Loan Modifications: The Lender's Perspective

David K. Conrad
Debra L. Auten Schrader
Bricker & Eckler LLP
February 2008

In today's real estate market there are many real estate loans that will not be repaid strictly in accordance with their terms. A loan modification is often the most cost effective method of dealing with this issue instead of recasting an entirely new loan or declaring a default and foreclosing on the real estate.

Examples of common loan modifications include the following:

• Extending the current maturity date

• Increasing or decreasing the loan amount

• Changing the interest rate or changing the method by which interest is calculated

• Modifying the payment provisions of the loan (interest only payments or deferred payments)

• Adding to or releasing the collateral securing the note

• Adding or removing guarantor(s)

• Amending or waiving covenants in the loan documents

• Adding or removing a revolving feature in an existing loan

• Allowing an assumption of the loan by a new borrowing entity.

In most situations, a loan modification will encompass two or more of the above-referenced amendments. A loan modification serves as an efficient way to alter specific loan terms, while leaving other original loan terms intact and enforceable. As loan modifications become more complicated and encompass several significant revisions to the terms of the loan, there is some risk that a subordinate lender or bankruptcy trustee may argue that the loan has been refinanced rather than modified with the possibility that the priority of the mortgage lien has been lost. The same argument can be raised if a substitute note is executed as a replacement for an existing obligation. In such cases, as later discussed, the purchase of a modification endorsement to an existing title policy may be the best method of protecting a lender's interests.

There are several benefits to modifying an existing loan, as opposed to issuing a new loan. In most cases, a loan modification requires less time and expense than a new loan. For example, loan modifications generally are easier to prepare, involve less due diligence and recording costs, and often require an update to an existing title insurance policy as opposed to the issuance of a new policy.

In most instances, a recorded modification will not be necessary. However, in some circumstances, a recorded modification may be required to ensure that the lender is protected. When a modification is being recorded, it is common to prepare two separate documents, one containing the significant business terms that is not recorded and one that is recorded that places the required terms of record. The following are the most common instances in which a loan modification will require recordation:

• Adding new collateral to secure the loan or releasing part or all of the collateral currently securing the loan

• Increasing the maximum available funds under the loan

• Adding a revolving feature to an existing loan

• Changing the borrower.

Most real estate secured loans include a lender's title insurance policy. The main title insurance problem associated with loan modifications is that the lender's title insurance policy specifically excludes matters that occur subsequent to the date of the policy; such as a subsequent loan modification. Generally, an endorsement or update to the existing title insurance policy should be obtained when:

• Subordinate liens are present

• The loan amount is being increased

• Additional collateral is being added to secure the loan

• A revolving feature is being added to an existing loan

• A loan assumption is being permitted

• Significant changes to the loan are being made so an argument could be made that the mortgage could lose priority to subordinate liens, including mechanics liens.

An update or modification to an existing title policy can take many forms. When the modification is very simple (perhaps just a one-year extension of the maturity date) no title update may be required or, at nominal cost, a simple title search may be sufficient. If the modification is significant, especially those requiring a recorded modification, a "modification endorsement" may be purchased from the title insurer. A modification endorsement insures the lien as modified by the endorsement and brings the date of the policy forward to the date of the modification (the actual endorsement should be carefully reviewed to see if any additional title exceptions are being added as a result of the endorsement).

A modification endorsement can be expensive. In Ohio, the cost is a non-negotiable rate equal to $.50 per $1,000.00 based upon the outstanding balance at the time of issuance of the modification endorsement. In addition, if a revolving feature is added to a loan, a revolving credit endorsement (also known as the future advance endorsement) should also be obtained. The cost is 25 percent of the premium for the original policy (with a minimum cost of $250.00). In certain cases, the lender should insist upon removal of the creditor's rights exception (to cover the issues of preferences and fraudulent conveyances), which removal may be resisted by the title insurer.

Depending upon the size of the loan involved, the outstanding balance of the loan, and the nature of modification, there can be significant cost savings depending upon how a modification is structured. For example, if a borrower and lender desire to increase the maximum amount of a loan by modifying a loan to increase the maximum amount from $10,000,000.00 to $10,500,000.00, the title insurance cost would be approximately $6,000.00. If this same request is structured as a second mortgage loan for $500,000.00 while keeping the existing $10,000,000.00 unmodified, the title premium would be approximately $1,550.00, a savings of almost $4,500.00.

Loan modification documents should include the following terms:

• Reaffirmation of liability and waiver of all defenses by borrower

• Reaffirmation of liability and waiver of all defenses by all guarantors

• Consent to modification as required (junior lien holders/guarantors, etc.)

• A specific description of the modification being granted

• If the note is cognovit, a reaffirmation of the warrant of attorney and repetition of the cognovit warning

• Borrower's agreement to pay the costs and expenses for the modification (including title, legal, recording costs, and any loan fee)

• Borrower's acknowledgement of Lender's performance of all of its obligations under the loan documents

• A statement that the modification is not intended as a novation of the existing loan documents and the existing mortgage lien and security interests created under the original loan documents continue unimpaired as liens on the collateral.

Certain modifications will require additional due diligence. For instance, if a loan is increased or a revolving feature is added, the lender should obtain documentation from the borrower establishing the authority for the transaction. Also, an increase in a construction loan may require a new budget, amendment to construction contracts and cost analysis. Loan modifications for a distressed project may warrant litigation searches, updated financial information regarding the borrower, any guarantors, and significant tenants. Sometimes take out sources such as purchase contracts or permanent loan commitments may be at risk as a result of an extension. In those cases, it is wise to get the purchasers or take out lenders to ratify their obligations and analyze the conditions in such purchase agreement or commitment to be sure they can be met.

In order to properly and efficiently document loan modifications for real estate loans, it is essential that:

• All modifications be in writing.

• All parties involved sign the modification.

• In appropriate cases, the modification should be recorded.

• The title company and attorneys be involved early in the process to properly structure the modification to protect the lender's interest at the lowest cost.

• Any modification title endorsement should be carefully reviewed to make sure it insures the proposed modification and does not add any improper exceptions to the existing title policy.