September 12, 2018
Author: Lawrence R. Anderson, Jr.
Organization: Seale, Smith, Zuber & Barnette
A. DISADVANTAGES OF USING FORECLOSURE AS REMEDY
Foreclosure by executory process may not be the quickest or the safest alternative for maximizing recovery of a loan. It may be disadvantageous, depending upon the factual circumstances, including the following: (1) it may cause the debtor to file bankruptcy and thereby further delay and hamper collection efforts; (2) it may substantially impair the debtor’s business which may be the necessary vehicle to provide effective recovery; (3) it may delay collection efforts against co-debtors and nonmortgaged collateral; (4) if there is a defect in the foreclosure process, the creditor may lose its deficiency judgment and may subject itself to a damage action for wrongful foreclosure; (5) the foreclosure may increase the potential exposure of damages to the creditor, if there are grounds for lender liability; (6) the creditor usually has a harder time selling the collateral after foreclosure than the debtor prior to foreclosure; and (7) the fees and costs of a foreclosure action usually are more expensive than those of a workout agreement.
1. Foreclosure May Cause Debtor to File Bankruptcy and Thereby Further Delay and Hamper Collection Efforts.
In many situations, the seizure of the collateral pursuant to foreclosure is the primary factor causing the debtor to file bankruptcy. This is particularly true where the foreclosure effectively shuts down the business of a debtor. For example, if the only or major asset of the debtor is an apartment complex or a hotel and a keeper or receiver is appointed pursuant to the foreclosure, which effectively stops the cash flow of the debtor, there is a particular tendency of the debtors in these situations to file for relief under Chapter 11 of the Bankruptcy Code. There are also many situations in which the only asset mortgaged to the creditor is the debtor’s home which causes the debtor to file a petition under Chapter 7 or 13 of the Bankruptcy Code. The filing of bankruptcy automatically stays collection efforts by operation of law pursuant to 11 U.S.C. §362(a).
If the debtor files for protection under Chapter 11, a Bankruptcy Court usually is going to afford the debtor every presumption of confirming a plan and will not modify the automatic stay during the 120-day period after filing. See In re Timbers of Inwood Forest Associates, Ltd., 793 F.2d 1380 (5th Cir. 1986), rehearing denied and panel opinion reinstated en banc 808 F.2d 363 (5th Cir. 1987.)
2. Foreclosure May Substantially Impair Debtor’s Business Which May Be Necessary Vehicle to Provide Effective Recovery.
If the only or major assets securing the loan are the debtor’s business assets and the assets are necessary to the business to produce the cash flow to pay the loan, a foreclosure which effectively shuts down the business may kill the one vehicle which might provide substantial recovery on the loan. For example, the debtor may operate a manufacturing or processing plant which is a specialty type of business. The land, building and operating equipment only have full value to a buyer engaged in a similar type of business. If such a buyer is unable to purchase the debtor’s business assets as a going concern, the assets are worth substantially less.
3. Foreclosure May Delay Collection Efforts Against Co-Debtors and Non- Mortgaged Collateral.
If is not unusual for a loan to be made primarily on the strength of financial statements of endorsers or guarantors of the loan, rather than the value of assets owned by a corporate maker. Also, in today’s economy, particularly in the oil patch, it is not unusual for assets to have significantly decreased in value within a short period of time from when the loan was made, leaving the strength of the financial statements of endorsers or guarantors as the only alternative for significant recovery on the loan. At a minimum, foreclosure by executory process on real estate takes 90 days, if the creditor is fortunate in getting the sheriff’s sale held that quickly, because of necessary delays in advertising the sheriff’s sale. Usually though, in metropolitan areas like Baton Rouge and New Orleans, it takes a minimum of four to six months from the date of filing of the foreclosure petition until a sheriff’s sale is held.
Because of this delay, in the interim, the debtor and guarantors can dispose of significant non-mortgaged assets, place the assets beyond the reach of creditors by converting them to exempt assets or take other action which will make enforcement of a judgment against them more difficult. Whereas, if an ordinary suit is filed against the debtor or guarantors, a judgment usually can be obtained much quicker and the creditor can take action sooner to tie up non-mortgaged assets.
4. If Defect in Foreclosure, Creditor May Lose Deficiency Judgment and Subject Itself to Damage Action for Wrongful Foreclosure.
There are many reported cases in which a creditor lost its right to deficiency judgment because there was some defect in the foreclosure process. Although recent amendments to executory process have helped make it easier for creditors to obtain a deficiency judgment, there is always a possibility of some fatal error occurring which bars deficiency judgment. Also, if the foreclosure is wrongful, this can subject a creditor to a damage action and possible liability for attorney’s fees of the debtor.
5. Foreclosure May Increase Potential Exposure to Damages to the Creditor, if There Are Grounds for Lender Liability.
The typical grounds of lender liability in reported cases include bad faith, fraud, breach of fiduciary obligation, and/or tortious interference with business. Since foreclosure has the particular ability to terminate a debtor’s business, if a court, or usually a jury, finds that the lender has violated some duty to the debtor, a foreclosure substantially increases the damages because of lost revenues or profits.
6. The Creditor Usually Has a Harder Time Selling the Collateral After Foreclosure Than the Debtor Prior to Foreclosure.
Although creditors are becoming more and more adjusted to the realities of selling repossessed collateral in today’s economy, the usual rule of thumb is that lenders are not good sellers of collateral. Generally, creditors have a more difficult time selling the collateral after foreclosure than the debtor selling the collateral prior to foreclosure.
7. The Legal Process Usually is More Expensive Than a Workout Agreement.
Competent creditor’s counsel usually requires compensation commensurate with their abilities. Attorney’s fees of a foreclosing creditor generally are more than the creditor’s counsel fees in obtaining a workout agreement. Also, there are the costs of custodians, sheriffs or marshals, and appraisers in a foreclosure, whereas the lender usually can make the debtor pay for any necessary legal and appraisers’ fees of the lender in obtaining a workout agreement.
B. GOALS OF LENDER – COMMENCING COLLECTION
In commencing collection efforts, the creditor should make an informed business judgment on all the alternatives. First of all, the goals of the lender have to be considered. Secondly, the proper steps in commencing the collection process need to be taken. As much information should be gathered as soon as possible before a decision is made. Next, all the alternatives should be weighed and balanced. And finally, an informed business judgment on the proper alternative must be made and followed through effectively. In many situations, this whole process has to be done in a very short period of time.
1. The Goals of the Lender.
Whether it is the lender’s officer who has the responsibility for making the decision or reporting back to the lender’s committee who will make the decision or the lender’s attorney who will assist the lender in the collection process, each representative of the lender must first consider the goals to be achieved by the collection effort. Some of the usual goals of a lender in a loan recovery effort include the following:
a. To recover the principal of the loan.
b. To protect and recover the collateral securing the loan.
c. To recover interest, attorney’s fees, and litigation costs.
d. To avoid excessive collection costs.
e. To avoid lender liability.
f. To maintain good public relations.
2. Commencing the Collection Process (Or What Should the Lender Do When the Debtor Stops Paying?).
There are certain steps that should be taken by a creditor once it becomes apparent that a loan is in jeopardy. The most typical danger signal is when the debtor stops paying on time. There may be other danger signals, such as when a debtor is improperly disposing of the mortgaged assets, the major collateral for the loan has decreased substantially in value, the debtor is out of business, or the debtor has left the parish or state without a forwarding address. Any one or combination of these danger signals or other warnings of jeopardy should trigger the following action by the creditors:
a. Immediately investigate the facts.
(1) What is the condition of the lender’s loan documentation and collateral files?
(2) What is the condition of the collateral? Is it being maintained?
(3) Is the collateral insured?
(4) Are there superior mortgages on the collateral, and, if so, what is the status of any arrearages?
(5) If the collateral is real estate, have the property taxes been paid?
(6) What are the reasons for the debtor’s failure to pay?
(a) Market conditions.
(b) Unexpected catastrophe.
(d) Other reasons.
(7) What is the debtor’s financial condition?
(a) Financial records.
(d) Cash flow.
(e) Viability of business.
b. Obtain as much information as possible.
(1) Decisions should be made based upon the fullest and most accurate information possible.
(2) The information obtained may be used later in court against the debtor.
c. General considerations before making the decision on the collection strategy to be used.
(1) What will the lender do with the collateral after it is recovered?
(2) Has the collateral been maintained by the debtor? Is it in good condition?
(3) What type of person is the debtor? Is there evidence of debtor’s mismanagement or dishonesty?
(4) Are there factors beyond the control of the debtor?
(5) Are there any problems with the loan documentation or anything else which might expose the lender to liability?
3. Weighing the Collection Alternatives.
There are usually three alternatives, or a combination thereof, that a creditor considers when a loan is in default. Sometimes extraordinary remedies have to be considered by a creditor, particularly when the debtor is a bad actor. These alternatives can be classified as follows:
a. Usual alternatives:
(1) Workout agreement or out-of-court settlement with debtor.
(2) Foreclosure by executory process.
(3) Suit by ordinary process or with sequestration.
b. Extraordinary remedies:
(1) Filing involuntary petition against the debtor.
(2) Voiding actions under state law:
(a) Revocatory action.
(b) Action to void stimulation.
(c) Action to void bulk sales statute violation.
(3) Federal RICO action.
(4) Civil fraud action under state law.
(5) Requesting criminal prosecution.
c. Factors militating in favor of foreclosure.
(1) Immediate possession and possible cash flow to creditor through appointment of keeper or receiver.
(2) Lack of maintenance or significant devaluation of collateral.
(3) Bad management by the debtor.
(4) Debtor’s dishonesty or bad faith or creditor’s lack of trust in the debtor.
(5) Debtor’s business closes, debtors leaves parish or state or factors beyond debtor’s control such as bad state of economy or tough competitors driving debtor out of business.
(6) Start the bankruptcy “clock” running.
C. WORKOUT AS ALTERNATIVE
In many situations, the significant factors militate in favor of trying to reach a workout agreement with the debtor, at least as an attempted first approach before foreclosure is filed. Sometimes it is better to work with the debtor than to foreclose. The essential question is whether the creditor is more likely to recover its principal and interest in a workout with the debtor than through a foreclosure. A straight business judgment is involved. In attempting the workout, the creditor’s representatives must exercise their best human relations and financial analysis skills. The creditor’s representatives should be tough, flexible, reasonable, tactful, creative, communicative, and realistic. The general factors to be considered include the following:
1. What is the Cash Flow of the Debtor Available to Service the Debt?
2. Does the Creditor Need to Obtain Additional Collateral or Co-Obligors to Secure the Loan?
3. Should the Lender Try to Increase Its Control in Monitoring the Debtor’s Operations?
4. Should the Possibility of a Sale of the Assets to a Third Party be Explored?
D. SHORT-TERM WORKOUT VERSUS LONG-TERM MODIFICATION OF TERMS OF INDEBTEDNESS
Obviously, if a loan is in jeopardy, the lender would prefer a short-term workout rather than a long-term modification of terms of the indebtedness. However, if the lender has confidence in the debtor and the debtor’s problems are only temporary, a long-term modification of terms in the indebtedness may be the better business judgment.
E. TYPES OF WORKOUTS
There are many types of workouts. The possibilities depend upon the size of the debt and the nature of the collateral. Actually, the type of workout is limited only by the imagination of the parties and circumstances that cannot be changed. Workout agreements may include one or more of the following elements:
1. Master Loan Agreement Providing for More Effective Lender Monitoring of Debtor’s Business.
If the loan is secured by accounts receivable and inventory of the debtor’s business, and particularly if the debt is large, the creditor should have obtained a master loan agreement as a part of the original loan documentation. However, if this was not done when the loan was originated, a master loan agreement should be obtained as a part of the workout agreement. The clauses usually included in a master loan agreement are one or more of the following:
a. The debtor should furnish financial statements, including balance sheets, income statements and tax returns, to the creditor on a periodic basis.
b. A definition of working capital ratios, debt to tangible net worth ratios and/or cash flow that must be maintained by the debtor.
c. If the lender is a bank, maintenance of all of the debtor’s bank accounts with the lender.
d. If the loan is secured by accounts receivable, the debtor must provide an address on all invoices for the mailing of payments to a lock box controlled by the lender.
e. Events of default.
f. If the debtor is a corporation, a prohibition against the selling of existing stock or issuing new stock without the written consent of the lender.
2. Changing Various Terms of the Loan.
If the creditor decides that a long-term workout is the better business judgment, usually the terms of the loan are changed to accommodate the cash flow of the debtor. This can include decreasing the amount of the monthly payment, decreasing the interest rate and/or lengthening the term of the payout of the loan.
3. Sale of Part or All of the Debtor’s Assets Securing the Loan.
Sometimes the collateral can be sold at a reasonable price fairly easily to a third party. In this situation, the creditor must convince the debtor that it is in his best interest to do so.
4. Dation of Collateral to Lender and Lease Back to Debtor.
The dation and lease back can be a very satisfactory solution sometimes. The creditor may not have enough confidence in the debtor to allow the debtor to continue in business, but at the same time wants the debtor’s assistance in finding a buyer for the business assets as an ongoing concern. This arrangement has to be structured along the same guidelines and considerations as a dation en paiment or a partial dation. The lender should obtain current appraisals of the collateral at the expense of the debtor. The dation price is then fixed in an amount at which the creditor feels comfortable based upon the appraisals. If there is a difference between the debt owed and the values as indicated by the appraisals, then the lender should have the debtor and any guarantors sign a promissory note for the difference secured with as much other collateral as possible. The creditor should try to keep the lease on as short a term as possible. The primary advantage is that if the debtor misses a rent payment, it is easier to recover the collateral through eviction rather than foreclosure.
5. New Financing or Investors.
Sometimes, the debtor can find new financing through either a completely new lender or a government sponsored program. Usually, if a debtor is having financial problems, he also is going to have difficulty in finding a new lender to take out the old lender. However, sometimes this can be done, particularly if the debtor makes the new loan package more attractive by adding additional collateral, new investors, or a new experienced management team. Also, sometimes the debtor can obtain a government sponsored loan whereby the existing loan is guaranteed up to a certain percentage by a governmental agency or new financing is obtained through a governmental guarantee. In addition, sometimes the debtor can breathe life into his business by bringing in new investors.
F. IMPACT UPON THIRD PARTIES
The impact of a workout upon third parties usually involves public relations considerations. The debtor may have many employees, friends, and relatives in the community who do business with the lender based, at least in part, upon the good banking relationship between the lender and the debtor. If the lender drives too hard a bargain through the workout agreement, particularly if it results in the closing of the debtor’s business, this may have a ripple effect in the community which cause the lender to lose substantial business from third parties.
G. NEGOTIATING A WORKOUT AGREEMENT (OR THE IRON FIST IN THE VELVET GLOVE)
In negotiating the terms of the workout agreement, the creditor’s representatives must exercise all of those skills previously mentioned. They must be the “iron hand in the velvet glove.” The negotiating process is very similar to a poker game. The key for the lender is to be able to read the debtor’s hand, since the lender knows its own hand.
The best deal available to the creditor should be negotiated without giving the appearance of driving too hard a bargain. Before the creditor commences negotiations with the debtor, the creditor needs to first determine the objectives it wants to achieve through the workout agreement. Those objectives could include one or more of the following:
1. New Payment Stream.
2. Controls Over Debtor’s Operations.
3. Maintenance of Creditors Collateral.
4. Efforts by the Debtor to Sell Collateral to a Third Party
5. Additional Collateral and/or Co-Obligors.
6. Modification of Loan Documents.
7. Conditions of Debtor Doing Certain Things.
H. SRUCTURING WORKOUT AGREEMENTS
There are many different ways to structure a workout agreement. This could be simply drafting a master loan agreement or amendments to an existing master loan agreement. It also could include drafting new promissory notes and security agreements.
I. WORKOUTS IN BANKRUPTCY
Sometimes the filing of bankruptcy by the debtor is not all bad. The debtor will be under the supervision of the Bankruptcy Court. If the debtor files for Chapter 7 or 13, there will be a court-appointed fiduciary, the trustee, to look after the collateral. If the debtor files for Chapter 11, usually the debtor will be a debtor in possession and no trustee will be appointed, but as a debtor in possession, the debtor has certain fiduciary obligations. The bankruptcy may be particularly helpful, if the creditor does not trust the debtor’s management ability or if there is evidence that the debtor is a bad actor. The Bankruptcy Code provides creditors with an arsenal if remedies, not available under state law, to keep the debtor in line.
Moreover, in many situations, the debtor as a Chapter 11 debtor becomes a more attractive purchase for a prospective buyer. The sale of all or substantially all of the debtor’s assets usually is handled easier and safer through the Bankruptcy Court, if the debtor is having financial problems, in the eyes of a prospective sophisticated purchaser. As to negotiating a workout agreement with the debtor, the same considerations and strategies apply, except that any agreement has to be approved by the Bankruptcy Court, after notice and an opportunity for hearing being given to all creditors and other parties in interest. If the workout agreement is complex and covers all or substantially all of the debtor’s assets, sometimes it is better to include the agreement in a Chapter 11 plan or reorganization approved by the Bankruptcy Court.
J. AVOIDING LENDER LIABILITY
The reasonableness of a lender’s conduct in the creation, administration, or workout of a loan is more likely than ever to come under the scrutiny of a judge or jury if its borrower falls on hard times. The theories of lender liability are still emerging and have not been resolved by appellate courts. For that reason, firm standards, rules, and guidelines cannot be offered. However, good management practices generally are also good safeguards against liability. Subject to the foregoing qualifications, certain observations and suggestions can be made as follows:
1. Initial Observations and General Suggestions.
a. Incorporate the previous suggestions on commencing the collection process, weighing and balancing the alternatives, and making business judgment.
b. Retain experienced workout specialist (loan administrator and counsel) and remove anyone who displays an overly emotion reaction to the workout.
c. Watch out for internal memos to the file and make complete, accurate, and businesslike telephone notes and memos to the file.
d. Be businesslike, up-front, and honest in dealing with the debtor.
Deception, arrogance, and theatrics will not play well to a jury.
e. Where there is clear default in the credit document and the lender believes in food faith that a management change is necessary, it should be proper for the lender to refuse to make further loan advances or waive events of default until a management change is made. The lender should avoid being put into the position of selecting who the new management shall be. However, the lender may suggest an assortment of independent qualified candidates for the job and may comment upon those suggested by the borrower.
f. In a workout, the lender may hire an independent consultant or monitoring agent to visit the borrower’s premises, meet with company representatives and gather financial and other information of interest to the lender. However, the consultant’s role as a representative of the lender should be made very clear and the consultant should not give business advice to the borrower.
g. The lender may, and should, insist upon the development of a detailed plan by the borrower. The lender may comment upon that business plan, rejecting any aspect of it that is not acceptable from the standpoint of protecting the lender’s interest. In this respect, the lender may insist upon the business plan including a plan for disposal of nonessential assets to repay the indebtedness. However, the business plan and the identification of the nonessential assets should come from the borrower, and not the lender. The lender’s role should be limited to reviewing and commenting upon the borrower’s plan.
h. The lender should not place his representatives upon the Board of Directors of the borrower or in management positions. The lender should avoid becoming entangled in intra-management or intra-board disputes as to company policy. Although the lender may review and comment upon the borrower’s business plan, it should not become involved in day-to-day management decisions. It is particularly important that the lender not assume any degree of control over the purse strings of the borrowers in terms of deciding who will be paid and who will not be paid out of company funds.
i. It is not unlawful to refuse to provide commercial credit information. However, once the lender discloses any material or relevant information, the duty to disclose the full truth arises.
j. The lender usually should not rely upon provisions in the loan documents that permit them to call a loan without notice or to refuse to continue a longterm financing relationship without notice. Unless the lender must take quick action to protect its interest, it should give a borrower a reasonable period of notice to allow the borrowers an opportunity to obtain other financing.
2. The “Ten Commandments” of Avoiding Lender Liability.
One commentator1 has suggested the following “Ten Commandment” for avoiding lender liability:
a. Thou shalt not make a sudden move.
b. Thou shalt not tell a lie (or fudge the truth).
c. Thou shalt honor thy commitments.
d. Thou shalt not run thy borrower’s business.
e. Thou shalt not bail thyself out on my brother’s money.
f. Thou shalt keep thine own files clean.
g. Thou shalt transfer a troubled loan to a workout officer.
h. Thou shalt confer with thy workout counsel.
i. Thou shalt think carefully before suing on a deficiency.
j. Thou shalt not be arrogant.
1 H. Chatman, “The Ten Commandments for Avoiding Lender Liability,” The Secured Lender (November/December 1986), p.10.