Commercial mortgage delinquency rates are on the uptick. The United States economy is shrinking according to Commerce Department measurements. Economic volatility is the new norm. As borrowers navigate economic ebbs and flows, developing a course of action to navigate turbulent cash flows can save borrowers significant time, money and perhaps even their properties or other company assets.
Compliance Matters
Financial covenant testing is a standard procedure used by lenders to monitor a borrower’s financial health over the life of a loan, including mortgage loans, lines of credit and other types of credit facilities. Failure to comply with these covenants, even in the absence of a missed payment, may classify as an Event of Default. Lenders will typically intensify their monitoring oversight in response to economic challenges such as tariffs disrupting supply chains, rising costs and the Federal Reserve’s tighter monetary policies placing additional pressure on businesses’ cash flow and profitability. As a result, for borrowers who anticipate falling out of compliance, early recognition and a proactive approach are essential in mitigating the risk of loan acceleration or enforcement actions.
Anticipating a Default
Borrowers should review their loan documents carefully to determine whether they are in danger of triggering a default by understanding:
- What specific events constitute a default?
- Whether there are notice or grace periods?
- Whether a default under one loan might cause a cross-default under another loan (a common issue for companies with either multiple loans with one lender or multiple loans with more than one lender)?
- For example, will a default under a company’s line of credit or an equipment loan trigger a default under its mortgage loan?
While each loan agreement is different, some of the most common events of default include:
- Payment Default: Failing to make a scheduled payment of principal or interest when due;
- Financial Covenant Default: Failing to maintain certain financial thresholds such as debt service coverage ratio, leverage ratio, liquidity covenants and minimum net worth;
- Negative Covenant Default: A borrower may be restricted from certain activities such as taking on new debt, making distributions, selling assets or a change in the control of the company; and
- Affirmative Covenant Default: A borrower may be required to engage in certain acts such as maintaining insurance coverage, delivering financial statements and compliance certificates, paying taxes or maintaining properties and collateral in good condition.
Understanding the Financials
Once a borrower determines the potential risk or existence of a default, the next step is to understand the financial implications to best develop solutions or a workout strategy. A borrower should analyze:
- The accuracy of key financial documents such as profit and loss statements, balance sheets, cash flow forecasts and budgets;
- Guarantees provided to the lender or to third parties (off balance sheet contingent obligations);
- Asset protection strategies for personal guarantors;
- Tax implications;
- Implications or impact on other loans; and
- Steps taken by the business or guarantor to correct the issue.
Candid and Transparent Communication
Borrowers often hesitate to contact the lender before they default, but early and honest communication tends to lead to better outcomes. Being proactive shows a lender that the borrower takes the situation seriously and is acting in good faith. Good communication with a lender may result in an opportunity to cure a default.
While the lender has a right to pursue remedies such as acceleration of the debt, foreclosure, litigation, or seizing borrower funds and assets, most lenders prefer to explore a workout aimed at resolving defaults without immediate legal action. The most common ways lenders seek to resolve defaults include:
- Consent: The lender grants permission to take an action that would otherwise trigger a default, such as a corporate restructuring or an asset sale.
- Forbearance Agreement: The parties may execute an agreement in which the lender agrees to delay enforcement for a defined period while the borrower works on remediation. The agreement generally includes tougher loan terms, such as higher interest rates and loan fees, more frequent and more detailed financial reporting or actions such as marketing certain assets for sale or liquidation.
- Loan Amendment: When a more permanent solution is needed, the parties may agree to amend the terms of the loan. Loan modifications often include borrower acknowledgments, reaffirmation and waivers. Loan modifications often include a fee for waiving a default or amending a financial covenant.
Expertise Matters
Loan agreements may contain language and concepts that are foreign to even savvy business professionals. Consulting with an expert can assist borrowers with understanding risks, costs and benefits and options. A knowledgeable expert may be aware of opportunities outside of the terms of the loan agreement that can stabilize a troubled situation.
Conclusion
Loan defaults and loan workouts can be complex, but they can offer a viable path forward if approached thoughtfully. Borrowers should act early, communicate openly with their lenders, and work with experienced legal and financial advisors to structure solutions that balance short-term financial instability with long-term viability. Understanding these tools and being proactive can mean the difference between restructuring a business and losing it entirely.
