A Lessor's Guide to Workouts

Next month's installment will continue the discussion of key provisions to include in the workout provision.

Frank Peretore is a founding partner of the law firm of Peretore & Peretore, P.C., with offices in New Jersey and New York. He represents national and regional financial institutions and lessors from the transactional and financing stage throughout the litigation stage in the state, federal and bankruptcy courts. He also represents creditors in general commercial litigation and commercial foreclosure matters. Peretore may be reached at 973-729-8991. This article is adapted from the author's book titled Workouts and Enforcement for The Secured Creditor and Equipment Lessor, (2008) by permission of Oxford University Press, Inc.

Part One of a Two-Part Article

The primary goal of a workout should be to place the creditor in the strongest possible collateral and procedural positions in the event of a default. Every workout should be structured to anticipate a future default and enhance procedural, substantive, and collateral positions. If properly drafted, the workout agreement will assure that the creditor will avoid duplicative litigation costs and delays in the event of the future default, and will obtain all collateral and judgments against all obligors and guarantors expeditiously, preferably with priority over other lienholders and creditors.

Preliminary Issues to Address in Workouts

Precisely Identify All Parties

The creditor should confirm the exact legal names of all obligors or lessees (collectively hereinafter “obligors” and whether they are individuals, partnerships (limited or general), proprietorships, corporations, or limited liability companies. If workout documents misspell a name or otherwise misidentify an individual or entity, the creditor may have difficulty enforcing the agreement against the misidentified person or entity, or more importantly, may find that a UCC-1 or other lien perfection documents were filed under an incorrect name, possibly jeopardizing the perfection of the lien. If a person or entity is misidentified in litigation and in the resulting judgment, the creditor will not, without amending the judgment, be able to levy on the defendant's assets because the sheriff or marshal will generally not levy upon assets held in any name other than that of the precise defendant identified in the caption of the judgment.

Review Credit Applications

At the time the credit application was submitted, the obligor and guarantors needed the funding and were likely to have freely provided financial information that they would now prefer to withhold from the creditor. Equipped with this identity and asset information, the creditor can often swiftly identify and locate the obligors and guarantors and their assets, speeding settlement negotiations and enhancing the terms of the workout.

Include All Guarantors and Determine the Nature and Scope of Guaranties

All guarantors, whether they are cross-corporate guarantors or personal guarantors, should be made parties to any workout or litigation. While a well-drafted guaranty agreement will provide that the creditor may restructure the debt (or even impair collateral) without the guarantor's knowledge or consent, it is nevertheless advisable to require all guarantors to be parties to all workouts.

Before negotiating a workout, creditors must also review all guaranties to determine their nature and scope. For example, if the creditor has two separate transactions with the obligor two years apart, and there are three personal guarantors, the creditor must determine whether all guarantors are liable on both transactions. The answer will depend on whether guaranty agreements are continuing in nature. If the guaranty agreements are not continuing guaranties, all three guarantors will only be liable on both transactions if they all executed two guaranty agreements, one for each transaction. If all of the guaranty agreements are continuing guaranties, they will all be liable for both transactions even if they only executed one guaranty agreement, contemporaneously with either transaction, before the first or after the last transaction or indeed at any time in between. Of course, if any guaranty agreements are not absolute, unconditional and continuing guarantees, the workout agreement should be sure to convert them to same.

Address Lien Perfection and Priority Problems

Prior to workout negotiations, the creditor should confirm the perfection of its liens. The creditor must be sure to have properly documented and continued all liens. If any perfection problems exist, the creditor should try to remedy the defects in the workout.

In addition to confirming the perfection of its liens, the creditor negotiating a workout must also consider the priority of its liens. The creditor should consider not only recorded liens, but also secret liens ' liens that are not filed of record. This possibility is most likely to occur if the creditor has a lien in accounts receivables. The two most common secret liens in accounts receivables are those of the United States, usually the Internal Revenue Service (“IRS”), and those of the bank where the obligor deposits its receivables.

The IRS holds a lien on all assets created more than 45 days after it records a judgment. Since accounts receivables are regenerated daily, those accounts receivables (and inventory) created more than 45 days after the IRS records its judgment will be subject to the IRS lien. The IRS lien will be superior in these newly created assets to the perfected creditor's lien even though the creditor filed a UCC-1 long before the IRS judgment was recorded. The IRS lien will generally not have priority on equipment and machinery because they were not created after entry of the IRS judgment, but pre-existed or are the subject of a purchase money security interest.

Under Revised Article 9, the obligor's depository bank will also likely have a lien superior to the perfected creditor's in accounts receivables deposited with the bank. This is so even though the bank may never have filed a UCC-1 in connection with its security agreement, unless the creditor has procured a control agreement from the bank wherein the bank acknowledges the superiority of the creditor's lien. UCC ” 9-340(c) and 9-104(a)(2) and (3) (2005). Notably, even a non-depository bank will gain this priority if it has a control agreement in the obligor's deposit account.

Liens may also arise under particular state statutes. Local law may grant liens to landlords and mechanics on equipment on the landlord's premises or on a vehicle left at a mechanic's shop, respectively.

The creditor may be able to eliminate or minimize the impact of secret liens by negotiating subordinations or restructuring the assets. For example, in the case of a superior claim to cash and receivables by the obligor's bank because the creditor did not previously obtain a control agreement, the creditor may require in a workout that the obligor move all bank accounts to the creditor's bank or another bank that agrees to enter into a control agreement with the creditor.

Key Provisions to Include in the Workout Agreement

Cross-Default, Cure and Three Strikes

The definition of default should include not only a default under the original transaction documents and the workout agreement, but also under any other loan or lease with the creditor or its assigns. Cross-default provisions are very important if the obligor defaults under one transaction, but not others. Generally, if the obligor defaults on fewer than all its transactions, creditors will find that the obligor has defaulted under the transactions in which there is no equity in the collateral, and conveniently not defaulted on the deals in which equity exists in the collateral. The cross-default provision works hand-in-hand with a cross-collateralization provision (referenced below), allowing the creditor to default all transactions on account of a default on one, and further allowing the creditor to use the equity of one transaction to cover the deficiency of another.

The default provision should also include a cure penalty provision and a “three strikes and you're out” provision. The cure penalty provision states that if the obligor requires notice and an opportunity to cure for any default, the creditor will assess an administrative fee for the cost and expense of issuing default notice if the obligor cures the default within the required time. A “three strikes and you're out” provision states that after three noticed and timely cured defaults, no further default notices will be required and the creditor can pursue all remedies immediately upon default. These provisions are necessary to motivate the obligor to fully and timely make the required payments. Absent these provisions, obligors are often habitually and willfully late in making payments.

Cross-Collateral

Like cross-default provisions, cross-collateral provisions may have been included in the original transaction documents, but even if they were, reincorporating them in the workout is advisable. A cross-collateral provision provides that all debts of the obligor to the creditor are secured by all collateral referable to each of the then-existing or subsequently entered transactions with the creditor. Cross-default and cross-collateral provisions work well in tandem, allowing the creditor to apply the value of collateral from all deals to all debts. As noted above, this combination enables the creditor to take the equity from one deal and apply it to satisfy a deficiency in another deal.

Waiver of Counterclaims, Defenses and Setoffs, Known and Unknown

Even if already addressed in the transaction documents, the workout agreement should contain the obligor's and guarantors' specific and unambiguous waiver of any counterclaims, defenses, or setoffs, whether known or unknown, at the time of entering the agreement. Although the original documents will almost always include these waivers, the enforceability of such provisions drastically increases when they are entered into months or years after the original transaction, post default and in a “settlement negotiation” context.

Waiver and Consent to Jurisdiction

The agreement should contain a consent by the obligor and all guarantors to a jurisdiction that is convenient and cost effective for the creditor and its counsel in the event of future litigation. The creditor should, however, generally avoid an exclusive jurisdiction provision requiring the parties to bring all litigation in a designated forum. The provision should generally be nonexclusive, allowing the creditor to proceed with litigation in the designated forum, or, if it chooses, to pursue its remedies in any other lawful forum. The nonexclusive provision, also known as a consent to jurisdiction clause, is preferable because there are some circumstances in which the creditor may wish to forgo the right to sue in the identified forum. One example is where the collateral is located in a state other than the designated forum and the creditor wishes to pursue a replevin. Another example is where the obligor or any guarantors have valuable assets outside the forum identified in the workout agreement, and the creditor hopes to seize or secure these assets pending the litigation. To avoid having a forum selection provision designated an exclusive forum selection provision, creditors should avoid words like “all,” “exclusive,” “only,” and “shall” in identifying the forum.

Waiver of Jury Trial

The agreement should provide for the waiver of a trial by jury. While most contested cases can be resolved by summary judgment, there may be a few cases that require a trial. Most original documents include jury waivers. Like the other waiver provisions, these waivers are far more likely to be enforced if conspicuously reaffirmed in the workout agreement. A number of jurisdictions may, however, refuse to enforce jury waivers. For example, California law holds that such waivers are unconstitutional, even in commercial transactions. Grafton Partners v. Superior Court , 36 Cal. 4th 944, 116 P.3d 479 (2005).

Most state jurisdictions and the federal courts will generally only enforce jury waivers if they are voluntary and knowing, and conspicuous. Thus, it is advisable to put jury waivers in bold and capital letters, and if possible, require the waiver to be separately initialed by the obligor and guarantors.

Review By Counsel

The creditor should encourage the obligor's retention of counsel. The agreement should reflect that the obligor and guarantors were represented by counsel in the negotiations and that counsel had the opportunity to review the workout agreement prior to execution, if that is the case.

This clause undercuts arguments of unfairness and unequal bargaining power; courts are far less likely to entertain an unconscionability defense if the obligor was represented by counsel or advised to be represented by counsel in the negotiation of the agreement.