Enforcing Defaulted CMBS Loans through Receivership Sales: Risks and Rewards under California’s “One Action” Rule

CMBS servicers are talking about a new way to enforce a defaulted CMBS loan (i.e., a commercial real estate loan held by a CMBS trust). Instead of a traditional foreclosure on the collateral, followed by a sale, some suggest:

(1) filing a lawsuit to have a receiver take possession of the mortgaged property; and

(2) arranging for the receiver to market and sell the mortgaged property subject to the loan.

As part of the transaction, the servicer would likely reduce the loan principal and otherwise modify the loan terms to make buying the property subject to the loan attractive to an independent buyer (the “assuming buyer”).  In return, the assuming buyer would provide some amount of “fresh cash” to the servicer and would formally assume the modified loan.  The fresh cash would be used to pay down a portion of the loan; otherwise, the modified loan and the lien against the property would remain in place.

If this whole process seems somewhat complicated, it is.  Why bother?

The answer lies in the special rules that govern what a CMBS servicer can and cannot do to enforce a defaulted loan and realize on the collateral securing it.

Unlike a bank, a CMBS servicer that forecloses on a property cannot provide a new loan to facilitate a sale of the property to a new buyer.  However, the servicer can generally modify the terms of a defaulted loan, and usually the servicer can also permit a loan (whether or not the loan is in default) to be assumed by a buyer of the property securing the loan.  When both techniques are used in a single transaction, the servicer is able to provide the functional equivalent of a “loan to facilitate” made by a bank — financing for the new buyer’s purchase.

Since financing for commercial real estate acquisitions is relatively difficult to arrange in the current market, the ability of the servicer to provide financing for an acquisition expands the universe of prospective buyers.  This can result in a potentially greater recovery (higher net present value) than that which could be obtained by an all-cash sale after a foreclosure.

How much bigger could that recovery be?  A lot.  For example, in a recent Arizona case, a receiver (Trigild’s Bill Hoffman) was able to arrange for several Phoenix-area apartment complexes to be sold subject to the existing loan (on modified terms) for a total purchase price that was 75% greater than the best all-cash offer ($123 million vs. $70 million). For details, look at the article in the Arizona Republic describing this transaction, click here.

In some states, this two-step approach appears to work without any problem.  But in California, the situation is more complicated.  If the current borrower consents to the sale of the property to a new buyer (which it often does in exchange for a complete or partial reduction in the guarantor’s liability under the guaranty), this approach certainly works.  If the current borrower does not consent, however, things get tricky.  To understand why, we must first take a look at California’s one action rule, set forth at California Code of Civil Procedure Section 726(a).

Basically, California’s one action rule provides that generally a lender may bring only one type of “action” (i.e., court proceeding) to recover on its secured loan: a judicial foreclosure.  A lender who violates the one action rule by pursuing another type of action against the borrower (e.g., a suit on the note) runs two risks:

  1. The first risk is that the borrower will assert the one action rule as an affirmative defense in the lender’s action against it.  In that case, the lender will be required to amend its complaint to seek judicial foreclosure rather than monetary damages or some other form of relief.
  2. The second, more serious risk is that the borrower will not assert the one action rule as an affirmative defense in the lender’s action, and the lender will prosecute its other (non-foreclosure) action to judgment.  In that event, the lender will generally lose its real property security (i.e., the lien of its deed of trust will no longer be valid).  This is sometimes referred to as the “sanction aspect” of the one action rule.

Fortunately for lenders, there are various exceptions to California’s one action rule.  One of these exceptions relates to receivers.  Under this exception (the “receivership exception”), codified at California Code of Civil Procedure Section 564(d), an action by a secured lender to appoint a receiver under California’s receivership law is not an “action” for purposes of California’s one action rule.  In addition, Section 568.5 of the California Code of Civil Procedure gives receivers the right to sell property in their possession, provided (1) that the sale is pursuant to a court order; and (2) that the sale is confirmed by the court.

The challenge is that the interaction of the two California statutes is a grey area in the law:  the language of the statutes governing receivers does not expressly state that the receiver has the right to sell mortgaged real property belonging to the original owner to an assuming buyer, while leaving the existing loan and its lien in place.  And while we think it makes both economic and legal sense for a receiver to have this ability, because there are no reported court cases squarely addressing this issue, we cannot say for sure that such a course of action would be upheld in court.

Of course, one of lawyers’ jobs is to counsel clients about their best course of action even when the law is not precisely clear – and how best to minimize the risks of the business decisions our clients make.

If a CMBS servicer wishes to enforce a defaulted loan in California by arranging for a sale of the property through a receivership to an assuming buyer, without the current borrower’s consent, the transaction must be structured to minimize the legal risks.

So what are those primary risks? Simply put, that either (a) the current borrower might make a one action rule challenge to the validity of the transaction or, (b) the assuming buyer might later make a one action rule challenge to the enforceability of the secured loan (and the related lien against the real property). And how can a servicer resolve them?

The gist of any challenge by the current borrower would be that, under the one action rule, a judicial foreclosure is the only action that the servicer may pursue to enforce the loan. To avoid or defend against this possible challenge, the servicer could seek a court order authorizing the receiver’s sale of the property subject to the lender’s lien pursuant to California’s receivership law permitting a receiver to sell property in its possession if a court so orders.  In its motion and proposed order, the servicer would need to ask the court to make a specific finding that such a sale would not violate the one action rule because of the receivership exception to that rule.  If the servicer were to obtain such an order, the current borrower’s rights to attack it would be cut off at the end of the applicable appeal period.  So the risk of a one action rule challenge by the current borrower can be mitigated by obtaining such an order, then waiting until the appeal period for the order has run before actually closing the sale of the property.

The gist of any challenge by the assuming buyer would be that the lender’s action to appoint a receiver to sell the property constituted its only allowed action to enforce the loan and, therefore, the lien of the deed of trust would no longer be valid after the sale.  The assuming buyer could argue that the receivership exception allows the appointment of a receiver for ordinary purposes (such as the preservation of property or the collection of rents), but does not authorize the receiver to sell the property without the original borrower’s consent unless the lender forecloses on the property first.  Bottom line, the assuming buyer could argue that the sale of the property without the original borrower’s consent is, essentially, the “one action” allowed to a lender — which in turn, would mean that the lender’s lien is extinguished by the sale, as if the sale through a receiver were a nonjudicial foreclosure.

It seems unfair to allow the assuming buyer to invalidate the lien in favor of the party that enabled the assuming buyer to acquire the property in the first place, but the risk of a one action rule challenge by the assuming buyer can’t be discounted because (1) there are no published cases squarely addressing this issue, as noted, (2) California courts are notoriously hostile to lenders on one action issues, and (3) the court’s order allowing the receiver to sell the real property would in fact take away the original borrower’s title to the real property, which is the essence of a foreclosure action.  The worst part of this risk is that there may be no time limit on when the assuming buyer must assert the “sanction aspect” of the one action rule.

The best steps that the servicer can take to mitigate the risk of a one action rule challenge by the assuming buyer include the following:

(a) obtaining a court order specifically addressing this issue (as discussed above);

(b) waiting until the appeal period for the court order has run before actually closing the sale-and-assumption transaction (also as discussed above);

(c) in the loan assumption documents, requiring the assuming buyer to acknowledge and confirm the court’s findings related to the one action rule; and

(d) if circumstances permit (i.e., if there would be no loss of lien priority), structuring the loan assumption so that it constitutes both (i) an allowable assumption transaction under the rules governing CMBS mortgage pools (the so-called REMIC regulations) and (ii) a novation (the substitution of a new obligation for an existing one) under California law. That way, the assuming buyer should be cut off from arguing that the lender had already brought an action to enforce the loan because, by law, the modified loan assumed by the buyer would be deemed a new obligation.

While selling a property subject to the loan may provide significantly enhanced recoveries for CMBS trusts and their servicers, this approach is not entirely risk-free in California.  

However, with careful structuring by the servicers and their counsel, these risks often may be reduced to an acceptable level, particularly in light of the improved loan recoveries that such transactions make possible.

 
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Is the Slow-covery in Trouble?

Last week, the Fed’s Open Market Committee said the pace of the economic recovery had “slowed” and that growth “is likely to be more modest in the near term than had been anticipated.  The Fed announced it was going to take some of the payments it has received from CMBS bonds and other assets it purchased as part of the stimulus, and reinvest them in Treasuries – effectively holding down mid-term interest rates –  in an attempt to stimulate the economy further. The Fed noted that high unemployment, modest income growth, lower housing wealth and tight credit were holding back household spending.

Sudeep Reddy of the Wall Street Journal explained succinctly how the Fed’s plan is supposed to work:

“After cutting short-term interest rates nearly to zero in December 2008, the Fed essentially printed money to expand its portfolio of securities and loans to above $2 trillion, from $800 billion before the global financial crisis. Its purchases of mortgage-backed securities and U.S. Treasury debt, aimed at keeping long-term interest rates down, were discontinued in March. The Fed began talking about an “exit strategy” from the unprecedented steps it took to prevent an even deeper recession.

But on Tuesday, the Fed shifted its stance. It said it would act to keep its securities holdings constant at around $2.054 trillion, the level on Aug. 4. Had the Fed not acted, its mortgage portfolio was set to shrink by $10 billion to $20 billion a month, as mortgages matured or were paid off early. Now, the Fed will reinvest those proceeds in U.S. Treasury securities of between two- and 10-year maturities.

Some Fed officials have been uncomfortable with the size of the Fed’s position in the mortgage market. To assuage their concerns, the Fed won’t be enlarging its mortgage holdings.”

Will this further stimulus work? No one knows. But this move is generally not being seen as a good sign for an economy we’ve been repeatedly told is recovering.

The idea that the “recovery” isn’t going so well has been common for months across the bleaker reaches of the economic blogosphere (such as the comments sections of the Calculated Risk blog, or the ZeroHedge blog, or David Rosenberg’s well considered newletters for Gluskin Scheff — where he suggests today that we may not be headed for a double dip because the recession may not, in fact, have ever ended).

However, concern about the pace of the recovery has recently been cropping up more frequently in the mainstream media – especially since the Fed’s announcement. For example, in Saturday’s New York Times, Jeff Sommer questioned whether a double dip recession is likely, asking, “Will the economy pick up momentum or slip back into recession?”

 After noting that Ben Bernanke had recently called the current economic outlook “unusually uncertain”, that Lakshman Achuthan, Managing Director for the Economic Cycle Research Institute agreed that “growth has definitely slowed” and that Bill Gross of bond manager Pimco said, in essence, that the momentum of the economy from the first to the second quarter was downhill, and that it’s possible we’re close to a double-dip recession, Sommer stated:

“Still, the economic signs are ambiguous. . . . What’s been lacking is broad consumer demand, a revival of the housing market and sufficient business confidence in large-scale hiring.  And, of course, there are deep structural economic problems — the highest ratio of public debt to gross domestic product since World War II, for example — that will need to be dealt with over many years.”

At the risk of stating the obvious, with so many folks worried about their jobs, or underemployed, or paying down debt, and so many companies sitting on money but not hiring, it’s simply not clear what new business developments are likely to spur sufficient “consumer demand, a revival of the housing market and sufficient business confidence” to lead to large scale hiring.  I have a sneaking suspicion that we ultimately will regret greatly allowing so many jobs to be outsourced, especially manufacturing jobs – ultimately our economic viability as a country boils down to whether we can produce things that others want to buy — and in doing so, whether we can keep our own citizens employed.

Keeping interest rates down to stimulate the economy seems to work in smaller economic downturns, where there’s pent-up demand and ordinary folks can afford to buy things.  But, where so many households are wildly overleveraged and worried about their futures, the Fed may simply be “pushing on a string” – trying to create demand that simply won’t be there until the overhang of debt is paid off by borrowers, or written off by creditors (who of course then have to recognize their losses), or both.  (Maybe there’s another way to create demand and deal with that debt, but if so I don’t see it.)

And until the huge amounts of debt are somehow cleared or something else makes businesspeople more confident about hiring (and employees more confident about getting and keeping jobs), the current levels of distress in the commercial real estate market seem likely to continue and perhaps increase.  According to Costar’s Commercial Repeat-Sales Indices, the largest metro commercial real estate markets have been “attracting significant institutional capital and forcing prices upward over the first two quarters of 2010 . . . while the broader market has continued to soften. . . . This divergence of the two worlds may soon change as we are now witnessing a pause and softening even within the investment or institutional grade primary markets.”

Doesn’t sound much like a CRE recovery.

CoStar goes on:

Many of the opportunity funds continue to seek out distressed properties, which are affecting the prices shown here, but the expectations of a tsunami of opportunities have not materialized and overall transaction volumes remain below normal.

Distress is also a factor in the mix of properties being traded. Since 2007, the ratio of distressed sales to overall sales has gone from around 1% to above 23% currently. Hospitality properties are seeing the highest ratio, with 35% of all sales occurring being distressed. Multifamily properties are seeing the next highest level of distress at 28%, followed by office properties at 21%, retail properties at 18%, and industrial properties at 17%.

Since current governmental policies seem to be encouraging a “delay and pray” approach to resolving bad real estate loans, this approach (which I don’t think can really be called a strategy) seems to be to hope for a broad economic upturn.   It seems likely that the distress in commercial real estate won’t improve significantly unless hiring picks up, and the trend seems to be going the wrong way.  PRI’s The Takeaway reported that, according to Newsweek and Slate columnist Dan Gross :

“An unemployment rate of 9.6 percent in America may sound bad, but it doesn’t include millions of discouraged American workers. . . The real unemployment rate is closer to 16.5 percent . . . . That’s the Bureau of Labor’s U6 number, which takes into consideration so called “discouraged workers” who have given up looking for work, as well as people who are working part time but would like to be working full time. Overall, according to Gross, the number means that there is ‘one out of six adults in this country whose talents and time and skills are not being utilized anywhere near to the extent of their abilities.’ ”

I hope I’m wrong, or missing something about the economy, but it seems to me that the “Slow-covery” is getting even slower. Instead of a long hot summer, we may be looking at a long cold winter of discontent.

ICSC: What’s New in Green?

I’m at the ICSC convention, along with about 30,000 of my closest friends in the CRE business.  It’s a vast convention, even though somewhat diminished in size from a few years ago.  It’s much busier than last year though:  a lot more people on the leasing mall floor, a lot more meetings taking place, and a lot of folks trying to do deals.

The “green” vendor displays this year include some pretty cool new technologies for saving energy, money and the environment.  Here’s  my opinionated view of a few I thought were very interesting.  (For the record, I have no financial interest or other connection to these companies, and have not worked with any of them; their products on display just seemed interesting — it’s great to see American ingenuity being deployed to create cost-effective solutions addressing some of our energy needs and environmental goals.)

1.  Sunoptics.  Sunoptics makes skylights for commercial roofs, as well as a “light cube”:  a tubular skylight that allows natural light to be brought into buildings with dropped ceilings.  Its technology involves the use of prismatic molded polycarbonates:  that means that its skylights can capture light from outdoors even from low sun angles, which means the skylights can provide light more hours each day. 

Sunoptics’ skylights are designed to prevent leaking and condensation:  the company’s design includes an insulated thermal break which reduces condensation, foam curb seals and an integrated weather sweep designed to prevent leakage (and backs up its claims in a  long term warranty against leaks).  Sunoptics regrinds its post-industrial scrap plastic and reuses it in the manufacturing of its skylights.  Sunoptics’ skylights allow the lights in buildings to be turned off, saving energy, during daylight hours, and can be used in addition to solar panels or film by buildings seeking to reduce their energy costs.  Sunoptics is based in Sacramento, CA, and its website is www.sunoptics.com.

2.  greenscreen.  Founded by a LA-based architect, John Souza, greenscreen sells lightweight metal panels, which look rather like two garden trellises made out of heavy wire joined together by horizontal wires connecting them so that they are about an inch apart.  These panels are used to support plants that climb:  this allows the installation of green walls that are separate from building walls, eliminate the damage to walls done by planting plants with suckers on them, and provide shade in the summer (lowering heat gain in the building).  The panels can be used as fencing, to create a softer look than standard fencing does; for horizontal areas such as trellis roofs; and for several other applications.  The screening is made in Fontana, California.  You can find out more at www.greenscreen.com.

3.  Skystream Commercial.  Skystream makes and sells small wind turbines that range in size from about 18 inches diameter (for use on a sailboat) up to about 12 feet (for use at a commercial building).  These micro-wind turbines have recently been installed at a Sam’s Club in Palmdale, California.  They can be mounted on lights in parking lots, and used to power the lights as well as to feed electricity into the neighboring buildings.  And, of course, the small ones can be used to charge your boat’s batteries!

4.  Presto Geosystems Filterpave.  Filterpave is a porous pavement system:  an alternative to impermeable asphalt — which of course creates stormwater runoff problems, Filterpave is a hard surface material made out of recycled glass bound with a high-strength flexible bonding agent.  The pavement is porous — though it feels hard — allowing surface waters to drain through it into  the earth or into a collection system for stormwater storage.   Apparently huge amounts of the glass bottles we so assiduously collect and recycle still end up in landfills — and the Filterpave system uses this post-c0nsumer recycled glass as its basic material.   It minimizes heat island effect, and reduces site disturbance by creating permeable surfaces.  It’s also rather pretty:  the glass glints in light.   You can find out more about Presto Geosystems’ pavement systems at www.prestogeo.com.

Will your deal survive the Devil’s Triangle? (part 4 of Bank Failure series)

As noted in the last post, what ultimately happens to a creditor’s specific claim against a financial institution often depends on what type of claim it is, and what priority it has.  This differs depending on whether the creditor is a  depositor, borrower, trade creditor, landlord or letter of credit holder.

Deposit Accounts.  Deposit accounts are a favored class of liability — provided that the accounts in question are federally insured.  FDIC coverage may be affected simply by the balance on deposit in the account.  Many business accounts (such as cash management, impound or lockbox accounts, through which a business’ essential daily cash flow moves) are likely to exceed this limit.  Therefore, businesses should carefully consider the effects of a freeze of, or partial loss from, such essential accounts, and should also give serious consideration to the stability of their banks.   One indication that a bank may be troubled occurs if it offers unusually high interest rates, because institutions trying to increase capital reserves sometimes offer high rates to attract deposits.  Deposit accounts which are not fully federally insured likely will experience losses or delays if they are not quickly transferred in a resolution to a new, solvent bank.

Secured Loans.  Another type of contract to which the FDIC as receiver may show relative deference is a loan secured by legitimate collateral.  A nondefaulted secured real estate loan, for example, with an adequate loan-to-value ratio and proper documentation, can be a valuable asset to the bank.  Even if moderately diminished in value, it may have a strong chance of being packaged into an asset sale, and surviving with a new, stable lender. 

Also, regulators are somewhat limited in their ability to abrogate or change vested property rights.  The FDIC has stated that it usually will not seek to reject properly perfected and documented security agreements (including real estate mortgages).  However, the outer limits of that protection are not well defined.

Securities, Swaps and Forward Contracts.  Regulatory laws also provide some limited protection for some kinds of specific derivative, option, swap and forward contracts (defined as “Qualified Financial Contracts”) and for some kinds of “true sale” asset structuring transactions for securitization.  Although a lengthy description of these “QFCs” is beyond the scope of this article, these generally are contracts with sophisticated parties, often executed at high speeds and in large denominations to serve specific financial risk management goals such as foreign currency exchange exposure, and are thought necessary in order to keep capital markets working well.

Unsecured Loans and Open Contracts.  Counterparties that have ongoing unsecured deals with a bank, such as unfunded loan commitments, agent bank responsibilities, real estate leases or servicing contracts, are less protected.  Such counterparties should evaluate the likely attractiveness their deal has to the bank and its successors in a potential resolution.  As noted, the FDIC may seek to take on only favorable contracts, or may reform contracts, accepting only the “good parts.”  For example, the FDIC might continue to collect on amounts due under a partially funded construction loan, but repudiate the duty to fund any future advances.

Another common case of an unsecured bank contract is a real estate lease in which the bank is either a tenant or a landlord.  Here, as in corporate bankruptcy, either kind of lease may be re-evaluated by the receiver and accepted, rejected, transferred in a sale, or partially assumed and partially rejected.  As with other unsecured obligations, the careful and timely filing of a proof of claim may be important to preserve a creditor’s priority for possible reimbursement.

Multiple Lender Transactions.  Multiple lender arrangements also may provide some safety.  The receivership of one member of a syndicated loan’s lender group may not be highly consequential to the borrower or the other lenders.  While that lender’s receiver probably will not fund future advances under the loan (especially on a construction loan), the typical syndicated deal has provisions for lender replacement, so long as the lender satisfies certain eligibility requirements (or other lenders in the group can make up the share).  The failed lender that does not advance will become a defaulting lender, and likely will lose its voting rights and its right to distributions.

A deal originated by a lender and then sold (as in securitization transactions) is even less likely to be affected by a receivership of the originating lender after the loan has been sold to others.   If the originating lender has retained loan servicing rights, they may be transferred with the loan, or to a new servicer, either by FDIC action, or by the new owner or trustee of the relevant special purpose entity if the FDIC repudiates the servicing contract.

Letters of Credit.  Letters of credit, often considered a rock-solid commitment in business transactions, do not necessarily fare well in bank receiverships.  Letters of credit constitute a bank’s forward commitment to pay an amount on demand to a beneficiary, based on the credit of another (the “account party”).  However, unlike the FDIC statement about perfected collateral, the FDIC does not give a clean assurance about letters of credit.  The FDIC states that “payment will be made to the extent of available collateral, up to . . . the outstanding principal amount . . . of the secured obligations, together with interest at the contract rate . . .” and certain contractual expenses.  But an unsecured or undersecured letter of credit, with a credit-impaired account party, is at risk of repudiation, as the FDIC is likely to view it as akin to an unfunded loan commitment to a shaky borrower.   That is little comfort to the letter of credit beneficiary.  However, the FDIC’s rationale appears to be that the beneficiary accepted the letter of credit based on the creditworthiness of the issuing bank, and that it should take the risk of having erred in that assessment.  Counterparties relying on letters of credit may want to re-examine the stability and credit risk presented by the banks that issued them.

No magic bullet will keep a deal with a bank facing regulatory resolution or receivership from being terminated or changed.  The legal processes for resolution are complex and discretionary.  However, counterparties still can exercise vigilance and take some steps to recognize and protect against risks in their deal structuring with banks.

Avoiding The Devil’s Triangle (of Bank Failure, part 3)

In the last post, I described the methods used by the FDIC to “resolve” banks.  This post talks about what steps you can take if you are entering into a contract with a bank, and want to minimize your risk of having your deal pulled apart due to the bank’s failure.

Practical Steps to Take if you are Making a Deal with a Bank that may be Failing

Some kinds of deals have a reasonable chance of riding through a bank resolution.  In packaging banks’ assets (including loans) for sale, regulators have discretion to favor and preserve assets they think are essential to the marketplace.  The type of financial institution with which a company deals may matter also, because regulators can, and do, “play favorites” to ensure that their resolutions and bank closings do not excessively disrupt either geographic markets or market segments. In choosing which troubled banks to take over, and how to handle their receiverships and the ongoing deals those banks were involved in, the FDIC tries to keep some credit available to all creditworthy marketplaces.

In documenting deals with a bank to minimize the risks of its failure, even the most careful attorney faces several handicaps.  As discussed in the prior posts in this series, a bank is not likely to be able to provide timely reliable notification of its adverse or declining financial condition.   So, many of the covenants, certificates or defaults typically used in deals by lawyers to create early warnings and remedies if one party is about to fail do not work well with regulated financial institutions.

For this reason, if you are doing business with a bank, you usually will be best protected against receivership risk by economic, rather than contractual,  deal structuring.

To avoid being sucked into the morass of a bank receivership, first try to carefully select which bank you want to do business with, based on the market data you can find about that bank’s financial health.  Large counterparties dealing with financial institutions frequently distribute their risk across banks, using such mundane approaches as syndicated loan commitments, letters of credit with “confirming banks” (additional banks with undertakings to pay), and other risk-diversifying options.

Deal design may also play a role. Once a bank is near or in receivership, it is more likely that your deal with the bank will survive if it is a mutually positive transaction.  A bank receiver who is rejecting “the bad parts” of deals is not as likely to repudiate or sever off a “good deal.”  Together with your lawyers, you should watch for, and consider fixing, deal structures which put all of the bank’s obligations, or those most expensive or risky to the bank, at the end of a long timeline, such as interest rate resets, automatic extensions and certain unsecured credit funding commitments.  If the bank’s obligations and your company’s obligations come due about the same time, or alternate, there’s much less risk to your company.

If your company is entering into a contract with a bank, you need to work with your lawyer to protect your company in light of bank regulators’ power to reform or reject contracts and deals.   If the bank fails, your company’s post-resolution fortunes may be influenced by variables, including:

  •  whether the bank’s failure presents systemic risk to the financial markets,
  • the quality of documentation, and
  • the applicability of some protected classes of transaction.

Proofs of Claim and Creditors’ Evidence Generally

Anyone with rights against a failed bank, such as a debt, an existing lawsuit, or anticipated damages from a contract repudiation by the receiver, must take timely steps to keep the bank’s regulators officially aware of his or her rights.  Bank receiverships include a bankruptcy-like “proof of claim” process.  Failure to comply can result in a claim being rejected no matter what its merits.  So, creditors must be vigilant concerning notices of deadlines for their claims, and should work with counsel familiar with troubled bank workouts.

Another risk arises in the event of incomplete documentation or approvals.   Current receivership law codifies the special authority requirements set by the courts in the case D’Oench, Duhme & Co. v. FDIC.  The D’Oench, Duhme case held that a contract with a bank would not be honored in its later receivership if it is not in writing, signed by the right parties, formally approved by the bank at an appropriate board level, and correctly and continuously reflected in the bank’s official financial records.   When documenting a transaction with a bank, a company and its lawyers should insist that all important aspects of the deal are fully documented and approved by the bank.   Side letters and similar informal devices risk being repudiated by the FDIC.

In addition, the appearance of a deal may matter.   Because the FDIC’s Purchase and Assumption transactions happen at lightning speed, the receiver’s assessment and resolution of the bank’s commitments, or at least its initial sorting of the obligations (into those worth selling to an acquirer and those slated for liquidation), may be done very quickly.   Transactions that on their face appear economically feasible and perhaps are secured by valuable collateral, but in any case are not extraordinarily burdensome, may fare relatively better.

Finally, what ultimately happens to a creditor’s specific claim against a financial institution often depends on the nature and priority of the class of claim:   whether the creditor is a depositor, borrower, trade creditor, landlord or letter of credit holder.   Some of these specifics will be discussed in the next post.

The Devil’s Triangle of Bank Failure (part 2)

In the last post, I discussed the FDIC’s three roles, as bank regulator, insurer of certain deposits and receiver for failed banks, and how hard it is to figure out from official sources if a bank is in trouble.   One final related point: although it can be difficult to figure out if a bank is in trouble, there are some sources that can help one make that determination.  There are certain private “watch lists” that, for a fee, will disclose to you their opinions about a bank’s health based on their proprietary research.   In addition, the Calculated Risk blog,  which periodically (usually on Fridays) posts an unofficial list of troubled banks among the many other treasures of economic data in that blog.

In this post, I’ll discuss the five basic options that the FDIC has to handle a failed bank and its process for doing so.

The five options are:

1. open bank assistance;

 2. management change;

 3. purchase and assumption transactions;

 4. receivership; and

 5. depositor payoff.

These options are described, along with some commentary about the FDIC’s choices of methods, in the FDIC’s Resolutions Handbook.  Though a bit dated because it was last updated in 2003, the Resolutions Handbook provides an extensive description about the FDIC’s official resolution process. 

FDIC  process.  The FDIC “resolution” process usually takes about 90 to 120 days, but much of this process occurs in secret before the official closure of a failing bank, and typically without notice to most of the bank’s employees.  

Once the FDIC gets the needed data about the bank, a team of FDIC resolution specialists analyzes the condition of the failing bank.  This team estimates the value of the bank’s assets, generally using a statistical sampling procedure to populate valuation models (because it does not have enough time to assess every asset).   For each category of loans, the FDIC identifies a sample, reviewing selected loans to establish an estimated liquidation value based on discounted future cash flows and collection expenses.   A loss factor for that category of loans is derived and is applied to all of the failed bank’s loans in that category.  

Least costly resolution is required.  Since 1991, the FDIC has been subject to federal laws that require it to use the type of resolution process that is the least costly of all possible options. The FDIC’s determination of which resolution will cost the government least, over time on a net present value basis, governs its choice.

 The cost to the FDIC can vary depending on a wide range of factors, including the premium paid by the acquirer that is agreeing to purchase the deposits and perhaps the assets (loans of the failed bank), the likely losses on contingent claims, the estimated value of the failed bank’s assets and liabilities, the levels of insured and uninsured liabilities, any cross-guarantees available against the failed bank’s affiliates, and the cost of collecting on assets not transferred in purchase and assumption deals.

Any losses are to be borne first by equity investors (shareholders) and unsecured creditors, who are supposed to absorb all losses before the depositors.  The remaining loss is shared by the FDIC and customers with uninsured deposits, as the FDIC shares all amounts it collects proportionately with uninsured customers. 

Open Bank Assistance (“OBA”) and Similar Devices.  The FDIC can leave a troubled bank open and pump assistance into it.  This option has not been used frequently by the FDIC since the savings and loan crisis in 1989, when the FDIC started comparing the cost of such OBA proposals against selling failed bank assets via competitive bidding, and found that selling assets usually cost less. 

In addition, in a 1992 policy statement, the FDIC announced that its concerns about bank soundness would require that it make certain positive findings concerning the competency of management of an institution after an OBA transaction.   In 1987, the FDIC was first authorized to establish free-standing “bridge banks,” meaning temporary banks created to service a failed bank’s assets prior to their sale.  A bridge bank provides the FDIC more time to find a permanent solution for resolving a significant collection of assets.  These and other policies changed the FDIC’s preference from leaving a troubled bank’s assets in the hands of its original management.  As a result of such less expensive policy options, OBAs are no longer commonly used, unless required by threatened systemic risks to the financial system, as seen in late 2008 and early 2009 when the Troubled Asset Relief Program provided billions of dollars to banks deemed by the government as “too big to fail.”

A number of similar programs, which amount to propping up or deliberately overlooking some of a troubled bank’s failings, also have been used from time to time. These include net worth certificates, essentially a temporary fiat that the bank will be deemed to have more reserves than its examination verifies; and other forms of income maintenance and regulatory forbearance in which a bank is acknowledged (at least privately between the regulators and the bank’s management and board) to have defects in its balance sheet or sound practices, but permitted to continue to operate, generally subject to certain conditions.  Few of these methods, though, preserve the possible value of a troubled bank’s assets — or minimize the running losses — as quickly as an asset sale (“Purchase & Assumption”) transaction, so in the current decade, these older options tend not to be favored.

Management Change.  While this option is not found in the FDIC’s official resolution playbook, the FDIC appears to use it with some frequency.  As a regulated industry, banks always are subject to “safety and soundness” supervision, and to continuing vigilance over the qualifications, competency and absence of conflicts of interest of a bank’s senior management and board of directors.  The wide-ranging powers of a bank’s principal regulators to unilaterally remove a bank’s management are difficult to challenge.  This uneven power relationship is rarely far from the minds of senior management; a bank’s reduced health often gives the FDIC a control-change hair trigger to use in negotiations.  Most of the large-scale bank merger and sale transactions accomplished at the beginning of the current wave of resolutions in 2008 clearly were regulator-instigated.  News reports  suggest that even management of some buying institutions may have felt that that their jobs were threatened if they did not accept federal bank regulators’ urgently suggested rescue transactions.  In their business dealings with banks, counterparties should be sensitive to the bank’s loss of flexibility and other changes in tone;  such changes can indicate trouble is brewing.

Purchase and Assumption Transactions.  Purchase and Assumption transactions currently are the FDIC’s most favored procedure for resolution. Through this procedure, the failed bank, or some of it, is sold to a healthy acquirer.  The buyer assumes certain liabilities (deposits foremost), in return for assets and, usually, some federal assistance/risk protection. 

If the FDIC decides that a Purchase and Assumption transaction is the most cost-effective resolution, it will choose whether to sell the failed bank as a whole or in parts, what assets should be offered for sale, how to package them, whether loss sharing will be offered, and at what price the assets should be sold. Operating under strict confidentiality prior to the bank closure, the FDIC markets the failing bank as broadly as possible to its list of approved potential acquirers.  Acquirers, who must have adequate funds, may be either financial institutions or private investors seeking a new bank charter. 

Typically, all bidders are invited to an information meeting, sign confidentiality agreements, and are provided with an information package prepared by the FDIC’s resolution team.  The deal terms usually focus on the treatment of the deposits and assets held by the failing bank. 

Once the bidders’ due diligence is complete, each bidder submits its proposal to the FDIC.  A typical process might require bid submission 1 – 2 weeks before the scheduled closing.  The FDIC evaluates the bids to determine which is the least cost bid, and compares them to the FDIC’s estimated cost of liquidation.

We’ve been informed that many of the FDIC deals are structured essentially as “as – is” deals, with negotiation allowed over price, and possibly downside loss protections, but not much negotiation of other terms.  This makes some sense in light of the large current and anticipated volume of resolution transactions facing the FDIC, and its desire to assure lowest-cost outcomes by letting the market set the prices, thus reducing the risk that the resolution will be second-guessed later. 

The FDIC submits a written request for approval of the negotiated Purchase and Assumption transaction to the FDIC Board of Directors.  Following Board approval, the FDIC notifies the acquirer (or acquirers, if assets of the failed bank are split up), all unsuccessful bidders and the failing bank’s chartering agency; arranges for the acquirer to sign all needed legal documents; and coordinates the mechanics of the closing with the acquirer.  After the FDIC closes the bank, typically on a Friday, the acquirer reopens, usually on the next business day. If the Purchase and Assumption Transaction includes continuing help, such as loss sharing, from the FDIC, then the FDIC monitors the assistance payments until the agreement expires, which may take several years.

If the resolution of a failing bank  is not completed before the bank fails, or before there’s a run on the bank or other liquidity crisis for the bank, the FDIC may not have time to conduct the careful valuation and analysis needed for a Purchase and Assumption transaction.   In that case, the FDIC must use its other options, by electing to pay off the insured deposits, to transfer the insured deposits to another bank or to form a bridge bank.  To avoid those typically more expensive and therefore less desirable results, the FDIC prefers speed and relative secrecy in its Purchase and Assumption deals.

Receivership.   If a Purchase and Assumption transaction is the FDIC’s “carrot,” its power to undo a failed bank’s deals in a receivership is the “stick.”  Most bank receiverships are administered by the FDIC who, as the insurer and protector of the bank’s depositor claimants, represents what often is a troubled bank’s largest creditor group. 

The formal rules of a receivership proceed much like a corporate bankruptcy: based on a finding that the institution is insolvent, the “receiver” takes over for the bank’s management, many claimants are required to make their claim known rapidly in a formal process or lose their rights, the receivership can “stay” litigation against the bank and undo fraudulent conveyances, the regulator can clean up or reject many of the bank’s liabilities using other special legal powers that change or ignore the bank’s legal obligations, and the regulator can sell off, liquidate or close pieces of the bank’s business or the entire business as a whole. 

But there are some serious differences between receivership and conventional bankruptcy.  But there are some tremendous differences between receivership and conventional bankruptcy, so the analogy only goes so far.  For one thing. the finding of insolvency, which generally comes from the institution’s lead regulator, e.g., the OCC for national banks, OTS for thrifts, etc., is discretionary to the regulator, and based on special regulatory accounting principles (not GAAP).  Receivers simply do not have anywhere near the same degree of responsibility, liability or obligation to listen to creditors, as typically are enjoyed by creditors in a corporate bankruptcy.

Another significant unique feature of bank insolvencies is the special priority of deposit accounts, in an insolvent bank’s estate, under the National Depositor Preference Act and FDIC insurance rules. Whatever funds are available in the bank’s resolution or liquidation will, after receivership costs, generally be applied first to pay off insured deposits.  This means that there’s a whole (and usually large) class of creditors ahead of general unsecured, contract and trade creditors of the bank, who may get nothing, unless the assets are sufficient to pay off all of the depositors in full first.

The avoiding powers that an FDIC receiver has, under 12 U.S.C. Section 1821, also are far broader and more powerful than those in an ordinary bankruptcy.  Ongoing contracts with a bank may be “repudiated” (e.g., broken) if the regulator simply decides that they are disadvantageous to the bank, within a “reasonable” time; or if the regulator is dissatisfied with the bank’s original level of paperwork and approval of the contract. These expanded powers may overturn ongoing leases; the unperformed parts of partially completed contracts, including loan funding commitments; and apparently the bank’s issued letters of credit.  A party can sue the receivership for its damages for a repudiated contract … but only “actual” (not consequential or punitive) damages are allowed, and the claims will be paid off as a general unsecured claim with the same dubious after-the-depositors chance of payment as the trade creditors.  Finally, the FDIC as receiver can prevent a counterparty from enforcing most contract clauses that are specifically triggered by a bank insolvency or receivership.

Depositor Payoff.  The backstop option for the FDIC — which it tries to avoid –– is a straight payoff of federally insured depositors from the FDIC’s insurance funds.  As this option comes at relatively high cost to the insurance funds, and occurs when total assets fall short and there is no lower-cost option, other counterparties of the bank frequently lose their rights.

Practical and Tactical Considerations in a P&A.  Three things should be noted in connection with this currently most common form of resolution.

First, it creates some interesting asset purchase opportunities for institutions and investors.  Like any regulated government bidding process, careful attention to the rules, and speed, and the advice of experienced counsel with regulated assets expertise, is essential.  Qualifying as a bidder, at the right time and place, and navigating through the precise offer being made, require agility.

Second, from the viewpoint of a bank’s borrower, creditor or contractual counterparty, use of P&A transactions will quickly sort out that entity’s deal into either a pool of assets and obligations to be sold, and thus very possibly ride through the bank’s resolution as just another special case of a change of lender, or into a bucket of the bank’s operating obligations.  In the latter case, the survival, repudiation or other future fortunes of that entity’s deal depend on the receiver’s choice whether to sell the whole bank or the parts of its business relevant to the deal.  If a bank asset or obligation is not transferred to an acquiror, that asset or obligation will likely be handled by the FDIC through the resolution process, and this is likely to be very slow from the point of view of the original bank’s counterparty.

Finally, it cannot be emphasized enough that the current FDIC prefers speed, and usually, relative secrecy, in its P&A deals.  Recently, Calculated Risk ran a helpful pointer to an interview in the Orange County Register in which one healthy bank CEO describes his actual experience with shopping for an bank asset sale. The buyer indicated interest, assembled a quick bid, quickly conducted the diligence with the FDIC on-site under the nose of the (unknowing) troubled bank’s employees, and wrapped it all up in a few days:

“We finished up on a Thursday and had to provide a bid the following Tuesday. The next day (Wednesday June 24) they asked for some clarification … Thursday … they notified us that our bid was accepted. … Then it happened that Friday at 4 p.m. They went in and took over the bank and we followed them.”

In a later post, I’ll discuss some of the impacts the FDIC resolution of a bank  can have on various counterparties who were doing business with the failed bank before it was closed.

The Devil’s Triangle of Bank Failure (part 1)

What happens if a bank is on the other side of your deal, and then the bank fails? Most people have not spent much time thinking about this – but now more and more of us who are involved in the CRE world must do so. 

37 banks have failed to date in 2010, after 140 such failures in 2009.  All of these banks have been closed by the FDIC.  More bank failures are expected as commercial real estate loan defaults increase, and high unemployment keeps the economy limping along at best.  What legal impacts will those failures have on you and your business?  To assess that, you need to understand the FDIC and its role in “resolving” failed banks. 

This set of posts will first provide an overview of how the FDIC handles bank failures, then will discuss how a bank’s failure and resolution by the FDIC might affect an entity that is doing business with a bank in various capacities (as borrower, landlord, etc.).   (The topic’s a bit dense, so I can’t fit it into one post.  I’ll try to describe it as clearly as possible.)

What is the FDIC and what does it do?  

The FDIC is a bank regulator.  The Federal Deposit Insurance Corporation oversees U.S. insurance funds for depositary financial institutions.  It has several functions.  The FDIC is one of several regulators responsible for banks and thrifts.  Others include the Office of the Comptroller of the Currency, which is responsible for supervising national banks, the Federal Reserve, which is responsible for supervising both state member banks and holding companies, the Office for Thrift Supervision, for S&Ls, and various state agencies. (For purposes of this set of posts, I’ll simply refer to all such institutions as “banks.”) 

The FDIC is an insurer.  As the insurer of certain deposit bank accounts, the FDIC manages and controls risks to two separate deposit insurance funds, the Bank Insurance Fund and the Savings Association Insurance Fund, and protects the depositors in FDIC-insured institutions. When a federally insured depository institution fails, ultimately the FDIC pays out insured bank deposit accounts (if no other resolution is less costly). 

The FDIC is a receiver for failed banks.  In addition, the FDIC acts as receiver, conservator or liquidating agent for failed federally insured depository institutions, as well as for most state-chartered financial institutions, in order to promote the efficient and expeditious liquidation of failed banks and thrifts.  In this capacity, the FDIC has broad power and authority:  

  • it can  “resolve” the problems of the failing institution, through asset sales or a number of techniques discussed later; or 
  • it can put such an institution into receivership, and close it; or
  • it can combine a partial resolution with a receivership.

The FDIC has two main goals: to maintain stability and public confidence in the U.S. banking system, and to minimize the government payout of monies from the FDIC insurance fund.  The FDIC’s actions become more understandable when one understands these priorities. 

Overview of bank failure.  Like other businesses, which are subject to bankruptcy when they fail, failed banks are subject to a legal regime for sorting out their balance sheet, their commitments and their inability to honor them.  U.S. insolvency law for financial institutions is similar to, but quite different from (and excluded from), conventional corporate bankruptcies under Title 11 of the U.S. Code. To some extent, workout lawyers will recognize the process: it looks like a horse, and runs rather like a horse, but it’s a zebra, and some parts are very different.  Federal bank regulators handle troubled banks with two principal public policy goals in mind: special protections for the benefit of depositors (who are a protected class), and the need to protect systemic soundness of the financial markets.  As a result of the latter, regulators enjoy far more discretion in working out a troubled bank’s obligations than in a typical corporate bankruptcy. 

Few early stage warnings.  It can be difficult for a counterparty to anticipate a bank’s  failure.  A bank’s creditors and contractual counterparties should be aware that, long before any official “resolution” process, troubled banks may be subjected to special rules or limits on their transactions.  Additionally, the “supervisory” correspondence, examination reports and warnings from a bank’s regulators often are explicitly confidential. 

Banks are obliged to maintain both “capital adequacy” and balance sheet solvency.   However, those calculations are rarely simple, and sometimes they are not wholly transparent to outsiders.  Complex banking regulations relating to capital adequacy complicate evaluation of a bank’s assets and liabilities.   So, for example, a bank with inadequate capital — which inadequacy might occur passively by negative revaluations of investment assets in the bank’s portfolio — may not have the ability to make new loans or extend more credit to existing borrowers.   Or interest rate or similar restrictions on permitted loan terms may be imposed by regulators on a troubled bank, if the regulator feels that the bank’s interest rate practices or exposures are questionable. 

Bank regulators usually work very hard to keep a troubled bank’s predicament quiet to prevent a run on the bank, to preserve systemic economic confidence, and to obtain the best price for the bank’s assets in any arranged deal.   In some cases, regulators issue an order requiring the institution to take certain actions (usually to increase its capital within a certain period of time),  but it is still difficult to determine the status of the bank’s compliance.  Often, the only public advance signal of a bank failure is a securities filing from the bank itself that it cannot continue as a going concern, which usually comes only days before serious regulatory action occurs. 

Since the government is given broad discretion in making decisions about banks, there is also some risk that the contracts of a healthy bank may be altered for public policy reasons, particularly in a difficult economy.  See, e.g., the consumer home mortgage forbearance and reformation provisions in FDIC Financial Institutions Letter 36-2009 (the Obama Administration’s home mortgages protection initiative). 

The beginning of an official “resolution”, comes with the issuance of a “Failed Bank Letter” to the FDIC by the agency which charters the bank, stating that the bank is failing or is in imminent danger of failing, and will be closed.  (This typically happens when a bank becomes critically undercapitalized, insolvent, or unable to meet requests for deposit withdrawals.)  As a practical matter, these notices are not likely to be a timely source of guidance or warning for the bank’s creditors and counterparties.  Once the official resolution phase has started, using one or more of the specific methods described later, the cow already is out of the barn. 

In the next post, I’ll discuss what the FDIC’s options are for “resolving” a failed bank, and which of these options it uses most often. 

 Note:  Many thanks to my co-author and partner Ed Karlin of Seyfarth Shaw LLP and to my co-author James Bryce Clark, General Counsel of Oasis-Open.com, who both coauthored with me a shorter version of this material in an article entitled “Take it to the Bank” which appeared last October in Los Angeles Lawyer Magazine, and to LA Lawyer Magazine for its permission to reuse some of the same material.
 
 
 
 

  

 
 

 


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Attorney Advertising. This blog is a periodical publication of Maura O'Connor, a partner of Seyfarth Shaw LLP and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. You are urged to consult a lawyer concerning any specific legal questions you may have. The contents are intended for general information purposes only and represent the individual views of Maura O'Connor only. Any tax information or advice contained herein is not intended to be and cannot be used by any taxpayer to avoid tax penalties that may be imposed on the taxpayer.