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Giving Debtors a Break During COVID-19: How to be Flexible But Still Protect Your Rights

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Foster Swift Finance Real Estate & Bankruptcy Law News
May 28, 2020

Past DueTimes are tough, and the rallying cry that “we’re all in this together” is being taken to heart by many creditors who are making financial accommodations to debtors. While accommodation may be the altruistic thing to do, and in many cases is a smart business decision, it shouldn’t be undertaken without careful consideration and thorough legal review. Any short-term actions you take as a creditor to modify or waive payment and performance obligations under a contract can have long-term consequences, so it’s important to consult with your attorney to make sure your rights are protected.

It’s Not Business as Usual

During “normal” times, efforts to collect unpaid debts follow a common playbook. When a debtor defaults, and informal outreach efforts don’t work, formal collections efforts ensue. If out-of-court collection is unsuccessful, litigation may be initiated. In some cases, debtors opt for bankruptcy to avoid collection and/or stay litigation.

These, of course, are not normal times. Many creditors are being accommodating to debtors, proactively deferring payment obligations, delaying collection efforts, and holding off on litigation. There may be a strong business case to be made that more leniency is the right course of action. After all, no one wants to throw more good money after bad, and pushing more debtors into bankruptcy almost certainly won’t lead to greater recoveries. However, creditors shouldn’t merely adopt a “wait and see” approach, and any leniency extended to debtors should be carefully considered. Any accommodation made outside of contract terms should only be done after consultation with legal counsel, and be clearly documented.

How to Deal With Debtors While Protecting Your Business

In good and bad economic times, the best way to deal with a debtor—be it a business or an individual—who is late on payment or otherwise experiencing financial distress, is to first engage in a conversation.

By engaging in a dialogue, you can gain valuable information about the debtor’s circumstances that will inform next steps. For example, you may learn that the debtor is late because they are waiting on payment from one of their customers or funding from a government stimulus program. Do not necessarily trust without verifying, and it is a good idea to consult with legal counsel before having these conversations. Always talk to your lawyer before agreeing to any sort of financial accommodation and make sure to get it in writing.

Businesses of all varieties will likely have to deal with financially distressed debtors over the coming months. The best path forward may be to allow a debtor more time to pay, but there are important legal issues to consider before going down that path. By consulting with your lawyer, you can ensure that you’re not modifying or waiving important rights, or worse, becoming the first party to breach the contract. With the assistance of counsel, you can also appropriately document whatever agreement is struck to increase the likelihood that you will get paid and to ensure everyone “is on the same page” in relation to the intent of the agreement.

Some of the most common questions and scenarios, along with best practices, are discussed below.

Contract Modification. If you are under contract with a debtor, and come to an agreement that alters any terms or conditions of the existing contract, such changes must be documented as part of a contract modification. A contract can be modified in whole or in part, such as changes to interest rates or payment terms, depending on the needs of the parties. Before modifying an existing contract, it’s important to think through the ramifications, as well as determine whether the terms you seek to change are subject to a “no-modification” clause in the contract. Your lawyer can help you to determine how to best proceed when contract terms must change.

Forbearance Agreement. A forbearance agreement is distinct from contract modification in that a forbearance agreement is a new contract, not a modification to an existing one. In a typical forbearance agreement, a debtor/borrower acknowledges that it has defaulted on its contractual obligations, and the creditor/lender agrees that it will refrain from exercising its remedies for such defaults as long as the borrower performs or observes the new conditions set out in the forbearance agreement, and, by a certain date, cures the defaults. A forbearance agreement is not necessary for a simple modification, but rather, it is needed when the default is expected to continue for a longer period or the debtor is required to take action (such as refinance) during the forbearance period.

Reservation of Rights Agreement. One of the risks of accepting performance under a contract that is inconsistent with contract terms is that such conduct can result in an implied modification of the contract. One of the ways to guard against this is to use a reservation of rights agreement. Such an agreement can be used when a party becomes aware of facts which may amount to breach of contract, but needs time to investigate and consider its options, and wishes in the meantime to reserve its rights to terminate or enforce the contract.

Repayment Plans. From lenders to landlords, another tool that can be used to collect debts over time is a repayment plan. A repayment plan, which is executed as a new agreement, is used when a debtor/borrower has fallen behind in payments. Such a plan requires the debtor/borrower to make regular payments to cover current obligations, plus an additional amount to catch up gradually on past due debts.

Get Advice and Get it in Writing.  There is no single, foolproof way to deal with debtors. There are a number of tools and techniques that businesses can use to increase their likelihood of getting paid. However, when dealing with a debtor, it’s critical to ensure that you’re not relinquishing any rights in the process of trying to accommodate a debtor who is experiencing financial distress. Whatever action you take, you want to come out of the situation in a stronger position than you were going in. That’s why you should consult with legal counsel before taking any steps to communicate with a debtor, and certainly before finalizing any contract modification or new agreement.

Please contact your Foster Swift lawyer to discuss best practices for collecting debts, enforcing your rights under contracts, and any legal questions you have during these unprecedented times.

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