Forbearance Contracts: An Introduction
In legal and financial terms, forbearance refers to the postponement of an obligation such as the repayment of a loan. For creditors and collection agencies, it is generally regarded as the "refraining from taking an action" such as the filing of a lawsuit. Forbearance may also involve a temporary postponement of the right to induce the borrower to comply with other obligations, such as staying proceedings that a lender would otherwise be entitled to take. The omission act will ordinarily only be effective if the lender expressly promises not to compel performance at the end of the specified period. Forbearance as a contract can be found in any incident of transit where time is of the essence , including loan agreements, credit agreements and other types of financial or legal documents where the parties have agreed to allow more time to process information or otherwise defer any pending issues. In order to provide stability to both parties, it is typical in most commercial forbearance contracts to specifically stipulate a specific right of action that the party charging the interest on money lent can take if the debtor does not adhere to their obligations.
Forbearance Contracts in Law
There is no express statute in the civil code on the books for "forbearance contract" law. This should not be a surprise because forbearance is simply one approach to securing enforcement of a plaintiff’s claim, albeit a procedural remedy to accomplish a result.
Section 1003 of the Civil Code, entitled "Freedom of Contract; Rescue and Settlement Agreements Laws," basically establishes the right of action to set aside a forbearance contract if newly discovered evidence shows that the promisee can obtain a more favorable order from a court. It does not specifically limit the circumstance only to contested cases.
When a debtor defaults on an obligation, section 2815 of the Civil Code creates a presumption that a forbearance agreement will be in all parties’ best interests: "a creditor’s forbearance to enforce the creditor’s remedies is as beneficial to the debtor as the creditor’s release of the obligation." The reasons are obvious: a creditor waives a claim and the debtor gets to preserve the loan. Section 2845 tells creditors how to protect their security interests: by reducing the debtors insolvency risk, taking and holding a pledge, accepting an assignment in satisfaction, or agreeing not to sue.
Forbearance is a voluntary relinquishment of a right, with no requirement that there be a written agreement. The doctrine of forbearance depends on the circumstances and each case must be judged on its own merits. Swindoll v. Perkins, 184 Cal. App. 3d 1, 229 Cal. Rptr. 280, 284 (1983). Creditors are not required to give up remedies for the debtor’s subsequent performance – unless the creditor accepts a compromise, estops itself from getting the full amount or is held equitably liable. In Chanin v. American Trust Co., 41 Cal. App. 2d 99, 105, 105 P.2d 632 (1940), the creditors knew that the land was worth $40,000 at the time they released their lien claim, but they intended to preserve any additional claims for damages to the land. The delay gave rise to a later claim when the land was sold for $50,000. The Court said: "To compel the trust company, under a deed of trust providing for such a release, at the same time to hold a trust deed, or exercise the power of sale, would be the imposition of an impossible burden." If the debtor had adequately protected his rights by filing a judicial lien, he could have preserved his rights.
An extension to forbearance doctrine exists – the estoppel rule: where a party to a contract knowingly accepts and acknowledges late performance under a contract, this waives the right to claim that the contract was breached due to some purported failure to file under the statute of frauds.
Forbearance can also exist in the form of a contingent right to obtain financing or extend or refinance an obligation. For example, California courts have traditionally recognized "an implied-in-fact promise to forbear on the right to immediate recourse to the obligor and await eventual payment in the troth or security deposited to secure performance upon exercise of that right." That is, the promise can be made during negotiations for financing. Kirayama v. Olguin, 162 Cal. App. 3d 1057, 1082-83, 208 Cal. Rptr. 584 (1985); Trustline Ventures No. 2 v. Westland Skyways Corp., 233 Cal. App. 3d 220, 225, 284 Cal. Rptr. 742 (1991).
Fundamental Elements of a Forbearance Agreement
A forbearance agreement requires mutual consent between the parties, and should always be for an adequate consideration. A forbearance agreement is a contract whereby one party agrees not to exercise a legal right against another for some specified period of time.
A forbearance agreement may apply to foreclosures, repossessions, levies, garnishments, and other collection matters. The most common use for a forbearance agreement is to prevent a secured creditor from repossessing collateral prior to maturity of the debt, or at least until some event occurs, such as sale on the economic environment improving. Lenders often work with borrowers who are behind on their loans and right before taking action to repossess collateral, especially if its values are plummeting. In addition, many lenders will extend the maturities of loans if the borrower has temporary financial difficulties.
Even when there is already a contract between parties, the terms of a contract can be modified by a subsequent agreement. Therefore, a forbearance agreement also may apply to other rules of contract law.
Considerations to be considered are significant when drafting forbearance agreements. Consideration, which is part of the essential elements of a forbearance agreement, is the inducement by which one party moves an act from the other party. Consideration is an element of every contract. In essence, forbearance is something given up in exchange for something that when completed, is worth more than the thing given up. As a result, the lender should forgive the legal right against the debtor in exchange for timely payments. A good rule of thumb is that an adequate consideration need only be a little more than a peppercorn.
Pros and Cons of Forbearance
The primary advantage of forbearance in both creditor and debtor contexts is a delay in the time frame for payment of principal and/or interest. While this may positively impact debtors in certain circumstances, it can also create significant negative financial consequences. For example, in personal bankruptcy cases under Chapters 13 or 11, forbearance agreements can be used to stretch out payment of secured debts over five or even more years. In that case, the benefits of the forbearance generally go to the debtor but the costs are often borne by unsecured creditors who must wait significant periods of time for repayment of money that is otherwise owed them, or worse yet may not even be paid back after payment of various fees and costs in connection with the plan.
A forbearance agreement can be beneficial to creditors when the legal implications of default are especially undesirable to them, or at least require further consideration. In the State of Georgia the holder of a security deed does not have to foreclose against the property if they choose instead to sue for a money judgment based on the default. It can be beneficial to a creditor to forbear initiation of a foreclosure while at the same time allowing the debtor time in which to catch up, sell the property or otherwise satisfy the debt. However, if such an agreement is entered into then the creditor may be limited in its ability to foreclose later on, should that ever be necessary, if proper language was not incorporated into the forbearance agreement prior to its execution.
Common Scenarios for Forbearance Agreements
In addition to the mortgage relief package providing delayed mortgage payments, many lenders also offer forbearance for missed loan payments. A forbearance agreement would allow a borrower to skip or reduce monthly loan payments for specific, defined periods. It acts as a temporary reprieve from monthly principal and interest payments until the borrower can get on more stable footing. Often, a forbearance agreement arrives after a borrower has defaulted on a loan (by not making payments) and is unable to make a lump sum payment. While they are an option, forbearance contracts are not the first line of defense in loan payment or mortgage delinquency.
An example of where forbearance contracts are used is in the case of late payment student loan borrowers. Student loan lenders have offered the option of skipping loan payments for a set period of time during the course of the loan if the borrower becomes unable to continue payments. The borrower agrees to forbear payments rather than to move toward default , which could not only damage the borrower’s credit rating but also lead to further penalties such as wage or bank levy. One student loan lender even offers a hardship forbearance that allows borrowers to forbear their education loans for more than 36 months. For scattered borrowers with individual defaulted loans, albeit, a forbearance agreement provides an option to cut the financial loss. For those borrowers with substantial defaulted loans taken as whole by the bank, a forbearance agreement can allow the individual to forgo a lump sum payment in exchange for a penalty-free, agreement-based repayment program.
However, forbearance contracts are often ill-advised for a borrower who has fallen into arrears on their monthly payments. This is because interest still accumulates on their loans while the borrower skips payments and, as with most contracts, the terms lock the borrower into a pay schedule for an extended period of time that they cannot often get out of once it becomes expired. When a bank or lender offers a borrower multiple forbearance contracts, there comes a time when the borrower needs to reevaluate their financial situation.
Forbearance Contract Disputes
Disputes concerning forbearance contracts are all too common. Parties may disagree as to the scope of the promise, the performance of the promise, or the conditions under which the promise may be enforced. Generally, there are two types of remedies sought by parties in these disputes. The first involves damages. A party may seek money damages for actual losses suffered as a result of the other’s breach. Often, an equitable remedy called specific performance is sought. Under this remedy, the court not only awards money damages where the remedy at law is insufficient, but also requires the party at fault to perform its promise. If the promise in the forbearance contract is a promise not to do something, such as pursue a debt collection lawsuit, a court will enjoin a party from violating its promise. This practice is known as injunctive relief and has been endorsed in a line of cases pertaining to debt collection.
While some disputes may be satisfied without need for court involvement, others will require extensive litigation, and the review of relevant contracts by an appropriate court or tribunal. Administrative review also may be involved. Depending upon the underlying nature of the cause of action, the prevailing party may be awarded its attorneys’ fees and costs.
Fees shifting is a common practice among states. In order for a party to qualify for fees, the contract generally must afford a right to same and provide that fees may be awarded to a prevailing party who resorts to court (in some jurisdictions, an administrative review). The American Rule, however, applies to most disputes over forbearance contracts. Under this rule, the presumption of the recovery of fees is that the litigant pays its own attorneys’ fees, unless a statute or other authority provides otherwise. As such, absent a fee-shifting provision, a party seeking to obtain attorneys’ fees in connection with a forbearance contract dispute will usually bear those fees himself or herself.
Parties to forbearance contracts may also seek relief from an appellate court. Appeals take two forms – interlocutory and final. Interlocutory appeals are pursued prior to the entry of a final order, while final appeals are prosecuted after the court has entered a final order. In the federal context, the next level of appellate review is the Court of Appeals. The Court of Appeals is the final authority in most instances. The Supreme Court is the final authority on federal matters only.
Appeals of interlocutory decisions from time to time may be brought before the Supreme Court. Generally, the Court will not grant permission to appeal an interlocutory decision unless there is substantial ground for a difference of opinion, or that the immediate appeal will materially advance the ultimate termination of the litigation. The president of the Court will decide whether to allow the appeal. Though rare, the Court also at times will issue a writ of certiorari. In such instances, the Court will grant permission to appeal a case from a lower court, even though the petitioner did not follow the ordinary appellate procedure.
Trends in Forbearance Contract Law
As we move further into the 21st century, the forbearance contract landscape is expected to evolve in response to various economic, social, and regulatory factors. While it is difficult to predict the exact shapes that these shifts will take, some of the potential future trends in forbearance contract law may include the following:
Economic Factors
As the economy moves through cycles, so too has its impact on the forbearance process. In 2008, as the housing crisis unfolded, forbearance became a litmus for the effect of bad economic times on all areas of business. As the economy improves many thought that the flood of forbearance requests that certain sections of the economy had seen at that time would lessen. But in California, the steady drip of sales of troubled corporate assets by a wide range of companies and the winding down of bankruptcy cases has kept forbearance a part of the bankruptcy landscape.
Forbearance requests have continued to plague the courts in light of the improved economy. In recent years there has been an increase of requests to stay enforcement actions of all types, including replevin and receivership access actions. While some courts have required the forbearance agreement to be enforced while the court determines the ultimate merits of the request, others have tended to view the forbearance agreement itself to be the source of the claim and have required the moving party to post a bond to ensure payment pursuant to the forbearance contract in lieu of the immediate payment of the claim that the forbearance is designed to secure. Things have become even more interesting as bankruptcy judges have begun to address the question of whether such requests must and will be treated by a bankruptcy judge or whether they can be handled by a district court judge.
Small business owners continue to face economic hardships not only in bankruptcy but outside of bankruptcy. Forbearance has been a way for them to try to reduce their claims and deal with the issue of business survival. As these efforts continue to evolve, they will inevitably produce interesting developments and trends for the future.
Legislative Factors
In response to shifting social sentiments , legislative and regulatory bodies are likely to enact or further develop several measures that could significantly alter forbearance practice in the coming years.
Foreclosure and Debt Relief
As the mortgage foreclosure crisis continues to unfold, state legislatures may pass additional laws to facilitate foreclosure avoidance or alleviation, including but not limited to legislative avenues such as moratoriums, mediation programs, and loan modification programs. Other legislative measures may include the reduction of underlying debt through reductions in interest rates, principal balances and/or loan fees. The existing foreclosure crisis also may be addressed through federal legislative measures; possible debt reduction proposals include the attached interest rate reduction and loan guarantee programs that are already enacted in existing law and designed to reduce the median mortgage rates.
New Directions for Small Business Owners
Forbearance contracts for small businesses may serve as an increasingly valuable tool for business owners; the concept of forbearance has begun to expand into a number new intriguing areas, such as tax debt forbearance, student loan forbearance and, potentially, medical debt forbearance. Individual tax debt forbearance, which began to surface during the early part of the decade, has become an increasingly popular tax relief strategy for a number of small businesses. The student loan forbearance may have recently emerged as a new debt balance remedy for small business owners. Lastly, medical debt forbearance is also likely to gain significant traction in the coming years, particularly in front of rising healthcare costs and the growing number of uninsured individuals.
While several key factors are likely to shape the future of forbearance contract law going forwards, the full implications of these factors will depend on how they are implemented by creditors/debtors, the courts and the legislature. What is certain is that during times of economic uncertainty, the search for more effective forms of forbearance is certain to continue and be reflected in future amendments to the Bankruptcy Code and future judicial treatments of claims under the Bankruptcy Code.