Weird California loan enforcement issues

When a lender needs to enforce a loan secured by California real property, there are several issues that may need to be addressed.  Some of them come up as a result of the California one-action and antideficiency rules which I’ve been blogging about for a while.  Some are just created by state law.  Some arise from the types of deals done here.  Here is a non-exhaustive list of some odd issues that sometimes need to be considered by lenders and their counsel:

Letters of credit:  It’s pretty clear that letters of credit are not generally subject to the antideficiency issues described earlier in this blog.  Generally, an issuer of a letter of credit that supports a real-estate-secured loan may honor the secured lender’s demand to draw on that letter of credit, and then compel reimbursement from the borrower (or guarantor), without triggering that  borrower’s (or guarantor’s) one-action and antideficiency defenses.

 Multi-state collateral:  Borrowers facing foreclosure of loans secured by property in several states including California will often seek the antideficiency and one-action protections of California law.  For this reason, it is important to carefully consider the structure of any such loan and how to enforce it — ideally before making such a loan, but at a minimum before taking steps to enforce it.  The law in this area is complex and far beyond the scope of this blog, but requires careful consideration by competent California counsel prior to enforcement.

Indian land:  An active local market is that of financing casino developments on Indian lands (lands held by the Bureau of Indian Affairs in trust for certain Native American tribes).  Many of these developments are on land that has little or no innate value.  Typically, these loans are collateralized by a combination of revenues from the tribes’ casinos and leasehold mortgages secured by long term leases of tribal lands to tribal development companies (because the tribes cannot directly mortgage their interests in their lands).   Transactions involving tribal lands tend to be complex because the tribes have sovereign immunity and are often reluctant to waive it when doing such deals.  For this reason, many traditional real estate remedies are not available, and enforcement of such loans can be challenging.

 Coastal land/Tidelands trust lands:  An extra layer of regulation is imposed upon coastal land in California.  As a practical matter, this means extra time must be allowed to make or enforce a loan secured by coastal lands.  Lender’s counsel needs to make sure the development securing the loan has been or will be approved by the Coastal Commission or other applicable agency, and that enforcement of the loan will not trigger adverse consequences to the development.

Limitations on lenders’ ability to use insurance and condemnation awards:   If a building burns down, many states allow a lender to require that insurance proceeds be used to pay off the loan.  However, even if the deed of trust provides this right to the lender, certain California laws limit a lender’s use of insurance and condemnation awards to pay down principal under a deed of trust if the borrower is not in default under the terms of the loan or if the lender’s security is not impaired.

 Limitations on late fees:  California law generally provides that liquidated damages provisions in commercial contracts are valid unless the party seeking to invalidate the provisions establishes that they are (were) unreasonable under the circumstances existing at the time the contract was made.  A California court may limit the right of a lender to impose prepayment penalties, late charges and a default rate of interest for defaults by a borrower under certain circumstances, if the court determines that such penalties bear no reasonable relation to the damage suffered by a lender as a result of such delinquencies or defaults.

Commercial Code provisions:  If the collateral for a loan consists of both personal property and real property, compliance with the California Commercial Code is required.  Although a discussion of these issues is beyond the scope of this blog posting, a secured party under Division 9 of the Commercial Code must comply with numerous requirements regarding the sale of personal property collateral.

Qualification to do business in California:  Regularly lending to California borrowers constitutes doing business in California, although California Corporations Code Section 191(d) states that certain loan servicing activities do not constitute “doing business”.  However, this exclusion does not extend to making the loan itself.  Therefore, a non-California based lender (other than a national bank) needs to qualify to do business in California (which is not terribly hard to do, but requires some filings and payment of fees).  In addition, under some circumstances, a non-California based lender may need to become licensed as a “finance lender” under the California Finance Lenders Law in order to make loans in California or to California borrowers.

Attorneys’ fees provisions:  In any action on a contract where such contract specifically provides that attorneys’ fees and costs incurred to enforce the provisions of such contract shall be awarded to one of the parties, a California statute provides that the prevailing party, whether it is the party specified in the contract or not, shall be entitled to reasonable attorneys’ fees in addition to costs and necessary disbursements.  This sometimes gives borrowers leverage in a workout situation.

Guarantors and the California antideficiency and one-action protections

Unless the guarantor has signed an effective waiver, guarantors of California real estate loans are usually protected by California’s antideficiency and one-action rules.

As a practical matter, most savvy California lawyers routinely include waivers of the California antideficiency and one-action statutes in guaranty forms, so such guaranties should be enforceable pursuant to Civil Code Section 2856(a)(3).  (See the September 23, 2009 blog entry on effective waivers.)  However, as the law is not entirely consistent or well-developed in this area, it’s easy to mess up.  A very careful review of the language and facts surrounding any guarantor waiver is vital to assessing whether it would be enforceable.

 As with any other obligation secured by real estate collateral, if a guaranty itself is secured by an interest in California real property, then that guaranty is itself an obligation protected by the California antideficiency and one-action rules.  (For example,  if a guarantor co-signs an obligation also signed by the borrower, and the obligation is secured by California real estate, then the guarantor should be protected by California’s antideficiency and one-action rules, and would not be allowed to waive them.)  However, if the guaranty itself is not secured by an interest in California real property and only the underlying guaranteed obligation is secured by California real property, then some, if not all, of the antideficiency and one-action protections will probably extend to the guarantor – unless such protections have been effectively waived by the guarantor.  

California law provides certain (waivable) statutory protections for sureties which were extended to guarantors as well in 1939 in an amendment to Civil Code Section 2787.  The extent to which the antideficiency and one-action protections extend to guarantors is a rather muddled area of California law, because of certain old case law which predates the elimination of the former legal distinction between sureties and guarantors.

California law starts from the proposition that sureties and guarantors have some specific rights because of their roles as  secondary parties providing credit support to someone else’s obligations.   Such rights can generally be waived, but only if the waiver is specific and clear.  Civil Code Section 2809 provides that the obligations of a surety (and per Section 2787, a guarantor) may not be more burdensome than those of a principal.  If this rule were to be strictly enforced, then it might be logical to extend to guarantors all of the antideficiency and one-action protections applicable to borrowers of real estate loans.  For example, under Civil Code Sections 2845 and 2850, a surety has the right to demand that the lender proceed against the security encumbered by the deed of trust first.  Civil Code Section 2787 might be read also to apply these provisions to guarantors in the absence of a waiver, which would give guarantors protection like borrowers’ security-first protections under Civil Procedure Code Section 726. 

Also, in the absence of a waiver by the guarantor, if a lender first enforces its deed of trust by a nonjudicial trustee’s sale and then seeks to collect from the guarantor, Civil Procedure Code Section 580d might preclude the lender from obtaining the deficiency from the guarantor because the lender made the choice to enforce its loan through nonjudicial foreclosure.  The lender’s choice provides the borrower with immunity from a deficiency judgment, whether sought by the lender or by the guarantor seeking reimbursement from the borrower.  Because the lender could avoid cutting off the guarantor’s rights by foreclosing judicially or by suing the guarantor before the foreclosure, in the absence of an effective waiver by the guarantor, the lender is prevented from pursuing the guarantor for a deficiency after a nonjudicial trustee’s sale of the real property collateral (the so-called “Gradsky” rule).  

It gets more complex:  an independent rule of law, such as Civil Procedure Code Section 580b,  in some cases might prohibit subrogation or reimbursement no matter which remedy the lender pursued, then the guarantor would be  liable to the lender even if the lender foreclosed through a nonjudicial trustee’s sale.   For the same reason, if the guarantor has previously released its rights against the borrower, the “Gradsky” rule may not apply to preclude the lender from enforcing a guaranty after completing a nonjudicial trustee’s sale.

 You can see how, with this tangle of interlocking suretyship and antideficiency rules, the California courts quickly built up a huge pile of conflicting cases, and the state of the law in this area by the early 1990’s was extremely muddled and yielded little guidance and less predictability.  After many cases arose that reached inconsistent rulings concerning whether guarantors could waive such protections (and the terms of the guaranties), the California Legislature passed a statute that attempted to create a safe harbor for such waivers.  As discussed in the September 23 blog entry, the statute generally permits guarantors to waive most one-action and antideficiency defenses by using careful statutory language.  There have been few reported cases challenging the statute or interpreting the law in this area since the statute was passed in 1994 and revised in 1996.

 Civil Code Section 2856 permits effective waivers of any rights or defenses the guarantor may have by reason of protections provided to the borrower with respect to the obligation so guaranteed, including antideficiency and one-action protections, as well as certain subrogation and other rights of a surety.   Note that this safe harbor applies to allow waivers of the antideficiency rights of an unsecured guaranty of a loan secured by California real estate.  Importantly, the statute also sets out certain non mandatory “safe harbor” waiver language.

Guaranties that include conforming waivers should be enforceable by California courts.  Unfortunately, many guaranties routinely used are incomplete and do not fully waive all of the guarantors’ suretyship or subrogation rights.  I’ve been constantly surprised by the number of commercial loans where lawyers (frequently, but not always, non-California counsel) omit these waivers, or provide incomplete versions, with the result that the guaranty may not be enforceable.  All guaranties of California real estate loans should cover this issue carefully.  One caveat, however:  as there is little reported case law construing such waivers, a possibility remains that certain courts seeking expansive enforcement of obligated parties’ antideficiency and one-action rights may find some way to construe even a guaranty with appropriate Section 2856 waivers in unexpected ways to protect guarantors from enforcement.

“Sham guaranties” in California

California courts have consistently held that a guarantor who, by virtue of its corporate position (such as general partner of a partnership borrower), is already fully liable for an entity’s secured CRE debt is entitled to the non-waivable antideficiency and one-action protections of the borrower entity.  (By contrast, in one case, a guaranty from a corporation of an individual’s debts was held not to be a sham, as the guarantor was a genuine entity with its own assets, not merely a shell.)

 Unlike most independent guarantors, such “sham guarantors” are deemed to be equivalent to the borrower and therefore may not waive their protections under the one-action and antideficiency rules.   Note that a finding that a guarantor is actually a principal obligor in guarantor’s guise does not necessarily invalidate a guaranty, but instead only subjects it to the antideficiency and one-action defenses.

 However, any attempt by a lender to allow or insist that the intended borrower finds someone else to take title to the property so that the intended borrower can instead become the guarantor invites trouble, as it may tempt a court to view that guarantor as the “real” borrower and thus able to enjoy the nonwaivable protections discussed elsewhere in this blog.

Enforceability of Guaranties in California

California courts generally should enforce guaranties (other than “sham” guaranties, which will be discussed in a later blog entry), provided that such guaranties are carefully drafted to conform to California’s complex law in this area.  California courts tend to construe guaranties strictly and against the lender.  California case law generally provides that, in the absence of an effective waiver, a guarantor who is otherwise fully liable for a borrower’s secured debt is entitled to the non-waivable antideficiency and one-action protections provided by California law to borrowers, as discussed below.  [Please note that a person or entity characterized as a "guarantor" whose obligation is secured by an interest in real estate is an obligor entitled to California's antideficiency and one action protections as if it were the borrower, despite being labelled a "guarantor".]

 Summary of California guaranty rules:  A note secured by real property may also be guaranteed by a third party (the “guarantor”), giving the lender potential claims against the guarantor on the guaranty, as well as against the property under the deed of trust, and the borrower on the note.  Such guaranties of real estate secured loans are generally enforceable in California subject to the limitations discussed below. 

 The law in this area is complex for two main reasons.  First, the state’s Depression-era antideficiency and one-action protections for borrowers are sometimes also applied to guarantors as well, in a set of inconsistent cases discussed below.  Second, California law originally made some significant distinctions between sureties and guarantors, and while such distinctions have been eliminated by the legislature, case law in this area remains somewhat murky.

 Suretyship waivers and Civil Code Section 2856:  Suretyship and guaranty law gives guarantors many defenses to enforcement and collection and other rights.   Careful waiver of these rights and defenses is essential in California.  Substantial controversy arose over time among the various California courts, and among legal scholars and treatise writers, as to which waivers (of suretyship rights and defenses in general or of “one action” and “antideficiency” protections in particular) by guarantors are enforceable, and how those waivers must be worded in order to be enforceable.  In one particularly controversial case, Cathay Bank v. Lee,  waivers by guarantors were held unenforceable if they were not sufficiently detailed so that the guarantors could understand the consequences of the waivers.

 To ameliorate lending industry concerns about the enforceability of guaranties after Cathay Bank, the California Legislature enacted two different versions of Civil Code Section 2856, one in 1994 and another in 1996.  The 1994 version sought to preserve the validity of guarantors’ waivers of the one-action and antideficiency protections available to borrower.  In 1996, the legislature further amended Section 2856 to clarify the abilities of guarantors to effectively waive certain statutory and common law rights and set forth “safe harbor” language concerning the election of remedies defense and certain other defenses.  Both have broad effects on guaranty enforcement.

 In its current form, Civil Code Section 2856(a) contains three basic rules regarding guarantor waivers: 

1. A guarantor may waive its rights of subrogation, reimbursement, indemnification and contribution and any other rights and defenses that are or may become available to the guarantor by reason of Civil Code Sections 2787 through 2855.
2.  A guarantor may waive any rights or defenses the guarantor may have in respect of its obligations as a guarantor by reason of an election of remedies by the creditor.
3. A guarantor may waive any rights or defenses it may have because the principal’s obligation is secured by real property, including any rights or defenses based on the application of Section 580a, 580b, 580d or 726 of the Code of Civil Procedure to the principal’s obligation.

 Civil Code Section 2856(b) adds that “[a] contractual provision that expresses an intent to waive any or all of the rights and defenses described in [Section 2856(a)] shall be effective to waive these rights and defenses without regard to the inclusion of any particular language or phrases in the contract to waive any rights and defenses or any references to statutory provisions or judicial decisions.”  On the other hand, Civil Code Section 2856(c) and (d) provide specific “safe harbor” language for creating effective waivers.

 The court in Cathay Bank held that for a waiver to be valid, it must sufficiently describe the consequences of each waiver.  The Cathay Bank case was not specifically nullified by the Legislature in Section 2856.  Therefore, if the safe harbor language of Section 2856(c) and (d) is not employed, the validity of the waivers may depend on compliance with the requirements of Cathay Bank and related cases.  The model waivers in Section 2856(c) and (d) do not deal with all of the rights and defenses described in the first of the three Section 2856(a) rules described above.  Accordingly, waivers of the type described the first of these three rules should contain a description of the defenses being waived and arguably may need to include the consequences of such waivers.  (In our experience, the waivers allowed under the first rule are frequently omitted.)

 In making real estate loans in California, lenders often use guaranties as a credit support, but should include the accepted model language of Section 2856 and certain other specific waivers to assure against the risk that a guarantor will assert one of these highly technical defenses.  The exact extent of the enforceability of any waivers of suretyship rights and defenses (including those based on the one-action and antideficiency rules) which are contained in a guaranty is difficult to predict, given (i) the recent vintage of the current form of Section 2856; (ii) the disagreement among the various Courts of Appeal in California about the type of detail and specific wording required for waivers of defenses which do not employ the safe harbor language contained in Section 2856 and when such detailed waivers are required; and (iii) the lack of any appellate or statutory discussion of the exact wording of such a waiver if it is to be effective (as there are few reported cases evaluating lender practices following the adoption of Section 2856).  However, I believe that a court which correctly construes and applies Civil Code Section 2856(c) and (d) should generally enforce such waivers.

[More on sham guaranties later. . . . ]

CA Nonjudicial Foreclosures (Trustee’s Sales)

 “Nonjudicial foreclosures” (also known as “trustee’s sales”) are available in California to enforce defaulted real estate loans.  The procedures for nonjudicial foreclosure proceedings, including service and recordation of the notice of default and the posting and publication of the notice of trustee’s sale, are highly technical and are governed by various provisions of the Civil Code.   Borrowers’ advance waivers of these provisions are not effective.

Lenders generally prefer nonjudicial foreclosure to judicial foreclosure because (i) usually (barring a bankruptcy filing by the borrower) a nonjudicial foreclosure can be completed in a much shorter time period than a judicial foreclosure (in approximately four months versus up to two years), (ii) the borrower does not have a right of redemption following a nonjudicial foreclosure sale, and (iii) the legal and other fees incurred in connection with a nonjudicial foreclosure are usually much less expensive  than those incurred in a judicial foreclosure.  However, in a nonjudicial foreclosure, the tradeoff is that the lender loses up any the right it may have to pursue a deficiency judgment against the borrower:  under California law, a deficiency judgment is always prohibited after a nonjudicial foreclosure has been completed.

The timetable for nonjudicial foreclosures requires the trustee to wait three months after recording and serving the notice of default before giving 20 days’ notice of sale.  In addition, trustees customarily allow for an additional 11 days in scheduling the sale date in order to determine whether any federal tax liens were recorded as of 31 days before the sale date.  These timetables can be significantly extended if the borrower files for bankruptcy protection, triggering the automatic stay to preclude foreclosure, or if the borrower brings an action challenging a nonjudicial foreclosure.

The borrower has a right to cure the default under the loan up to 5 business days before the date that the real property collateral is sold in the nonjudicial foreclosure.  If the sale date is postponed, the borrower’s right to cure is extended.  If the lender fails to provide the borrower with the information about the amount that is due, and as a result the borrower tries to, but cannot, cure its default, the lender opens the foreclosure to challenge.

The lender may credit bid (bid up to the amount owed to it under the loan) at the nonjudicial foreclosure sale.  However, the lender must carefully ascertain the amount that is due to it under the loan, because if it claims amounts not due to it (for example, a usurious rate of interest if the loan was not exempt from California’s usury laws), the borrower may have grounds to challenge the foreclosure sale.

It is not uncommon for lenders and borrowers to extend the sale date for a nonjudicial foreclosure in order to continue workout discussions.   (Sometimes lenders unilaterally extend the sale date for other reasons.)  There are limits on how many extensions can be done before the trustee must provide a new formal “Notice of Sale” for the rescheduled nonjudicial foreclosure sale.

Many nonjudicial foreclosure sales of commercial real estate attract no bidders other than the foreclosing lender.  Because bidders other than the foreclosing lender must immediately pay their bid amounts in cash or cash equivalents, such as cashier’s checks, many would-be bidders would rather buy foreclosed properties after the foreclosure, from the foreclosing lender.  However, the foreclosing lender is not allowed to “chill the bidding” by taking certain steps to discourage other bidders from attempting to bid.  Specifically, it is unlawful to (1) to offer to accept or accept from another,
any consideration of any type not to bid, or (2) to fix or restrain
bidding in any manner, at a nonjudicial foreclosure sale; however, it is lawful for any person including the trustee, to state that a
property being foreclosed is being sold in an “as-is” condition.

Though bidding strategies can vary, many foreclosing lenders will credit bid not more than about 90% of the current appraised value of the property.    However, bid strategies vary considerably from lender to lender.  It is usually imprudent to bid in the entire amount of the debt owed, in case a problem with waste or fraud is discovered later, after the winning bidder (usually the foreclosing lender) takes title to the property.

[Under recently enacted legislation that expires January 1, 2013, certain additional requirements apply to foreclosures involving residential real property.  These requirements include the following:

•  In the case of a mortgage loan made during 2003 through 2007 to a borrower whose principal residence is the mortgaged property, the foreclosing lender generally must contact (or take specified due diligence actions to contact) the borrower in person or by telephone in order to assess the borrower’s financial situation, discuss the borrower’s options for avoiding foreclosure and provide the borrower with certain additional information.  The lender must do this at least 30 days prior to recording the required notice of default.
•  In the case of a loan secured by a property that includes one or more rental housing units, any tenant or subtenant in possession of a unit at the time of the foreclosure sale must be given at least 60 days’ notice (double the amount of time afforded under prior law) to move from the foreclosed property.
• In all cases, the legal owner must maintain vacant residential property purchased at a foreclosure sale or acquired through foreclosure under a mortgage or deed of trust.  This maintenance requirement includes caring for the exterior of the property (such as preventing excessive foliage growth that diminishes the value of surrounding properties) and taking action to prevent trespassers or squatters from remaining on the property, to prevent mosquito larvae from growing in standing water and to prevent other conditions that create a public nuisance.  A governmental entity may impose civil fines and penalties (of up to $1,000 per day) for failure to do so.

 (The last two of the above requirements apply to both judicial and nonjudicial foreclosure proceedings.)]

Many technical requirements must be met in the various notices and other steps in a nonjudicial foreclosure.  In California, obtaining a trustee’s sale guaranty is virtually required in order for the lender to make sure it provides the required notices to the right parties.  If a lender makes a mistake in the notices or the process, the borrower may be able to challenge the validity of the foreclosure.

More on Judicial Foreclosures in California

Judicial foreclosure is generally available in California:  it is the “one form” of judicial action allowed by statute for recovery of a debt or enforcement of a right that is secured by a mortgage or deed of trust on real property.   In addition, if the California property is worth less than the loan balance and the lender seeks a judgment against its borrower for the difference (referred to as a “deficiency”) between the unpaid balance of the secured debt (plus certain expenses) and the greater of (a) the amount produced by the sale of the collateral or (b) the fair value of the collateral, the lender must judicially foreclose.  (Note, however, that some sorts of real estate loans cannot be judicially foreclosed, as discussed below.)

No separate action against the borrower to enforce the debt without foreclosing on the real property is allowed for loans secured by California real property.  In fact, California courts will severely penalize a lender for attempting to collect a debt secured by real estate by means other than foreclosure on the real property collateral.  This can be a significant trap for lenders seeking to collect or work out loans.  

In a judicial foreclosure, the secured lender brings an action to have the court (i) determine that the loan is in default, (ii) order that the security (the California real estate) be sold to satisfy the loan balance, (iii) declare that the borrower is liable for any deficiency arising from an insufficient sale price at the foreclosure sale, and (iv) enter a deficiency judgment against the borrower.

While judicial foreclosure allows most lenders to obtain deficiency judgments against their defaulting borrowers (see below, however, for a significant exception), such foreclosures are time-consuming and expensive.  In addition to the delays inherent in any civil proceeding, in California the borrower/judgment debtor or its successor in interest has a significant period of time after the property is sold to “redeem” it (to buy it back for the amount paid at the foreclosure sale), up to three months if the proceeds are sufficient to satisfy the secured indebtedness with interest and the costs of the action and the foreclosure sale, and up to one year if the proceeds are not sufficient.   Obviously this right of redemption makes reselling the recovered collateral difficult, which is one reason the judicial foreclosure procedure is not commonly completed in California. 

In a major exception to the general rule that deficiency judgments are available in judicial foreclosure actions in California, a deficiency judgment may not be pursued after a judicial foreclosure of a “purchase money” loan, which is defined as either (1) a loan to borrower from the seller of the real property securing payment of the balance of the purchase price of that real property, or (2) a loan given by any lender to a borrower used to pay all or part of the purchase price of a dwelling for not more than four families occupied entirely or in part by the borrower.

Under recently enacted legislation, certain additional requirements apply to foreclosures involving California residential real property.

Judicial foreclosure proceedings almost always take longer than nonjudicial trustee’s sales.  The timetable for notice in a judicial foreclosure depends on whether a deficiency judgment is available.  If a deficiency judgment has been waived or is prohibited, the notice of levy must be served at least 120 days before the notice of sale.   After the 120-day period has run, the levying officer gives an additional 20 days’ notice of sale.   Thus, when a deficiency judgment is not available, the borrower is entitled to 140 days’ notice before the foreclosure sale.  When a deficiency judgment is available, the notice of sale may be recorded and served with the writ of sale immediately on the entry of the foreclosure judgment.   

As with nonjudicial foreclosures, these timetables can be significantly delayed if the borrower files for bankruptcy protection, triggering the automatic stay to preclude foreclosure, or if the borrower brings an action challenging a judicial foreclosure.

More on nonjudicial foreclosures and related topics in later posts.

Workouts 101, Part 6: Lenders’ Negotiations and Documentation

The most recent installment of this Workouts 101 series discussed lenders’ business review of loans when they are considering workouts, and gave an overview of early stage moves frequently used by lenders.  This post provides an overview of the negotiations and documentation of a workout agreement from the lender’s side.

Negotiating the workout. Based on its business and legal reviews concerning the loan, and any additional information provided by the borrower, the lender and its counsel will negotiate a workout.  Typically, the parties work off one or more expressly non-enforceable terms sheets which set out the basic terms and conditions.  Usually the basic framework of the workout deal is based on ideas proposed by the borrower.  Many lenders are concerned that if they make the first offer of workout terms, but ultimately are not able to agree on all terms for a loan modification or workout with the borrower, the borrower may later claim that the project failed because the lender overstepped its appropriate boundaries by telling the borrower what to do. 

Regardless of who makes the first offer, however, many issues need to be addressed, including the following:

• changes in timing and amount to the payment terms of the loan;
• the possible addition of supplemental collateral or guaranties;
• tax issues affecting borrower and lender (note that both portfolio lenders and the beneficial owners of trusts holding CMBS loans usually face tax consequences from modifications of loans). 

If the loan did not already impose a lockbox or other cash management arrangement on borrower, a lender frequently will seek to impose one so that it can control the cash generated by the property as the property’s tenants pay rents.

Documenting and closing the workout.  When the basic terms are settled, the workout must be documented.  Frequently additional issues arise at this point; sometimes they can be resolved, sometimes not.  Loan workout documents frequently include some or all of the following:

•  the basic terms of the deal modifying the loan,
• express modifications of the loan documents,
• covenants by borrower parties to do certain things (pay reduced amounts, meet certain financial standards, and the like),
• acknowledgements, admissions and estoppels by borrower to confirm the outstanding loan amounts and limit potential claims against lender,
• releases, waivers and covenants by borrower not to sue lender, and
• reaffirmation of the existing loan documents by all parties, including any guarantors and other secondary obligors. 

The latter is very important, as the failure to obtain the consent of guarantors, indemnitors or other secondary obligors might effectuate a partial or complete discharge of such parties.

As noted above, the documentation usually will include express modifications of the existing loan documents.   The workout documentation will need to be signed, possibly acknowledged, and delivered, and some of the documents will likely need to be recorded.  If the note is modified, an “allonge” – an addendum to the note – typically must be permanently affixed to the promissory note.  Any amendment or modification to a mortgage or deed of trust must be recorded in the appropriate real property records, and any UCC financing statement must be filed in the proper UCC filing office.  And, of course, the borrower will need to pay any fees or charges due to the lender and third parties for the modification before the workout closes.

Long lead items.  Certain items need to be completed early to allow the closing to occur.  Usually a title policy endorsement is required (to insure that the priority of the mortgage or deed of trust is not changed as against other creditors) if the mortgage or deed of trust is modified.  The lender’s counsel will have negotiated the form of any such endorsement and will arrange for its delivery (or the title company’s commitment to deliver the endorsement) concomitantly with the delivery of the loan documents. 

Consents of third parties (such as mezzanine lenders or potentially even of a court, if the borrower has filed for bankruptcy protection) must be obtained before closing.  Any cash management agreements and arrangements must be put into place (including notifying any tenants and obtaining the consent of any third party bank to any control agreement providing the lender with control over borrower’s bank accounts for the property).

Conclusion and caveat.  It is very important for a lender contemplating a workout to do its homework:  it must bring in new counsel and, with that counsel, analyze its business and legal position.  A lender needs to understand what it would reasonably expect to collect in a foreclosure (and/or borrower bankruptcy) as compared to what it would reasonably expect to collect through a workout.  To avoid increasing its potential liability, the lender must carefully document any actions it takes. 

Once its analysis is complete,  a lender needs to decide if a workout is feasible.  If the lender moves forward to negotiate and document a workout agreement, it must make sure that all necessary loose ends are tied up:  that all needed corrections to loan documents are made, that any needed consents are obtained in writing, that any filings are completed. 

The workout may provide the last best hope for a consensual resolution.  If it does not work, the lender will probably face litigation and much higher costs in order to collect on its loan.

One caveat: this series of blog entries provides an overview of the mindset and key issues and tasks that must be handled by a lender and a borrower in doing a workout.  However, every lender has different internal and external priorities.  In addition, every project and borrower present their own challenges.  For that reason, please note that this is a general guide, but not an exhaustive one.  A summary as short as this one cannot take the place of a full review of a specific loan and project done by competent businesspeople and local counsel.

Workouts 101, Part 5: Lenders’ Leverage and Actions, contd.

Earlier installments of this series on Workouts 101 have discussed borrowers’ and lenders’ mindsets, borrowers’ points of leverage, and some of lenders’ points of leverage, as well as the need for new counsel to review any loan documents prior to commencing any workout (the term “workout” is used generically in this series of posts, to mean anything the lender does to change the original terms of the loan to come to a consensual deal to resolve the loan, including loan modifications, extensions, forbearance agreements or complete loan restructurings).  In addition to legal review, however, a business review is also needed.

 Business review:  the lender usually knows what the property is worth (or can find out).   As noted in Workouts 101, Part 4, the lender will typically hire an appraiser to evaluate the property, and the value will guide the lender’s business and strategic enforcement and workout decisions.   A good appraiser, who is competent to testify in court if needed, is absolutely vital.  It is not uncommon for workout and even bankruptcy outcomes to be determined utterly by a dispute over the actual value of the underlying real estate. So don’t go into that possible battle unarmed.

Frequently lenders may not have as much knowledge about the potential upside of, or challenges facing, a given property as the developer/owner, so the developer/owner may be able to provide the lender with more information to build on the lender’s appraisal of the property, which may lead to more creative resolutions of the outstanding loan.

In addition to reviewing an updated appraisal, a lender should obtain and review borrower’s and any guarantor’s updated financial statements, the actual use made of the loan to date, project budgets, borrower’s compliance with loan covenants (including financial covenants), market conditions, borrower’s and guarantor’s ability to pay and other criteria used by the lender to determine if a workout is feasible and would net the lender a better return than would a foreclosure.

Lender’s early stage moves.  Once a lender decides to negotiate a possible workout of a real estate loan, there are several steps it usually will take.

• A lender will probably require that the borrower enter into a “pre-negotiation” agreement:  an agreement to limit any claims by the borrower that it relied on statements by the lender or its representatives when negotiating a potential workout, and to expressly agree that any discussions between the parties are settlement discussions and won’t be admitted as evidence in any later litigation between them.  This agreement is very important to preserve the lender’s right not to enter into a workout at all, or on terms that the lender finds unacceptable.  These agreements typically provide, among other things, that there is no legally binding agreement to modify the loan until and unless it is fully documented in a writing signed by all parties.  They also usually include a requirement that all of the lender’s costs be paid up front by borrower and/or any guarantors.
•  A lender may elect to transfer the loan to a separate newly formed special purpose entity.  This allows the lender to shield itself from potential new lender liability claims arising as a result of any workout, workout negotiations or foreclosure activities.
• A lender may take steps to put pressure on the borrower and/or to gain control of the property by initiating foreclosure proceedings (under real estate law and/or under the Uniform Commercial Code), seeking appointment of a receiver, exercising its right to collect rents or taking any other enforcement steps.  This is frequently done to speed up the process of figuring out whether or not a workout is possible, while starting the clock on foreclosure for the lender.  Lenders frequently take one or more of these steps for one of three reasons:  (1) many attempted workouts cannot be successfully negotiated, so the loan ultimately is foreclosed anyway; (2) many borrowers wait until they are defaulting or about to default before contacting their lenders to attempt to work out a loan; and (3) many borrowers frequently do not bring realistic expectations and/or meaningful concessions to early stage workout negotiations, instead dragging them on.  A lender is more likely to do a deal with its borrower if the borrower acts cooperatively and is willing to “cut to the chase” even if that means making painful concessions.
• If it thinks a borrower is acting in good faith and is acting rationally, a lender may enter into a short term forbearance agreement to refrain from exercising its remedies for a specific short period of time to give the borrower and lender time to work out a deal.  These agreements range from simple, with few conditions, to extensively negotiated, and can impose many more obligations on borrower.  If there are deficiencies in the loan documents, it is often prudent for a lender to condition its entering into a forbearance agreement on borrower’s execution and delivery of documents that fix any such problems.

A later post (Workouts 101, Part 6) will address the negotiation and documentation of the workout.

Introduction to California’s one-action and antideficiency rules

I’ve received a number of questions offline about California’s one-action and antideficiency rules, and related legal rules, which come into play when lenders make and enforce real estate loans in California.  (They are quite different from the analogous legal rules in many other states, particularly those in the East; many lenders based elsewhere find them confusing at best.) So here is a brief introduction to these California laws.   I’ll follow up with more detail in later posts.   (Please note, as with all other statements in this blog, the summary below is not a not legal opinion and cannot substitute for informed legal advice regarding a specific transaction from a California lawyer.) 
 
When it comes to enforcing loans secured by California real estate, California is a “single action” state. Civil Procedure Code Section 726(a) provides in part that “[t]here can be but one form of action for the recovery of any debt or the enforcement of any right secured by a mortgage upon real property.” This “one-action” rule applies whenever a lender with a loan secured by real property collateral exercises its remedies to recover a debt or to protect its security. The purpose of the one-action rule is to protect a defaulting mortgagor from being harassed by a lot of different actions filed against it by the mortgagee.
 
California’s “one-action” statute prohibits the secured lender from pursuing any other judicial cause of action, such as suing the borrower directly, without foreclosing on the real property collateral. As a result, if a lender takes real estate collateral as security for a loan, then lender must foreclose on its real estate security first. Further, a lender can only bring one “action” against the borrower, and must use it as the primary source of repayment when collecting the loan.

A corollary to the one-action rule, the “security-first” rule (also codified in Civil Procedure Code Section 726(a)) provides that a creditor must first proceed against the security for the debt prior to trying to enforce, by judicial action or otherwise, the underlying debt. Perhaps the most notorious instance of a creditor running afoul of this prohibition is Security Pacific National Bank v. Wozab, where the creditor set off approximately $3,000 in the debtor’s accounts held by the creditor in partial satisfaction of a $1,000,000 debt without first foreclosing on the real property securing the debt. The California Supreme Court held that the creditor’s exercise of its equitable right of setoff, while it was not an “action,” violated the requirement that a creditor rely on its security before attempting to enforce the debt. As a result, the creditor in that case lost its security.

Even though California’s “one-action” rule applies to foreclosures, lenders can start both a judicial process and a nonjudicial power of sale process (also known as a “trustee’s sale”).  Simply beginning a nonjudicial foreclosure is not deemed to constitute an “action” in California.  Neither the commencement of a judicial foreclosure action, nor the filing of a notice of default which commences the nonjudicial foreclosure process, is considered an irrevocable election of remedies under the one-action rule.  A lender is deemed to have elected its remedy, and had its one action, only when a judgment has been entered if a judicial foreclosure action is completed.  A lender that completes a nonjudicial foreclosure sale is also deemed to have elected its remedies and may not seek a deficiency judgment against the borrower.  So, a lender will not be deemed to have made an election between these two foreclosure methods until one of them has been completed.

For these reasons, when enforcing the lien of a deed of trust in California, prudent lenders often begin both an action for judicial foreclosure and nonjudicial foreclosure proceedings.  Starting both offers the lender a more streamlined and reliable method of seeking the appointment of a receiver as part of the judicial foreclosure proceeding (as distinguished from seeking a receiver as an adjunct to an action for specific performance of the lender’s assignment of rents clause in its deed of trust).   It also enables the lender to maintain the threat of a possible deficiency judgment against the borrower (assuming, of course, that the loan is of a type where a deficiency judgment is allowed, and has not been made fully non-recourse by contract).

More on judicial foreclosures and deficiency judgements in the next post.

Beware of green shoots: there may be snakes in the grass

There’s good economic news breaking out all over,  it seems.  The Fed’s Beige Book report, released July 29, suggests that the pace of economic decline has started to slow.  The stock market liked this news, responding with gains per Bloomberg. But does a little bit of economic improvement mean that the worst is over for commercial real estate?  or that we’ll have a fast recovery in CRE?  I don’t think so.

Despite all the talk of “green shoots” and economic improvement,  it is likely that CRE will suffer for a significant amount of time.

Why?  There is simply not enough growth to increase demand for commercial space.   Consumer demand, which for better or worse drives our economy, is way down, for a number of reasons:

• The continuing high rate of unemployment (14.5 million Americans were out of work in July per the Boston Globe) scares even those consumers who have jobs.  So they spend less.
• So many people overleveraged themselves through home equity extraction (and must either repay that money or have their houses foreclosed upon) that they don’t have much money to spend.  (Bloomberg reports that banks held a record $674 billion of HELOCs and $211 billion of closed- end home-equity debt as of March 31, according to FDIC data.)
• So many people overleveraged themselves through credit card and other debt that they don’t have much money to spend.  And instead of buying more, they are apparently paying down their debts — probably good for them personally, but collectively not great for increasing demand and growth in the economy.  CNNMoney reported that since last August, the amount of outstanding consumer credit has declined, according to the Federal Reserve, with total consumer borrowing sinking a seasonally adjusted $10.3 billion, or 4.9%, to $2.503 trillion, and revolving credit, which includes credit card debt, fell $5.3 billion, or 6.8%, to $917 billion. 

Until consumer demand increases for goods and services, companies have no reason to increase their use of commercial real estate by taking on new leases or purchases of retail, office or industrial space.   In fact, since demand is down, many users of CRE will continue to look for ways to cut their expenses for CRE as a way to reduce their expenses overall — and to survive the downturn.   Obviously, if enough tenants default on their leases, this creates problems for landlords, who in turn may default on their mortgages.  This is happening now; for example, prominent Southern California developer Maguire Properties recently announced it will sell or return to lenders seven buildings in Southern California per Business Week.

In addition, the death (or serious incapacity) of the CMBS market has wiped out about 40% of the total financing capacity that was available to finance CRE.   That means that, over the next few years, unless an alternative source of funding is found, many CRE projects will have trouble finding refinancing at maturity.   Since CRE prices have fallen significantly, it is very difficult for many CRE owners to get financing.  For that reason, we should expect to see a lot more defaults (including maturity defaults), workouts and foreclosures. 

Many banks have been quick to extend loans and slow to foreclose, because they could not afford to recognize losses as doing so would increase their capital requirements and perhaps push them into insolvency — and the undesired embrace of the FDIC.  However, as banks move toward recovery, assisted by the massive federal bailout, their capital reserves should improve.  This should allow them to move forward to recognize their losses and foreclose on their troubled CRE loans over time.

So instead of thinking that CRE will recover soon, based on what I’m seeing,  CRE has not yet absorbed the brunt of the recession, and will likely continue to get worse over the next couple of years, until much of the CRE market has been significantly repriced downward.

Of course, the wild card in this is government intervention:  if the federal government decides that massive CRE failures would destabilize the financial system, it might well retool existing governmental bailout programs, invent new ones or change tax policies to cause the injection of more liquidity into the CRE market.   It is hard to guess at the government’s likely intervention, but this Fed and this administration have been very willing to use taxpayer money to stabilize the financial markets, and so might do the same for CRE. 

What do you think?  Share your views by replying below.