Loan Defaults - Monetary vs. Non-Monetary
So, you can readily see that your collateral is headed south. Your job is to jump on it and come up with some solutions. Before you jump into action, it would be wise to take a breath and consider what the default situation is and why you have the right to start taking action – now, as opposed to later.
Types of Defaults
Generally, borrower defaults fall into one of two buckets – monetary and non-monetary. Monetary defaults involve the borrower's failure to pay money to the noteholder. Non-monetary defaults involve the borrower's taking some action which is prohibited or failing to take some action which is required by those lengthy "covenants" that appear in the loan documents. Depending on what your loan documents say, either type of default may be automatic – without any sort of warning notice – or may require formal notice and a period of time for the borrower to cure the shortcoming. Generally, loan agreements require more from the noteholder in the way of advance notice and time for cure when non-monetary defaults occur than when monetary defaults occur.
Creditor rights are limited before default
It seems simple, but worth stating – your borrower is entitled to own and operate the collateral property without lender interference, so long as she is living up to the terms of the deal reflected in the loan documents. This is true, even if you know the crash and burn is inevitable. The noteholder has no right to interfere with the collateral and its operations unless and until there has been a borrower default. That bright line event is important to a myriad of rights between borrower and noteholder, including whether the debt can be accelerated, the right to collect and hold rent and income from the collateral, and whether default interest begins to accrue – to name just a few.
Bright line of default
Since so many issues turn on default, careful loan servicers will strictly comply with loan document terms before asserting loan document rights. When possible, act only on clear-to-identify (and prove in court, if it should come to that) defaults. Between borrower and noteholder – the easiest to identify and prove is a monetary default. Either the borrower has paid or it has not. Declaring a default and taking your workout to the next level of hostilities on non-monetary, covenant breach defaults is often a risky proposition. Many of these defaults are subject to second guessing and after-the-fact paper grading. – and are therefore harder (and more costly) to prove if you are ever put to the test in a court of law.
Convert the non-monetary to monetary
Although it may take some time and additional effort, many non-monetary defaults will become monetary with some additional notices and time. For example, if the collateral is not being properly maintained in your opinion, you may be able to give notice of non-monetary default. But you can be assured of an argument about this subjective call if your borrower or guarantors have any fight in them. Consider adjusting (in strict compliance with the loan documents) the monthly amount of the borrower's reserve for replacement escrow to ensure that sufficient funds are available to spend to maintain the collateral. Chances are good that the circumstances could then mature into a monetary default – which will be much easier to defend in the future.
