Maximizing Recovery of Distressed Debt* By Scott A. Lessne and Vincenzo Paparo

Lenders must understand the full scope of enforcement remedies.

he past several years have been a busy time the Debt for financial markets. The economy has Texhibited consistent economic growth, and Generally, a successfully negotiated restructuring an unprecedented amount of capital has been of a loan is preferable to outcomes achieved as a made available for investment. As a result, new result of enforcement actions. Lenders should not, debt structures, new debt providers and new debt however, shy away from commencing appropriate products have become available for commercial enforcement action if a borrower needs some en- borrowers creating an overheated and highly risk couragement to engage in or complete a satisfactory tolerant debt market. restructuring. As we will see below, enforcement While lending activity and opportunities have does not necessarily mean an all-out litigation battle. continued to grow, it appears that the steady eco- Timely and limited use of enforcement actions can nomic growth of the past fi ve years has slowed, be used effectively to achieve a tactical advantage possibly foreshadowing a slowdown that will to enhance the restructuring process. directly affect lenders in all parts of a company’s Lenders today are faced with numerous options capital structure. The recent rapid meltdown of when pondering the possibility of restructuring the subprime mortgage lending industry amply distressed debt. The options available are often demonstrates how quickly an industrywide credit narrowed by internal and external considerations, problem can leave lenders with little time to ratio- including (1) the investment return objectives of nally analyze a problem and to prepare a strategy the lender; (2) the nature of the borrower’s diffi cul- to enhance recovery. ties, that is, fi nancial covenant defaults vs. payment Similarly, the overnight shutdown of the capi- defaults; (3) industry-specifi c trends; (4) liquidity in tal markets in the early part of the decade found the market for distressed debt; and (5) third-party many lenders creating their debt recovery strat- pressures on the borrower. Most important, how- egies on the fly. Warning signs went unnoticed, ever, lenders should factor into the restructuring opportunities to prepare and plan recovery equation the contractual relationship between the strategies were ignored, and significant losses were incurred. While experience shows that one Scott A. Lessne is the General Counsel—Corporate Operations and Cor- should always be prepared for , porate Compliance Offcier of CapitalSource LLC. Contact him at the impending shift in the economy suggests that [email protected]. there is not a better time than now to focus on potential problem credits. Vincenzo Paparo is a Partner in the Corporate Department and Co-chair When a credit exhibits signs of fi nancial distress, of the Finance Group of Proskauer Rose LLP. Contact him at vpaparo@ lenders have various enforcement and recovery proskauer.com. options. This article will review those options, with The authors thank Joseph Choi, an Associate in the Corporate Department emphasis on being prepared to act.1 and Finance Group of Proskauer Rose LLP, for his assistance with this article.

JULY–AUGUST 2007 COMMERCIAL LENDING REVIEW 21 Maximizing Recovery of Distressed Debt

borrower and the lender. One could argue that the losophy toward the specifi c credit, the borrower’s seeds of a successful or failed restructuring are sown industry or other internal portfolio management at the time the loan is initially negotiated and closed. concerns have not shifted in a signifi cantly dramatic Today’s “covenant-lite,” borrower-friendly credit fashion so as to warrant a wholesale revision of the agreements; multitranched capital structures; and underlying initial strategy. Many lenders, but par- lender syndicates comprised of various institutional ticularly those driven by quarterly public reporting interests will make consensual debt restructures requirements, are prone to adjusting their philoso- more challenging than ever. While consensual phies midstream in order to achieve big-picture restructurings will always continue to play an im- corporate goals. While there is nothing inherently portant role in the resolution of distressed credits, wrong with a philosophical shift in approach, it nonconsensual enforcement options (to the extent makes the job of the people in the trenches that not negotiated away at the outset of the transaction) much more diffi cult if the philosophy shift requires will likely play a more prominent role during the a signifi cant change in the restructuring strategy. next economic downturn. Review Your Enforcement: Enforcement Options When Does It Start? After identifying the strengths and weaknesses of Restructuring and enforcement is a process the credit together with the relevant industry trends moving along a continuum where institutional that may affect them, it is important to formulate a objectives are the control- strategy to enhance the re- ling factor. Institutional covery of the debt. While objectives will drive the deviations from the initial pace of the restructur- The recent rapid meltdown of the strategy are inevitable, ing and the breadth of subprime mortgage lending industry the initial path to achiev- available enforcement ing the end result should options. Lenders should amply demonstrates how quickly an always be kept in sight clearly communicate in- industrywide credit problem can leave as a benchmark. A lender stitutional objectives to lenders with little time to rationally may consider a number counsel and other profes- analyze a problem and to prepare a of options when devel- sionals engaged to assist oping its debt recovery in the restructuring and strategy to enhance recovery. strategy. A prudent lender enforcement process. For will carefully evaluate the example, some institu- widest array of options tions may view a series of fi nancial covenant defaults available to it at that point in time. These options as a signal that a credit weakness exists. The credit is will include contractual business decisions, such as moved to a restructuring unit, which then executes implementing a rate or terminating advances the institution’s objectives. Another institution may (if contractually permissible) and decisions such as be more risk tolerant and view a series of covenant whether to aggressively pursue legal rights with or defaults as opportunities to obtain further leverage without judicial assistance. This determination may through waivers or forbearance agreements coupled depend on certain factors, including but not limited with additional fees; the defaults are not suffi ciently to the law of the state where the borrower and/or serious to sound the alarm. Therefore, the fi rst step any collateral is located, the cooperation of the bor- is to understand your institution’s restructuring and rower, the presence of other holding an enforcement philosophy. Subsequent actions by the interest in the collateral and the various implications deal team and the restructuring team should align of a fi ling. with this philosophy. One should also periodically While a full discussion of a lender’s rights in step back and confi rm that the institution’s phi- bankruptcy are beyond the scope of this article, a

22 COMMERCIAL LENDING REVIEW JULY–AUGUST 2007 Maximizing Recovery of Distressed Debt

note of caution is appropriate here. Enforcement op- stick approach is often advisable and should be tions should always be viewed against the backdrop considered as the situation warrants. Section 9-601 of a possible bankruptcy fi ling. More than once, a of the Revised Article 9 of the Uniform Commercial lender has marched down the path of enforcement Code (RA9) expressly sanctions the use of multiple only to be faced with a bankruptcy fi ling that the enforcement mechanisms. lender believed or was told would never occur. The Assuming the lender and the borrower have authors have been witness to explanations of lender reached an impasse, that is, the borrower is unre- surprise such as the following: “We believed that sponsive or unwilling to enter into a negotiated the CEO was too honorable to fi le.” “We thought resolution satisfactory to the lender (which can occur the company did not have enough money to fi le.” either before, during or after one or more forbearance “He wouldn’t dare do it without talking to us or agreements), the lender is now faced with the choice fi nding a new lender fi rst.” To the surprise and of either fi nding a method to motivate the borrower the detriment of these lenders, bankruptcy fi lings to cooperate or undertaking unrelated enforcement occurred in each instance. The analysis is simple. actions. Below, we describe actions that a lender What is the realistic likelihood that the enforcement may initiate that may result either in the borrower action will precipitate a bankruptcy? If the realistic reengaging in cooperative activity or in legal action answer is likely or better, then the lender should against the borrower and/or the collateral. consult with counsel and its fi nancial consultants to develop one or more bankruptcy outcome Nonjudicial Remedies models. Those outcome models should be used to balance the bankruptcy outcomes against outcome Part 6 of RA9 provides a variety of options for the alternatives that could result from restructuring secured lender after a default has occurred under the paths other than the chosen mode of enforcement. lender’s loan documents. Lenders should note that When viewed in light of a bankruptcy, a negotiated RA9 does not provide a defi nition of default, nor resolution, a sale of the loan or another noncon- does it provide guidance as to when enforcement frontational strategy may be a preferred course of action should be initiated after a default. Whether the action. Again, the institutional philosophy toward lender is entitled to act upon a default and the timing the specifi c credit or the borrower’s industry or a of such action are issues governed by the terms of whole host of other internal factors will play an the loan documents and law outside of RA9. important role in this analysis. The enforcement provisions of Part 6 of RA9 focus on the collateral for the loan. Unsecured lenders Enforcement Options generally will need to rely on their credit agreement, other state law and the Bankruptcy Code to enforce Available to a Lender legal rights. Part 6 of RA9 provides a variety of options that may be employed singly or in combina- Enforcement options run the gamut of escalating tion with other enforcement mechanisms. The RA9 severity as follows: sending a notice of default drafters sought to provide an effi cient and effective and reservation of rights; implementing a default method for a secured lender to realize upon the rate; terminating revolving advances (if allowed value of its collateral without the associated time under the credit agreement); accelerating the loan; and expense of protracted litigation or a bankruptcy entering into a waiver, amendment or forbearance proceeding. In order to take advantage of the Part 6 agreement; exercising self-help remedies; seeking provisions, the lender will need to be aided by either judicial assistance (enforcement of contractual a genuinely cooperative borrower or a borrower obligations, money judgments, or who has been motivated by the lender to assist in bankruptcy); or, where appropriate and applicable, the process of unlocking the value of the collateral. filing an involuntary bankruptcy petition. The Note that for RA9 purposes, we are assuming that process is not linear, and many of these and other the borrower is a “” as defi ned in RA9. Absent related enforcement options may be implemented some level of cooperation, the Part 6 provisions of simultaneously. In fact, a multitrack carrot-and- RA9 may be of limited utility.

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The enforcement mechanisms authorized in Part under the right circumstances), in many instances 6 of RA9 are as follows: lenders do not anticipate and plan for this conse- Collection of payments from account quence. The bankruptcy will immediately bring to through notifi cation or judicial assistance and ac- a halt all RA9 enforcement activity and will force cess to any collateral securing those payments the lender into the world of bankruptcy law and If the secured party is also the borrower’s de- bankruptcy lawyers. pository institution, application of the balance Finally, lenders must consider the impact of RA9 in the borrower’s deposit accounts to the out- enforcement activity on the borrower’s business standing loan and on other creditors. For example, if the secured If the secured party is not the depository insti- lender redirects all of the borrower’s cash collections tution but has a in a borrower or empties a borrower’s deposit account, in most in- deposit account that is perfected by control, in- stances the impact will be immediate and dire. Take structing the depository to pay the balance care to assess the consequences of this action in the in the deposit account to the secured party for context of facts and circumstances uncovered dur- application to the loan ing the initial restructuring due-diligence process. Taking possession of the collateral with judicial Numerous lenders seeking to shut off a borrower’s process or without judicial process provided, access to cash have found themselves in trouble over however, that if self-help is the option chosen, unrecognized course-of-dealing issues. the secured party may not commit a breach of the peace Judicial Remedies Rendering equipment unusable and disposal of the collateral on the borrower’s premises The lender may pursue judicial remedies against the Selling, leasing, licensing or otherwise disposing borrower and/or any guarantor by commencing a through a public or private disposition any or all legal proceeding in state or federal court. The lender of the collateral in its then-existing condition or generally will commence its action in state court, following commercially reasonable preparation as federal subject matter jurisdiction by virtue of a Accepting the collateral in full or partial satisfac- federal claim or diversity is not always available in tion of the debt proceedings involving the collection of debt. Gener- Reviewing the specifi c steps that a lender must ally, the loan documents will provide the governing follow to execute on one or more of these various law, jurisdiction and venue for any actions taken options is beyond the scope of this discussion. It with respect to the loan and usually are enforce- should be noted, however, that while RA9 provides able against the parties to the loan documents. In effective and efficient procedures for a secured most states, the lender may pursue multiple judi- lender to realize upon its collateral, RA9 can also cial remedies by commencing a single proceeding, be a trap for the unwary. Much litigation has arisen including remedies such as seeking repossession of over a lender’s use of these processes under the collateral and obtaining a money judgment against prior version of Article 9. The bulk of the litigation the borrower or any guarantor. Note that some states is primarily due to lender inattention to the Article have statutes with respect to election of remedies. 9 rules or overzealous activity, mostly in the areas of In those states, the lender may be limited to pursu- commercial reasonableness of dispositions, breach ing one type of action (for example, ) of the peace and valuation of the collateral for defi - and may lose its rights to commence other actions. ciency purposes. In such cases, the lender will need to determine Further, initiation of one or more of the RA9 which procedure would net the highest recovery. enforcement options without at least a modicum Below, we explore such remedies and the various of cooperation from the borrower may precipitate considerations of which a lender should be aware a bankruptcy fi ling or result in a lender liability in exercising such remedies. claim. While a bankruptcy fi ling may be the con- Obtaining a money judgment. The lender may sequence intended by the initiation of the RA9 obtain a money judgment against the borrower and process (a perfectly valid strategy if planned for any guarantor by commencing a simple legal pro-

24 COMMERCIAL LENDING REVIEW JULY–AUGUST 2007 Maximizing Recovery of Distressed Debt

ceeding. While the procedure for obtaining a money dissipation of assets. Often, the hearing is scheduled judgment may differ based upon the particular state long after the assets have been liquidated or trans- rules, typically, proceedings based upon a failure ferred. The burden on the lender to show a need for to pay a defaulted and accelerated or matured loan an emergency hearing is often diffi cult to meet. provide an expedited treatment, and the lender One state, Connecticut, appears to have dealt with may expeditiously proceed to obtain a judgment the issue in a manner favorable to creditors. If the loan against the borrower and other parties obligated documents contain conspicuous language indicating on the debt. Some states may allow defenses or that the borrower/guarantor in a commercial trans- counterclaims to be raised, which may derail an action knowingly and intentionally waives its rights expedited judgment process. State laws may pro- to a hearing on a prejudgment remedy application, hibit the lender from pursuing multiple actions a prejudgment remedy such as a real estate attach- against the borrower based upon the same debt ment, a bank garnishment or an asset replevin may instruments. In New York, for example, a lender be obtained on the signature of lender’s counsel prior may be required to proceed either with foreclosure to a hearing, so long as the borrower/guarantors are or personal judgment proceedings. provided with notice and an opportunity to be heard Injunctive/prejudgment immediately thereafter remedies. The lender can and the papers served on also proceed by obtaining the parties meet certain prejudgment remedies, While RA9 provides effective and effi cient statutory requirements including obtaining a procedures for a secured lender to realize including, but not limited temporary restraining to, allegations establishing order or a preliminary upon its collateral, RA9 can also be a trap probable cause that a judg- injunction against the for the unwary. ment will be rendered in borrower in situations the ’s favor.2 when the borrower may be attempting to sell or dispose of its assets below Replevin market value or otherwise divert or dispose of its assets or illegally transfer its property in order to “Replevin” is non-RA9 judicial remedy by which prevent the lender from recovering the collateral. a lender forecloses upon its security interest in The lender’s counsel can protect and thereby pre- personalty (non–real-estate collateral) granted serve the value of the collateral on an emergency under a security agreement. This type of action basis with such remedies. The lender can obtain is typically instituted by way of an expedited such remedy by way of an expedited proceeding proceeding known in many jurisdictions as an known in many jurisdictions as an order to show “order to show cause,” which is supplemented cause, which is generally supported by a verifi ed with a verified complaint laying out the factual complaint laying out the factual basis for the lend- bases for the lender’s right to replevy (recover) er’s right to such prejudgment remedy. The order to the collateral. The order to show cause would show cause and temporary restraining order should also be accompanied by an application for a also require that the borrower cooperate with the temporary restraining order prohibiting the bor- lender during the pendency of the lender’s proceed- rower from wasting or transferring the collateral ing, including providing the lender with access to during the pendency of the replevin action. The the collateral and the business records. This would order to show cause and temporary restraining allow the lender to inspect the books and records order may also require that the borrower cooper- and thereby ascertain information about collection ate with the lender during the pendency of the of the borrower’s pledged accounts receivable or action to provide access to the collateral and other income streams. the borrower’s business records for purposes of Note, however, that prejudgment remedies in the inspecting and ascertaining information about form of injunctions after a show-cause hearing are collection of the borrower’s pledged accounts often diffi cult to obtain and may not prevent the receivable or other collateral.

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As replevin is an action that may deprive the bor- Real Estate Foreclosure rower of its possession or use of the collateral, many jurisdictions require the creditor to post a bond in A real estate foreclosure action in most states is a an amount that is a multiple of the collateral value. relatively straightforward process that allows the Often, a hearing on collateral valuation is required lender through a sheriff or other state offi cial to sell before the court will set the bond requirement. The real estate securing a loan free and clear of all purpose of the bond is to protect the borrower in the junior in right to the mortgage or interest being event the creditor does not prevail on its replevin foreclosed. In some states, however, for the lender claim and the borrower is damaged as a result of to obtain title or sell the property, the lender must being temporarily deprived of possession or the use endure a foreclosure process that entails all-out of the collateral. litigation, including motion practice, discovery, If the lender proceeds with replevin and subse- potential borrower defenses and the possibility quent sale of the collateral, consideration must be of a trial. As an alternative, a lender may attempt given in advance as to how the collateral will be sold to negotiate a deed-in-lieu of foreclosure if there once the replevin is accomplished and the lender is in are no subordinate liens. The borrower will gen- possession of the property. All nonjudicial secured- erally require a settlement on any defi ciency and party sales of repossessed a release of any further collateral must comply liability before entering with the notice and com- into an agreement to mercial reasonableness When pursuing a replevin, the maxim “be deed over the property requirements of RA9. careful what you wish for” often applies. to the lender. Lenders As a practical matter, the should also be mind- lender may not have the ful that any guarantor expertise to sell the type of claims should be ad- goods or equipment that comprise the collateral and dressed at the same time in order to steer clear of may thus need to retain an industry-savvy broker or any possible defenses guarantors may invoke for auctioneer to conduct a public or private sale. With negotiating a settlement with the borrower without respect to the collection of replevied accounts receiv- guarantor involvement. able, if the lender does not have a factoring or other As part of the real estate foreclosure process, a division accustomed to account collections, an agent lender may be able to seek certain prejudgment may need to be retained to conduct such collections. equitable remedies, such as the appointment of a In a case where the lender holds a guaranty from the rent receiver to manage the property or the sale of principals of the borrower, the guarantors’ cooperation the premises while the property is still in foreclosure in these collection efforts may well be forthcoming as (a/k/a a sale pendente lite) if such remedies are they try to minimize their guaranty exposure. supported by the facts. It is important to keep in The lender may not have a practical alternative mind, however, that often a prejudgment remedy to the replevin of collateral. In reality, however, in foreclosure will require the lender or its agent to the value of collateral at a distressed sale, further post a bond and bear all of the costs associated with reduced by the costs of the sale process, often can the requested relief. Finally, the recovery of litiga- be signifi cantly less than the value of the collateral tion expenses in foreclosure proceedings (attorney used in the ordinary course of the borrower’s busi- fees, hard costs and associated expenses) may be ness on a going-concern basis. As a result, when limited or capped by statute or court order. Indeed, pursuing a replevin, the maxim “be careful what in some jurisdictions the very availability of a fore- you wish for” often applies. Depending upon the closure remedy is limited by “election of remedies type of collateral involved, sale of assets by the bor- statutes,” whereby the lender must decide at the rower in a carefully restructured business-as-usual outset as to whether it will seek to obtain a money atmosphere will usually net a higher return. The judgment against the borrower (in personam) or question is, what is the cost of buying borrower and proceed with a foreclosure action against real estate guarantor cooperation? assets (in rem).

26 COMMERCIAL LENDING REVIEW JULY–AUGUST 2007 Maximizing Recovery of Distressed Debt

Receivership quickly insert an experienced manager by proposing a list of possible receivers for selection by the court. In certain circumstances, a state or federal court In addition, when compared to bankruptcy, there receivership may be a better alternative to precipitat- are fewer procedural rules and statutory regulations ing a bankruptcy fi ling. There are advantages and resulting in greater fl exibility. In situations where a disadvantages of proceeding with a state or federal special receiver is used, the receiver can focus on court receivership. For one, in most jurisdictions, certain assets and/or businesses, while leaving the receivership law is not a well-developed body of existing management in place to operate other busi- law. A notable exception is Rhode Island, where nesses and assets. state court are a signifi cant cottage industry. At the same time, however, a receivership actually provides additional fl exibility not offered Assignments for the by well-established law. It may also provide the Benefi t of Creditors ability to narrowly tailor relief to particular assets and/or a particular business, which may otherwise Another potential option is to proceed with an be unavailable under bankruptcy law. The creditor assignment for the benefi t of creditors. This asset also has broad discretion to propose the receiver. process is generally nonjudicial and in- One signifi cant consideration, depending on the volves a transfer of both legal and equitable title to federal or state court where the action is brought, all the borrower’s property to an assignee who has is the ability or inability of a receiver to sell assets the authority to liquidate the borrower’s assets and free and clear of liens, claims, security interest and distribute the proceeds equitably to the borrower’s other encumbrances. creditors. Some states like New York, however, have There are two types of receiverships: a general statutory requirements for judicial oversight of an (or liquidating) receiver and a special receiver. The assignment proceeding. An assignment of this nature general receiver is similar to a bankruptcy trustee, is generally created and governed by statutory au- while the special receiver typically only takes pos- thority and common law. The lender and its counsel session of certain designated assets or businesses will need to determine the requirements in the state and operates or sells same, leaving the rest in the in which the borrower and its assets are located. This borrower’s possession. Federal receiverships are es- option should only be considered in situations where pecially useful when assets are located in more than there is no possibility of a turnaround or restructur- one jurisdiction. To access a federal receivership, the ing, and liquidation is the only viable option. lender must satisfy the federal subject matter juris- There are certain advantages in proceeding with diction requirements, which require diversity and a such action. The personal liability of directors minimum dollar amount in controversy (as federal and offi cers for running an insolvent borrower question jurisdiction is generally not applicable to ceases to be an issue once the assignment occurs. creditor’s rights actions). In addition, asset sales can occur quickly, thereby State court receiverships are authorized under commanding a higher sale price. Also, the assignee certain specifi c circumstances, including but not can maintain limited operations of the borrower, limited to waste or material injury to property of which can maximize the remaining value of the the debtor, , fraud or mismanagement borrower’s assets. Finally, certain contractual ob- of corporate assets. Many states also provide for ligations can be negotiated and resolved effi ciently appointment of a receiver on general equitable by the assignee, whereas existing management of principles regardless of whether the debtor is in- the borrower may have been at loggerheads with solvent or solvent. its creditors. There are certain advantages to seeking a receiver- In New York, for example, the assignor/borrower ship, including the ability of a single creditor to seek must fi le such assignment with the county clerk in appointment as opposed to involuntary bankruptcy the county where the principal place of business is proceedings, where multiple creditors are required. located. Such assignment must be in writing and In addition, a party seeking a receiver is able to include the address and type of business of the as-

JULY–AUGUST 2007 COMMERCIAL LENDING REVIEW 27 Maximizing Recovery of Distressed Debt

signor/borrower. The assignor/borrower must fi le in satisfaction of the creditors’ claims against the bor- a schedule of assets and a list of creditors with the rower on a timely basis. Under common law, this was county clerk and the assignee within 20 days of the the assignee’s chief function. Even if the assignment assignment. In addition, the assignor/borrower document does not expressly empower an assignee must deliver books and records to the assignee. to sell the property, the assignee still has the power The assignee is able to review, control, clean up to do so in order to pay the creditors. and work toward closure of the corporate situation before and during the sale of assets. Thereafter, the Liability Considerations assignee must (1) post bond to the state in an amount ordered by the court; (2) give notice to all creditors Lenders should carefully analyze the potential of proposed sale of property, payment of dividends, consequences of initiating various enforcement op- fi ling of an interim report and fi ling of a fi nal report; tions in order to minimize potential liability risks in (3) fi le a list of creditor claims with the court and connection with undertaking enforcement actions. make appraisals of the property; (4) sell property of Factors to analyze should include, but certainly are the estate; (5) fi le an interim report with the court not limited to the following: six months after the assignment unless property has Whether the lender should take title to the col- already been sold and the proceeds distributed; (6) lateral and the risks associated with taking title fi le a fi nal report with the court; (7) pay dividends; Whether there are other creditors who hold and (8) close the assignor/borrower’s estate. Any senior or subordinate claims with respect to the sale must occur at a public auction unless otherwise collateral and the necessity of properly notifying authorized by the court. such parties in connection with litigation or other The court also has the following rights in connec- nonjudicial enforcement actions tion with the of such procedure: (1) The need to analyze actions with respect to cer- upon a showing of cause, remove the assignee and tain equipment and machinery that may be on appoint another; (2) authorize the assignee to con- lease to the borrower by equipment fi nancing tinue the assignor’s business; (3) allow or disallow companies or equipment manufacturers claims; (4) direct distributions of any dividend; (5) Whether any signifi cant course-of-conduct or authorize private sales of the estate; (6) require fur- equitable subordination issues have been de- ther security in the event that the assignee’s bond is tected during the preenforcement review of the not adequate; and (7) authorize creditors to present legal and credit fi les claims to the assignee by a specifi ed date advertised Further, in connection with a foreclosure of real in a newspaper. All creditors are required to pres- property or a deed in lieu of foreclosure, the lender ent claims within six months of such assignment. In may be faced with a host of potential issues, rang- addition, the assignee must notify creditors by mail ing from environmental, zoning, subdivision or title at least 10 days prior to any sale of the assets of the defect issues to whether there exists a market for the estate. Before paying any creditors, the assignee must sale or rental of the property. Postforeclosure or deed pay (1) employees any amounts contributed to retire- in lieu, the lender will have the responsibilities of an ment plans (plus interest); (2) wages for any services owner, including providing for insurance, payment rendered up to two months prior to the assignment of taxes and utilities and the cost for general mainte- (up to $1,000 per entity); and (3) for the purchase of nance. In certain circumstances where the borrower any merchandise purchased within six months of has limited funds, the lender may take on many of the assignment (up to a maximum of $300). these responsibilities before obtaining title for the From a legal perspective, trust law generally gov- sole purpose of maintaining collateral value. In the erns any assignments for the benefi t of creditors. event that the sale process has commenced but (as The assignee is considered a trustee, and its duties is usually the case) is delayed, the carrying costs of and responsibilities to the borrower’s creditors are preserving the value of the real property collateral the same as a trustee’s duties to the benefi ciaries of a can mount quickly. trust. The operative assignment document authoriz- For these reasons, many lenders set up separate es the assignee to liquidate the borrower’s property subsidiaries or affi liates to act as the entity that

28 COMMERCIAL LENDING REVIEW JULY–AUGUST 2007 Maximizing Recovery of Distressed Debt

will ultimately hold title to real property through for any actions the lender has taken in connection an assignment of the lender’s rights under the loan with the collection and enforcement of its rights documents so the parent lender never succeeds with respect to the collateral. Certainly there are to the obligations imposed upon a fee owner of times when a lender should be concerned. Under the property. Another viable approach, where a most circumstances, however, if the lender has third-party buyer is known, is for the lender or its acted in a commercially reasonable manner (and subsidiary entity to assign its right to bid at the fore- that can include exercising aggressive enforcement closure sale to the ultimate buyer of the property. provisions contractually agreed upon in the credit The result is that neither the lender nor the foreclos- agreement), defenses or affi rmative lender liability ing entity is in the chain of title. This assumes, of claims ultimately will not prevail. Lenders should course, that a purchaser for the property is located seek advice of counsel to assist in the analysis of before the sale. these defenses and claims. Most often these claims The last point raises another practical consider- and defenses are recognized for what they really are: ation that must be weighed when the decision to an effort to forestall the inevitable; an effort to force foreclose is made: Is there a buyer willing to pay a the lender to spend large, potentially unrecoverable price approaching the lender’s conception of mar- sums on legal fees; and an effort to force the lender ket value? In many instances, a ready market exists to a negotiated settlement. and this consideration is of minimal concern. The foreclosing lender, however, must weigh the real Tap the Full Scope of Remedies possibility that a market may not exist and that the lender may well hold title to the property for Understanding the full scope of enforcement rem- an extended period of time until market conditions edies available (contractual, statutory and judicial) improve. A related issue arises from the fact that under the specifi c circumstances presented will enable the borrower may be entitled to a fair-market-value a lender to intelligently select the course of action best credit in a subsequent suit seeking recovery from suited to achieve the lender’s loan recovery goals. the borrower or guarantor for a defi ciency on the note. That fair-market-value credit, typically deter- Endnotes mined at a hearing before a court, may far exceed what the foreclosing entity may actually realize * This article is designed only to give general information on from the sale of the property under distressed cir- the topics actually covered. It is not intended to provide legal cumstances. This would substantially reduce the advice or render a legal opinion. The views expressed herein amount of the money judgment that the lender can are those of the authors and do not necessarily refl ect the views obtain against the borrower and the guarantors. of Proskauer Rose LLP or of CapitalSource Finance LLC. While there may not be a practicable way to avoid 1 This article is the authors’ second in a two-part series for com- this result, the potential impact of this reality must mercial lenders who want to be proactive when faced with be analyzed when the lender is considering the a credit exhibiting signs of fi nancial distress. The fi rst was foreclosure option. Preparation: The Key to Enhancing Distressed Debt Recovery Op- The lender should also be aware that the borrower portunities, COMMERCIAL LENDING REV., Jan.–Feb. 2007), at 18. may seek to commence an action against the lender 2 See Connecticut General Statutes §52-278f.

This article is reprinted with the publisher’s permission from the COMMERCIAL LENDING REVIEW, a bi-monthly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publisher’s permission is prohibited. To subscribe to the COMMERCIAL LENDING REVIEW or other CCH Journals please call 800-449-8114 or visit www.CCHGroup.com. All views expressed in the articles and columns are those of the author and not necessarily those of CCH or any other person. All rights reserved.

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