Posts Tagged 'Borrowers'

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.

Advertisements

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.

Workouts 101, Part 3: More Points of Borrowers’ Leverage

Continuing from last week, here are more points of potential leverage for borrowers facing potential workouts or foreclosures.  A borrower should figure out its position and points of leverage before proposing a workout to its lender.

Review the loan documents (including guaranties and correspondence)Or have new counsel do so.  It’s a good idea to bring in new counsel to look at the deal documents, because new counsel will bring in fresh eyes, and will be able to see what’s actually written in the loan documents, rather than what counsel that did the original deal thinkswas done.  (It’s simply human instinct to see what one thinks is there.)  Obviously the new counsel should be experienced in real estate workouts in the state where the property is located, as there are lots of subtle legal issues that are state-specific in this area.  (See my response to Selina Parelskin’s letter on the first week’s post for some of the California issues and a war story — the names have been omitted to protect the guilty.  In the current market, we’re unfortunately seeing a lot of real estate and other transactional lawyers — even former municipal law lawyers — reinventing themselves as workouts lawyers.  While it is certainly possible to learn a new area, in many states including California, the law about how to enforce loans secured by real estate is technically very complex and quite difficult, and we’re  frequently dismayed by the low caliber of advice given by some lawyers to their borrower or lender clients in this arena — it is very common to see basic issues simply missed altogether.)

It is not uncommon for loan documents to contain flaws that could affect their enforceability — or could at least give the borrower some leverage in a workout.   About 1 out of every 2 or 3 deals we see has had at least one major documentation problem that could be used by a borrower to increase its leverage.  For example, a few problems I’ve seen over and over in 20 years of practice are the failure to attach the proper legal description; inadequate or ineffective guaranty waivers (there’s one of 3 needed waivers that is frequently missed in California); and incorrect UCC filings (very important in loans secured by certain asset types:  you can’t run a hotel after foreclosure without its beds, furniture, etc.).

Also, sometimes correspondence with the lender will disclose that the lender agreed to do certain things, and has not done so; this can provide leverage to the borrower.

Basically, a business and legal review of the property and the loan documents should be done to fix any potential defaults or similar problems the borrower can fix (such as a failure to deliver required information that could trigger a default) and to develop leverage.  That allows the borrower to make a proposal reflecting a practical solution to the problems facing the property that is likely to be accepted by the lender. 

Maintenance and waste.  Early in a workout, a key issue for borrower/owners will be to make sure that the property is not wasting (generally having its value significantly diminished by lack of care).  

Specifically, borrowers should assess and confirm that the condition of the property doesn’t deteriorate to where it triggers covenant breaches that make it more likely the lender will foreclose rather than doing a workout. 

Also, it’s fairly common for “non-recourse” loans to have a carve-out, reimposing personal liability, for some grave defaults often including significant waste.  In such cases, it’s in the borrower’s  interest not to risk personal liability by letting the improvements start to fall apart. 

 Insurance coverages.  Financed owners should check their casualty and liability insurance coverage for the property, to confirm that adequate coverage is in place; premiums are paid;  and all needed policies are up to date, in force, and sufficient to satisfy any loan covenants about mandatory minimum coverage.   

 Other areas of personal or pass-through liability.  Another set of issues, where the borrower should analyze the situation and try to get ahead of the game, is any other loan document clauses that give the lender direct right against assets beyond the property itself … like the borrower’s principal (if the borrower is a corporation, LLC or other entity) or any guarantors.   

 At the outset of a possible workout, a borrower should carefully check whether:

  • There is an unfulfilled capital contribution obligation, a possibility of future mandatory capital calls.
  • There is an argument that the property’s ownership vehicle is undercapitalized and can be ignored (sometimes called “veil-piercing”), and liabilities passed through to the next level of ownership.
  • There is personal liability for real estate taxes.
  • There is a guaranty (or arrangement that amounts to a guaranty) that can be called.
  • The legal fees incurred by one party in a default or workout must be reimbursed by, or can be demanded from, the other side.
  • If an investor and developer are in partnership (or similar arrangement), what further calls or liability can be placed on the investor.
  • Officers, directors or partners have personal liability for actions taken or not taken … and whether there is directors and officers insurance in place to address those risks.
  • What exactly has been granted as collateral for the loan?  There may be omissions that the lender will wish to see corrected.  A borrower can sometimes agree to correct such omissions in order to negotiate for concessions it needs to work out the loan and return the project to profitability.

Only a thorough legal review up front by experienced local real estate workouts counsel will give the borrower the understanding of its situation and potential liability that will allow it to do a thorough business review and to then understand what the best possible outcome is — and negotiate a workout that moves as much in that direction as possible under the circumstances.

More on workouts from the lender side to follow, and a new thread shortly.  If you have ideas for topics to be addressed, questions, concerns, agreement/disagreement or other comments, just let me know.

Workouts 101, Part 2: Borrowers’ Leverage

Last week’s post talked about some of the basic issues that often are overlooked by both sides in a problem real estate loan workout.   Many of us were in the market for the last boom & bust cycle, and simply need a quick refresher on our workout skills.  

For others,  including many property managers and even some investors and lenders, this is their first serious down market, and it may take some time to adjust to the fundamentally different issues and priorities of real estate workouts in a systemic recession.  

This post looks more closely at some of borrowers’ points of  leverage and opportunity in typical real estate loan workouts.

 Knowing the property.  Borrower/owners usually are in a far superior position to a lender in understanding what it takes to run, and profit from, the real estate and its related operating assets.  Normally, the lender looks to the owner, or his operator managers, to know how best to keep the property performing and adequately maintained. 

The bottom line here is that, in an early stage workout, property owners should try to continue to be the “experts” for themselves and lenders both, and anticipate problems.  In that role, owners can offer solutions or compromises on any problem areas, and keep the momentum, forestalling the lender from considering trying to take over and bring in someone else (like a receiver).

Cash flow considerations.  In a workout, cash is king.  A smart lender will look at these issues straightaway, so as a borrower, you want to be ahead of the game here as well. 

Obviously, a failure to keep up with required debt service on the loan will trigger payment defaults and is the common path to a tough workout.  But other cash issues must be kept in mind as well. 

It’s entirely reasonable in a early stage workout to try to reduce operating expenditures to utterly necessary minimums.  Troubled borrowers sometimes are counseled to slow pay or shut down some nonessential items, to build a cash kitty, which might be used to reduce the secured debt and forestall enforcement or foreclosure.  However, failure to pay necessary maintenance, utilities, insurance or similar costs could trigger waste or covenant defaults.  (Shut down utilities, for for example, and you may lose fire/life safety protection, or suffer mold due to HVAC being down.)    Shorting unsecured trade creditors also might alienate them, reducing the chance, in a later bankruptcy, that this class of creditors would be friendly to the borrower and support a reorganization plan that keeps current ownership in place.    

Distributions of cash to an owner or partner, even prior to default, can be problematic in a workout.  This is because bankruptcy law (and some other remedies) may give a lender, and other creditors, some rights to recall those funds later.  Any plans of a borrower/owner to make payments to owners or insiders should be carefully discussed with legal counsel once a workout or default approaches.

Intrinsic value of the property.  Again, this is something a sophisticated  borrower may understand much better than the lender (even though the lender will almost certainly order an appraisal).  Remember, the lender is not necessarily expert in what makes your specific property special.  The borrower needs to highlight for the lender the unique features of the property, as well as the reasons why the borrower is the best person to run the property in a way that makes the best out of those unique features in the long run, even if the property is having difficulty in the short run.

There are more borrower points of leverage to come.  Look for another post early next week to find them.

  A note to readers:  I really appreciate all of your comments, and like my fellow Globest.com bloggers, encourage you to participate, throw out ideas and arguments, and ask questions (just not specific questions about specific deals, as we can’t give legal advice here).  Hopefully we can get a good conversation going here about what’s going on in the market and in law.


Archives

October 2017
M T W T F S S
« Sep    
 1
2345678
9101112131415
16171819202122
23242526272829
3031  

RSS GlobeSt.com’s Top Stories

  • An error has occurred; the feed is probably down. Try again later.


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.