December 7, 2009
Recognizing that "financial institutions face significant challenges when working with commercial real estate ("CRE") borrowers that are experiencing diminished operating cash flows, depreciated collateral values, or prolonged sales and rental absorption rates," recently, members of the Federal Financial Institutions Examination Council ("FFIEC") (collectively, the "Regulators") adopted a new policy (the "Policy") that advocates the prudent workout of CRE loans. The purpose of the Policy is threefold–(1) to promote consistency among examiners responsible for evaluating financial institutions’ efforts to renew or restructure loans; (2) to enhance the transparency of CRE workout transactions; and (3) to ensure that supervisory policies and actions do not curtail the availability of credit to borrowers capable of repaying their debt on reasonable terms. The Regulators promise that "[f]inancial institutions that implement prudent CRE loan workout arrangements after performing a comprehensive review of a borrower’s financial condition will not be subject to criticism for engaging in these efforts even if the restructured loans have weaknesses that result in adverse classification."
The Policy outlines the key elements of a "prudent CRE loan workout", discusses the factors that examiners should focus on in determining whether a loan should be adversely classified, placed (or maintained) on nonaccrual status or reported as a Troubled Debt Restructuring and analyzes each of these determinations in the context of hypothetical workout scenarios involving income-producing property, construction loans, commercial operating lines of credit, and land loans. What follows is an outline of the characteristics of a "prudent CRE Loan workout" and the Policy’s other key points, a discussion of the Policy’s implications for financial institutions with substantial loan portfolios, borrowers and CMBS servicers, and a brief description of initial reactions to the Policy.
Characteristics of a Prudent Loan Workout
The Regulators promise that financial institutions will not be criticized for engaging in workouts so long as they have, at the institutional level, a prudent workout policy and, at the individual credit level, a well-conceived and prudent workout plan.
a. Risk Management Policies
Recognizing that restructured loans represent an elevated credit risk, the Policy provides that an institution should have risk management practices for renewing and restructuring loans that are "appropriate for the complexity and nature of its lending activity and . . . consistent with safe and sound lending practices and relevant regulatory reporting practices." According to the Regulators, an institution’s risk management practices should, at a minimum, address the following:
These elements do not represent an exhaustive list of the elements that an institution’s risk management practices need to address in order for the institution’s workout policy to qualify as "prudent". The Policy makes clear that risk management practices should be tailored to the specific nature of the institution’s lending activity and therefore, there is likely to be some variation between what is appropriate for one institution as opposed to another.
b. A Prudent Workout Plan
The Policy indicates that at the individual credit level, financial institutions need a plan that analyzes current financial information and supports the ultimate collection of all outstanding principal and interest. The elements of a prudent workout plan are: (i) updated and comprehensive financial information on the borrower, the real estate project and any guarantor; (ii) current valuations of the collateral; (iii) analysis and determination of the appropriate loan structure; and (iv) appropriate legal documentation for any changes to the original loan terms. In addition, the Regulators request the following:
Other Key Points
In an environment in which property values are rapidly declining and the CRE industry is experiencing significant financial difficulties, financial institutions dealing with a large number of loans on their books are likely to find the following Policy statements particularly helpful:
Implications for Financial Institutions, CRE Borrowers and CMBS Servicers
While borrowers are clearly in favor of the Regulators’ attempt to encourage workouts over foreclosures, the Policy’s impact on borrowers will necessarily depend on financial institutions’ reactions to the Policy’s guidelines. The Policy will most likely spark different reactions among CMBS loan participants. While borrowers and junior creditors are likely to be in favor of workouts over foreclosures, senior creditors wanting to foreclosure on mortgages and have their loans satisfied in full are likely to have negative reactions to the Policy’s guidelines. To the extent that the Policy highlights the divergent interests among junior and senior debtholders in the CMBS context, CMBS servicers may find it increasingly difficult to negotiate these conflicting interests and "adhere to ambiguous ‘servicing standard’ directives to maximize returns to all creditor classes."
Reactions to the Policy
Reaction to the Policy among members and observers of the CRE industry has been varied. Some believe that the Policy’s guidance will help financial institutions workout challenged loans without having them classified as "bad" loans. Others believe that lenders may have difficulty adequately addressing all of the elements of a prudent workout policy and plan and therefore, have suggested that financial institutions consider hiring a loan workout officer or elevating such a position to a senior level. Another point of view is that the Policy is necessarily vague because it is impossible to craft precise regulations that address all of the complexities of specific loans. On the other hand, some criticize the Policy as not going far enough and say it may actually slow down the recovery of the CRE industry by allowing financial institutions to delay writing down bad loans. The belief is that while the Policy may prove to be successful if asset prices increase, if they do not, the Policy merely delays the inevitable. Despite the varying positions described above, its seems that, at a minimum, the Policy has put financial institutions on notice that the federal government is not going to bail out the commercial real estate market like it did the residential market.
The Policy comes on the heels of the Internal Revenue Service’s September 16, 2009 release of regulations that remove tax obstacles to CRE loan workouts and allow borrowers and servicers to pursue the modification of CMBS loans not only if there has been a default, but also, if there is a "reasonably foreseeable default." This, combined with the fact that the Policy was issued in the face of the impending maturity of a large number of CRE loans and in a market that has seen prices for existing commercial properties fall 35 to 40 percent since peaking in 2007 (and with more declines anticipated) suggests that the Policy represents the federal government’s effort to encourage CRE loan workouts over foreclosures. Even if the Policy does not represent a dramatic shift in policy, at minimum, it provides comfort to financial institutions that have been reluctant to renew or restructure loans because of inconsistent treatment from examiners. If financial institutions follow the steps outlined above (and Regulators are true to their word), they will not be criticized for engaging in workouts. Lastly, by promising that loans will not be adversely classified solely because of a decline in the value of the underlying collateral and by authorizing the use of a two-note structure, Regulators have given financial institutions opportunities to reduce the amount of charge-offs, which should make workouts a more attractive option. Only time will tell whether the Policy will have a significant global impact on the CRE market.
 The members of the FFIEC are: the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), the office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS), and the Federal Financial Institutions Examination Counsel (FFIEC) State Liaison Committee.
 The Policy does not explicitly state that risk management policies should include documentation standards to verify the guarantor’s financial condition. However, financial institutions should make such standards a part of their risk management policies since the adequacy of the guaranty as a source of repayment is a primary area of focus for examiners evaluating loan workouts.
 See Andrew Lance, Romina Weiss & Daniel Wasserman, Gibson, Dunn & Crutcher LLP, New REMIC Federal Tax Regulations and Revenue Procedure Provide Initial Direction for Response to CMBS Distress (forthcoming).
 IRS Revenue Procedure 2009-45 (26 CFR 601.105) (available at http://www.irs.gov/irb/2009-40_IRB/ar15.html). See also Lance, et. al., supra note 4.
 Karey Wutkowski, US bank regulators warn on commercial real estate, Reuters (Oct. 30, 2009) available at
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