We are going through a particularly turbulent time for the real estate sector with the costs of materials for developments and interest rates and energy costs soaring. The industry is also facing shortages in the labour market and the need to repay or refinance Covid era loans.
Data from the Government's Insolvency Service paints a bleak picture with 4,165 construction firms becoming insolvent in the 12 months ended 31 March 2023 equating to 19 per cent of all cases where the industry of an insolvent firm is known. This article sets out some key considerations for lenders should borrowers have defaulted under a loan.
Has an event of Default occurred?
Usual default in real estate finance loans include:
- non-payment;
- breach of financial covenants (the most common financial covenants being loan to value of the property or interest cover);
- breach of other obligations (which captures all other breaches of other obligations under the loan);
- misrepresentation;
- insolvency events;
- cross-default (i.e. the borrower defaults under any other agreement - either with the lender or a separate third party), and
- material adverse change (although a lender is unlikely to solely rely on a material adverse change to call an event of default given the ambiguity and subjectivity as to whether the breach does amount to material adverse change).
There will usually be a requirement for a borrower to notify upon the occurrence of an event of default.
Is an Event of Default continuing?
Usually, a loan agreement entitles the lender to accelerate the loan and declare it immediately payable if an event of default has occurred "and is continuing". A well advised borrower will ensure that the "and is continuing" is included to avoid the situation where a borrower is technically in default under the loan, for example, by making late payment by a period of 24 hours, but having then made the payment and remedied the event of default, the Bank could still technically call an event of default anytime in the future and accelerate the loan. Logically, a well-advised lender will try to reject the inclusion of the "and is continuing" language to retain flexibility to call an event of default even for a temporary or technical breach.
If the continuing wording exists, is it balanced by the caveat that the continuing event of default is "unremedied or unwaived" or simply "unwaived"?
Returning to the example of a late payment under the loan agreement (assuming any grace period has expired), is the event of default is capable of remedy by the borrower? The interpretation of “continuing” will be key in determining this. If the interpretation of "continuing" in the context of an event of default is “continuing unremedied or unwaived”, the borrower should be able to remedy the breach by its own accord, without requiring an express waiver from the lenders. So once the borrower pays the interest, albeit late, the event of default would no longer be "continuing". However, if the interpretation of continuing in the context of an event of default is only "continuing unwaived" by the lender, that borrower will be unable to remedy an event of default (such as the late payment) after the end of the grace period, without the express agreement of the lender. Clearly this is advantageous for the lender.
Consequences of an event of default and actions available
Having established a continuing event of default, the lender will have a number of options available to it. It could proceed under what is known as the "acceleration" clause and immediately declare all outstanding loans due and payable and declare any security taken enforceable (and cancel any undrawn element of the loan).
However, there are other options available which are less drastic and would be more appropriate for minor breaches where the lender thinks they can be remedied to its satisfaction. One option is to issue a reservation of rights letter to the borrower following an event of default (or sometime earlier before the breach has become an event of default i.e. at the potential event of default stage). These letters are a mechanism by which lenders seek to reserve any rights or remedies it may have under the loan agreement in connection with an event of default - even if the lender has not taken prompt action in relation to the event of default. A reservation of rights letter aims to protects the lender’s ability to take subsequent action following a pause to consider it’s options.
However, the case of Lombard North Central Plc v European Skyjets Ltd [2022] EWHC 728 confirms that caution should be taken by lenders in the context of events of default as a lender's conduct (in particular positive action such as accepting late payments) may implicitly waive an event of default even if a reservation of rights letter has been issued (and there is a no waiver clause in a loan agreement).
There are various other options that a lender may wish to consider:
- Issuing a waiver whereby a lender agrees to waive the event of default (or potential event of default).
- Amending the loan agreement provisions to allow the borrower to comply with the loan (this may be for minor technical breaches such as a representation no longer holding true or breaches that are due to changing market conditions meaning a sector as a whole cannot comply with certain provisions – examples of this may include failing to meet required milestones in time given the challenges around labour shortages and failure to comply with financial covenants given factors such as falling property values and increased costs for developments). It is also possible for the amendment to be wide ranging should the borrower and lender agree to renegotiate and restructure the existing loan as part of an out of court restructuring plan.
- Exercising rights of set-off against deposits that a lender may hold of the borrower.
- Charging the borrower default rate interest.
- Taking enforcement action against the borrower and if applicable any guarantors of the loan.
Conclusion
Given the complexity around events of default and how to enforce them, we would recommend that both borrowers and lenders reach out to their legal counsel as early as possible upon becoming aware of events of default or potential events of default. Legal counsel can assist borrowers by helping to set out potential options available to them and then helping to negotiate the best outcome with lenders. Whilst for lenders, legal counsel can also assist in deciding the best way to proceed including enforcement and other options available. Legal counsel can ensure the relevant legal documentation is drafted if required and no potential issues arise for lenders such as by action or lack thereof that could be seen to waive events of default.
