Written by: Andrew Sapiano and Michael Brown
In light of the COVID-19 crisis, we have had more and more clients (both borrowers and lenders) approach us to ask about the benefits and risks of forbearance agreements.
A forbearance agreement is a contract entered into between an existing lender and borrower whereby the lender agrees to temporarily refrain from pursuing its strict legal rights or remedies under existing loan and/or security documents in exchange for certain terms, conditions and other concessions by the borrower.
Below, we outline the general purposes, benefits (for both lenders and borrowers), key provisions, risks and pitfalls of forbearance agreements.
The purposes of a forbearance agreement include:
- Providing more time for the borrower to repay its debts, by temporarily suspending the time for repayment or reducing payments owing;
- Providing opportunity for the lender to maximize profitability and/or recovery in the event of default by the borrower;
- Clarifying or resolving disputes and setting mutual expectations for repayment;
- Modifying the original terms and conditions of the loan and/or security agreements; and
- Avoiding costly and uncertain litigation or bankruptcy/insolvency proceedings.
Forbearance agreements can be mutually beneficial to both lenders and borrowers. The benefits for lenders include the opportunity to:
- Correct any deficiencies in the loan documents;
- Perfect any unperfected security interests against the assets of the borrower or any guarantors;
- Obtain additional or increased security such as third-party guarantees;
- Obtain indemnification or releases of outstanding claims against the lender by existing borrowers or guarantors;
- Amend existing loan documents to include new covenants, acknowledgements, conditions or amend the repayment terms or schedule;
- Require the borrower to report certain information to the lender in a timely manner or allow the lender to monitor or manage the borrower’s activities more closely, if not already included in the original loan documentation; and
- Collect additional fees and interest.
The benefits for borrowers include:
- the opportunity to defer payment to a lender in order to restructure its business or to await improved business conditions;
- the opportunity to avoid the situation where the lender removes or takes control of certain equipment or other collateral from the borrower’s business; and
- the opportunity to avoid the expense and distraction of having to defend claims or proceedings initiated by a lender to recover under the loan documents.
- Key Provisions
The content and structure of any forbearance agreement will vary depending on the circumstances of each case, but typically, a forbearance agreement will include the following key provisions:
- Borrower Acknowledgment – where the borrower acknowledges certain facts such as the current amount of outstanding indebtedness, any past default(s) or non-compliance by the borrower under the loan documents, the continued validity of the lender’s security interest and the objectives of the forbearance agreement;
- Lender Forbearance – where the lender agrees to forbear its rights and remedies under the existing loan documents and the length of the forbearance period;
- Conditions Precedent – where certain conditions are set out that must be met by the borrower before the forbearance agreement becomes effective, such as the delivery of certain documents, payment of additional fees or retention of a restructuring consultant or financial advisor;
- Covenants – whereby the borrower makes certain promises to the lender, such as continued compliance with the loan documents, achieving additional or amended financial targets and refraining from paying dividends; and
- Other Key Provisions – which include (i) reaffirmation of guarantees, (ii) waiver of defenses and releases of claims by the borrower, (iii) indemnification of the lender, (iv) events of default and (v) lender remedies.
- Risks and Pitfalls
In negotiating or entering into a forbearance agreement, lenders will want to:
- Ensure proper financial and legal due diligence of the borrower and any guarantors (including a full understanding of the borrower’s present assets and liabilities, the lender’s security position relative to other third-party lenders, and the viability of the borrower’s business going forward);
- Ensure proper “consideration” (i.e. quid pro quo) at the time of entering into the forbearance agreement to avoid the risk of legal invalidity for lack of consideration;
- Ensure any new security granted by the borrower or payments made by the borrower to the lender would not constitute a ‘preference’ over other third-party creditors;
- Ensure there is evidence to show no coercion, undue influence or unconscionability in the making of the forbearance agreement that can be later used by the borrower to attack its legal validity;
- Consider whether forbearing will provide greater returns than simply relying on existing loan documents;
- Consider whether to require a forbearance fee to be paid or to require the borrower to pay the lender’s fees and expenses (including legal) of preparing the forbearance agreement; and
- Consider whether to require the borrower to obtain or acknowledge they are waiving independent legal advice before the borrower enters into the forbearance agreement.
For borrowers, they will want to:
- Ensure they and any guarantor are not inadvertently providing more or new security to a lender above and beyond what is reasonable;
- Consider whether there are any additional fees or interest payments over the term of the loan resulting from the lender’s forbearance; and
- Ensure that they will be able to meet ongoing obligations even after the forbearance period has ended.
The above lists are not exhaustive.
It is critical from both a lender and borrower’s perspective that any agreement to delay payments or rights of enforcement under any existing loan facilities be in writing and signed by all parties. A “DIY” approach to a forbearance agreement is not recommended. In fact, going it alone may render a forbearance agreement unenforceable, inadvertently undermine or modify existing security interests, forgo opportunities to avoid disputes later on, and squander a borrower’s opportunity to recover its business during the forbearance period. If you are considering entering into a forbearance agreement, whether as a lender or borrower, speak to your lawyer and other professional advisors first to ensure you are adequately informed and protected.