Posts Tagged 'Financing'

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.

Distressed Note and REO purchases (part 2)

Part 1 of this series dealt with representations and warranties that are typically provided in distressed note purchases and distressed REO purchases.  This post gives an overview of some of the diligence issues that must be addressed in purchases and sales of (whole) distressed notes.   (Other issues arise in the context of sales or purchases of participations in notes, which are not addressed in this post.) 

Why do due diligence?  When a lender chooses to sell, rather than to enforce, a distressed note secured by CRE, it may have made that decision for any one of a number of reasons.   For example, the lender’s regulator may have decided that the lender is carrying too many distressed real estate loans, and may have told the lender it needs to quickly rebalance its portfolio.  Or the lender may need to improve its liquidity quickly, and may determine it can do so faster by selling one or more distressed notes rather than by enforcing them, then selling the distressed REO after it is foreclosed upon by the lender.  Or it may have decided to get out of a given type of lending business, and therefore to sell all its loans in that line of business.  It may be rebalancing its risks geographically, or based on changes in the market.  Alternatively, the lender may need to improve the overall quality of its portfolio quickly.   Or it might be selling to change its yield and duration risks.   It might be selling the note due to its merger with another lender.  Another reason a lender might sell is because it thinks it will have a tough battle with the borrower to enforce the note, and does not want to commit the time or money.  Or the property may carry with it liabilities of one sort or another:  for example, foreclosing on a retirement home or a hospital may create public relations problems for a lender; or the lender may simply not want to, or have the resources to, manage certain types of property, such as land not yet subdivided; or a property may have environmental problems that concern a lender.   Or, in a declining market, the lender may decide it ultimately can collect more in a fast note sale (or lessen its costs — such as property taxes and other costs it must advance — to hold the declining property) than in a slow foreclosure (and possible bankruptcy). 

A potential buyer simply does not know why a lender is selling a distressed note, and so it needs to do diligence at two levels to understand and price the risk it is taking by buying the loan: 

  • First, it must do diligence to determine the status of the note, the other loan documents, the borrower, any guarantor, and the relationship and actions to date taken by the borrower and the selling lender, because the buyer will be stepping into the shoes of the selling lender; and
  • Second, it must do diligence to determine the status of the real property and any other collateral securing the note as if it were buying that property, so that it can understand, evaluate and price the current value and possible risks inherent in foreclosing upon that collateral.

“Due Diligence” defined.  Although most of you probably know what “due diligence” is, a simple definition is that “due diligence” means an appropriate investigation about all aspects of a note or an interest in property on behalf of a person or entity who plans to purchase an interest in it.  Generally, in commercial real estate transactions, the rule is “Buyer Beware!” which means the buyer must ferret out all the information it needs about what it is buying to make sure it is actually getting what it thinks it should be getting in its deal.

Lender/Seller’s position on due diligence.  A lender typically will agree to some diligence concerning the loan:  it should be willing to provide access to and copies of  its loan documents, correspondence to and from borrower and related parties, and loan file (other than any privileged documents and any appraisals) to the buyer and its counsel for review after a loan purchase agreement has been negotiated and before the buyer (and its deposit money) is irrevocably committed to complete the purchase.  Typically, a lender will require a buyer to enter into a nondisclosure and confidentiality agreement prior to providing such information, which is usually a reasonable thing to require.

It is in the lender’s interest, up to a point, to have the buyer do its own diligence on the loan documents and underlying collateral:  the lender’s goal is to get as close as possible to an “as-is” sale, and a lender will typically insist that the buyer make express representations that it has had the opportunity to perform diligence on the loan and on the collateral, and that the buyer is relying solely on its own diligence in electing to purchase the note.  Structuring a deal that way provides a selling lender some comfort that the sale will truly be final, and the buyer will not later be able to argue that the seller should be liable if the buyer has problems with the loan it buys.

Recommended due diligence for distressed note purchases.  While it’s pretty straightforward to review a lender’s loan file (assuming a complete loan file can be located), the process for evaluating the underlying collateral can be more complex. 

To review a loan file, one must carefully read (and preferably also have counsel read) all of the loan documents and all of the correspondence between the lender and the borrower.   The purpose of this review is to confirm the basic business terms of the loan (its amount, times and terms for payment, etc.) as well as the legal effects of the loan:  that the loan was made and documented properly, that it appears to be enforceable against the borrower and the property, and that the security documents work (create liens against the property that is collateral for the loan, whether personal or real property).   It’s usually a good idea to run a litigation search on the borrower to see if it or its principals have a history of litigation — that can be an indication of how hard it might be to enforce the loan.  Further, a legal analysis of the likelihood that the borrower has defenses to payment or other leverage (such as a fraud or other lender liability claim) that it could use to oppose the enforcement of the loan should be done by competent CRE counsel.  For example, my group has a standard form CRE loan checklist that we use to review loan documentation; it is quite long and detailed, and reminds us to check (and to document in summary form) a wide range of issues that can hamper the enforcement of a CRE loan.  After we complete initial diligence for a loan purchase, we provide that checklist (as well as an executive summary of it) to our client, so that it can make its internal determination about what to follow up on.  It is not uncommon for an initial round of diligence both to resolve certain issues and to uncover other issues that must be investigated further in order to really understand the risks of enforcing a particular loan. 

Typically in a loan purchase transaction, the buyer’s lawyer first looks at the lender’s loan file; if there are insurmountable problems in it, then the deal may be terminated before review of the collateral takes place.  But if the loan file seems okay, then the next order of business is typically the due diligence review of the real estate collateral securing the loan.

Diligence concerning the real property collateral should ideally be essentially like diligence on any purchase of real property.   What amount of diligence is “due” depends upon the circumstances, including the risks created by the prior use of the property, the risk tolerance of the buyer, the monetary value of the transaction, and the budget available.  The type of investigation that a buyer and its lawyer should perform in any real estate transaction depends upon both the type of transaction and the kind of land which is being purchased or encumbered.  However, some basic questions common to all types of land are outlined below:

  1. What interests in the property collateral are encumbered by the loan?
  2. What is the value of these interests?  Are they sufficiently valuable that if the note borrower fails to pay the note, the buyer can collect the amount owed by foreclosing on the land or taking other allowed liquidation actions?
  3. Who owns the property collateral? (Generally, it should be owned by the borrower.)
  4. What is the property used for? (This information is very important in determining the value of the land and the likelihood that it is environmentally contaminated.)
  5. Where is the property located? And can it be located with specificity on a survey? Has it been subdivided (so that it can be resold after a foreclosure if necessary)?
  6. How has the property been used in the past? (Also very important when determining environmental risks.)
  7. If it were to have to foreclose, what use could the buyer make of the land?
  8. Does anyone other than borrower (and typical easement holders, like utilities) have any rights to all or parts of the land?  If so, could such interest holders block buyer’s use of the property after a foreclosure?

The common goal of all of these questions is to find out precisely what the seller is selling and what the buyer is buying. This sounds simple but is not.  The key is to be able to find out about the property while relying only on sources of information that are known to be highly accurate (and, if possible, on sources that carry liability insurance against their own errors).  I could go on and on about the specifics of due diligence, but won’t:  just understand that in order to know whether it makes sense to buy a distressed CRE note, a buyer must do diligence on the collateral property as well as on the note. 

Key due diligence provisions in note purchase and sale agreement.  In negotiating the due diligence provisions of a note purchase and sale contract, the parties usually have to negotiate several points:  (a) the length of time the buyer has to  complete its due diligence; (b) whether the buyer can do environmental testing or physical inspection of the underlying property collateral (both are very important, but frequently the would-be note buyer’s access to the property is constrained by the seller/lender, which may itself only have limited rights to access the property; (c) the amount of cooperation during the diligence process that the selling lender must provide; (d) what happens if the buyer completes its diligence, then new information comes up about the status of the loan or the property collateral; and similar issues.  These issues and others are typically negotiated in the note purchase and sale agreement; once negotiated, both seller/lender and buyer must comply with those terms.

What we’re seeing now.  We’re seeing generally an uptick in distressed note purchases and sales.  However, there are fewer of these sales than one might expect.  It appears that regulators who in other CRE downturns might have pushed lenders to sell notes to maintain their liquidity, are instead allowing them to wait longer or go through foreclosures and other enforcement actions instead of doing faster note sales.  Many lenders think they can get a better return by enforcing the notes themselves, through foreclosure, then selling the real property collateral.  Further, there seem to be a lot of would-be investors in distressed notes relative to the number of distressed notes on the market, so there seems to be a fairly stiff competition to buy these notes — and many investors seem to be buying them at prices that do not take into consideration the potential costs and likelihood of enforcing these loans through foreclosure, or even despite a borrower bankruptcy; so it is unclear if many of these deals are actually healthy for the buyers.

Weird California loan enforcement issues

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

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

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

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

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

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

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

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

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

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

Workouts 101, Part 6: Lenders’ Negotiations and Documentation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Introduction to California’s one-action and antideficiency rules

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

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

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

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

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

The approaching tidal wave: Maturity defaults in CRE loans

 

Bloomberg has reported this week that “almost $165 billion in U.S. commercial real estate loans will mature this year and need to be sold or refinanced as rents and occupancies fall, according to First American CoreLogic.  The U.S. South has the most maturing loans with 60,893 mortgages valued at $96 billion coming due on shops, offices, hotels, apartment buildings and land . . . .The West is second with 20,549 mortgages maturing for a value of $35 billion.  Commercial property owners are struggling to pay debt as the recession reduces demand and forces landlords to cut rent. . . . Properties worth more than $108 billion were in default, foreclosure or bankruptcy as of July 8, according to data firm Real Capital Analytics Inc.  .  .  .  U.S. commercial property prices fell 7.6 percent in May from a month earlier, bringing the total decline to 35 percent since the market’s peak, Moody’s Investors Service said last week.  .  .  . More than 5,000 commercial properties in the 10 biggest U.S. metropolitan areas got at least one default notice in March, marking the first time that’s happened in First American records going back to January 2003. ”

This looks like an approaching tsunami to me for banks, special servicers and other CRE lenders. 

Now we’re seeing lenders generally extending their loans when possible to avoid having to sell properties at current low prices and into a market where potential buyers are having difficulty arranging new financing.   (The smart lenders are using this as an opportunity to review their loan documents and fix anything that could block or hamper later enforcement through foreclosure.) 

These extensions are, essentially,  bets that the economy will recover soon enough that these lenders won’t have to foreclose or do larger scale workouts.  Extensions are also protective measures for each individual institution —  by postponing any writedown, the lender preserves its own capital and protects its short term solvency.  And it is possible that the massive governmental stimulus will reinflate the economy and the demand for CRE (though I am skeptical about this).

But I can’t figure out where the needed replacement financing is going to come from, especially since the CMBS market appears to be dead, leaving a huge gap (perhaps 40%) in the financing available for CRE.  (Few banks have an appetite for more real estate loans.  Haven’t heard a lot about life insurance companies wanting more  CRE loans either.  One of my partners has done one of the two covered bond deals completed to date, and thinks that structure is unlikely to replace the missing CMBS financing.)   Do any of you have any ideas about what will replace this missing financing?


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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.