by John C. Murray

© 2000. All rights reserved.

LENDERS SEE IT HAPPEN almost every day. A borrower faces some kind of economic hardship or downturn and the borrower's mortgage loan goes into default. The lender then has to decide what to do. Is a negotiated solution the best answer? Or should the lender commence foreclosure proceedings? The answer is never an easy one for the lender. There are numerous practical, economic, and legal factors to consider, and they may not all point to the same solution. This article will discuss the factors to consider, and this part will address:

REASONS TO FORECLOSE - In some situations, the lender may want to take the initial steps toward foreclosure soon after the occurrence of the default or during workout discussions with the borrower. The lender may take these steps because it feels that the borrower isn't negotiating in good faith or simply to create leverage during the workout discussions.

Putting Pressure on the Borrower

Commencing a foreclosure action puts time pressure on the borrower and, by starting the clock running on the notice of default and foreclosure process, time is not lost if the negotiations fail.

Going on the Offensive

Foreclosure is also the logical alternative if the borrower has threatened the lender with lender liability claims, if the lender has concerns regarding the borrower's lack of management and leasing ability, or if the borrower has allowed the property to deteriorate physically. In addition, if the lender anticipates a significant negative change in the market, in the borrower's financial condition, or in the condition of the mortgaged property during workout discussions or the remaining loan term, foreclosure may be the only solution.

Initial Alternatives

If some or all of the foregoing factors are not present, the lender may wish to consider alternatives to foreclosure such as accepting a deed in lieu of foreclosure from the borrower (assuming the borrower has offered a deed in lieu), obtaining a transfer of stock when the borrower is a corporation, or entering into a modification agreement with the borrower that contains adequate safeguards to protect the lender in the event of a future default.

THE FORECLOSURE PROCESS - The foreclosure procedure begins when the lender sends the borrower a default letter defining a cure period.

Notices and Cure Periods

Notices and cure periods, if any, are usually specified in the note or mortgage, or both (although they are occasionally inconsistent). However, in a dispute over notice and cure periods, the lender's history of accepting payments and its consistent behavior with regard to notice, cure, and reaction time vis-a-vis other borrowers may be considered by the court. In addition, state law may require that a certain form of notice, or a specific minimum time period to cure the default, be given to the borrower before acceleration of the loan.

Even at this simple first step, it is important to check with in-house or local counsel on the appropriate notice and cure period for each loan. Also, be aware that there are major differences between the handling of monetary and non-monetary defaults, with nonpayment of taxes usually being considered non-monetary (unless specifically stated otherwise in the loan documents).

Deed of Trust States

The second step depends on whether the foreclosure is occurring in a deed-of-trust state or a mortgage state. In a deed-of-trust state, a notice of default is filed with the county recorder at the end of the cure period by the trustee and a date is set for the trustee's sale. The notice of default states the time period in which other interested parties, including creditors, can file objections or reinstate the loan. After a specified period of time, which will vary from state to state, a notice of sale is filed setting or confirming the date for the trustee sale. All interested parties are once again notified. At the same time, the trustee, often a title insurance company, supplies a foreclosure guarantee that in essence tells the beneficiary which parties must be notified of the date of sale.

Mortgage States

In states that use mortgages, the process is either by judicial foreclosure or nonjudicial foreclosure. In a judicial foreclosure (which is the only method of foreclosure permitted in 15 states), a petition or complaint for foreclosure is filed with the court. It typically gives the defendant (the borrower) a period of time (usually 20 or 30 days) to respond after being served with the petition or complaint. If the defendant is difficult to serve, a public notice may be published. After the response period has expired, the lender may move for summary judgment. The summary judgment hearing is usually granted upon proof of the borrower's default and the outstanding indebtedness due under the loan, and at the hearing, if summary judgment is granted, the judge (or in some states the lender) sets the date for the sheriff's sale. Summary judgment on any matter can only be obtained if the judgment is uncontested or there is no dispute between the parties nor any questions in the mind of the judge about the facts of the case as presented to the court.

Sometimes There Is a Choice

Some mortgage states permit both judicial and nonjudicial foreclosures. A nonjudicial (or ``power of sale'') foreclosure (which is currently available in 32 states) often takes significantly less time to complete, because no complaint is filed and the sale is held promptly after the applicable statutory notice and publication requirements have been complied with by the lender.

This procedure is less expensive than judicial foreclosure, and the redemption period is often shorter. However, the lender may be precluded from obtaining a deficiency judgment in a nonjudicial proceeding, and a receiver may not be obtainable. Nonjudicial foreclosures are often advantageous only when the title report shows no subordinate or adverse interests and there is no threat of a lender liability action, because the interests and priorities of the various parties are not adjudicated.

Antideficiency Statutes

Some states (including Alaska, Arizona, California, Connecticut, Florida, Idaho, Minnesota, North Carolina, North Dakota, Texas, Utah, and Washington) have enacted antideficiency statutes. These statutes generally prohibit a lender's deficiency judgment against a borrower (often in connection with a nonjudicial foreclosure action) or limit a deficiency judgment to the difference between the debt and the greater of the fair market value of the secured property (as determined to the satisfaction of the court) or the price paid at the foreclosure sale.

Depending on the applicable state antideficiency statute and court decisions interpreting the statute, the protection afforded by the antideficiency statute may or may not be extended to apply to a guarantor if a lender elects to foreclose and then brings a suit against a guarantor for a deficiency judgment.

One-Action States

Some states (including California, Idaho, Montana, Nevada, New York, and Utah) have also enacted ``one action'' statutes or rules, that limit a lender to one lawsuit to collect its debt and enforce its security interest. In certain states that have enacted one-action statutes or rules, such as California, a lender must commence a foreclosure action (judicial or, if permitted, nonjudicial) contemporaneously with or before any action for a monetary judgment against a borrower. In other states with such statutes or rules, such as New York, a lender can elect its one action either by suing on the debt or by foreclosing on the secured property.

Redemption Period

In most states in which a mortgage instrument is used, and in states with deeds of trust where the foreclosure is pursued judicially, there is usually a redemption period, which varies by state. The redemption period may be either before or after the sale. In many states, the borrower's redemption rights may be waived in advance or as part of a workout. (Some states prohibit such a waiver if the borrower is an individual or residential or agricultural property is involved).

Receivers

In addition to beginning the foreclosure process, the lender should take all steps necessary under applicable state law to perfect or enforce its assignment of rents and leases and be entitled to the income generated by the property. To avoid the issue of ``control'' or being deemed a mortgagee-in-possession, the lender should seek the appointment of a receiver by the court in which the foreclosure is proceeding. The receiver usually has control over property income and accounts receivable, as well as management, leasing, operational, and employment matters. The receiver acts as a substitute for the borrower during the term of the receivership. In some states the receiver may be nominated by the lender, but the receiver is always an appointee of and responsible solely to the court. Some states, such as California, are fairly open insofar as the appointment of a receiver. Other states have the receivers appointed from a preapproved list within the specific court's jurisdiction.

Advantages of Receivers

Although receivers are sometimes costly, they prevent claims against the lender as an owner or mortgagee-in-possession and can serve to keep the mortgagee out of the chain of title if serious defects in the property exist, such as environmental contamination. In some states, appointment of a receiver or actual possession by the lender are the only sure ways to ``perfect'' or activate an assignment of the rents, which provides the lender with important leverage in the event the borrower files for bankruptcy.

Jurisdictional Issues--Federal or State Court

When pursuing foreclosure, the lender must determine whether to pursue the foreclosure in the federal or state court system. Diversity of citizenship is the most typical basis for bringing the matter to a federal court rather than a state court. The federal court can hear the claim on this basis only if the amount of the claim exceeds $50,000. To avoid excessive fees sought by federal marshals for foreclosure sales in some states, the lender may wish to ask a local sheriff or other official of a state court to conduct the sale, subject to the approval of such a procedure by state court officials. The local sheriff will typically charge from $600 to $2,000 to perform a sale for the state court, while the federal marshal's fees are based on a percentage of the value of the property and can be as much as $50,000 or higher.

Advantages of State Court Proceedings State courts are useful when the matter is less litigious, especially in the case of a consensual or ``friendly'' foreclosure. Also, if there is a question of the diversity of citizenship, state courts should handle the case. In states where the court system is reasonably neutral, as opposed to debtor-oriented, using the state court system may also be considered. The lender's choice of state court or federal court may also be affected by the existing backlog of pending cases in the respective court systems. (For example, as a result of the large volume of drug-related cases pending in federal courts in Florida, it may be more advantageous for a Florida lender to file its foreclosure action in state court.)

Be Sure To Check State Law First

Before deciding to pursue a foreclosure action in federal court, the lender must be certain that the applicable state law regarding the appointment of a receiver will be followed, because federal courts in various states have issued conflicting decisions on whether federal law (which holds that a default alone is not sufficient) or state law governs the terms and conditions of the appointment of a receiver. Some federal courts have also held that the federal interest rate (based on Treasury bills) rather than the state statutory rate applies for the calculation of post-judgment interest.

Judicial or Nonjudicial Foreclosure?

In deed-of-trust states and some mortgage states, the lender will have to determine whether to pursue a judicial or nonjudicial foreclosure. In some states, these can be and are ``double-tracked'' until the time of the nonjudicial sale. (This practice of double-tracking is particularly common in California.) Then, at the time of the nonjudicial sale, as long as there are no counter-actions by the borrower, the lender requests dismissal of the judicial action and it is granted. In California, where the one-action rule exists, the judicial sale is used as a vehicle for the appointment of a receiver.

If the sale is eventually done on a nonjudicial basis, the trustee will ``cry the sale'' at the courthouse and file it of record. At about the same time, a motion is filed with the court for a final accounting and termination of the receivership.

Timing Issues and Local Requirements

Timing issues will vary in different states. In several states, such as Texas and Missouri, the time between the filing of a notice of default and the sale is relatively quick (in Texas it can take less than six weeks, depending on how close the filing is to the first Tuesday of the month). In contrast, in the State of New York the process can take two years even when the foreclosure is uncontested.

Local Procedures

Although foreclosure is governed by state real property law and practice, there also may be local requirements. These may include transfer or ``stamp'' taxes (though in most states foreclosure sales are exempt), local and other taxes that may be assessed against the property upon a transfer, the cost of having a receiver appointed, and reassessment issues regarding real estate taxes. Analyze these factors during the early stages of foreclosure or even before filing the notice of default, as the cost may have some bearing on the decisions involved in foreclosure as described above.

NEGOTIATED SOLUTIONS - You may negotiate foreclosures to include timing and tax issues. Postponing the sale into the following year may allow borrowers to postpone recapture of certain tax benefits. Another concession would be to agree not to pursue a deficiency or personal judgment, if the loan is recourse or separate guaranties for the loan have been executed. In return for concessions, the lender may obtain the borrower's agreement to not defend or delay the foreclosure and not to assert any affirmative lender liability claims.

Also, if the borrower has been helpful in completing the foreclosure and is competent, it may be considered for management and leasing of the property upon the transfer of ownership to the lender (although this would be rare and should be approached with caution because of inherent conflicts of interest). In short, a negotiated settlement can eliminate exposure to lender liability and borrower delay, and can reduce foreclosure costs including receiver, management, attorney and consultant fees.

What About Bankruptcy Filings?

A lender cannot in any event force a borrower to give up its right to file for bankruptcy. Therefore, even if the lender negotiates on a friendly basis to postpone the sale until the following year, the borrower could file for bankruptcy at the last moment, unless a safeguard is built into the deal, such as an indemnification or ``springing guarantee'' by a solvent third party in the event the borrower files for bankruptcy, or an agreement that the lender will be entitled to automatic relief from the bankruptcy stay in the event of a bankruptcy filing (such agreements have been upheld by several courts, when no equity existed in the property for other creditors). Unfortunately, the worsening economic environment has made bankruptcy a practical and acceptable business choice for the owner of real estate secured by a mortgage.

ALTERNATIVES TO FORECLOSURE - Two of the most effective alternatives to foreclosure are the deed in lieu of foreclosure and stock transfers.

Deed in Lieu of Foreclosure

The most common alternative to foreclosure is a deed in lieu of foreclosure, with title transferred voluntarily from the borrower to the lender. However, this does not eliminate other liens, nor does it affect the status of the leases, which are often subordinated to the mortgage and therefore affected by foreclosure. Transfer tax and real estate tax issues must be examined as they apply to deed-in-lieu transfers (although many states exempt deed-in-lieu transfers from transfer taxes).

Do Not Merge Fee and Mortgage Interests

Care must be taken in connection with deed-in-lieu transfers so when the lender becomes the owner of the property, the fee and mortgage interests are not merged. If this happens, the lender may become the owner of the property subject to other liens, and the lender's mortgage may be deemed extinguished. If the lien is extinguished and the deed is later set aside for any reason, including as a preferential transfer or fraudulent conveyance in bankruptcy, the lender would have no secured claim for the debt. The language in the deed should specifically state that it is subject to the existing mortgage on the property, which is not extinguished. Also, the lender should be certain that the title insurance policy recites the existence of the mortgage and insures, through a non-merger endorsement, the continuing validity, priority, and enforceability of the mortgage.

Maintain Mortgage on Record

After the deed-in-lieu is completed, the mortgage should remain of record until the property is subsequently sold to a third party, at which time the mortgage lien would be released or discharged of record.

Stock Transfer

When the borrower is a corporation, the lender may in certain circumstances accept a stock transfer from the corporation in lieu of a title transfer. The main benefit of such a transaction is avoiding foreclosure and the concomitant transfer taxes for both borrower and lender. The downside involves assumption by the lender of the obligations of the corporation, such as other loans, environmental problems, taxes, accounts payable, and obligations to tenants and other third parties. Such a transfer should not be pursued by the lender unless there are overriding countervailing arguments to a foreclosure, such as severe negative tax consequences.

TAX AND LIABILITY ISSUES - The earnings to an institutional lender in a foreclosure are reduced by the depreciation expense that must be taken on the property. In addition, when a foreclosure occurs, the property is typically written down to its current market value or, as an alternative, to a value which could be obtained in the near future, given certain circumstances.

A potential future value might be used when clear market improvement is anticipated based on current market trends and knowledge of specific events occurring in the particular market. Physical deficiencies of the property could be corrected, leading to an immediate enhancement of value. If the current manager has a poor leasing and management track record, efficient new management might be expected to improve the performance and increase the cash flow of the property.

Reassessing Value

Whether the value used is the current market value or some variation of this amount, to the extent that this value is below the loan amount outstanding, an impairment is created, thus cutting into the reserves that have been set aside.

Contingent Liabilities

When the property does come into a lender's ownership, it may be forced to assume a number of contingent liabilities associated with the property. These may include environmental liabilities related to asbestos, soil toxins, or other contaminants. Additional items it may inherit from the borrower are lease obligations and development or impact obligations from the local municipality or state.

Mortgagee-In-Possession Issues

As mentioned previously, mortgagee-in-possession issues can arise when an assignment of leases is perfected, but no receiver is appointed on the property. Without an appointed receiver, the borrower may assert that the lender misused or misapplied funds while it had control over the revenue stream. Also the borrower may claim that the property was damaged by the assignment of rents insofar as the ability to lease the property is concerned (although this argument is not likely to prevail since the borrower agreed to the assignment of rents and the lender is merely exercising its rights under the loan documents).

When an assignment of rents is activated by the lender pursuant to a prior perfected security interest in the rents, absent a receiver or a state statute obligating the tenants to pay the rents directly to the lender in such a situation, the tenants may opt to pay no one until a clear resolution of ownership is determined. During this time, there is often little if any revenue to pay the bills which will accrue on the property, and the borrower will have no incentive to pay those bills, especially if the loan is nonrecourse. And in the current economic climate, tenant credit may weaken, with a tenant's rent-paying ability deteriorating to the point where subsequent collection efforts prove futile.

In addition to these issues, a lender may be liable for any injuries that occur on the property if it has taken actual physical possession of the property or is otherwise deemed to be in control of the property or the borrower's business. Obviously, a major institution would be a more inviting target for a lawsuit than would the borrower should such an injury occur.

ASSET MANAGEMENT AND FINANCE GROUP LIAISON - During the entire foreclosure process, a close liaison with the institutional lender's asset management group should be maintained, particularly the specific asset manager targeted to take over the property once the foreclosure sale occurs. The asset management group should be a valuable resource for advice regarding potential receivers, management companies, and leasing agents within a given market for a given property type. This pre-screening can save the account manager considerable time and effort.

Advice and Assistance

The lender's asset management group can also provide assistance and advice regarding management, leasing, and service contracts for a specific property. When appointed, the receiver will typically inform both the borrower and the lender about various courses of action. (However, under no circumstances should the lender direct the receiver to take specific actions, as the receiver is appointed by and is the agent of the court). The asset management group can provide valuable guidance and expertise regarding receiver issues and management of the property.

Timing, Taxation, and Bid Prices

In addition, the lender's internal tax or finance department should be consulted regarding the reserve impact that is projected for each property. Their input is critical for timing issues relating to the foreclosure. There may be financial reasons for booking a property in a particular quarter or, if the foreclosure is likely to occur at the end of the year, it may be beneficial to move it into the next year. The price at which to bid and book the project at the foreclosure sale should also be discussed with such departments before the sale. They can provide advice about the ramifications of many financial issues related to the bid.

For example, in states where transfer taxes are high, minimizing payment of these taxes may be an argument for bidding low. However, a bid must be ``commercially reasonable'' or it could be subsequently voided by the court in certain states. Also, if the amount bid is substantially below the value of the property (which may be determined at a later date) and the former owner files for bankruptcy, a fraudulent transfer claim may be raised by the debtor or bankruptcy trustee. (However, a recent decision by the U.S. Supreme Court, BFP v. Resolution Trust Corp., 114 S. Ct. 1757 (1994), has held that when a foreclosing lender has obtained title to the property as the result of a regularly conducted, non-collusive foreclosure sale in accordance with applicable state law, the sale cannot later be set aside as a fraudulent transfer.) A second opinion on valuation can be very valuable. As a general matter, the amount bid at foreclosure should not exceed the lesser of the carrying value of the mortgage loan or the appraised market value of the property.

OTHER RISKS AND SOLUTIONS - Other risks and possible solutions to consider arise in the context of financing issues during receivership, environmental and engineering reports, and lender liability questions.

Financing Issues During Receivership

When cash flow or capital shortfalls occur during a receivership the receiver may, in some states, issue "receiver certificates" to obtain financing to cover the shortfalls. The receiver can also use receiver certificates to cover tenant finish and leasing commission costs, and capital items such as environmental cleanup. Such receiver certificates have priority over all other liens on the property. In other states, loans may be obtained from the first mortgage lender, which is generally the best source for receiver financing, through the issuance of loan commitments and the execution of nonrecourse promissory notes by the receiver. The first mortgage lender can usually provide financing at a lower cost than can be obtained by having the receiver obtain financing from third-party sources. In return for providing the financing, the priority of such advances and their inclusion as part of the mortgage indebtedness should be confirmed by the court and deemed to automatically occur, and affirmatively insured by an endorsement to the mortgagee's policy of title insurance.

Environmental and Engineering Reports

Environmental cleanup and engineering costs are always a concern in a foreclosure action. At a minimum, a ``Phase I'' environmental inspection report from a qualified environmental consultant or engineer should be obtained by the lender before any trustee or sheriff's sale on the property. In some states, such as California, structural engineering reviews should also be obtained if they were not already conducted. Should the Phase I environmental report recommend further testing or remedial action, obtain a ``Phase II'' report before the foreclosure sale so any risks, and the estimated cost of dealing with those risks, are known and quantified in advance. If the lender does not want to own the property or even be in the chain of title for environmental or other reasons, it may cancel the foreclosure sale, decide not to bid at the sale, or have the receiver handle the liquidation of the property through a court order. This would avoid the lender being responsible for the cost of cleanup in the instance of environmental contamination.

Lender Liability

During the course of a foreclosure, the lender must always anticipate that additional litigation may occur, such as bankruptcy or lender liability. Therefore, sensitive information should always be funneled through in-house or outside counsel. Appraisals, environmental audits, engineering reports, and other information pertaining to the property should be ordered through counsel to shield them (in most instances) from discovery. In all written information, be straightforward and businesslike, avoiding inferences, opinion, sarcasm, or frivolous statements. Remember that anything put in writing could someday be shown in a court of law, with the lender's representative on the witness stand. Thinking it through in advance will avoid a very embarrassing and potentially costly moment at a later date.

MODIFICATION STRUCTURES - In some circumstances, a modification structure may be a workable alternative to a traditional foreclosure.

Choice of Structure

Once it has been determined that a modification is feasible, there are a number of possible structures to consider. Take into account the analysis and input that had previously been done and the value of the property and the trend of this value as they relate to the principal balance and the anticipated accrual amounts. Also, choose the particular structure in light of anticipated trends, both long- and short-term, within the property itself, the market, and with respect to the lender's current policies, procedures, and position for modifications.

Basic Modification Structure

The most basic modification structure is a simple accrual and compound-interest rate modification that reduces the pay rate to an amount lower than the contract rate, and the difference continues to accrue and compound monthly at the contract rate. This structure tends to work best when the value of the property indicates that there will be an excess value relative to the total accruals and principal balance. If the trends are less positive, the pay rate may be lowered with the difference between the coupon and pay rates accruing, but not compounding.

Other Modification Structures

If the market situation is extremely difficult, with the property's value dropping below the current principal balance, or market trends appear to be adverse, a reduction in the coupon rate for the term of the modification with no accrual or compounding could be considered. (The potential tax ramifications of this action are discussed below.)

Anticipating Improved Performance

If there is a reduction in the coupon rate for the term of the modification with no accrual or compounding, the modification structure should include some protection for the lender in the event that the property may perform well at a future date. There are several conditions that can mitigate the loss to the lender in the event the property trends show improvement. The most common is to include a contingent-interest or shared-appreciation feature in the modification. When the lender is giving up its rights to future yields through a reduced interest rate modification, such features should be incorporated.

Standard Features

Standard features in a modification structure should include the lender's right to any excess cash flow, a shortened maturity date on the loan if deemed desirable, a tax escrow, and other safeguards that would reduce the probability of future default and lower the lender's exposure on the loan.

Special Arrangements

In properties requiring capital improvements, or significant tenant improvements and leasing commissions, the estimated expenditures for such items should be set forth in a budget prepared by the borrower for the lender's review on an annual basis, if not more often.

Another alternative in lieu of a longer-term modification would be to allow for a payoff of the loan at par or at a discount. Payoffs at par should be encouraged when the lender sees a deteriorating situation and can get its principal back at 100 cents on the dollar and not risk future exposure to deteriorating conditions. If the lender provides for a future date payoff at par or discount in conjunction with a modification, it may also wish to include a contingent-interest or shared-appreciation feature.

LENDER'S SAFEGUARDS - The two most important safeguards a lender can take advantage of are cash management agreements and expanded default provisions. They can protect the lender during negotiations and can be incorporated into the modification itself.

Cash Management Agreements

A cash management agreement can provide the lender with perfection and activation of its rent assignment (through acknowledgment by the borrower that the lender is perfected, or by requiring tenants to send rents directly to a lockbox, or by appointment of a receiver) and will become a stipulated cash collateral order should the borrower file for bankruptcy. The cash management agreement can contain other bankruptcy protections, including an agreement by the borrower not to challenge a motion to obtain relief from the automatic stay by the lender and an agreement not to seek any extension of the period during which the borrower has the exclusive right to file a bankruptcy plan.

Release from Lender Liability Claims

The borrower should also release the lender from any claims the borrower may have or allege concerning lender liability. Both parties should explicitly agree in any modification or cash management agreement that all future agreements must be in writing and that neither party is bound by any oral statements or representations. During this time, the lender should not give up any rights to commence or proceed with foreclosure upon a default under the cash management agreement, the modification agreement, or any of the original loan documents.

Management Safeguards

Cash management agreements often require that the lender remit cash for operating expenses back to the borrower. If the borrower has a hard time sticking to a budget, or if its reporting abilities are weak, it may help to have a third-party management company or accounting firm represent to the lender that the funds are being spent in accordance with the cash management agreement, if the lender is not in a position to replace the managing agent.

Expanded Default Provisions; Deed in Escrow

Another lender's safeguard, which should be included in the modification documentation, is to expand the default provisions under the loan documents. These default provisions should state that if certain events do not occur by specific dates (such as income or debt-service coverage requirements), an event of default results, causing either immediate title transfer or commencement of an uncontested foreclosure. This would require that a deed to the property be placed in escrow such that the agreed-upon transfer will in fact occur uncontested. A further inducement to the borrower to gain his or her cooperation on title transfer would be a personal ``springing'' guarantee by a solvent third party, of a specified amount in the event the borrower or any of its principals attempts to block transfer of title or the borrower files for bankruptcy.

Shorter Notice and Cure Periods

If possible, the lender should shorten existing notice and cure periods and obtain personal recourse for post-default rents. These may be alternatives, if not belts and suspenders, for deeds in escrow.

Pre-packaged Bankruptcies

Pre-packaged bankruptcies are another way to enforce, through the court's blessing, what the borrower may be agreeing to do under the modification.

Expanded Indemnities

If environmental indemnities in the original loan documentation are insufficient, an expansion of these indemnities should be inserted in the modification documentation. Most loans made before the mid-'80s may not include environmental indemnities. This is an ideal time to obtain them. In addition, this is an ideal time to obtain additional protective provisions, or strengthen or update clauses in older loan documents, such as due-on-sale clauses, prepayment-premium clauses, tax escrow clauses, anti-forfeiture provisions, carveouts in non-recourse provisions, and ERISA and RICO provisions.

TITLE POLICY ENDORSEMENTS - For the mortgagee's policy of title insurance, the following endorsements must be obtained, at the borrower's expense, in if applicable, any changes in the existing collateral or to incorporate additional collateral that may be added to the loan. (Note that obtaining additional collateral as part of a loan modification is risky, as it may constitute additional security for an antecedent debt and be declared a preferential transfer under the Bankruptcy Code); and

- For mortgage modifications providing for the periodic addition of contingent interest or shared appreciation payments to principal, endorsements covering, when applicable, such issues as usury, non-imputation, shared appreciation, interest-on-interest and compounding of interest, variable rates, and negative amortization and (if available) recharacterization.

ATTORNEY-CLIENT PRIVILEGE - During any workout phase, it is important to maintain the attorney-client privilege for any sensitive written correspondence or work product. These materials should flow through either the lender's in-house counsel or to outside counsel. Any memos that are sent to counsel with copies to other people may not fall into the realm of attorney-client privilege and may be subjectthat such actions on the part of the lender actually caused some of the problems that resulted in a loan default.

Record a Chronology

The lender should consider recording a personal chronology of factual events during negotiations, including any requests the lender may have made of the borrower. This can assist outside counsel if they have not been involved in the case or for clarification purposes if negotiations deteriorate into litigation.

Formalize Meetings

Additionally, to avoid potential lender liability actions or misrepresentations on matters discussed, it is useful to have at least one other person present during negotiation sessions, including telephone conversations. Until the negotiations turn hostile or litigation has commenced, it may be better to have a business person present at the negotiations rather than an attorney. If either party intends to bring counsel, advance notice should be given to allow the other party to also arrange for legal representation at the meeting. If the borrower appears at a meeting with counsel and this has not been previously arranged, the lender's representative should excuse himself or herself from the meeting.

COST AND TIMING ISSUES - The lender should establish a preliminary timeline and a budget for legal counsel, services, consultants, and other outside sources before beginning the modification negotiations. Although the preliminary budget will frequently be exceeded and the timelines extended, having an initial plan will help contain costs and highlight time requirements. In negotiating a modification, fees can vary substantially, depending on the complexity of the modification and the willingness of the borrower to cooperate in the negotiations. These fees, along with any closing costs, should be passed on to the borrower since the modification results in a major benefit to the borrower. The pre-negotiation agreement should expressly provide that all such costs will be borne by the borrower.

The Importance of Drop-Dead Dates

At all points during the modification negotiations, through and including execution of the modification agreement, drop-dead dates should be established with the borrower. Although these dates can be extended during the process, they put pressure on the borrower to reduce the amount of time spent during the entire procedure. This will often result in a faster closing. Without such dates, the borrower may attempt to stall and delay every discussion, sometimes with no intention of closing the modification, simply to gain a tax advantage by pushing a potential bankruptcy or foreclosure action into the next tax year.

This illustrates how important it is to know the borrower's true goals in the negotiations. For example, if the lender knows up front that the borrower is simply seeking tax advantages, a stipulated foreclosure to occur not earlier than an agreed upon date could be considered as a possible alternative to fruitless negotiations toward loan modification. This would result in a lower cost of foreclosure to the lender and yet give the borrower some of the desired tax advantages. Although such a stipulated foreclosure is probably not the most desirable alternative for the lender, it could be acceptable if the time periods involved are not extensive, and the risk of a bankruptcy filing or other litigation cropping up along the way is mitigated.

TAX ISSUES - If principal forgiveness is negotiated as part of the modification agreement, the principal forgiven is taxable to the borrower. Thus, even if principal forgiveness has some appeal in a specific modification, it may also have a significant negative effect on the borrower. This tax effect will vary for each transaction.

Contract Rate Reductions

Reductions of contract rates can also have negative tax consequences. If the contract rate is lowered to or below the Applicable Federal Rate ("AFR"), a taxable event will occur for both the borrower and the lender. In this case, the total number of payments made during the modification period, as well as the repayment of principal at the end of the period, are discounted back to present value at the current AFR rate. To the extent that the sum of this discounted series of payments is less than the current outstanding principal balance, the Internal Revenue Service ("IRS") views the difference as forgiveness of debt and this amount becomes taxable.

Effect of Modifying an Existing Loan

A modification of an existing loan may constitute a taxable event if the modification is so substantial that it amounts to the issuance of a new security. Gain or loss will be realized depending on the borrower's adjusted basis in the debt instrument and the amount realized from the "disposition" of the "old" debt instrument. A modification will be deemed "material" if there is a reduction in the interest rate or an advance of additional funds by the lender. Such a transaction is treated by the IRS as a taxable disposition of "property" for new cash or property.

Book Value Enhancement

Another tax concern relates to the borrower's book value for the property versus the loan amount. In the event of a foreclosure, the borrower would recognize a gain on the difference between these amounts for income tax purposes. If the difference is significant, this tax liability may provide a strong incentive for the borrower to proceed with a modification. On the other hand, the borrower may have suspended (passive) operating losses that can be used to offset any taxable gain produced by foreclosure. In some instances, accumulated losses can more than cancel any gain, actually improving the borrower's balance sheet.

Be Prepared to Make Adjustments

If it appears that a modification is going to require a reduction in the contract rate or a principal reduction, the lender's tax or finance department should be kept informed so they can assist with any necessary adjustments.

SUBORDINATE LIENS - In connection will all loan modifications, written consents and subordinations of lien must be obtained from all junior lienholders. If those consents and subordinations are not obtained, junior lienholders may argue that they have been prejudiced or that their security has been impaired as a result of the modification, and that the first lienholder's priority should therefore be voided or subordinated to the extent of that prejudice or impairment. Courts have been generally sympathetic to such claims by subordinate lienholders.

Courts Likely To Interpret Changes Unfavorably

Some courts have held that virtually any change in the terms of a mortgage, even an extension of the maturity date or the postponement or accrual of interest payments, may prejudice junior lienholders. Any change that makes an increased demand on the borrower's cash flow, increases the likelihood of default or encourages a lack of financial responsibility by the borrower (for example, a large balloon payment or payment of a significant amount of accrued interest at maturity) could be interpreted by a court as prejudicing intervening lien claimants.

RETAINING LIABILITY OF PARTIES - The lender should make certain, in connection with all loan modifications, that all guarantors, endorsers, and the like, either execute the modification agreement or else reaffirm their obligations in a separate (or attached) written document at the time of execution of the modification agreement, and that the modification agreement expressly reserves all rights against guarantors; otherwise, that guarantors may be released from personal liability.

Suretyship Model

When the property has been previously conveyed from the original owner/borrower to a party who has assumed the debt, and such party enters into a modification agreement without the consent of the original borrower, the general rule (based on suretyship principles) is that the original borrower is released from the debt obligation (assuming the lender had knowledge of the loan assumption). Of course, if the original borrower consents to or executes the modification agreement, the original borrower remains liable for the debt and other loan obligations.

Extent of Release: It Depends on the Jurisdiction

If the transferee from the original borrower took title subject to the mortgage and did not expressly assume it, the "minority rule" releases the original borrower if he or she doesn't consent to the modification agreement executed by the transferee. However, the "majority rule" is that since the grantee never assumed any liability under the mortgage, the original borrower is only released to the extent of the value of the property at the time of the modification, because the original borrower is not a surety here, as he or she would be if assumption occurred.

If the original borrower enters into a loan modification agreement with the lender after a conveyance of the property to a third party, the transferee is still bound by the modification, even though he or she did not consent. This is true whether or not the transferee took subject to or assumed the mortgage.

When Do These Considerations Matter?

The foregoing considerations may not be important if the mortgage loan is nonrecourse; whether or not the original borrower executes the modification agreement may be unimportant to the lender because the property constitutes the lender's sole security. However, if the original borrower has any personal liability on the loan, or if there are ``carveouts'' from the exculpatory provisions in a nonrecourse loan, such considerations become important to the lender.

Part 2 of this article will address the mechanics of pre-negotiation agreements, and discuss credit agreement statutes which have been enacted in 37 states, and will examine the nuts and bolts of one of these agreements.