By Landon A. Hardcastle, Jones Waldo
When a borrower defaults on its loan, its lender is faced with a major decision — will it exercise its remedies under the loan documents, including foreclosing on the collateral? Or will it work with the borrower to possibly waive the default, enter into a forbearance agreement or otherwise modify the loan and loan documents? Before getting to this crucial decision, however, there are other preliminary issues to consider. Among these issues is the following question: how should it respond to the borrower’s communications regarding the default and requests to discuss possible loan modifications? Should it send a reservation of rights letter? And should any other step be taken before entering into workout discussions with the borrower? The purpose of this article is to advise lenders on these key preliminary issues.
Communications with Borrower
It isn’t always easy to know what to say to a borrower when it reaches out to discuss a default. There are customer relationship issues to consider. However, there’s also the concern that something you communicate to the borrower may come back and be used against you during a potential workout. Thus, as a general rule, a lender should always be careful when discussing any default and potential forbearance or other loan modification with the borrower. This need for care means all communications should include appropriate disclaimers.
However, being careful doesn’t necessarily mean one must take an adversarial or overly formal tone in responding to the borrower. This qualification is especially true with verbal communications, which are generally not binding on either the borrower or the lender due to the language in the loan documents providing that the loan documents cannot be modified except by a written agreement. Nevertheless, in almost all cases, after a verbal communication with the borrower, it makes sense to send a simple, informal email. Use the email to memorialize the verbal communication and to avoid misinterpretation by the borrower. Below is a simple example:
Thanks for today’s call to discuss [describe loan/issue]. As you know, and as discussed, the bank can’t agree to any forbearance or other modification of the loan without credit approval and then only on the terms of a written agreement executed by the bank.
Similar disclaimer language can also be used at the end of written communications, including text messages.
While adding such disclaimer language to communications with the borrower may seem minor, it is a good way to set the borrower’s expectations for workout discussions. You can show you’re willing to work with the borrower in good faith and, at the same time, have written evidence that you have not waived any default or otherwise agreed to any specific course of action.
Reservation of Rights Letter
The terms of most loan documents clearly state that a lender cannot waive its rights, except by a written waiver executed by the lender. However, your goal should be to help avoid any potential defense from the borrower that the lender (through its course of conduct with the borrower) waived a default. A lender should always send a reservation of rights letter to the borrower in the following scenarios:
- Anytime the lender has been asked to waive a default or prospective default; and
- Anytime the lender becomes aware of a default and does not intend to take immediate action related to the default.
A prudent lender must be smart in deciding what course to take to maximize its recovery on the loan. As a result, both of the above scenarios are quite common, especially in times of economic uncertainty, like the current COVID-19 pandemic, when a lender needs time to evaluate the specific default and its effect on the loan.
Also, for additional information purposes, while the scope of a reservation of rights letter varies depending on the specifics of a given loan, every reservation of rights letter should contain the following components:
Describe the existing default(s) in detail with reference to the circumstances that precipitated the default and the provision of the loan documents that was breached. To describe the existing default(s), one will also need to clearly define the loan and relevant loan documents in the letter;
Clearly state that the lender is not waiving its rights under the loan documents and specifically reserve the right to exercise any and all remedies available to the lender with respect to the existing default(s); and
Make clear that no forbearance or other modification of the loan will be binding except in a final written agreement executed by the lender.
Pre-Negotiation Agreement
One additional step should be taken prior to entering into any workout discussions with the borrower, and that is entering into a pre-negotiation agreement (PNA). As a general rule, a PNA is needed as soon as the lender decides to enter into formal discussions with the borrower regarding a forbearance or modification of the loan and should be executed prior to the beginning of those discussions. The purpose of a PNA is to allow workout discussions to proceed openly and in good faith. The PNA does this by establishing that the discussions are (a) nonbinding in nature and (b) cannot be used as evidence against the lender if it later exercises its rights and remedies or other litigation between the parties ensues.
The PNA is a formal agreement between all loan parties. It should be signed not only by the borrower, but also by any guarantors, indemnitors or third-party pledgors/trustors of the loan. Below are the main provisions that a lender should include in every PNA:
- A list of all loan documents and any modifications with an acknowledgment that the loan documents, as modified, are in full force and effect;
- An acknowledgment of all existing defaults as well as a reservation of the lender’s rights and remedies;
- An acknowledgment that the workout discussions are settlement discussions and are not admissible as evidence against either party in the event of a later action;
- An affirmative statement regarding the voluntary nature of the discussions and each party’s right to terminate negotiations at any time; and
- A representation and warranty that counsel represents each party.
Conclusion
These are unprecedented times. With numerous borrowers either defaulting on their loans or reaching out to lenders to discuss potential future defaults, lenders should remember that the communications they have with their borrowers matter. Every lender should consult with its counsel to discuss the preliminary steps it should take to deal with such defaults. The steps may include sending a reservation of rights letter and entering into a PNA. By taking such precautionary steps, lenders can feel more secure in their rights and remedies and in their ability to maximize recoveries and limit risks.
Landon A. Hardcastle is an attorney with the law firm of Jones Waldo Holbrook & McDonough, and he concentrates his practice in real estate and commercial finance. Landon may be reached at lhardcastle@joneswaldo.com or 801-534-7288.
This story appears in Issue 3 2020 of the Utah Banker Magazine.
