Given the severe economic impact of the coronavirus pandemic, lenders across the country are facing, and will continue to face, increasingly difficult decisions regarding borrowers that cannot make payments or fulfill financial covenants because their revenue has dramatically decreased. In recognition of the national financial crisis arising from the fight against COVID-19, the Board of Governors of the Federal Reserve, the Federal Deposit Insurance Corporation and several other federal regulatory agencies issued an Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus, encouraging lenders to work with borrowers that are unable to meet their contractual payment or other obligations and to mitigate the adverse impact on borrowers due to COVID-19. The Interagency Statement indicated that the agencies would not criticize institutions for working with borrowers and would not automatically categorize all COVID-19 related loan modifications as troubled debt restructurings (TDRs). See Manatt COVID-19 Update.
Importantly, although the Interagency Statement did not set precise parameters, it indicated that this relief for financial institutions would be available where a lender’s actions are prudent, consistent with safe and sound practices, and constitute short-term modifications (e.g., less than six months) that can be characterized as “insignificant,” such as short-term payment deferrals, fee waivers, extensions of repayment terms or other delays that are insignificant under Accounting Standards Codification (ASC) Subtopic 310-40. The Interagency Statement also indicates that the federal agencies issuing the statement have confirmed such accounting treatment with the Financial Standards Accounting Board. Subsequently, the Senate passed the $2 trillion coronavirus relief bill known as the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which includes substantial further relief for financial institutions related to TDRs, including a suspension of the U.S. generally accepted accounting principle rules that would otherwise apply to TDRs. After the final bill is passed and the accounting authorities have commented on these provisions, Manatt will provide an update on the CARES Act.
Thus, as lenders take proactive steps to engage with their borrowers and help their communities while mitigating credit risk, lenders should also proactively obtain the legal, accounting and industry-specific advice that is necessary to make prudent decisions consistent with safe and sound banking practices and to remember key lessons learned during prior economic downturns.
Below, we identify ten initial steps that lenders can and should take to address the new risks to their assets.
1. Proactively Review Loans. Include not only loans previously identified as involving material risks, but also loans made to businesses in the numerous industries that have been heavily impacted by COVID-19, such as real estate, oil and gas, tourism, travel, restaurants, entertainment, and retail. Determine whether and to what extent the current business slowdown will impact the borrower’s ability to continue to perform under the loan and the length of the likely impact. This could include triggering rights in the loan documents to obtain updated financial information and determining whether the borrower is likely to receive material financial assistance due to the recently enacted economic stimulus measures. Based on this information, lenders should establish a proactive plan to preserve asset value and ensure that they have the necessary expertise to make safe, sound and prudent credit decisions.
2. Consider Force Majeure and Related Defenses. Determine whether the COVID-19 pandemic establishes a defense—such as force majeure, impossibility, impracticality or frustration of purpose—to enforcement of the loan or guaranties. While many loan documents do not exhaustively address the issue of force majeure events, or those situations that are unforeseen or unavoidable and beyond the reasonable control of both parties, they often have some form of force majeure provisions. The impact of such provisions will likely depend on the specific facts-and-circumstances analysis and specific provisions of the loan documents. Without specific force majeure language directed to the circumstances we currently face, there is no bright-line test delineating when a force majeure provision may be triggered. The more directly a loan provision refers to a pandemic or the related circumstances, such as new regulations that force closure of businesses or require employees to work at home, the stronger the borrower’s claim for protection may be. Lenders may decide to accommodate a borrower’s request for an extension of time or may proactively work with the borrower to forbear from enforcing certain loan provisions. However, such actions should be taken carefully, be documented in writing, and constitute safe, sound and prudent lending practices.
3. Consider the Interagency Statement on Loan Modifications and the CARES Act. If a lender is considering making concessions—including a temporary modification or waiver of loan provisions—the lender should first consider limiting relief to loan modifications that would fit within the provisions of the Interagency Statement discussed above and the potentially broader provisions of the CARES Act (if passed). The reasons for the modification should be documented to establish the lender has acted prudently and the modification should be properly documented in a writing signed by the borrower and all guarantors.
4. Identify and Address Existing Defects in Loan Documents. In connection with any modification or concession, lenders should scour the existing loan documentation to identify any defects that can be fixed, such as unexecuted loan agreements and modifications, unexecuted personal guaranties, incorrect or incomplete descriptions of security, incomplete perfection of security interests, and any prior waivers or modifications that were not properly documented. Also, the lender should consider obtaining a release of any liability and a reaffirmation of the borrower’s obligations in connection with any loan modification. While the federal regulators have encouraged financial institutions to proactively work with borrowers to prudently modify loans or otherwise make accommodations in light of the coronavirus-related financial crisis, the regulators have not immunized banks from potential liability or increased risks from doing so.
5. Avoid Lender Liability Claims. In connection with enforcement or modification of a loan, lenders should be careful to avoid any actions that could give rise to lender liability claims, such as effectively making business decisions for a borrower, mandating specific borrower actions, sharing in profits, and otherwise taking actions or structuring the relationship in a manner that falls outside the traditional role of creditors and could be deemed more akin to a joint venture.
6. Take Steps to Preserve Collateral. In some cases, lenders must make the difficult decision to take actions to preserve pledged collateral because the borrower is not likely to be able to repay the loan. In that case, lenders should consider all available actions to preserve collateral. This could include seeking a temporary restraining order and/or the appointment of a receiver to protect collateral and/or to collect rents, as this will avoid lender liability claims. Generally speaking, such relief is appropriate (a) where collateral is in danger of being lost, removed or damaged; (b) where a loan obligation is not being performed and the collateral is insufficient to satisfy the debt; (c) to obtain performance of an assignment of rents; and (d) where necessary to preserve the collateral or rights of the lender. A receiver can be particularly important when the collateral is an ongoing business or assets such as intellectual property or inventory that are legally complex and/or subject to theft, removal or sales in which the lender may not be repaid. Given court closures due to COVID-19, lenders should determine whether it is possible to obtain appointment of a receiver. Where this may not be possible, lenders may be able to obtain a temporary restraining order preserving the status quo.
7. Consider Nonjudicial and Judicial Foreclosures. If the collateral is real property or real property is a portion of the collateral for the loan, lenders should consider whether to proceed with nonjudicial or judicial foreclosure of a defaulted trust deed. While nonjudicial foreclosure is quicker and less costly, the lender pursuing this remedy waives the right to obtain a deficiency judgment against the borrower. If the value of the collateral is insufficient to satisfy the debt, consider proceeding with a judicial foreclosure to conclusion and obtaining a deficiency judgment. However, as noted below, it is essential to determine whether there are applicable state laws that impact the lender’s choice of remedies. In addition, lenders should determine whether any of the recently enacted local, state or federal laws impact their right to foreclose on collateral.
8. Consider Applicable State Laws. Lenders should focus on applicable state laws, such as California’s one form of action rule. Determine the state law applicable to the loan based on contractual choice of law clauses as well as the location of collateral, and be mindful of limitations on legal action. For example, under California’s one form of action rule, the lender must seek to foreclose on real property collateral prior to taking any other action against the borrower (including freezing or setting off against bank accounts) or pursuing the borrower’s property not given as collateral through prejudgment attachment. Failure to carefully follow this rule can result in loss of a lien on the real property collateral.
9. Consider Pursuing Guarantors of the Loan. Doing so can put considerable pressure on the principals of the borrower to perform and/or satisfy the lender in order to avoid recovery from the guarantors directly. Moreover, state laws protecting the borrower do not require the lender to pursue the borrower or collateral before seeking payment from guarantors.
10. Consider Bankruptcy Implications. Finally, take the possibility of bankruptcy into account. Often, the actions taken, or not taken, by lenders prior to the filing of a bankruptcy petition can have serious implications in a future bankruptcy. For example, where a payment is made to the lender within 90 days of a bankruptcy filing, the payment may be deemed a preferential payment that can be recovered by the bankruptcy trustee. Moreover, in some circumstances, a lender may find it useful to force an insolvent borrower into bankruptcy involuntarily, such as where the borrower makes a preferential payment to a third party, to the lender’s detriment.