What to do when the bank comes knocking

The advantages and risks of entering into a forbearance agreement with your lender

COVID-19 is creating financing difficulties for all businesses.  It is now harder to pay lenders and suppliers.  What can you do about these financial difficulties?  Is bankruptcy the only option or is there something less disruptive than a formal restructuring that can help?  

A forbearance agreement with lenders can give your business the time it needs to recover from the crisis, move forward and avoid insolvency.  But is a forbearance agreement always the right plan for your business?  And what effect will the terms in a forbearance agreement have on your ability to continue operating?

What is a forbearance agreement?

A forbearance agreement is an agreement by a lender not to enforce the strict terms of a loan agreement.  

Usually, forbearance agreements arise because a borrower has defaulted either by failing to make loan payments or because of some other non-monetary breach.  The lender is in a position to enforce by suing for judgment, commencing power of sale proceedings or moving to appoint a receiver.  

Instead of taking these steps, the lender agrees to give the borrower additional time to find alternate financing to pay off the loan or to cure the default in some other way.

Recently, in light of the COVID-19 shutdowns and the related economic impacts forbearance agreements are coming up in a different context.  Some lenders, anticipating that borrowers will not be able to make loan payments, are reducing the payments to allow borrowers to ride the crisis out in the hope that business will return to a level that will allow full payments at some point in the future.

What are the common terms in a forbearance agreement?

For the borrower, the most important terms will deal with when payments have to be made and in what amount.

If the loan is in default then the entire amount will be due and owing.  The lender will want the loan paid off but the borrower will need additional time to find other financing. In these circumstances, the forbearance agreement will usually provide that, for a set period of time, the borrower can continue making the regular monthly payments even though there is a default and the entire amount is due.  The forbearance agreement will specify when the entire amount is due and in the meantime, the borrower will try to find an alternate lender or an alternate source of funds to pay off the loan.

Forbearance agreements during COVID-19

In the current COVID-19 environment the goal of the forbearance agreement is a bit different.  The goal is not to end the relationship between lender and borrower.  Instead, the goal is to allow the borrower to work through a short but particularly difficult period with the hope that at the end of the emergency the borrower’s business will return to something close to normal and the borrower will return to making regular loan payments. 

In this case, rather than continue with the regular loan payments, the forbearance will reduce or eliminate the loan payments for the duration of the forbearance period.  The payments may be reduced to interest only, the interest rate may be reduced, or the payments will be changed in some other way but the result will be to reduce the amount that the borrower has to pay at a time when the borrower is unable to pay. 

Now that the borrower has what it wants, the question remains:

What will the lender ask for in a forbearance agreement?  

The lender will ask for terms to cover its expenses of entering into the forbearance agreement, reduce its exposure to risk and make enforcing easier if it becomes necessary.  

The lender will incur legal fees to negotiate the forbearance and its own internal fees for the additional administration of the forbearance terms.  As part of the agreement, the borrower is usually required to pay a forbearance fee and the lender’s legal fees.  The legal fees will be the actual amount that the lender pays to its lawyer to negotiate the forbearance agreement.  The forbearance fee is not directly linked to any specific expense the lender can show.  It may look like a windfall to the lender however bear in mind that the lender has to spend additional time negotiating the forbearance agreement and administering it.  The forbearance fee covers these additional expenses.  

A lender, especially a secured lender, will want to make sure that the borrower protects its priority.  Certain debts, such as unremitted H.S.T. or source deductions or unpaid property taxes will rank ahead of a secured creditor.  The lender will want to make sure that these payments are made.  The lender will want to see proof that property taxes, source deductions and H.S.T. have been fully paid on the date that the forbearance is entered into and that these payments are made regularly during the forbearance period.

The lender will also want to avoid lending any more money.  This means revolving loans, such as lines of credit, are usually capped during the forbearance period.  Even if there is room to borrow more the borrower will agree that the limit will be reduced to the current outstanding amount.  This may also mean that any payments deposited into the borrower’s account will be used to pay down the loan and cannot be withdrawn again. 

Similar to ensuring that the lender does not lend more, the lender will want to make sure that ongoing revenues are not being rerouted to other lenders.  Lenders will regularly ask the borrower to get similar forbearance relief from its other lenders.  This avoids the risk to one lender that its forbearance terms are being used to pay down another lender but it is also useful for a borrower to use to negotiate forbearance terms with other lenders who may otherwise be reluctant.  

Finally, the lender will want more detailed information about the borrower’s ongoing business.  Usually, a borrower will have to provide annual financial statements to its lender so that the lender has a general sense of the borrower’s business.  With a forbearance agreement in place, whether because of a breach or because of a COVID-19-type crisis the lender will want more current information about the borrower’s business.  At the very least a borrower can expect to have to provide monthly statements but biweekly or even weekly reporting is not unheard of.  This gives the lender a much more current sense of the state of the business and whether quick action to enforce is needed. 

Now that the lender has reduced its exposure, we come to another question:

What can the lender ask for to make enforcement of the forbearance agreement easier?  

The first term that a lender will ask for to assist in enforcement is an acknowledgment of the outstanding amount and that the loan documents (the loan agreement and any related guarantees or security documents) are valid and enforceable.  The lender will want the borrower to confirm exactly how much is owing to avoid any dispute about the amount down the road.  The lender will also want the borrower and any guarantor to confirm that the borrower or guarantor will not dispute the loan agreement and, often more importantly, the security agreement and guarantees that go with the loan agreement.

In addition to acknowledgments of the amount owing, the borrower will often ask for additional security for loans.  This may take the form of guarantees from the principals of the business or related companies, mortgages against the homes of principals or security against the assets of related companies.

The most useful term for a lender to assist in enforcing is a consent to judgment and a consent to the appointment of a receiver.  Under normal circumstances, a lender has to go to court and prove its case to get a judgment or an order appointing a receiver.  With a consent in hand, this process is much quicker.  It still requires going to court but the lender no longer has to prove its case since it can rely on the consents.

Are there any risks to a borrower in entering into a forbearance agreement?

At first blush, a forbearance agreement seems like an obvious choice for a borrower.  Lower payments and more time – what’s not to love?  But there are risks in entering into a forbearance agreement, ranging from higher overall costs to additional time spent on reporting to losing the right to dispute enforcement.  

In the current COVID-19 environment forbearance agreements are being used to reduce monthly payments.  Payments may be reduced to interest-only or waived altogether during the crisis.  However, the payments are not forgiven.  

The skipped monthly payments are either capitalized, increasing the amount that has to be paid back, or future monthly payments are increased to make up the difference.  This means higher payments in the long run and potentially higher monthly payments in the near future.  While reducing payments now may be useful, it is important to consider whether the business can bear increased payments at a future date. 

The additional reporting requirements that come with a forbearance agreement will take time and often cost additional money.  Either the borrower’s management will have to prepare the reports, taking them away from running the business, or the borrower will have to pay accountants or other external professionals to prepare the reports.  The additional reporting will tax the business at a time when it is already strained because of its financial situation.  

There are also risks associated with capping the borrower’s facilities and using any deposits into the borrower’s accounts to pay down the facilities.  If this happens, where will the borrower get funding to run its operations during the forbearance period?  It is important to negotiate a forbearance agreement that allows the borrower to keep operating.  If the borrower does not have the required funds to operate then it will fail to the detriment of both its owners and the lender.

Granting additional guarantees means exposing the owners of the business personally or other related businesses.  One of the greatest advantages of a corporation is separating the corporation’s liabilities from the assets of the owners or other related corporations.  Guarantees take away this protection.  

Acknowledging the amount that is owing and the validity of the loan documents and to an even greater degree consenting to judgment or the appointment of a receiver takes away the borrower’s ability to dispute any enforcement.  

For example, in the current COVID-19 environment courts may be reluctant to appoint a receiver to allow a lender to seize assets, especially if there is no direct risk to the lender of assets being dissipated and the borrower can show that it has a chance of finding alternate financing if given enough time.  By consenting to the appointment of a receiver the borrower loses any such rights. 

A guarantor may also lose potential defences by signing a forbearance agreement.  A guarantor may be able to avoid liability by arguing that the terms of a loan changed after the guarantee was signed.  By signing the forbearance agreement, which includes an acknowledgement that the guarantee is valid and an acknowledgement of the amount that is owing, the guarantor loses the right to argue that any changes to the terms of the loan from when the guarantee was originally signed invalidate the guarantee.

How do you mitigate these forbearance agreement risks?

You should not blindly sign a forbearance agreement.  Don’t be lulled by lower payments and more time.  It is important to understand your business and to know how the new forbearance terms fit with your operations.  It is also important to know what is possible.  You won’t get more time without giving something to your lender.  Understanding what the lender wants and why is key to understanding what the options are.

At KMB Law we act for both lenders and borrowers.  We listen to understand your business needs and we know what lenders want.  We can help negotiate a forbearance agreement that will work for both you and your lender.  If your company is facing financial difficulty and you are considering entering into a forbearance agreement, contact Wojtek Jaskiewicz at wjaskiewicz@kmblaw.com or visit our website at www.kmblaw.com

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