Loan Modifications: Let the Borrower Beware

Modifications represent a change in one or more of a loan's terms, allowing the loan to be reinstated and offering affordable payments to the borrower. However, they do not come without their share of risk.

With borrowers falling into default on their loans, an alternative option for preventing foreclosure has arisen. Loan modifications represent a change in one or more of a loan’s terms, allowing the loan to be reinstated and offering affordable payments to the borrower.

These can benefit both borrower and lender by providing an extension, rate reduction, deferral of interest, principal forgiveness or additional advances in exchange for principal pay-down, additional collateral, a new guaranty or management change.

However, loan modifications do not come without their share of risk. It is the borrower’s responsibility to be aware of possible pitfalls before signing on the dotted line.

First off, the borrower parties, including any guarantors, should verify the holder of the loan, mortgagee of record and authority of lender representatives to bind all parties with an interest in the loan. Multiple workout discussions might be required. Be prepared to demonstrate the ability to service the modified loan, pay property taxes and provide a market return to new money as well as evidence that the proposed modification will yield a better return to the lender than foreclosure.

You should expect a pre-negotiation agreement providing for non-binding negotiations absent a mutually acceptable written modification agreement is customary, but resist such pre-negotiation agreement additional provisions as release, stipulation as to the debt, waiver of defenses and admissions of default. These additional provisions may be acceptable in the ultimate modification agreement.

Don’t neglect to analyze the tax consequences of the modification with tax advisors, which carry different consequences for different partners. Debt forgiveness may result in cancellation of indebtedness income (COD), and other modifications can result in taxable income, even without a principal reduction. Under new IRC Section 108(i) (part of the 2009 stimulus package), COD incurred in 2009 or 2010 can be deferred until 2014 and then included ratably over 5 years. This deferral is conditioned on the borrower maintaining ownership of the property; if there is a disposition, the COD would have to be recognized in the year of disposition.

Be certain to secure any necessary consents from constituents and other third parties. Are reimbursement obligations in place in favor of those providing guaranties or other credit for the modification? What remedies will be exercised against constituents not providing their share of resources necessary to effect the modification? Senior lenders typically require the consent from junior lienholders (since a loan modification might otherwise be subordinated to the extent of a modification prejudicing the junior). Try to negotiate early with junior lienholders, and consider the lender’s need to comply with any intercreditor agreement.

It is important to attempt as early as possible to negotiate any affidavit or indemnity required by title company to issue an endorsement to lender’s loan title policy affirming the priority of the mortgage. Lenders will typically require a release from the borrower parties, including lender liability claims. Negotiate for a reciprocal release or waiver of all past defaults, especially waiver of non-recourse carve-outs claims — excepting, of course, the obligations to repay the modified debt and the prospective obligations under the modified loan documents. Any release or payments from the borrower parties should be effective with the closing of the modification, as there may be conditions to closing beyond the borrower’s control.

A breach of conditions or covenants after the modification should not render the modification void (which would result in loss of concessions including waivers from the lender in favor of the borrower parties); rather, any such breach should merely be the basis for a default, possibly subject to cure. Carefully review any requested representations and warranties, especially the accuracy of representations in the original loan documents if affirmation is requested and any implicit representations in the recitals to the loan modification documents.

Finally, if the lender is regulated by the FDIC or other agency, confirm satisfaction of applicable federal requirements for the modification to be enforceable on successor holders if the lender is taken over by the agency.