It goes without saying that lenders are aware of the risk that a borrower may default. Lenders may not, however, be aware of the risk that they may unintentionally assume liability if a borrower defaults and such lenders enter into workout discussions that do not end in an agreement.  A lender may believe it is acting in the spirit of mutual cooperation by talking to a defaulting borrower about modifying the loan instead of immediately exercising statutory or contractual remedies.  But, as the saying goes . . . no good deed goes unpunished.

We’re Working it Out … What Could Go Wrong?

If negotiations between the parties fail, lenders are opening themselves up to a myriad of potential lender liability claims. The term “lender liability” is itself amorphous and can describe a variety of contract and tort theories under which borrowers have sued lenders.

Under such blanket theory, borrowers generally claim that the lender has exercised undue control over the borrower, thereby making the lender responsible for the borrower’s losses. But, a borrower’s claims can be even broader and include allegations of fraud, negligence, conversion, breach of implied covenant of good faith and fair dealing, and breach of fiduciary duty. If successful on a lender liability claim, a borrower may be entitled to recover not only compensatory damages but also substantial punitive damages. The bottom line is … a lot can go wrong for a lender.

You Have My Attention – What Should an ABL do to Protect Itself?

Now that you are aware of the lender liability peril that may befall a lender, let’s discuss what such lenders can do to protect themselves in a workout context. Lenders can reduce exposure to liability claims by entering into a pre-workout agreement that, among other things: (1) obtains a general release of liability from the borrower and any insider guarantors and subordinated creditors; (2) makes clear that no agreement is final unless it is in writing and duly executed by persons authorized to sign; and (3) obtains an acknowledgement that the lender is under no duty to restructure the loan or grant any concessions.

In addition to reducing a lender’s exposure to lender liability claims, pre-workout agreements are also helpful in establishing ground rules for negotiations and identifying the individuals that are authorized to negotiate on behalf of each party. Establishing this framework can help keep the discussions focused and more productive. These agreements are also useful to obtain estoppels from the borrower, which prevent the borrower from asserting certain defenses in the event of litigation. For example, the lender can obtain a written acknowledgement by the borrower of the events of default under the loan documents and their materiality, in order to estop the borrower from later disputing the same. Lenders can also obtain an acknowledgement by the borrower that the loan documents are in full force and effect, preventing any later argument that the agreements are not enforceable. Finally, if workout discussions prove unproductive, the pre-workout agreement can set forth a plan to terminate the discussions in an orderly fashion.

But, How I am Going to Convince the Borrower to Sign One of These Agreements?

Send a friendly reminder that if the defaulting borrower does not agree to enter into a Pre-Workout Agreement, you may elect to enforce the rights and remedies provided under the loan documents.

Good Point, Now What Should I Put in My Pre-Workout Agreement?

While it may be necessary to include additional provisions tailored to your transaction, here’s a good starting point for the items to incorporate in a pre-workout agreement:

• a schedule of all loan documents
• a schedule of all known defaults
• an acknowledgement by the loan parties that:

1. such defaults continue to exist
2. the lender has not waived such defaults
3. all loan documents are in full force and effect and will remain so throughout the workout negotiations
4. the obligations owed to the lender remain outstanding
5. any extensions of credit or acceptance of partial payments during the workout negotiations do not constitute a waiver of the defaults
6. the lender is not obligated to negotiate or modify the loan documents
7. workout discussions are not binding until written and signed by the lender
8. any loan modification is subject to formal credit approval

• an agreement by the lender to forbear from exercising remedies during the course of the negotiations
• an agreement that the lender’s expenses (including legal fees) will be paid by the borrower
• a cutoff date for workout negotiations
• a general release by the loan parties
• a confidentiality provision
• a provision stating that workout negotiations are to be deemed settlement discussions and are not admissible in state or federal court
• a bring-down of the borrower’s representations and warranties in the loan documents

The Long and Short of It…

Lenders who attempt to salvage problematic loans by entering into workout negotiations may find themselves at risk of facing a variety of “lender liability” claims if an agreement cannot be reached. Such claims can be broad and brought under a variety of theories. These broad risks can be mitigated, however, by entering into pre-workout agreements. Pre-workout agreements also provide the benefit of establishing both a framework for productive discussions and a plan to terminate unfruitful negotiations in an orderly fashion.