Financial Regulators Encourage “Prudent” Workouts of CRE Loans

December 7, 2009

Recognizing that "financial institutions face significant challenges when working with commercial real estate ("CRE") borrowers that are experiencing diminished operating cash flows, depreciated collateral values, or prolonged sales and rental absorption rates," recently, members of the Federal Financial Institutions Examination Council ("FFIEC")[1] (collectively, the "Regulators") adopted a new policy[2] (the "Policy") that advocates the prudent workout of CRE loans.  The purpose of the Policy is threefold–(1) to promote consistency among examiners responsible for evaluating financial institutions’ efforts to renew or restructure loans; (2) to enhance the transparency of CRE workout transactions; and (3) to ensure that supervisory policies and actions do not curtail the availability of credit to borrowers capable of repaying their debt on reasonable terms.  The Regulators promise that "[f]inancial institutions that implement prudent CRE loan workout arrangements after performing a comprehensive review of a borrower’s financial condition will not be subject to criticism for engaging in these efforts even if the restructured loans have weaknesses that result in adverse classification."

The Policy outlines the key elements of a "prudent CRE loan workout", discusses the factors that examiners should focus on in determining whether a loan should be adversely classified, placed (or maintained) on nonaccrual status or reported as a Troubled Debt Restructuring and analyzes each of these determinations in the context of hypothetical workout scenarios involving income-producing property, construction loans, commercial operating lines of credit, and land loans.  What follows is an outline of the characteristics of a "prudent CRE Loan workout" and the Policy’s other key points, a discussion of the Policy’s implications for financial institutions with substantial loan portfolios, borrowers and CMBS servicers, and a brief description of initial reactions to the Policy.

Characteristics of a Prudent Loan Workout

The Regulators promise that financial institutions will not be criticized for engaging in workouts so long as they have, at the institutional level, a prudent workout policy and, at the individual credit level, a well-conceived and prudent workout plan.

a.  Risk Management Policies

Recognizing that restructured loans represent an elevated credit risk, the Policy provides that an institution should have risk management practices for renewing and restructuring loans that are "appropriate for the complexity and nature of its lending activity and . . . consistent with safe and sound lending practices and relevant regulatory reporting practices."  According to the Regulators, an institution’s risk management practices should, at a minimum, address the following:

• Management infrastructure to identify, control, and manage the volume and complexity of the workout activity.
• Documentation standards to verify the borrower’s (and presumably, the guarantor’s[3]) financial condition and collateral values.
• Adequacy of management information systems and internal controls to identify and track loan performance and risk, including concentration risk.
• Management’s responsibility to ensure that the regulatory reports of the institution are consistent with regulatory reporting requirements (including GAAP) and supervisory guidance.
• Effectiveness of loan collection procedures.
• Adherence to statutory, regulatory and internal lending limits.
• Collateral administration to ensure proper lien perfection of the institution’s collateral interests for both real and personal property.
• An ongoing credit review function.

These elements do not represent an exhaustive list of the elements that an institution’s risk management practices need to address in order for the institution’s workout policy to qualify as "prudent".  The Policy makes clear that risk management practices should be tailored to the specific nature of the institution’s lending activity and therefore, there is likely to be some variation between what is appropriate for one institution as opposed to another.

b.  A Prudent Workout Plan

The Policy indicates that at the individual credit level, financial institutions need a plan that analyzes current financial information and supports the ultimate collection of all outstanding principal and interest.  The elements of a prudent workout plan are:  (i) updated and comprehensive financial information on the borrower, the real estate project and any guarantor; (ii) current valuations of the collateral; (iii) analysis and determination of the appropriate loan structure; and (iv) appropriate legal documentation for any changes to the original loan terms.  In addition, the Regulators request the following:

• An analysis of global debt service that reflects a realistic projection of the borrower’s and the guarantor’s expenses.  Global debt service includes all of the borrower’s and guarantor’s financial obligations, including contingent obligations.
• The ability to monitor the ongoing performance of the borrower and the guarantor under the terms of the workout.  Thus, the loan modification documents should include financial reporting obligations and covenants. 
• An internal loan grading system that accurately and consistently reflects the risk in the workout arrangement.
• An allowance for loan and lease losses ("ALLL") methodology that covers estimated credit losses in the restructured loan, measured in accordance with GAAP, and recognizes credit losses in a timely manner through provisions and charge-offs, as appropriate.

Other Key Points

In an environment in which property values are rapidly declining and the CRE industry is experiencing significant financial difficulties, financial institutions dealing with a large number of loans on their books are likely to find the following Policy statements particularly helpful:

• When evaluating the sufficiency of the underlying collateral for a loan, lenders should use the market value conclusion (and not the fair value) that corresponds to the workout plan and loan commitment.  For example, if the lender intends to work with the borrower to get a project to stabilized occupancy, then the lender should consider the "as stabilized" market value in its collateral assessment.  And, if the institution plans to contribute the resources needed to complete the project, it should use the project’s prospective market value and the committed loan value in its analysis. Conversely, if the institution intends to foreclose, it should use the fair value (less costs to sell) of the property in its current "as is" condition.
• Loans to sound borrowers that are renewed or restructured in accordance with prudent underwriting standards should not be adversely classified (i.e., classified as substandard, doubtful or as a loss) or criticized solely because (i) the value of the underlying collateral has declined to an amount that is less than the loan balance or (ii) the borrower is associated with a particular industry that is experiencing financial difficulties.
• Lenders may restructure troubled loans using a multiple note structure in which the lender separates a portion of the debt into a new note that is reasonably assured of repayment and performance, while the other portion is covered by a second note that will be adversely classified and charged-off as appropriate.  This structure promotes the recognition of income on the portion that is reasonably assured of repayment because the note evidencing this portion can be placed back on accrual status "in certain situations."  While these situations are not expressly defined, the Policy’s hypothetical workout scenarios indicate that returning the note to accrual status may be warranted where (i) the borrower has the ability to repay; (ii) the borrower has a record of performing at the revised terms for more than six (6) months; and (iii) full repayment of principal and interest is expected.  If the lender chooses not to use the two-note structure, the loan must remain (or be placed) on nonaccrual status.
• For performing loans, ALLL need not be automatically increased solely because the value of the underlying collateral has declined to an amount that is less than the loan balance.

Implications for Financial Institutions, CRE Borrowers and CMBS Servicers

While borrowers are clearly in favor of the Regulators’ attempt to encourage workouts over foreclosures, the Policy’s impact on borrowers will necessarily depend on financial institutions’ reactions to the Policy’s guidelines.  The Policy will most likely spark different reactions among CMBS loan participants.  While borrowers and junior creditors are likely to be in favor of workouts over foreclosures, senior creditors wanting to foreclosure on mortgages and have their loans satisfied in full are likely to have negative reactions to the Policy’s guidelines.  To the extent that the Policy highlights the divergent interests among junior and senior debtholders in the CMBS context, CMBS servicers may find it increasingly difficult to negotiate these conflicting interests and "adhere to ambiguous ‘servicing standard’ directives to maximize returns to all creditor classes."[4]

Reactions to the Policy

Reaction to the Policy among members and observers of the CRE industry has been varied.  Some believe that the Policy’s guidance will help financial institutions workout challenged loans without having them classified as "bad" loans.  Others believe that lenders may have difficulty adequately addressing all of the elements of a prudent workout policy and plan and therefore, have suggested that financial institutions consider hiring a loan workout officer or elevating such a position to a senior level.  Another point of view is that the Policy is necessarily vague because it is impossible to craft precise regulations that address all of the complexities of specific loans.  On the other hand, some criticize the Policy as not going far enough and say it may actually slow down the recovery of the CRE industry by allowing financial institutions to delay writing down bad loans.  The belief is that while the Policy may prove to be successful if asset prices increase, if they do not, the Policy merely delays the inevitable.  Despite the varying positions described above, its seems that, at a minimum, the Policy has put financial institutions on notice that the federal government is not going to bail out the commercial real estate market like it did the residential market.

Conclusion

The Policy comes on the heels of the Internal Revenue Service’s September 16, 2009 release of regulations[5] that remove tax obstacles to CRE loan workouts and allow borrowers and servicers to pursue the modification of CMBS loans not only if there has been a default, but also, if there is a "reasonably foreseeable default."  This, combined with the fact that the Policy was issued in the face of the impending maturity of a large number of CRE loans and in a market that has seen prices for existing commercial properties fall 35 to 40 percent since peaking in 2007 (and with more declines anticipated)[6] suggests that the Policy represents the federal government’s effort to encourage CRE loan workouts over foreclosures.  Even if the Policy does not represent a dramatic shift in policy, at minimum, it provides comfort to financial institutions that have been reluctant to renew or restructure loans because of inconsistent treatment from examiners.  If financial institutions follow the steps outlined above (and Regulators are true to their word), they will not be criticized for engaging in workouts.  Lastly, by promising that loans will not be adversely classified solely because of a decline in the value of the underlying collateral and by authorizing the use of a two-note structure, Regulators have given financial institutions opportunities to reduce the amount of charge-offs, which should make workouts a more attractive option.  Only time will tell whether the Policy will have a significant global impact on the CRE market.

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues.  Please contact the Gibson Dunn attorney with whom you work or any of the following: 

Real Estate Group
Jesse Sharf – Co-Chair, Los Angeles (310-552-8512, [email protected])
Fred Pillon – Co-Chair, San Francisco (415-393-8241, [email protected])
Alan Samson – Co-Chair, London (+44 20 7071 4222, [email protected])
Dennis Arnold – Los Angeles (213-229-7864, [email protected])
Peter Decker – Munich (+49 89 189 33 115, [email protected])
Eric M. Feuerstein – New York (212-351-2323, [email protected])
David J. Furman – New York (212-351-3992, [email protected])
Andrew Lance – New York (212-351-3871, [email protected])
Andrew Levy – New York (212-351-4037, [email protected])
Erin Rothfuss – Singapore (+65 6507 3685, [email protected])
Michael F. Sfregola – Los Angeles (213-229-7558, [email protected])
L. Mark Osher – Los Angeles (213-229-7694, [email protected])
Drew C. Flowers – Los Angeles (213-229-7885, [email protected])

Business Restructuring and Reorganization Group
Michael A. Rosenthal – Co-Chair, New York (212-351-3969, [email protected])
Craig H. Millet – Co-Chair, Orange County (949-451-3986, [email protected])  
David M. Feldman – Co-Chair, New York (212-351-2366, [email protected])
Oscar Garza – Orange County (949-451-3849, [email protected])  
Janet M. Weiss – New York (212-351-3988, [email protected]) 
Matthew J. Williams – New York (212-351-2322, [email protected])
J. Eric Wise – New York (212-351-2620, [email protected])

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