Defaults And Workouts Under Commercial Mortgage Loans: The Borrower's Perspective

This article is designed to identify those issues that a

borrower in Central and Eastern Europe should be thinking about if

its mortgage loan appears to be heading towards a default

situation, and, in the event a default occurs, what the leading

considerations of the borrower should be in formulating its

strategy to achieve the best possible outcome. This article is not

a review of laws in any jurisdiction, and we do not delve into the

legal minutiae of how a lender may enforce security interests in a

particular jurisdiction. Instead, we seek to set out a general

approach for borrowers on how to deal with problem mortgage loans

in the CEE.

1. Background

   Commercial mortgage financing is a relatively new practice area

   in the CEE, having only developed in the last fifteen years. The

   lending market has historically performed well, so in contrast to

   other economies which have previously lived through periods of

   defaults and workouts there is comparatively little experience both

   in the legal system and among market players in terms of dealing

   with defaulted commercial mortgage transactions. Based on knowledge

   of the legal system in place and the market, we can suggest a way

   forward for borrowers. Before proceeding on this path, we will take

   a brief look at the basics of the legal system, as this is the

   framework in which workouts will play out.

   1. The Legal System

      1. Collateral Enforcement

         The primary remedy available to lenders under legal systems

         throughout the CEE is foreclosure on loan collateral that is then

         sold at auction. Such sale procedures may be judicial (requiring

         the involvement of the courts) or non-judicial (whereby the lender

         can avoid having to go to court to enforce). In certain

         jurisdictions the availability of a non-judicial right of sale

         depends on whether this was agreed as an available remedy when the

         loan was originally documented.

      2. Taxation

         Whenever property is transferred, there is usually a transfer

         tax, stamp duty or similar payment obligation. Transfer tax is also

         applicable in a collateral enforcement scenario, although the

         amount of such transfer tax may be less than would be the case in a

         regular transfer (for example, currently the transfer tax rate in

         Hungary for an enforcement situation is 2% of the value of the

         collateral as opposed to the normal transfer tax rate which is

         10%).

         In addition to transfer taxes, most countries have a taxation

         regime for forgiveness of indebtedness. So, for example, if instead

         of going through an enforcement procedure, a borrower were to hand

         over the keys to a property to its lender in exchange for the

         lender forgiving the debt owed by the borrower, and the value of

         the collateral is less than the amount of the debt that is owed,

         the portion of debt that is forgiven would be taxable.

      3. Bankruptcy

         As a general rule, the failure of a company to promptly file for

         bankruptcy when it is insolvent can lead to harsh penalties (in

         some cases including personal liability of directors, shareholders,

         and/or criminal liability). Proceedings can either lead to a court

         ordered liquidation (sale of assets) or in limited cases to a

         reorganization. In addition to "voluntary" bankruptcy

         filings by debtors, "involuntary" filings may occur by

         creditors commencing bankruptcy filings against debtors.

         It should be noted that typically liquidation would be the

         outcome of bankruptcy proceedings, because in commercial mortgage

         loan transactions there is usually only a single important creditor

         and if agreement could not be reached with that creditor previously

         it is unlikely to be achieved during a reorganization. As a result,

         unless the borrower has other significant creditors (such as

         contractors, or in the case of residential apartment projects,

         purchasers under pre-sales), it is unlikely that borrowers would be

         able to benefit from reorganization laws.

         Following a bankruptcy filing by a borrower, in certain CEE

         jurisdictions the sale of assets would be run by the bankruptcy

         court or administrator in an open process and it may be difficult

         or impossible to agree a negotiated transfer to the mortgage

         lender.

   2. The Market

      The vast majority of commercial mortgage lenders in the CEE are

      banks, although some companies that are engaged in leasing may also

      have a license to do bank lending. Such institutions typically do

      not have asset management arms such as life insurance companies in

      the United States or pension funds in Canada, who engage in both

      lending and ownership of property.

      The typical structure for a commercial mortgage loan would be

      for a single purpose vehicle to own a single property and for the

      loan to be secured by a mortgage on the property, a pledge of

      shares in the SPV, a pledge over the bank accounts and an

      assignment of rents. It is not uncommon to also see portfolio

      mortgage loan transactions where an SPV holds several properties or

      where multiple borrowers each hold properties and a

      cross-collateralized and cross-defaulted structure is put into

      place.

      In the CEE, there are numerous construction loans that are in

      existence due to the boom in construction until this downturn. In

      addition to the collateral described above, well-advised

      construction lenders would have required assignments of

      construction documents and "step-in" rights for such

      loans, pursuant to which the general contractors agree

      contractually with the lender to fulfill their obligations to

      construct the project in the event of a default. Construction loans

      also have as part of their documentation cost overrun guarantees,

      pursuant to which a deep pocket guarantees payment of construction

      costs in excess of the development budget agreed with the lender.

      Construction loans have unique issues and in the context of this

      primer will be discussed separately from investment loans.

2. Approaching a Default

   So you are a borrower of an investment commercial mortgage loan

   in the CEE, in the second year of a five-year term loan from a

   lender and the real estate downturn is upon you. What should you

   do?

   1. Loan documentation

      A good place to start is to conduct a loan

      audit (that is, a review of the loan documentation by

      the borrower or its lawyers) to ascertain those provisions that are

      most likely to cause a default under the loan. Such provisions

      include financial covenants and certain default provisions, such as

      those related to leasing or material adverse change.

      Discover any defects in the loan

      documentation, such as whether the lender's lawyers failed to

      register a certain security interest or encumber a portion of the

      property with a mortgage? Did the lender put into place a

      non-judicial enforcement mechanism? Knowledge of such defects

      or potential sweeteners that could be

      offered up will be a useful tool later during the negotiation of a

      workout. Borrowers should also be aware of the requirements of the

      loan documents as they pertain to valuations and the delivery of

      additional information so as to be able to control, and if

      necessary, limit, potential overreaching by lenders.

   2. Focus on communications with your lender

      The basis of any workout is trust. If it becomes apparent that a

      default is imminent, it would be appropriate to alert the lender to

      this fact and for the borrower to offer up a plan to deal with it.

      This lets the lender know that the borrower is aware of

      the situation and in control of it and builds a basis

      for further cooperation. Lenders tend to react badly when they hear

      about problems at a property from a source other than their

      borrower.

      In the course of such communications, the borrower must be very

      careful not to unintentionally trigger an event of

      default (for example, by admitting that it is unable

      to meet its debts as they fall due, which potentially could be tied

      into the insolvency default) or open up problems that did not

      previously exist.

3. Default

   It is common that a lender will not immediately call an event of

   default. In part, this is because they do not want to carry problem

   loans on their books (which generally involves greater

   administration responsibilities internally and potentially negative

   effects on reserves, balance sheets or credit ratings), and also

   because the lender would prefer for the situation to be resolved

   and may feel that there is a possibility to do so within a

   relatively short time-frame. If the borrower commenced

   communications before the default and the process was already being

   managed at an early stage there is a greater likelihood that the

   "default" will not become an "Event of

   Default."

   If a breach of a loan agreement arises and cannot be quickly

   remedied and there is no agreement among the borrower and lender to

   restructure the loan, the lender is usually in a better situation

   to achieve its aims if it calls an event of default, in which case

   it would typically send out a default notice. It will also freeze

   the bank accounts of the borrower pursuant to rights under account

   pledges as a first measure. The lender, however, will also be

   analyzing the benefits and down-side to calling an event of

   default. For example, relying on a "material adverse

   change" default provision may be difficult to prove and could

   result in counter-claims for damages if in reliance on such default

   the lender triggers cross-default provisions contained in other

   loan agreements of the borrower or its affiliates.

   If the lender is on shaky ground in calling the default, then

   the lender may need to be reminded by the borrower of the

   potential liabilities it could face as a

   result of any actions taken in wrongly calling a default.

   Wrongfully calling a default may give rise to a damages claim

   against the lender, for example, if the borrower's reputation

   is hurt or if the wrongful default results in tenants backing out

   of leases or an apartment developer losing sales; however, proving

   such damages may be difficult.

4. Enforcement or Workout

   Once the default notice arrives, the borrower should

   already have determined whether it is in its best

   interests...