Lending Law Report : Corporate Finance Lawyer & Attorney : Reed Smith Law Firm : Lending Transactions, Secured Investments

In my last post, I gave some suggestions for reducing the risk of lender liability in a workout situation.  This time, let's talk some more about what to do when you're working through a workout, and focus on what happens when you're getting ready to seek remedies.  

As a general rule, it is a good idea to act "reasonably" in a default situation.  

There is usually an implied requirement of "good faith and fair dealing" in a contract-based relationship, whether under general state contract law or under the UCC.  Good faith and fair dealing essentially requires that you follow commercially reasonable standards of behavior and be fair to the borrower.  In some states it means that you have to act "honestly" (the definition varies).   This concept is applied to your agreement regardless of what the contract otherwise appears to say.   And this is true all the time, of course, not just after a default. 

Here's an example of how this plays out in a loan agreement.  Secured loan agreements usually say that any kind of default gives the lender the right to terminate the loan and foreclose on all the assets.  In practice, however, even though the agreement would appear to permit a lender to foreclose on assets if (for example) the borrower is just five days late in delivering its financial statements, it would be unusual for a lender to do so.  Indeed, many courts would find that type of action to violate the implied covenant of good faith and fair dealing, as the remedy would appear to the court to be out of proportion to the harm suffered by the lender.  That said, the law does respect your right to negotiate your own terms, and a judge won't normally rewrite the terms you agreed to.  You shouldn't be asked to do more than what you agreed to, but you will be required to do what you agreed to do fairly and in good faith. 

What else can you do to reduce the risk of lender liability when seeking remedies after a default?

• Give notice.  Even though notice may not be required under your loan agreement, in some situations it may be wise to give the borrower some notice before taking any action.  This is especially true if you are contemplating actions like foreclosure, that have harsh results.  Depending on the situation (and this does differ from case to case), giving notice may be fairly easy and may not do any harm to the lender's position -- and it may help demonstrate to a court later that the lender acted reasonably, giving the borrower a chance to explore alternatives.
   
•  Follow a consistent procedure.  It helps if you have established policies and procedures for seeking remedies and for the decision process to get there.  This seems like a good business practice generally, as it not only establishes consistency in dealing with borrowers, but it also helps to ensure that the options you want to have considered are actually considered -- and that a measured and appropriate response is given.  Also, be aware that if your normal practice is to ignore defaults of the type at issue and then you suddenly deviate from that practice and terminate the loan, some courts have found this behavior objectionable.
   
• Figure out what the assets are worth, and what you're likely to be paid.  If you have sufficient security and you are unlikely to lose anything if you forbear or take lesser steps against he borrower, you might want to consider these other options.  Some courts may find your exercise of remedies inappropriate if it can be shown that you would've had full recovery by forbearing on the default; similarly, your exercise of remedies can be called into question if you recover more than the loan agreement would've given you otherewise.   In these situations, you might do some clever thinking to see if you can get an appropriate result with less harm to the borrower.  For example, maybe forbearance makes sense, or maybe you can do things over a longer period of time, foreclose on only certain types of assets, or seek other types of remedies, while otherwise allowing the business (or portions of it) to continue.  Lots of options here.

There's no way to completely eliminate the risk of liability, but taking careful action can help mitigate this risk.  Applying principles of "good faith and fair dealing" will help.

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In our prior posts on this topic, we focused on what your loan agreements might say about how to deal with a defaulting lender.  In this post,  we'll talk about what happens when a member of your bank group goes into default because it is taken over by the FDIC.  Special rules apply in that case.

Automatic Stay.  The Federal Deposit Insurance Act  provides for an "automatic stay" whenever a lender is taken over by the FDIC.  In part, the statute says that no one may "exercise any right or power to terminate, accelerate, or declare a default under any contract" that the failed institution is a party to, for a period of 90 days after appointment of the FDIC as receiver (45 days, if it is a conservatorship).  

My colleagues Colleen McDonald and Nikki Kolhoff have explained (pdf) that this means you can't do anything that would affect the contractual rights of the defaulting lender, if such action is based solely on the insolvency or FDIC takeover.  So, for example, you can still amend your loan documents, but you have to invite the defaulting lender to vote, and the amendment can't affect the rights of the defaulting lender without that lender's consent.  According to McDonald, the bottom line here is "if you are going to amend your loan agreement, make sure you do it correctly."  She points out that both the "D'Oench Dhume doctrine" (D'Oench, Duhme & Co. v. FDIC, 315 U.S. 447 (1942)) and 12 U.S.C. Section 1823(e) impose specific requirements on modifications of loans involving financial institutions taken over by the FDIC.  Contracts that don't meet the requirements can be avoided altogether by the FDIC - so it's worth taking the time to make sure those requirements are met.

In addition, even if the loan agreement would otherwise permit you to stop sharing payments with a defaulting lender, if the lender is taken over by the FDIC, you'll still have to share all principal and interest payments with it -- at least, to the extent of the obligations it has previously funded.  (As discussed in our prior post, the loan documents should ordinarily prohibit the defaulting lender from sharing in principal and interest payments relating to advances it did not fund.) 

As a practical matter, the automatic stay can create significant problems for a bank group, particularly if the defaulting lender is the administrative agent for the credit facility.  Since the agent manages the funding and payment processes, and often holds the borrower's bank accounts and controls other collateral for the loan, an FDIC takeover could bring everything to a halt - at least temporarily.  

McDonald recommends that to help protect against these problems, the loan agreement should include the right to declare the lender in default early -- before FDIC takeover.  This would allow the bank group to take action before the automatic stay kicks in.  For example, if the agent in a syndicated loan goes into default (pre-FDIC takeover), its rights as agent could be terminated and assigned to a successor, and all the collateral could be transferred to the new agent -- thus permitting the credit facility to function pretty much as usual through the FDIC takeover.  McDonald suggests including a definition of  "Impaired Agent" in the loan agreement that would include an agent that fails to make payments or fund loans required under the loan documents, or that rescinds or repudiates a loan document.

Exceptions.  There are other sections of the Federal Deposit Insurance Act that provide exceptions to the automatic stay, including an exception for when the FDIC as conservator/receiver fails to comply with otherwise enforceable provisions in the loan agreement.  Sometimes these exceptions can provide relief for the bank group, though their full effect is as yet untested.   I have a feeling we'll get the chance to test some of these provisions over the next few months.

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One question we hear a lot these days is whether a syndicated loan agreement can be amended to do certain things without consent of all of the lenders. 

Several kinds of changes that may be made to a loan agreement, such as reducing the principal amount, decreasing the interest rate, postponing payment dates and the like, typically will require all of the lenders affected by the change to approve.  With more borrowers in financial trouble, it has become increasingly important - and sometimes necessary for the borrower’s survival - to get amendments passed quickly.  But it can be difficult, if not impossible, to get all of the lenders to agree.

This is part one of a series of posts about what to do when this issue comes up.

When the borrower asks for relief on some of its obligations, and the agent and majority lenders are willing to agree to what the borrower has requested, in many deals there will be strong incentive to take a narrow view of the other lenders’ voting rights in order to get the amendment passed.  Agents are analyzing amendment provisions very carefully to determine precisely what is and is not required in terms of lender voting.  If there are ways to get the amendment passed without triggering the other lenders’ voting rights, then that can end up being the desired course.

For example, we know we can’t extend an interest payment date without a 100% vote, but there is no such prohibition on amending events of default.  So, the agent and majority lenders may start thinking about whether they can lengthen the cure period for payment defaults by a few days, which could have the effect of permitting the borrower to pay later without changing the date the payment is due.  This type of amendment would have other consequences, of course, and it may not be a good idea for a number of reasons.  Whether changes like this can even be considered will depend on the circumstances, and on the terms of the loan agreement.

In any event, these situations call for some clever thinking on the part of the agent and its counsel.  And they call for careful consideration of how the non-consenting lenders will view the amendment.  Elevating form over substance (i.e. “we know we can’t amend section 2.04 without consent, so we’ll add a new section 2.05”) is likely to result in objections from the non-consenting lenders – and rightfully so.  Finding alternative types of amendments that can properly be made, and other substantive provisions to amend, is a safer course.

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