In this Issue: Banking and Financial Transactions

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1 In this Issue: Banking and Financial Transactions FEATURES Sweeping Federal Financial Reform Legislation Overhauls the U.S. Financial System 5 by Audrey D. Wisotsky and David W. Freese There s a New Kid on the Block: What You Need to Know About the Bureau of Consumer Financial Protection 10 by Robert M. Jaworski Federal Financial Reform Legislation Bureau of Consumer Financial Protection New Jersey s Foreclosure Mediation Program Lending to Minority- and Woman-Owned Businesses Business Banking Outlook for New Jersey Also in this issue Lawyers Bookshelf Law Office Management Mortgage Finance in New Jersey A Regulatory Perspective 15 by E. Robert Levy Primer on New Jersey s Foreclosure Mediation Program 19 by Caroline M. Petrilla-Sagnip Servicing of Residential Mortgage Loans in Securitization Transactions 24 by Jonathan Wishnia Minority Rules: Lending to Minority- and Woman-Owned Businesses 28 by Michael J. Lubben Representing the Borrower in Commercial Real Estate Loan Financing 32 by Charles E. Reuther Counsel to Counsel: What to do When the Bank Comes Knocking at Your Door 36 by Timothy Duggan Negotiating Credit Documentation From the Borrower s and Lender s Perspective: A Meeting of the Minds 39 by Peter R. Herman Pre-Workout Considerations and Strategies of Borrowers/Lenders 46 by Thomas M. Scuderi Look Into the Crystal Ball: The Business Banking Outlook for New Jersey 51 by Stuart Hoberman and Susan Storch DEPARTMENTS PRESIDENT S PERSPECTIVE 2 MESSAGE FROM THE SPECIAL EDITORS 3 LAW OFFICE MANAGEMENT: Improving Intake Procedures 56 by Tim O Connell LAWYERS BOOKSHELF 58

2 Pre-Workout Considerations and Strategies of Borrowers/Lenders by Thomas M. Scuderi The combination of a depressed economy and significantly reduced property values has forced many commercial loans into a state of distress. A loan typically becomes troubled upon the borrower failing to comply with the payment provisions or the covenants contained in the loan documents. A lender utilizes covenants for the purpose of monitoring the status of the borrower, the guarantors and/or the security for the loan. Covenants provide the lender with recourse when a change in financial condition of the parties or the value of the security falls below certain predetermined ratios or values. The most frequently employed covenants are minimum loan-to-value ratios, debt service coverage ratios, minimum net worth covenants and occupancy ratios. When faced with a distressed loan, lenders, borrowers and their counsel should carefully analyze the dynamics of the loan, the security and the various available remedies prior to taking action. This article presents an overview of the pre-workout process and the considerations that should be carefully examined by lenders and borrowers when faced with a distressed loan. Initial Considerations In order to determine whether a workout is worthwhile, each party to the loan should weigh the advantages and disadvantages of a workout verses the other available alternatives, including but not limited to litigation and a bankruptcy filing by the borrower. Whichever alternative may be initially preferred, each party should conduct its own due diligence to determine the respective strengths, weaknesses and bargaining positions of the parties prior to deciding how to proceed. Due Diligence The first step in any effective workout negotiation starts with the completion of thorough due diligence by the parties. No party to the process can make an informed decision without being armed with accurate and up-to-date information relating to the parties, the security and the relevant market conditions. Generally, due diligence is comprised of a comprehensive review of the loan documentation, the collateral, the financial condition of the parties and the relevant market conditions. The loan documents should be carefully analyzed to determine whether they contain any defects or weaknesses. This review may reveal deficiencies such as a missing document, a defective document, or even a problem with the perfection of the security for the loan. Each party will want to identify the existence of such defects to establish the negotiating strengths and weaknesses of the parties involved in the workout process. For example, a borrower may use the knowledge of a defect as leverage in the negotiations, especially if it would seriously damage the lender s ability to enforce the loan or foreclose upon the security. The lender, on the other hand, will undoubtedly seek to correct the deficiencies in any of the loan documents in connection with any negotiated workout or forbearance. A review of the collateral involves a determination of its market value and marketability. Market values are typically determined through an appraisal prepared by a qualified third party. The appraised value of the collateral will be an important factor in determining whether, and to what extent, the lender is over or under collateralized. This determination will be crucial in both a voluntary workout negotiation and in a bankruptcy proceeding. The financial condition of the relevant parties must also be reviewed carefully. A material change in financial circumstances of any of the relevant parties may have a significant impact on any workout negotiation. If the loan is a recourse loan, the value of the guarantees will likely be a critical factor in the workout negotiations. For example, if one or more of the guarantors maintain a considerable liquid net worth, the lender may be less motivated to negotiate with the borrower, believing the guarantor can always make the lender whole. The positive liquidity of a guarantor, however, could also provide a lender 46 NEW JERSEY LAWYER October 2010

3 with the comfort level to proceed with a workout negotiation. On the other hand, if the credit of a guarantor has dropped significantly, such as where a creditor has obtained a significant judgment against the guarantor or the guarantor has recently filed a bankruptcy, the lender may be more inclined to work with the borrower during workout negotiations. Litigation After the due diligence is completed, the parties will be in a better position to address their respective strengths and weaknesses in any litigation seeking to enforce the loan documents. Defects in the loan documents may severely weaken the lender s collection efforts against the borrower, the guarantors and/or the security for the loan. Equally problematic for the lender is a reduction in the market value of the security, or the diminished financial condition of either the borrower or any of the guarantors. On the other hand, a lender may take their chances in litigation rather than agreeing to a workout if confident that the financial condition of the borrower, the guarantors and/or the value of the security significantly exceeds the loan balance. Determining the expected result of litigation will be invaluable to the parties in negotiating any voluntary outof-court workout agreement. Bankruptcy A competently negotiated and drafted workout agreement will undoubtedly take into consideration the effect of a Chapter 11 bankruptcy filing, and the likelihood that the borrower will be able to confirm a plan of reorganization. Another important bankruptcy consideration is whether the lender will be able to obtain relief from the automatic stay that prevents the lender from commencing or continuing its state court collection and foreclosure remedies against the debtor. 1 The value of the collateral is a critical determination in any bankruptcy filing. If a lender is over-secured in the collateral, it will be entitled to post-petition fees, costs, or charges provided in the loan documents, and to post-petition interest during the pendency of the bankruptcy proceeding. 2 Another important factor is whether the lender is adequately protected by the collateral that can either be satisfied with adequate cash flow or where the lender is over-secured in the collateral. Determining whether a borrower will be able to confirm a plan of reorganization involves various factors, including a determination of whether the proposed plan is feasible. In order to be feasible, the borrower must be able to convince the bankruptcy court that it will be able to reasonably perform its obligations under the plan. An important factor in this determination involves an analysis of the financial condition and projections of the borrower. Without the proper cash flow to support the plan, the borrower may need the investment of new money or post-petition financing to evidence feasibility. In addition, unless the lender consents, the borrower will need the support of at least one non-insider class of creditors whose rights are impaired under the plan in order to confirm a plan over the lender s objections. 3 This is commonly known as a cramdown, 4 and the value of the collateral in comparison to the loan amount will be a determinative factor. Understanding plan confirmation issues, including the feasibility of the plan, voting concerns, potential to effectuate a cramdown over the objection of the lender, and the available resources of the parties to fund the costs of the bankruptcy will play an important role in negotiating an out-of-court workout. Workout Alternatives Generally, there are three out-of-court options available to lenders and borrowers in dealing with a distressed loan. The first option involves another lender stepping in to refinance and pay off the existing lender. Depending on the results of the due diligence and the leverage of the parties, the existing lender may agree to a discounted payoff in order to satisfy and remove the loan from its balance sheet. The second option is a permanent restructuring of the terms and conditions of the loan, which provides the borrower with some breathing room to service and/or pay off the loan. The third option involves the entry into a forbearance agreement by the parties, where the lender agrees to refrain from exercising a right or remedy for a period of time on the condition that the borrower, the guarantors and/or the security remain in compliance with certain stated terms. Refinancing the Loan While this is typically the most favored alternative for the existing lender, it is also the most difficult to achieve for the borrower. The reasons are somewhat obvious, in that a distressed loan has certain inherent concerns and financial risks that may not be very attractive to a new lender. The ability of a borrower to obtain a discounted payoff, or the infusion of additional capital by the borrower or a guarantor, may be necessary to entice a new lender to get involved. Restructuring the Loan With many loans, the borrower may only require a restructuring of the terms. The loan terms that are typically modified are the interest rate, the term, and the security for the loan. A reduction in the interest rate and/or an extension of the term can result in a reduction in monthly payments to a level the borrower can manage. In return for its consent to permanently modify the terms of the loan, the lender may require certain conditions, including but not limited to modification fees, the curing of any defects in the prior loan documents, the infusion of additional capital and the granting of additional security for the loan. NEW JERSEY LAWYER October

4 Forbearance of the Loan As opposed to permanently restructuring the loan, the lender may be willing to temporarily refrain or forbear from taking certain actions against the borrower, the guarantors or the security for a stated period of time, as long as certain conditions are met. In most situations the borrower is already in default of the loan, and the lender is agreeing to forbear in acting on the default (i.e., commencing or continuing litigation). The forbearance term can range from a period of months to a period of years, depending on the type of loan and the collateral involved. Examples of forbearance conditions include the payment of a forbearance fee, payment of the fees of the lender s professionals, the loan being repaid or paid down in a specified manner, the achieving and maintaining of certain financial milestones, strict financial covenants, the providing of additional security and/or no further defaults. In essence the forbearance agreement provides a temporary resolution as opposed to the permanent modification that occurs in connection with a loan restructuring. Restructuring vs. Forbearance While the differences may sometimes be trivial, the general intent of a restructuring is to permanently alter the contractual rights of the parties to the loan, and the intent of a forbearance is for the lender to temporarily refrain from certain actions as long as certain conditions continue to be met. Deciding whether to restructure or forbear involves determining which alternative is the best vehicle to resolve the concerns of the parties. These concerns include waiving events of default, waiving or delaying the imposition of a default rate of interest, suspension or modification of compliance with loan covenants, providing additional collateral, infusing of new money, financial reporting and modifying the terms of the loan. The decision usually turns on the negotiating position of the parties, the financial condition of the borrower and the guarantors, and the value of the security. Where the security is valuable and the borrower has access to additional capital to infuse, the lender may be more willing to permanently restructure the loan. Alternatively, where the security for the loan is weak and the borrower has little financial wherewithal, the lender will likely seek a temporary forbearance to give the borrower a limited time to pay off the loan, obtain alternative financing or effectuate a sale of the security. Negotiating and Documenting the Restructuring/Forbearance Once the parties decide whether to pursue a restructuring or a forbearance of the loan, the substantive terms must be negotiated and documented. The terms that will most likely be the subject of negotiation between the parties are the costs, the interest rate, the term of the loan, the covenants, the collateral, the waiver of claims and the curing of defaults. Costs of the Restructuring/Forbearance As a general rule, the borrower will be responsible to pay the third-party expenses of the lender, such as appraisal fees, inspection fees and the lenders attorney s fees in connection with any restructuring or forbearance agreements. Most lenders will also require the borrower to pay a fee to the lender, which may be referred to as an extension fee, a modification fee or a facility fee. The rationale for these fees is to compensate the lender for the time and effort it has expended in connection with the due diligence, negotiation and approval of the terms of the restructuring or forbearance. Interest Rate and Term As with any loan, the interest rate and the length of the term will be significant factors in the negotiation. Although the borrower will seek to obtain the most favorable rate and term, the borrower may not have much leverage on these terms. Since the negotiations involve a distressed loan, the lender may seek higher-thanmarket interest rates to compensate it for the inherent risks associated with the loan. The length of the term will depend on whether it is being permanently restructured or a temporary forbearance agreement is being entered into. The term with a permanent restructuring will almost certainly be longer than with a temporary forbearance agreement. Either way, a lender will not likely be inclined to agree to much more than a short-term extension with a distressed loan. Covenants While the borrower will attempt to negotiate covenants and benchmarks that are more easily achieved, the lender will seek strict covenants and benchmarks that will effectively monitor the financial condition of the collateral, the project, the borrower and the guarantors. The lender will want to ensure that the risk attached to the loan does not deteriorate prior to maturity. With distressed loans, lenders occasionally employ third parties to monitor the loan and provide ongoing due diligence throughout the remainder of the restructured term or the forbearance period. Collateral Workout negotiations are an opportune time for a lender to seek to enhance the security for the loan, or to remedy any documentation problems uncovered during the due diligence. Deficiencies in the loan documents may be the result of changed circumstances, missing documents, improperly executed documents or even a collateral perfection problem. The lender may require that these deficiencies be remedied in connection with any restructuring or forbearance of the loan. If additional unencumbered collateral of the borrower or any guarantor is uncovered, the 48 NEW JERSEY LAWYER October 2010

5 lender may seek to include it as additional collateral for the loan. The pledging of additional collateral will certainly be viewed favorably, or may even be required, by a lender considering a restructuring or a forbearance. The parties must be aware, however, that any modification to the loan documents or the collateral for the loan may be subject to avoidance should the borrower file a bankruptcy proceeding later. In such an instance, the re-perfection or new perfection of the borrower s assets within 90 days of the filing may be subject to avoidance as a preferential transfer. 5 A bankruptcy filing may also subject the lender s loan or security interest to attack as an alleged fraudulent conveyance. Such an action may be present if the loan or security interest was incurred while the borrower was insolvent, and the borrower did not receive reasonably equivalent value in return. 6 Waiver of Claims An astute lender will normally require the borrower and the guarantors waive any claims against the lender, and any defenses that may exist regarding the repayment and enforceability of the loan documents in connection with any restructuring or forbearance. The reasons for this are somewhat obvious, but are nonetheless vital to a lender. Whether agreeing to permanently restructure the loan or temporarily forbear from taking action against the borrower, the guarantors or the collateral, it is only appropriate that the borrower acknowledge the enforceability of the loan documents and waive any and all existing litigation claims and defenses. Alternatives to Workouts Bankruptcy Under certain circumstances, a bankruptcy may be a favored alternative to a workout for both the lender and the borrower. In fact, many bankruptcies are pre-packaged and agreed to by the lender and the other creditors in advance. These bankruptcy filings provide benefits that would not otherwise be available in an out-of-court settlement. Debtors may be able to discharge, decrease or even spread out the payments of certain obligations in a bankruptcy, which provides the company with the financial breathing room necessary to operate. Many distressed companies have found a sale of assets within a bankruptcy proceeding provides benefits that cannot be obtained in a sale outside of bankruptcy. A sale of assets pursuant to Section 363 of the Bankruptcy Code enables a party to sell assets free and clear of the liens or claims of others. This enables the borrower to sell assets that may not otherwise be sellable, and to maximize their value. 7 For example, a Section 363 sale may provide a purchaser of the assets with protection against the claims of the creditors of the seller, including successor liability such as environmental claims or tort claims, which would be unavailable outside of bankruptcy. Deed in Lieu of Foreclosure In situations where the borrower is willing to relinquish control of the real property securing a loan, a lender may be willing to accept what is known as a deed in lieu of foreclosure. In such a situation, the lender accepts a deed from the borrower as a simple and quick alternative to a prolonged and potentially expensive foreclosure proceeding. Unfortunately, there can be significant pitfalls and problems associated with such a procedure. Where a foreclosure typically results in the stripping of the under-secured junior lien holders, a lender, upon accepting a deed in lieu of foreclosure, would be taking title to the property subject to the junior liens. This would force the lender to pay off the junior liens in order to sell the property. Where the aggregate value of the liens exceeds the market value of the property, the lender will be unable to sell the property and cure the liens without the lien holder(s) accepting a discounted payoff. In addition, if the borrower has other unpaid creditors a subsequent bankruptcy filing could result in the deed in lieu of foreclosure being set aside on the basis of a preferential transfer or a fraudulent conveyance. 8 A deed in lieu of foreclosure can also be subject to certain state court fraudulent conveyance claims that are not typically available after a foreclosure proceeding. Obtaining title insurance in connection with a deed in lieu of foreclosure can also be more complicated than subsequent to a court-ordered foreclosure proceeding. Consequently, a lender should be extremely careful before consenting to accept a deed in lieu of foreclosure. Assignment for the Benefit of Creditors An assignment for the benefit of creditors is a state-created procedure that is similar in concept to a Chapter 7 bankruptcy liquidation. The advantage of an assignment for the benefit of creditors is that the debtor can select a preferred assignee to liquidate the assets, which may be accomplished in a more efficient manner than in a bankruptcy. With an assignment for the benefit of creditors, a debtor transfers or conveys all of its assets to an assignee for the benefit of the creditors. 9 Another benefit is that a sale of assets through an assignment for the benefit of creditors may give the buyer some protection against fraudulent transfer risks. This protection occurs because the seller is a third party that serves as a fiduciary for the assignor s creditors. Further, the assignee typically obtains a valuation of the assets being sold, which helps prove that reasonably equivalent value was, in fact, paid for the assets. While an assignment for the benefit of creditors can be an effective vehicle if handled properly, it does not afford the parties with the level of protection that is NEW JERSEY LAWYER October

6 provided to transfers taking place pursuant to a federal bankruptcy court order. Receivers Most commercial loan documents contain provisions allowing the lender to seek the appointment of a receiver to take control of the property securing the loan. This can either be obtained by court order or pursuant to a voluntary agreement of the parties. Placing a third-party receiver in control of the collateral and the associated cash flow provides the lender and junior lien holders with a level of comfort, and is always within the discretion of the court. Where opposed by the borrower, the appointment of a receiver could prompt a bankruptcy to be filed to remove the receiver and retain control of the project or the collateral. In circumstances where a receiver has been appointed prior to the filing of a bankruptcy, the bankruptcy court will determine whether to remove the receiver after carefully reviewing the circumstances. In making its decision, the bankruptcy court must determine whether it is in the best interests of the creditors of the bankruptcy estate to permit the receiver to continue in control of the property of the estate. 10 Endnotes 1. See 11 U.S.C. 362(a),(d). 2. See Id. 506(b). 3. See Id. 1129(a)(1) and (10)(b)(1). 4. See Id. 1129(a)(1) and (10)(b)(1). 5. See Id See Id. 548(a)(1)(B). 7. See Id. 363(f). 8. See Id. 547, See N.J.S. 2A:19-1 et. seq. 10. See 11 U.S.C. 543(d)(1). Thomas M. Scuderi is of counsel with Connell Foley LLP in Roseland, where he is a member of the firm s banking, corporate and business transactions practice groups. Conclusion Whether representing a lender, borrower or guarantor, every distressed loan involves a unique set of facts and circumstances, which must be carefully analyzed. Appropriate and thorough due diligence is absolutely imperative before any decisions can be made. Once armed with adequate information and due diligence, the parties can assess the likely outcomes of both a state court collection/foreclosure action and a bankruptcy proceeding. Only then can the parties truly appreciate their respective strengths and weaknesses, and be positioned to determine the remedy that will best protect their interests. 50 NEW JERSEY LAWYER October 2010