February 12, 2008

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An Arizona Lender's Guide to Loan Modifications

By Michael P. Ripp ©
Ryley Carlock & Applewhite

A.        Introduction.

            A real estate loan modification presents concerns with respect to not only the proper documentation of the changes to the existing loan terms, but also the possible discharge of borrowers, guarantors or collateral owners, the possible loss of the lender's lien priority and the possible impairment of the lender's title insurance coverage.  This Guide addresses concerns commonly encountered with loan modifications involving Arizona obligors and collateral.  This Guide does not attempt to address conduit loans, mezzanine loans and other less frequently encountered loan structures, the income tax consequences or tax reporting obligations associated with loan modifications, choice of governing law issues, or concerns dealing specifically with loan assumptions, workouts[1] or enforcement.  Some of those topics will be addressed in future Guides.

B.        Getting the File in Order.         

            A loan modification presents an opportunity to make sure that the lender's loan file is in proper order and to fix any problems.  Check the loan file to make sure that (1) all of the proper transaction documents were used for the type of loan, project and obligors in question, (2) all documents used were fully and properly signed and acknowledged, (3) all referenced exhibits and schedules were attached and blanks were filled in, (4) all security documents were properly recorded and filed,[2] (5) the title insurance policy was issued in the proper form with the requested endorsements, and (6) any required post-closing items have been received.  If the borrower has entered into additional material project agreements since the closing, consider expressly encumbering the borrower's rights under those agreements and obtaining the consents from the other parties to those agreements to allow you to encumber and enforce the borrower's rights.  Approach any modification as if it is your last opportunity to get the file in order before a terminal loan default or bankruptcy filing.

C.        Documenting the Loan Modification.

            Most loan modifications involve some sort of a modification agreement.  Those agreements can be relatively abbreviated for simple extensions or where little time has passed since the initial loan closing (or the previous loan modification).  However, a modification agreement should generally include:

            •           An identification of the presently effective loan documents (or at least the major ones) and the obligors' acknowledgment[3] of their continuing effectiveness.

            •           A specific identification of any known defaults then existing under the loan.

            •           An acknowledgment that the obligors have no offsets against the amount due or defenses to the enforcement of the loan, an acknowledgment of the then outstanding loan balance and current status of the loan, and the obligors' release of the lender (and affiliated persons and parties) from any and all existing claims in connection with the loan.

            •           The obligors' reaffirmation, as of the effective date of the modification, of the representations and warranties in the existing loan documents.

            •           A statement of the loan modifications.  This should include not only the changed terms, but also any required "backfilling" of material provisions that were not included in the original loan documents (due to the age of the documents, lender oversight or negotiation by a borrower or guarantor whose negotiating leverage has now eroded), but that would have been included had the original loan documents been prepared today.

            •           An acknowledgment that the modification is not intended as a novation of the existing loan documents, and that all existing liens and security interests will continue to secure the modified loan.

            •           A listing of any conditions to the effectiveness of the modification agreement, including: (i) the delivery (and if applicable, recording in accordance with the lender's recording instructions) of fully signed modification documents, appropriate entity resolutions and authorizations, bringdown endorsements, UCC searches and tenant subordinations; (ii) the borrower's payment of a modification fee, title company premiums and expenses, lender closing costs, required principal curtailments and/or past due debt service and impound payments; and (iii) the absence of any uncured loan defaults.

            •           Consents to the modification from all obligors under the loan. Appropriate consents should also be obtained from present owners of the collateral, junior lienholders, mezzanine lenders, lending syndicate members or loan participants, take-out lenders and, if deadlines of any nature are being extended, from parties who have the right to exercise significant remedies for the failure to comply with the original deadlines.

            •           In a workout context, a lender may also want to include certain bankruptcy protections (for example, a springing full recourse guaranty or the borrower's agreement that, if a bankruptcy petition is filed by or against it, the automatic stay may be lifted and/or the modified loan terms will become part of any bankruptcy plan submitted).  While there is no assurance that a bankruptcy court would honor those provisions, it does happen on occasion.

            The lender should consider using a replacement promissory note if the original promissory note is now substandard, the payment terms are changing significantly, the principal amount is being increased or the readability of the promissory note will be enhanced by simply restating (rather than amending) it.  If a replacement note is used, the replacement note should (i) identify the note it is replacing and the security for the note, (ii) state that the replacement of the old note does not constitute a satisfaction of the debt evidenced by the old note, and (iii) state that any accrued but unpaid interest under the old note will automatically be evidenced by, and payable as part of the first installment under, the replacement note.

            Questions often arise as to whether to record modification agreements.  Lenders sometime indiscriminately record modification agreements, thereby placing of record numerous, and sometimes sensitive, subjects that were not previously displayed in the public records.  A simple notice of modification referencing the modification agreement can generally be recorded in lieu of recording the entire modification agreement (the author also prefers to state the general nature of the modifications).  If items that are, or would normally be, included in the deed of trust (such as an increase in the secured principal amount or the addition of collateral) are being changed, a deed of trust amendment should be recorded.

D.        Discharge and Lien Priority Concerns.

            Many local practitioners believe that Arizona follows the so-called "majority rule" with respect to loan modifications - that is, obligors (including guarantors and collateral pledgors) may be discharged (in full or in part), and the lender's lien priority may be broken or reversed, if the loan modification materially changes the terms of the debt to the possible detriment of non-consenting obligors, junior lienholders or collateral owners or materially increases the risk of a loan default.  (A minority of states follow the rule that even changes that benefit non-consenting obligors, junior lienholders and owners can discharge them or break lien priority.)  Mere extensions of the maturity date of a fully advanced loan, without an increase in the interest rate, should not break a lender's lien priority, and, as discussed below, local title companies are willing to insure the lender's continuing lien priority in that instance without searching title.

            However, increasing the interest rate or the loan principal, cross-collateralizing loans, shortening the loan maturity, releasing collateral or obligors, or taking other measures that may increase the likelihood of default, increase the amount secured by the lien at the expense of junior lienholders or owners, otherwise increase the burden on the collateral or the remaining obligors, or impair subrogation rights of junior lienholders, obligors or owners are generally considered to present lien priority or discharge issues.  In those instances, the lender should request that all obligors, junior lienholders and/or collateral owners consent to the modification.  Few hard-and-fast rules exist by which a lender can definitively determine whether a given loan modification will present discharge or broken priority problems, and the determination often turns on the court's perception of whether an obligor or owner of a junior interest will be materially prejudiced by the additional obligations imposed by the loan modification.

            What should a lender do when an obligor or other desired party refuses to consent to a modification?  The most conservative approach is to refrain from modifying the loan and, if the loan has matured or is in default, to proceed with loan enforcement.  In real life, this isn't always possible or prudent.  As an alternative, a lender may try to characterize its agreement as forbearance agreement, rather than a modification agreement.  A true forbearance agreement (which could require full or partial reinstatement payments in exchange for the lender's short-term forbearance from exercising remedies) should not present lien priority implications; the lender is simply forbearing from enforcing its remedies for a certain period of time.  However, at some point a short-term forbearance agreement begins to look like a modification agreement, regardless of the name given to the agreement, and a lender will face the same discharge and broken priority issues that it would face in the context of any other loan modification.  Another idea is to condition the effectiveness of the modification on the continuing personal liability of all obligors and the continuing priority of all of the lender's liens, with the lender reserving the right, if either continuing personal liability or lien priority is affected or later challenged, to treat the loan as never having been modified (at least as between the lender and the challenger).  Finally, as the absence of notice is often of concern to courts in evaluating the legal effect of loan modifications, a lender may wish to consider giving written notice of the modification to non-consenting obligors, owners or junior lienholders, particularly if the original loan documents purport to allow the lender to modify the loan without their consent.  While a number of other alternatives may exist depending on the circumstances, easy or certain solutions rarely exist if a party refuses to consent.

            Lenders should anticipate the need for later modifications when they draft their original loan documents.  Guarantors should agree that the lender may modify the loan in the future without their consent, and, if multiple borrowers have signed the original loan documents, the lender should consider requesting the consent of, or a limited power of attorney from, all borrowers to deal with a single representative of the borrower group with respect to subsequent modifications.  Likewise, the lender's security documents should be drafted to permit the lender to modify the loan in any fashion, including increases in principal amount and interest rate, without the consent of any party other than the borrower.  Protections of the foregoing nature will not prevent obligors from arguing that they have been discharged, but should provide the lender with firmer footing when enforcing its loan against non-consenting obligors.[4]

E.         Title Insurance Concerns with Real Estate Loan Modifications.

            As a general rule, material modifications should be title-insured so that the lender does not break its lien priority and unwittingly excuse its title insurer from honoring the title policy on the basis that an uninsured modification has impaired the insurer's right of subrogation (an insurer that pays a lender's title policy claim acquires the legal right to step into the lender's shoes and assume the lender's position in title litigation or to pursue the party responsible for the loss).  A local title company will require that a notice of the modification or deed of trust amendment be recorded, and will typically charge a premium equal to 30% to 40% of the "basic rate" (the premium that it would charge for a title insurance policy of the same amount) to insure a modification; it will charge 100% of the basic rate on any increase in liability (such as a commitment to advance additional principal) created by the modification.[5]  A lender should be very reluctant to record a modification agreement, notice of modification or deed of trust amendment if the document will not be title-insured, as such a step may operate to invite unwanted inquiry (with an eye toward challenging your continued lien priority) from junior lienholders and others as to the nature of the modification.  If the modification could create a priority problem, you will normally want your title insurer to be obligated to defend you against the problem.

            Some local title companies have "short-term reissue" or "revamp" rates or other less costly options available for insuring modifications if the title insurer has previously insured the deed of trust, if the loan principal has been paid down by less than a certain percentage and if the original borrower still owns the property.  Ask whether such rates, or perhaps developer discounts on the regular modification endorsement rates, are available.

            Title companies will insure modifications without a title search for simple extensions involving no interest rate increase; the premium for this endorsement is normally 5% of the basic rate.  While such an endorsement is likely to be of little value in most instances, a lender may wish to obtain such an endorsement if, for instance, a junior lienholder has threatened to challenge the lender's continued lien priority following a loan extension.

F.         Pre-Negotiation/Pre-Workout Agreements.

            Some lending institutions request or require borrowers to sign pre-negotiation or pre-workout agreements before discussing a proposed loan workout to, among other things, (1) acknowledge the existence of a default and the status of the loan (and smoke out potential lender liability claims), (2) establish the ground rules for the impending negotiations, (3) acknowledge the effect of partial payments following default, (4) acknowledge the inadmissibility of the contemplated settlement negotiations as evidence in litigation and the non-binding nature of the verbal negotiations, (5) agree upon an enforcement standstill during the negotiations, and (6) emphasize that no loan modification will exist until modification documents are signed.[6]  The form and content of these agreements vary, but they are worth considering for defaulted loans.


The goal of the RC&A Arizona Lending Guides is to provide helpful substantive discussion and insights, based on the author's 25 years of experience in Arizona commercial real estate lending, loan workouts and enforcement, regarding a number of general legal issues of concern to commercial real estate lenders.  Opinions expressed in the RC&A Arizona Lending Guides are the author's and do not constitute legal advice regarding any specific matter or situation.  Legal advice can be given, and an attorney-client relationship can be formed, only on the basis of specific facts discussed between client and attorney pursuant to an engagement to perform legal services.

Michael P. Ripp
Ryley Carlock & Applewhite

[1] Loan workouts differ from more garden-variety modifications in strategy, structure and desired or required lender protections, many of which can be quite project-specific.  At a minimum, attention must be paid to eliminating or minimizing any remaining obstacles to a smooth loan enforcement against the project, obligors and adverse parties, enhancing cash flow management, and ensuring that the loan documents contain the appropriate provisions to redirect project cash flow to the lender and to divest control of the project from the owner.  Section F of this Guide introduces readers to the concept of a pre-negotiation/pre-workout agreement, but the author will generally defer the treatment of workout issues to a future Guide.

[2] Under the revised UCC Article 9 provisions governing the perfection of personal property security interests, the proper UCC‑1 filing location for a "registered organization," such as a corporation, limited partnership or LLC, is the state in which the entity is registered (normally its state of formation), while the proper filing location for other entity types is the entity's place of business.

[3] As used in this Guide, the term "obligors" refers to not only the present borrower, but also to guarantors, collateral pledgors, general partners, prior owners and other parties who may be (or whose property may be) obligated to repay the loan in any fashion.

[4] Particular care should be taken to obtain consents from other lienholders of which the lender has actual knowledge before completing a loan modification or making additional advances.

[5] If the lender is increasing the principal amount of the loan, it is generally worthwhile to ask the title company to quote premiums based on insuring the increase as (i) a modification of the original loan, with a modification endorsement and an increase-in-liability endorsement, versus (ii) a separate loan secured by a junior deed of trust.  Particularly in the case where a large initial loan is being increased by a relatively small amount (the typical scenario with construction loans involving cost overruns), one will often find that insuring the increase as a second loan secured by a junior deed of trust will be substantially cheaper than insuring the transaction as a modification of the original loan.  A lender may also be compelled to adopt this approach if the project is subject to mechanics' liens at the time of the modification and the title company will not accept a borrower indemnity against those liens (meaning that mechanics' liens would show as exceptions on a modification endorsement issued with respect to the original title policy).

[6] Arizona's so-called "statute of frauds" precludes a party from bringing an action based on a contract, promise, undertaking or commitment to loan money or to extend, renew or modify a loan involving an amount greater than $250,000 which is not primarily for personal, family or household purposes, unless the agreement, or some memorandum thereof, is in writing and signed by the party to be charged.  However, certain exceptions to the statute of frauds have been created by the courts to address the sometimes harsh consequences of the statute.