The objective of every loan agreement from a creditor’s perspective is to avoid having to pursue remedies against a debtor because of an “event of default.” An event of default is a circumstance that provokes the creditor to demand full payment under the loan agreement. Suing a debtor can be a mistake in itself. As the debt begins to compound with interest and late fees, a debtor often has more incentive to ignore the debt, forcing a creditor to make collection efforts, than to pay according to the terms of the loan agreement. A debtor may even feel like bankruptcy is the only option in which case the creditor could recoup nothing.
There are common mistakes creditors make before deciding to extend credit, in drafting the loan agreement, and post-default. Generally, these mistakes can be avoided or mitigated by (1) proper due diligence at the onset of loan agreement negotiations, (2) reasonable efforts to allow the debtor to cure any breaches of the loan agreement, and (3) on the back end when initiating collection efforts.
Lack of Due Diligence
A critical pre-default mistake that creditors can make is not performing the requisite due diligence before entering into the loan agreement and, consequently, lending to the wrong person or business in the first place. Before embarking on the due diligence process, a creditor must:
- Calculate the amount of credit risk it is willing to take on.
- Assess the borrower’s creditworthiness by using credit reporting agencies.
- Evaluate the likelihood of getting repaid and what the profit margin will be with interest.
Without a thorough due diligence assessment, a creditor may overlook contingent liabilities the borrower may have (e.g. liens or tax liabilities). Overlooking contingent liabilities such as indemnification obligations or litigation can create issues later not only with the debtor, but with other creditors. Those contingent liabilities often provoke creditors to secure the loan with collateral or use other mechanisms to protect their interests.
While a creditor may rely heavily on accountants in performing the due diligence, a creditor should seek legal counsel as the loan agreement will need to be drafted based on any issues discovered during the due diligence process. Legal counsel, moreover, will need to consult with experts if there are regulations integral to the industry in which the parties operate.
Knowing what to look for in a due diligence assessment can help tremendously in avoiding mistakes early in the loan process. If the borrower is a business, the assessment may begin with public filings with the secretary of state in which that business operates. Where are the assets of the debtor and where are they located? Do the loan parties have real property or intellectual property that would require the review of specialists? For an individual, running a credit report with any of the major credit reporting agencies along with gathering income vs. debt ratio information can be sufficient although in some cases a full background check may be prudent.
Overlooking due diligence can affect deal structure, government disclosure and reporting requirements, and competing interests in collateral. Once the due diligence is complete, a creditor will want to avoid pitfalls in drafting the loan agreement.
A primary mistake that creditors make in the drafting of the loan document is that the events of default are drafted too narrowly. Lenders ideally want broadly drafted events of default so that a lender can quickly claim breach without having to wait for several conditions to materialize.
Clarity is key and any liability provisions should be conspicuous for the reader as every debtor may not have counsel to review the document with them. If the conditions are not defined in a coherent manner, inadvertent defaults may occur forcing the parties to deal with issues of waiver and breach. If the debtor is an individual consumer, he or she may not have the resources to obtain counsel. As any loan agreement is going to be construed against the creditor, it is even more important that a creditor communicate exactly the financial commitment and legal obligations the creditor is taking on. Describing exact payment amounts and a delineated payment schedule can avoid collection and enforcement problems.
A common post-default mistake is being too aggressive and not considering all alternatives to declaring an event of default. If the loan agreement contains an acceleration clause, a creditor can invoke the right to accelerate the full amount of the loan. A creditor may also exercise its rights against the collateral offered in consideration for the loan, or file a lawsuit against the debtor. However, these aggressive tactics can leave a creditor with the loan balance still owing and exposure to counterclaims for bad faith dealings and violation of consumer protection laws. They may be best reserved for situations in which negotiations with the debtor are or are likely to be futile.
Negotiating with the debtor may ultimately yield more payment, lower costs, and fewer headaches. By negotiating, you mitigate the tendency for debtors who are struggling to remain current with payments to shut down or file for bankruptcy protection.
Before entering into negotiations, a creditor should be careful not to inadvertently waive any rights. Instead, a creditor should ensure that all potential written offers state a reservation of rights and that the terms are for negotiating purposes only. Some common options for resolution and to keep the debtor paying are:
- Payment of a lump sum in exchange for a release from the loan.
- Providing for additional collateral in exchange for not pursuing remedies.
- Negotiating a forbearance agreement where the lender agrees not to pursue any claims for a certain period of time while the debtor regains employment.
- Amending the loan agreement to restructure payment terms or extend the cure period for debtor bre
- Out of court restructuring of the loan agreement.
Another common mistake is to fail to recognize competing creditors and negotiate inter-creditor agreements to protect interests. If a creditor does not recognize its loan is subordinate to other creditors, its efforts to pursue remedies against the debtor may ultimately prove wasted.
Yet another pitfall for the creditor is failing to give proper notice to a debtor regarding the default. Consult with an attorney on drafting the notice provisions in the loan agreement and identifying what type of information is required by law to be included with the notice.
Avoid common mistakes creditors make when trying to collect a debt by getting help from an experienced debt collection lawyer. Call Snellings Law LLC at 973.265.6100 to schedule an appointment.