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GUEST FEATURE: DEFAULTS

Your borrower has defaulted:


When do you pull the trigger?
How to act when a borrower encounters problems can be a tricky call. Bill Schwartz of
Levenfeld Pearlstein, with the help of a sliding scale of troubled loans, provides clarity
on what to do and when

Bill Schwartz

NEVER TRUST YOUR


BORROWER, ESPECIALLY A
HARD MONEY BORROWER,
NO MATTER HOW NICE
THEY ARE, NO MATTER
HOW GOOD THEIR
REPUTATION

JULY/AUGUST 2016

ad news! The bridge loan you


made to that great borrower nine months ago has
defaulted.
The borrower says it is just a temporary glitch, but you are now faced with
a decision: Do you pull the trigger and
exercise your remedies, or do you work
with the borrower to see if the ship can
be righted?
If you are an active private money
lender and have never been in this
position, you are either very lucky or
you are deluding yourself (and have the
holes in your bank account to prove it).
For those who are willing to admit that
they have made a bad loan, its time to
face the music and figure out what to
do next.

STEP 1 ASSESS THE STRENGTH OF


YOUR POSITION

Just as in any survival situation, the first


thing to do is to take stock of what you
have:
Is your collateral tied up appropriately?
Have you done a recent asset search
on your guarantors?
Are the guarantors actually collectible?
Is the collateral worth the same as
when you underwrote the loan?
Are your loan documents in order?
Do you have all of the financial or
property information from your borrower or guarantor that you would
need to collect from them, including

current PFS, A/R aging, and rent


roll, among others?
If the answer to any of these questions is no, then you should (a)
consider changing your underwriting
standards, the lawyers who helped you
close the loan in the first place, and
your internal closers; and (b) probably
consider a forbearance period while you
tie up your loose ends.
The forbearance period should be at
least 91 days if you are fixing a problem
with the security interest in your collateral. This will allow you to avoid a preference claim issue should the borrower
end up filing for bankruptcy. Otherwise,
the forbearance can last anywhere from
60 days to 180 days.
Any longer than 180 days is giving
the borrower too much leash, and
any shorter than 60 days is really not
worth it to a borrower who is going
to be giving up something in exchange
for the forbearance, such as a general
release of the lender. Its also important
to consider that the negotiation of the
forbearance may take some time. There
are always exceptions to the suggested
time period, but the typical forbearance
lasts 90 to 120 days.
If the answer to all of the above
questions is yes, then kudos to your
underwriters, lawyers and closers. They
have placed you in a situation where you
can make this decision from a position
of power.
So, how do you make the decision?
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GUEST FEATURE: DEFAULTS

STEP 2 DETERMINE THE REASON


FOR AND SEVERITY OF THE DEFAULT

Lets face it, not all loan defaults are


created equal. Some defaults are just
worse than others:
1. Fraud, misrepresentations, theft, and
maturity default are clearly the worst
kinds of default.
2. Financial covenant defaults and
reporting defaults are not pleasant,
but likely dont give rise to the severity level of the first category.
So, the first step is to determine
what the default is and how bad it is. I
obviously cant recommend exercising
all remedies when you have a borrower
whose only default was that they missed
a financial covenant by a few hundredths
of a percent.
Financial covenants were invented to
help predict whether or not a borrower
may default in the future. However, they
are generally not the reason a borrower
fails. If your borrower is still making
payments on a hard money loan but has
a financial covenant default, it is almost
always best to keep taking the payments
and allow the borrower some time to
get back into covenant. (A hard money
loan is a specific type of asset-based loan
financing through which a borrower
receives funds secured by real property
and typically issued by private investors
or companies). Closer monitoring is
certainly in order, but not a full-blown
exercise of remedies. On the Schwartz
Scale of Troubled Loans (my personal
rating system), this one rates a low 2.
However, if you have taken a good
assessment of your collateral, and are
worried the value may not be what you
thought, or if the value is decreasing
even though your borrower is making
payments, we are now at a 7.5 on the
Schwartz Scale and we are getting
closer to pulling the trigger.
If there has been a payment default,
we are at a 10. Its also important to
keep in mind that with hard money
loans, the trigger should be held by an

itchy finger. In other words, it shouldnt


take too much to set it off.
This takes us to the next part of the
formula, which is to determine why the
default has occurred.
If the default has occurred due to a
bump in an otherwise smooth road,
do not exercise remedies.
If the default has occurred for
almost any other reason, then it is
probably wise to start exercising
remedies. Again, with conventional
loans, I might advise a little more
patience.

STEP 3 TAKE DEFINITIVE AND


IMMEDIATE ACTION. ALSO CALLED:
DONT LET YOUR GUT GET IN THE
WAY

Generally, when a default occurs,


lenders take a moment to assess their
relationship with the borrower and ask
themselves the following, simple
question: Do they trust the borrower? If
your answer to that question is yes
or if you even ask yourself this
question during Step 3 of this process
I would strongly suggest you pick a
new profession.

THE SCHWARTZ SCALE OF TROUBLED PRIVATE MONEY LOANS

DEFAULT RESULTING FROM FRAUD,


MISREPRESENTATION, THEFT, OR
MATURITY DEFAULT, PLUS ALMOST ALL
PAYMENT DEFAULTS

PULL THE TRIGGER

BORROWERS DEFAULT, BUT LENDERS


LEGAL POSITION NEEDS TO BE
TIGHTENED

ENTER FOREBEARANCE AND


ADDRESS ISSUES PRIOR TO
PULLING TRIGGER

DECREASING OR UNCLEAR
COLLATERAL VALUE, THOUGHT
BORROWER MAY CONTINUE TO PAY
LOAN

STRONGLY CONSIDER
EXERCISING REMEDIES

FINANCIAL COVENANT OR REPORTING


DEFAULTS

CONSIDER EXERCISING
REMEDIES

BORROWER BARELY MISSES FINANCIAL COVENANT BUT CONTINUES TO


MAKE LOAN PAYMENTS

CLOSER MONITORING

LOAN AND COLLATERAL IN ORDER.


PAYMENTS MADE ON TIME

MONITOR

Source: Levenfeld Pearlstein

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REAL ESTATE CAPITAL

JULY/AUGUST 2016

GUEST FEATURE: DEFAULTS

Never trust your borrower, especially


a hard money borrower, no matter how
nice they are, no matter how good their
reputation, no matter how many times
youve played golf with them, no matter
how close a family member they are
(well, maybe you can trust your family,
but maybe not).
Most hard money borrowers are hard
money borrowers for a reason: they
have defaulted before, they have poor
credit, or perhaps they are disorganised
and could not get their act together to
secure conventional financing. Yes, there
may be the outlier borrower whose conventional lender wrongly backed out of
a loan at the last minute and they had no
choice but to use hard money. Most of
the time, though, your borrower cannot
be trusted to work their way out of the
situation, regardless of their desire to
do so.
Remember, we are at Step 3 here, so
there is already concern that you wont
be repaid. Now is not the time to ask
the trust question that ship sailed two
steps ago. However, your goal is to get
your money back, so take a moment to
ask a different question: Do you think
you will be repaid without having to
resort to a judgment or settlement?
If your borrower can provide a
good, believable (read: documentable)
repayment path, or the borrower would
be critical to liquidating the collateral,
and the default is low on the Schwartz
Scale of Troubled Loans, then allow the
borrower some time in a forbearance
agreement.
However, for just about every other
fact pattern, on a hard money loan
default, pull the trigger and ask questions later. Why? There are a multitude
of reasons:
1. Your borrower is likely transferring
assets, knowing the chase is about to
start. Allowing a forbearance period
gives the borrower a head-start in
hiding assets.
2. Giving the borrower extra time also
allows the borrower to build a war
JULY/AUGUST 2016

BORROWERS/
GUARANTORS SEEM TO
PROVIDE EXCUSES AND
PIPE DREAMS WHEN
THE KINDLY CREDITOR IS
GIVING THEM ANOTHER
CHANCE OR KEEPS THE
GUN IN THE HOLSTER

chest of funds to use in legal fees


against you.
3. You are probably not the only creditor pursuing the borrower or guarantor. It is better to be first in line at
the borrower buffet than the creditor
waiting for any remaining crumbs to
fall off the table.
4. When their back is up against the
wall, the borrower/guarantor is not
just going to cut you a check. You will
need ammunition (a judgment) to
collect the debt.
5. The borrower/guarantor is going to
do whatever they can to slow down
the collection process. Since delays
almost always mean more effort
and less recovery for the lender, its
important to begin the process early
with the knowledge that it can always
be shut down if you reach a settlement.
6. Borrowers/guarantors seem to
respond with real money and offers
when looking down the barrel of a
gun. Borrowers/guarantors seem
to provide excuses and pipe dreams

when the kindly creditor is giving


them another chance or keeps the
gun in the holster. In short: This is
business. Show them you mean it.
IN SUMMARY: ERR ON THE SIDE OF
ACTION

If all of this sounds a little jaded, you are


right.
The picture is usually not pretty
when dealing with hard money borrowers who have defaulted. Take it from
someone who has been working out
these kinds of loans for more than 25
years. Yes, it would be nice to think that
the guarantor that promised to pay you
back will actually write you a check for
payment in full the day your loan goes
into default. However, in the real world
that just does not happen. And, if you
still think it might, I encourage you to
re-read the first paragraph of Step 3
above.
So, assuming you want your money
back, you must take matters into your
own hands, right now, with these
straightforward steps:
1. Make sure your legal position is
strong.
2. Make sure your collateral position is
strong.
3. Take control of the assets as quickly
as you can, unless there is an incredibly persuasive reason not to.
4. Get your judgments entered before
anyone else does.
And then hope your borrower comes
to you with hat in hand, looking for a
settlement. If not, you are already a day
closer and with luck, first in line to
a judgment or a settlement. n

William Schwartz is a partner in


Levenfeld Pearlsteins Banking &
Restructuring Group. He concentrates his
practice on representing borrowers and
lenders in financial services, litigation
(including bankruptcy) and workouts.

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