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.

Bad 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?

William Schwartz is a partner in Levenfeld Pearlstein’s Banking & Restructuring Group. He concentrates his practice on representing borrowers and lenders in financial services, litigation (including bankruptcy) and workouts.
William Schwartz is a partner in Levenfeld Pearlstein’s Banking & Restructuring Group. He concentrates his practice on representing borrowers and lenders in financial services, litigation (including bankruptcy) and workouts.

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, it’s 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. It’s 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?

Step 2 – Determine the reason for and severity of the default

Let’s face it, not all loan defaults are created equal. Some defaults are just worse than others:

• Fraud, misrepresentations, theft, and maturity default are clearly the worst kinds of default.

• Financial covenant defaults and reporting defaults are not pleasant, but likely don’t 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 can’t 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. It’s also important to keep in mind that with hard money loans, the trigger should be held by an itchy finger. In other words, it shouldn’t 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.

Schwartz Scale

Step 3 – Take definitive and immediate action. Also called: Don’t 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.

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 you’ve 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 won’t 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:

•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.

• Giving the borrower extra time also allows the borrower to build a war chest of funds to use in legal fees against you.

• 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.

• 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.

• 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, it’s important to begin the process early with the knowledge that it can always be shut down if you reach a settlement.

• 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:

• Make sure your legal position is strong.

• Make sure your collateral position is strong.

• Take control of the assets as quickly as you can, unless there is an incredibly persuasive reason not to.

• 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.