With the new year upon us, now is the time to choose our favorite resolutions for a positive start to 2025. For banks, this process might include a comprehensive special asset plan.

An increase in interest rates over the last few years has caused variable rate loans to adjust upward. Higher rates have also made it more difficult for borrowers to refinance. At the same time, inflation and supply chain issues have led to disruptions in some businesses. The combination of these factors seems to have caused an increase in defaults and special asset referrals over the last year or two.

Banks should be prepared for the possibility that defaults will continue to increase in 2025. A special asset increase has been predicted for the last five years, ever since the COVID-19 pandemic. Some feared there would be a repeat of the 2008 mortgage crisis. The flood never happened.

In large part, the Paycheck Protection Program, Emergency Rental Assistance Program, student loan grace periods and internal flexibility of banks provided enough breathing space for business and consumer borrowers to prevent a large-scale downturn. Separately, some lenders made the decision to “extend and pretend” to maintain the status quo. This is not to say that all borrowers were saved, but thankfully, history did not repeat itself. With the end of these programs, the increase in interest rates and questions facing the economy generally, there is potential that the next special asset and restructuring chapter may be starting.

In the bankruptcy world, the Small Business Reorganization Act (SBRA) has become an extremely popular option for small businesses entering Chapter 11. This option became available in 2020 and quickly gained popularity because it offered a streamlined and less expensive process than a traditional Chapter 11 reorganization.

Since SBRA’s passage, the debt limit temporarily increased from $2.7 million to $7.5 million, allowing a greater number of businesses to qualify for this process. However, the higher debt limit included a sunset provision, which ended in June 2024, again preventing larger businesses from using SBRA.

There is significant support for restoring the higher debt level, and it is possible that this will happen in 2025. Restoring the cap may assist some small- to mid-sized distressed businesses in restructuring and addressing loan obligations.

Bankruptcies offer certainty and can be effective ways for borrowers to shed certain obligations while refocusing on their operational financing. But, in most circumstances a bank has little ability to force a bankruptcy.

Without a bankruptcy filing where a borrower falls delinquent in payments, a collection plan is straight forward. But the situation where a borrower is satisfying its payments and falling short of other loan obligations may present a different challenge.

A favorable climate for borrowers over the last decade led to some heavily negotiated loan terms and borrower‑friendly provisions in loan agreements, including favorable grace periods, financial covenants and cure provisions.

Some banks find themselves saddled with these provisions in the hands of uncooperative borrowers. This has led some banks to re-evaluate their relationship with these borrowers. But preparation in this situation can also mean patience. Just like a borrower did not fall into distress in a day, the relationship cannot be fixed in a day.

If a borrower is continually falling short on debt service coverage reporting, and generally being difficult, it may be time to try to convince the borrower to refinance. Banks may also be tempted to invoke non-monetary defaults in these situations. While this may be possible, a lender would be wise to follow the loan agreement closely and carefully document the defaults.

The case of Bailey Tool & Manufacturing Company¹ should be a warning to ensure that non-payment defaults are carefully enforced. In that case, the lender declared a default after deeming itself insecure among other defaults. Eventually, the lender took control of the borrower’s accounts and receivables, blocked the borrower from making payroll, and tried to replace the borrower’s management and otherwise “micromanaged” the company. Ultimately the borrower filed bankruptcy and sued the lender, obtaining a significant judgment including punitive damages.

In another case of interest to non‑payment defaults, Beaumont Lamar Apartments LLC v. Wallis Bank,² the lender grew frustrated with the borrower’s delays in construction (which were not the fault of the borrower) and ultimately refused to continue to fund the project and accelerated the loan. The borrower initiated a variety of claims against the bank and its individual directors for negligence, fraud and breach of fiduciary duty. The bank sought summary judgment on these claims, which was denied, forcing further litigation and ultimately settlement.

Non-payment defaults take a variety of forms, and any attempt to initiate a lawsuit against a borrower based on a non-payment default should be viewed objectively and coordinated with legal counsel from the beginning.

Each distressed borrower presents its own challenges for a workout, whether the default is a payment or non‑payment default. While it is impossible to forecast exactly what 2025 and beyond will mean for workouts, the ingredients are there for an increase. So, as you prepare for the next year, don’t forget special asset planning as part of your bank’s resolutions for a productive and profitable new year!