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When Loans Go Bad, Pre-Workout Agreements Allow Lenders to Protect Their Rights While Negotiating
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August 11, 2008
(This article first appeared in the July 16, 2008, New York Law Journal.)
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Thelen LLP
When negotiating the workout of troubled commercial real estate loans, lenders must take care to protect their existing rights and remedies against prejudice in the event a final agreement cannot be reached.
By entering into a pre-workout agreement before negotiations, lenders can ensure that all discussions and draft agreements exchanged between the parties are neither enforceable before execution of a settlement agreement (be it a forbearance agreement or an amendment to the loan documents) nor admissible in any court proceeding.
While the provisions of pre-workout agreements vary, prudent drafting will include key clauses that New York courts consistently find dispositive of the parties’ intent not to be bound before execution of a written settlement or workout agreement. The pre-workout agreement should confirm the borrower’s indebtedness (and, ideally, any guarantor’s obligations) to the lender while also setting forth the operative loan documents that evidence, secure or relate to the underlying loan. An “Expression of Intent” clause, under which the parties indicate that any discussions, negotiations, draft documents, term sheets or other communications between the borrower and lender concerning the underlying loan will not constitute an enforceable agreement, is another integral component of the pre-workout agreement. The protective nature of the “Expression of Intent” provision encourages negotiation and free exchange of draft workout agreements without fear of being bound to such terms in the absence of a signed, written final agreement. The pre-workout agreement also should include a covenant that neither party will assert any claim or institute any proceeding against the other arising out of discussions during the negotiations.
While some pre-workout agreements specify their duration, common practice is to include a termination provision by which either party may terminate the negotiations at any time and for any reason. Lenders also may require a waiver clause under which the parties agree that no provision of the pre-workout agreement will be construed to amend, modify, supplement, extend, terminate, waive or release the rights and remedies of the lender in the existing loan documents. Finally, a pre-workout agreement should confirm that no oral representations or agreements are binding on either party.
One of the principal protections of pre-workout agreements involves the validity of oral communication by the lender upon which a borrower claims to have relied. R.G. Group, Inc. v. Horn & Hardart Co. sets forth the standard that New York courts apply in determining the enforceability of oral communications exchanged between contracting parties. 1/
The court held that whether a borrower and lender are bound by oral discussions or agreements during negotiations hinges on whether the parties intended to be bound solely by execution of a mutually acceptable written agreement. To make this determination, the court used a four-prong test, with no one factor being decisive but each providing significant guidance as to whether the parties intended that all oral communications or agreements would be unenforceable unless provided for in a signed writing.
The court first looked to whether the parties explicitly agreed in writing that only a signed writing would operate as a binding agreement. The court noted that such a written expression need not be entered into before the start of negotiations to be probative of the parties’ intent to require enforceable agreements to be in writing. Second, the court examined whether a party had partially performed under the oral agreement it sought to enforce and whether that performance had been accepted by the party disclaiming the contract. The court wrote that it would interpret partial performance as probative evidence of the parties’ belief that an agreement was in place.
Third, the court considered whether all terms had been settled and negotiated, with nothing remaining but a mere memorializing of the agreement in writing. Finally, the court examined the extent to which the matter at issue involved such a level of complexity and sophistication that a writing requirement would be expected.
While the court often will consider the first factor as being most probative of the parties’ intent to bar oral agreements, the particular facts of the case dictate the weight afforded to each factor.
A properly drafted pre-workout agreement will satisfy all four factors of the R.G. Group test, thereby limiting the evidence that the court will consider to the pre-workout agreement. The first and second prongs are met by including language explicitly stating that neither party will be bound until a final written agreement is executed and that acceptance of any payment constitutes neither a modification of the original loan documents nor a waiver of lender’s rights and remedies. To satisfy the third prong, the pre-workout agreement should state that negotiations are ongoing until a final written agreement is reached. To satisfy the fourth prong, the pre-workout agreement should document the sophisticated and complex nature of the transaction and note that common practice for such transactions is to reduce all enforceable agreements to a writing. (The statute of frauds also may have an impact on any agreement involving real estate.)
Prudent drafting of a pre-workout agreement is illustrated in Crossland Federal Savings Bank by FDIC v. 114 E. Realty Co., in which the U.S. District Court for the Southern District of New York applied the R.G. Group test in the context of a real estate finance dispute. 2/ In Crossland, the borrower and lender orally agreed to an informal modification of monthly interest payments, which were timely made by the borrower for the next eight months. After that, the parties entered into a written pre-workout agreement concerning additional matters. After the parties were unable to agree on the additional matters, the lender commenced a foreclosure action.
In finding for the lender, the court noted that all four prongs of the R.G. Group test were satisfied by the provisions of the pre-workout agreement. The pre-workout agreement and the original underlying security instrument stated that any modification of a term, condition or provision of the loan had to be in writing in order to be enforceable. Another provision stated that any interest payments made by the borrower pursuant to an oral agreement did not cure the default. Consequently, the monthly interest payments were held not to evidence a belief by the parties that a new agreement was in effect.
By providing that all communications were settlement discussions and that the parties were in ongoing negotiations pending a final written agreement, the pre-workout agreement demonstrated that an enforceable agreement was yet to be reached and that discussions between the parties did not constitute a binding agreement. By noting in the pre-workout agreement that the value of the transaction exceeded $3 million and that it involved multiple mortgages, the letter conveyed that the sophistication and complexity of the transaction was such that it would customarily be memorialized in writing. As all four factors weighed in favor of the plaintiff, the court granted summary judgment to the lender.
In some circumstances, however, New York courts have refused to grant summary judgment to lenders seeking to foreclose when the borrower asserted an affirmative defense of reliance on oral exchanges during pre-workout negotiations. In Nassau Trust Co. v. Montrose Concrete Products Corp., the court critically distinguished between a modification of a written agreement and a waiver by the lender of certain rights or remedies under that written agreement. 3/ The underlying loan agreement lacked a provision prohibiting oral modification of its terms. When the borrower became delinquent on required debt service payments, the parties entered into an extension agreement that, unlike the loan agreement, contained a provision precluding oral modification. After failing to make the payments required under the extension agreement, the borrower requested that the lender refrain from instituting foreclosure proceedings until the borrower had an opportunity to negotiate the sale of the property to a third party. While the lender initially conveyed in writing a willingness to forebear from foreclosure proceedings provided the borrower meet certain obligations, the lender subsequently orally agreed to allow the extension without preconditions. Before the borrower completed the negotiations with the third party, however, the lender moved to foreclose on the property.
The court held that while the provision in the extension agreement prohibiting oral modifications precluded the agreement from being modified absent a writing, the provision did not preclude the lender from orally waiving rights or remedies. In holding that the lender’s spoken assurances amounted to a waiver of rights, the court created a method for a borrower to successfully assert a reliance claim based on an oral communication of the lender, even when the underlying document precludes oral modifications. The distinction between modification and waiver has encouraged borrowers to rely on the Nassau Trust decision in alleging that a lender’s oral communication amounts to a waiver of the lender’s rights and remedies under the loan documents rather than a modification of the loan documents’ terms. Such a distinction enables a borrower to remove itself from the R.G. Group analysis by shifting the inquiry to whether the lender’s oral assurances amounted to a waiver of rights rather than a modification of the underlying documents.
In order to combat such claims, the pre-workout agreement should provide that nothing contained in the pre-workout agreement or oral discussions relating to it will be construed by the borrower as a waiver of any of the lender’s rights or remedies under the loan documents. New York courts have been reluctant to give credence to oral communications when both the underlying agreement and pre-workout agreement have language disclaiming oral modification and waiver. 4/
Additional strategies can be employed to protect the client’s rights. When receiving interest payments from a defaulting borrower, lenders should prepare an acknowledgment unequivocally stating that the lender’s acceptance of the payment neither cures any existing default under the loan documents nor constitutes waiver of any of the lender’s rights or remedies. 5/ An acknowledgement containing such clauses will prevent a borrower from alleging that the lender’s receipt of the payment amounted to a cure of the underlying payment default. 6/ In addition, both the underlying loan documents and the pre-workout letter should include a provision expressing the parties’ agreement that any leniency on the part of the lender in exercising any rights or remedies under the loan documents will not be construed by either party as an ongoing waiver of such rights or remedies. 7/
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For more information about the issues covered in this report, please contact Richard Lapping in our San Francisco office at 415-369-7311 or at rlapping@thelen.com or contact your Thelen attorney. For more information about Thelen’s Construction and Government Contracts Department, click here.
ENDNOTES
| 1/ | R.G. Group, Inc. v. Horn & Hardart Co., 751 F.2d 69 (2d Cir. 1984).
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| 2/ | Crossland Federal Savings Bank by FDIC v. 114 E. Realty Co., 1994 U.S. Dist. LEXIS 753 (S.D.N.Y. 1994).
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| 3/ | Nassau Trust Co. v. Montrose Concrete Products Corp., 56 N.Y.2d 175, 436 N.E.2d 1265 (1982).
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| 4/ | Union Bank of Switzerland v. 890 Park Associates, 1995 U.S. Dist. LEXIS 3455 (S.D.N.Y. 1995); Security Pacific Mortgage and Real Estate Services, Inc. v. Canadian Land Co., 690 F. Supp. 1214 (S.D.N.Y. 1988); Massachusetts Mutual Life Insurance Co. v. Gramercy Twins Associates, 199 A.D.2d 214 (1st Dept. 1993).
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| 5/ | Travelers Insurance Co. v. Corporex Properties, Inc., 798 F. Supp. 423 (E.D. Ky. 1992).
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| 6/ | Marine Midland Bank v. Bullard Orchards, Inc., 140 A.D.2d 870 (3d Dept. 1988).
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| 7/ | Federal Home Loan Mortgage Corp. v. Drofan Realty, 1996 WL 15680 (S.D.N.Y. 1996).
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(Reprinted with permission from the July 16, 2008, edition of the New York Law Journal. © 2008 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited.)
©2008 Thelen LLP
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