As the economy continues to struggle, finance and banking lawyers across the country are seeing an increase in commercial loan workouts, which range from simple loan modifications to complicated bankruptcies. Patrick Lagrange, an investment banker and chairman of the Chicago-based Turnaround Management Association, says the number of so-called “amend and extend” arrangements has also been on the rise the past 18 months.
In the Sacramento area, where the real estate market has seen falling rents and tenant bankruptcies, lawyers’ work on commercial loan workouts has also soared.
“When things were on a positive upswing, finance lawyers were doing new loans, and there was a lot of positive activity,” says Gregg Josephson, a banking and finance attorney at Downey Brand. “Now, a significant amount of our lending practice is on the loan workout side, particularly in commercial real estate.”
Hayne Moyer, an attorney at Kronick Moskovitz Tiedemann & Girard, says the firm’s banking practice has increased significantly the past three years. “We have added three additional attorneys to assist the four attorneys that work in this field,” he says, adding that between 2007 and 2009, the banking segment of the firm’s practice has increased by about 250 percent.
Morgan Jones, a banking specialist with McDonough, Holland & Allen PC, which represents commercial and industrial banks, says his firm’s attorneys have also seen an increase in time spent on loan modifications and changes. In 2007, about 5 or 10 percent of Jones’ hours were devoted to workouts, and the majority of his time was spent on loan originations. That flipped in early 2008, and now at least 95 percent of Jones’ time is spent on workouts. The firm has met the increased demand in this area by redeploying senior attorneys with substantial workout and creditors’ rights experience, training associates in this area and hiring a veteran creditor’s rights lawyer.
Stephen Arnot, an attorney with Bullivant Houser Bailey PC’s Portland office, has a significant caseload in Sacramento and says his practice has increased 50 percent the past two years. The firm has hired another associate to help with loan workouts.
After the financial crisis hit, many banks tightened credit. Some of these lenders wanted to find a way out as opposed to staying with debtors, and they often wanted additional principal or more guarantors. At the same time, borrowers faced a cash-flow crisis. “It was really a perfect storm,” Josephson says.
For the most part, banks hire attorneys after borrowers default on loans. “Our firm represents lending institutions that pay our fees directly,” Moyer says. “Oftentimes our fees will be added to the borrower’s debt in a workout situation.”
According to Moyer, borrowers are generally looking for extensions of the maturity date, a reduction in interest rate, a deferral of payments and, in some cases, partial debt forgiveness. The banks are typically looking for additional security to add further protection for the loan balance. Josephson says many of his cases involve extensions of loans with changes to interest rates. “Banks are putting a very short leash on these borrowers by adding tight controls,” he says. Most of these extensions are short. For longer loan extensions, borrowers often need to pay down additional principal.
Although the lender usually hires a lawyer, Josephson says there are situations where it makes sense for a borrower to seek legal counsel. If a borrower is hitting a maturity date and the current bank doesn’t want to modify the loan, or if a borrower is on the hook with a separate personal guaranty, then they might want to consider a formal loan workout.
There is also a reputational risk. For example, real estate developers may want to preserve their names instead of filing for bankruptcy. “If the project is worth saving, bankers and developers are smart enough to analyze the numbers and work things out,” Josephson says. Some banks are taking significant write-downs if the developer can’t bridge the gap. Borrowers, for their part, might need to come up with cash to pay down principal on the loan.
Attorneys say they try to find some common ground where both the borrower and the lender can absorb some of the pain. “A successful workout will allow the borrower/debtor to remain in business and support employees of the debtor and the community overall,” Moyer says. “A successful loan workout almost always involves some form of loan modification.”
Jones says the long-term effect of a workout should be positive for both the borrower and the lender. If it is properly conceived and executed, it will save the borrower’s project or business and mitigate the risk and improve the balance sheet of the lender, as well as avoid potential regulatory pitfalls.
“If the project is worth saving, bankers and developers are smart enough to analyze the numbers and work things out.”Gregg Josephson, banking and finance attorney, Downey Brand LLP
Lawyers in the Sacramento area say several hurdles can stand in the way of successful loan workouts. Perhaps the biggest obstacle is the willingness of the principals to come to a resolution.
Josephson says he sees a different approach depending on the type of bank and type of borrower in the mix.
“Ultimately, the outcome of the workout process really depends on the bankers involved,” he says. “If the bank is in a sound position, it may be more willing to work with the borrowers. If it has a less favorable capital position, it may be more worried about taking the added risk.” A bank facing regulatory pressures might not be able to extend more problem loans.
If some lenders are more willing to negotiate than others, this is also the case with borrowers. “The personalities of the principals really are the biggest hurdles,” Josephson says.
Moyer notes that clients can be emotional, and says that the lack of experience of the debtors and their counsel is sometimes an issue.
“As a result of lack of experience, the debtor or its counsel may be unrealistic about the debtor’s or a project’s or an enterprise’s prospects and the rights and interests of the lender,” he says, adding that sometimes the debtor or the counsel will take an adversarial or antagonistic approach that could slow an otherwise successful process.
Unfortunately, certain deals can’t be fixed. Occasionally, a project or loan cannot be worked out because of values or lack of funds. In the case of a real estate development project, there could be environmental issues or land use entitlement problems.
Arnot says commercial workouts can be difficult to get approved because property values are down. If banks are willing to charge off or write off, there becomes more flexibility in getting a loan approved because regulatory compliance issues don’t come into play as much.
Banking and finance lawyers in the Sacramento area expect loan workouts will keep them busy for the foreseeable future. “This area of practice will remain strong for another two to three years,” Moyer says. “While the current volume may not increase, I predict that it will remain steady at this level for at least three years.” Jones says that, during the current recession, he has seen problems roll through different industries, including homebuilding, automobile, recreational vehicle and boat dealerships, and weaknesses are beginning to become more apparent in hospitality, commercial and retail sectors. He adds that it can take a while for some workouts to come to fruition.
Attorneys who work with banks and borrowers point out that, although work related to commercial loan workouts has increased, it is cyclical. Once the economy picks up, they expect the workload to shift. Josephson, for example, says he is encouraged by the increase in retail and restaurant activity in some parts of Sacramento.
“I definitely think there is light at the end of the tunnel,” he says.
Arnot, on the other hand, thinks we could be in for harder times.
“If the economy stabilizes, hopefully these workouts could be successful,” he says.
However, Arnot adds that if the economy doesn’t improve, then some of the current workouts are only delaying the inevitable.
“Loan defaults are probably going to increase, and we’ll see a lot more workouts in the next few years,” he says.
On the home front
On the residential side, loan workouts and modifications have also increased the past few years. According to a February 2009 statement from Gov. Arnold Schwarzenegger’s office, “From January 2008 to December 2009, a total of 282,717 loan modifications were completed with nearly 146,000 being done in just 2009.” The California Foreclosure Prevention Act, which came into effect June 2009, changed the foreclosure process so borrowers had more time to modify loans.
Later in 2009, the governor signed Senate Bill 94 into law, a bill focused on loan modifications. The legislation, which prohibits charging an upfront fee on loan modification services, resulted from concerns about scams. Senate Bill 94 makes it illegal for mortgage companies, law firms and attorneys to accept an upfront fee.
As a result of SB 94, many reputable law firms have stopped offering loan modifications or have started to screen cases more carefully. Sarah Litchney, founder of the Litchney Law Firm in Sacramento, says the firm began to reduce its loan modification caseload last year, and it currently doesn’t accept any additional loan modification clients. The firm started doing this even before SB 94 passed.
“The process with the lenders was becoming extremely difficult. They were playing games, losing paperwork, not respecting the attorney-client relationship and were erroneously denying applications and foreclosing improperly,” Litchney says.
During recent months the pace of loan workouts appears to have slowed. The California Department of Corporations reported that during the last quarter of 2009, there were 193,262 workouts initiated, down from about 260,000 the previous quarter. The biggest question remaining on the residential side is whether loan modifications will make it easier for people to avoid foreclosing on their homes.
If homeowners have experienced a significant reduction in income, they may not be able to afford to pay their mortgages, even with a loan modification.
“People are frustrated with their lenders and the time-consuming process,” Litchney says. “From our experience with those who do obtain loan modifications, often it is not enough to truly help, and foreclosure still remains a great possibility.”
Litchney, whose firm also practices in bankruptcy law, says she has seen an increase in short sales and foreclosures during recent months. In addition, the firm has started to take more litigation cases against lenders involving improper foreclosures.
This year could provide some of the first expansions in bank lending since 2008. So is the market back up to speed? No. But banks are slowly and smartly increasing their appetites for commercial lending, and the Capital Region will see its share of transactions.
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