by term debt, the borrower must agree that those obligations will also be paid in full on the termination date.
Discount Payoff. A good way to incentivize a borrower to exit is to provide a discount that decreases with time — the sooner the borrower exits, the higher the discount it receives. If the agreement contains a discount, it is important to tie the discount to payment by a date or dates certain. It should be stressed that a condition precedent to the discount is full and indefeasible payment; that there is no dispute, bona fide or otherwise, about the amounts due; and that the discount offer is not an accord and satisfaction.3 It is imperative to specify that strict compliance is essential and also that time is of the essence.
The agreement should clearly provide that a condition precedent to the right to the discount is that there has been no event of default.
Refinancing or Equity Infusion. The agreement should specify that a borrower will use its best efforts to obtain refinancing or an equity infusion. The agreement can set a schedule for the borrower to obtain and accept a commitment letter and for a closing. An automatic extension of the termination date if a commitment is accepted prior to the termination date may be included. The agreement should require monthly reporting on refinancing efforts and obligate the borrower to provide a copy of any refinance offer and accepted commitments to the lender promptly. Often one of key duties of turnaround consultant is to assist an obligor in refinancing efforts.
Payment of Professional Fees, Other Expenses. The agreement should re-obligate the obligors to pay the lender’s professionals’ fees and expenses. Fees incurred while negotiating the agreement, as well as those for collection efforts prior to negotiations, should be paid on execution of the agreement.
While there is an inclination on the part of lenders and borrowers alike to resist or defer this payment, it is important to an effective process that lender’s professionals not be made stakeholders in the borrower’s performance. A properly drafted provision for attorney fees, for example, provides a valid basis in a subsequent bankruptcy proceeding for finding that the borrower had agreed to pay these fees.4
Retention of Turnaround Professionals. Lack of confidence in management or its ability to effectuate a turnaround provides the basis for including a provision requiring the borrower to hire a turnaround professional. The agreement should specify that such consultants shall cooperate and share information (including financial information) with the lender and are expressly authorized to do so. If the lender retains a turnaround professional, the agreement will obligate the borrower to pay the lender’s fees and costs.
Waiver of Defenses, Release. These are critical provisions for a lender. After all, if a lender is going to forbear from enforcing its rights, it wants a clean slate. If the obligors can preserve every defense to fight another day, the lender may choose to undertake the battle immediately rather than delay.
A release can be transactional or general. A transactional release covers the relationship, the loan documents, and all past conduct. The release must be explicit, and a lender will want it to be broad.5 It should be clearly stated that obligors have no defenses and that they waive and release every defense and also covenant to not sue. The release should run through the date of the agreement. A release of future acts is usually seen as overreaching and unenforceable.
The Indemnity. The purpose of an indemnification provision is to protect the lender from incurring any additional expenses in connection with the obligations for which the borrower is liable but could otherwise argue are not “indebtedness.” The indemnity should include language stating that it survives repayment of the indebtedness. The indemnification obligations should be included within the definition of obligations under any security document.
Forum Selection. Especially important when the borrower and lender are in different jurisdictions, the lender will want the forum dictated in the agreement. Additionally, loan documents may provide for the specific jurisdiction in a location of the predecessor lender. In the wake of bank mergers, a forbearance agreement is a good place to correct this. Indeed, a choice of law and forum selection clause need bear no relationship to where the parties actually reside or do business.
Jury Trial Waiver. The agreement should separately affirm jury trial waivers that are in existing documents and maybe even restate the waiver entirely. If the borrower is an individual or a small business, a line should be included for the obligors’ initials under the waiver. For many lenders, the jury trial waiver is a standard non-negotiable term.
Events of Default. If appropriate, the agreement should require that obligors will continue to perform all of their obligations under existing loan documents. However, the agreement should specify what events will be defaults under the forbearance agreement. The effect of a forbearance default will be a termination of the lender’s obligation to forbear, and the “renewed” right to enforce its rights and remedies immediately.
Some defaults result in automatic termination without notice. These include a bankruptcy or insolvency proceeding of the borrower (or a key obligor), a suit by any obligor against the lender, and indictment, death, or incompetency of one or more key officers. Other forbearance defaults will authorize, but not require, the lender to notify the borrower of the default and affirmatively terminate the lender’s obligations under the agreement.
Bankruptcy Provisions. A covenant that the borrower will not file bankruptcy will not be enforced. For a time, forbearance agreements unfailingly contained provisions under which a borrower consented to relief from the automatic stay in the event of bankruptcy. Issues regarding enforceability of that waiver quickly arose. While a few jurisdictions may enforce a stay waiver, most courts either ignore them or consider them simply as evidence regarding adequate protection and lack of ability to reorganize and require a lender to file a motion.
In non-recourse deals, provisions that borrower or a guarantor will become personally liable upon a bankruptcy filing or in the instance of fraud should be included. Because of issues with the ipso facto clause of Bankruptcy Code, it also is better to require a separate agreement evidencing the liability.
Liquidation Remedies. The agreement can specify that the borrower consents to the appointment of a receiver or agrees to surrender collateral or hold a voluntary auction of assets by specified dates, and most certainly in the instance of a forbearance default.
A properly drafted forbearance agreement is an important and strategic tool for a creditor to assist in getting a borrower to cure defaults and return to a normal lending relationship, or in instances in which an exit is desired, to put an exit plan in place, while preserving the lender’s rights and defaults.
1A high fee in and of itself will not cause a court to find the fee to be “unconscionable.” “The doctrine of unconscionability is “intended to prevent oppression and unfair surprise, [but] is not designed to disturb the allocation of risks due to superior bargaining power. Barclays Business Credit, Inc. v. Inter Urban Broadcasting, Inc., 1991 U.S. Dist. LEXIS 17473 (S.D.N.Y. Nov. 25, 1991) citing Glopak Corp. v. United States, 851 F.2d 334, 338 (Fed. Cir. 1986). Moreover, when businesspeople contract in a commercial setting, a presumption of conscionability arises. Id., citing Earman Oil Co. v. Burroughs Corp., 625 F.2d 1291, 1300 (5th Cir. 1980).
2 Caution may be in order here. In In re Leatherland Corp., 302 B.R. 250 (Bankr. N.D. Ohio 2003), a forbearance agreement provided that a 2 percent “success fee” would be waived if the debt was repaid. The unsecured creditors committee argued the fee was a “liquidated damages” provision, disallowable under Ohio law. That argument was accepted by the court, which disallowed the fee.
3Generally, this is not a great concern, as an accord and satisfaction requires (1) a disputed debt (2) a clear and unequivocal offer of payment in full satisfaction and (3) acceptance and retention of payment. Law v. Mackie, 95 A.2d 656 (Pa. 1953); see also UCC Section 3-311.
4See, for example, In re Ryker, 2007 U.S. App. LEXIS 17993 (3d Cir. N.J. July 26, 2007), affirming that based on a forbearance agreement, attorneys’ fees of a secured creditor would be allowed.
5Dublin by Dublin v. Shuster, 598 A.2d 1296, 1298-99 (Pa. Super. Ct. 1991), appeal denied, 617 A.2d 1274 (Pa. 1992), quoting Estate of Bodnar, 372 A.2d 746, 748 (Pa. 1977) (Courts determine the effect of a release using the ordinary meaning of its language and to cover “only such matters as can fairly be said to have been within the contemplation of the parties when the release was given.”); Vaughn v. Didizian, 648 A.2d 38, 40 (Pa. Super. Ct. 1994); also see, Winer Family Trust v. Queen, 2006 U.S. App. LEXIS 31610 (3d Cir. Pa. Dec. 22, 2006) Court upheld forbearance release and dismissed nine counts of a counterclaim, noting that under Pennsylvania law, a signed release is binding on the parties unless procured and executed by “fraud, duress, or other circumstances sufficient to invalidate the agreement.” Wastak v. Lehigh Valley Health Network, 342 F.3d 281, 295 (3d Cir. 2003).