Posts Tagged 'Lenders'

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Proofs of Claim and Creditors’ Evidence Generally

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

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

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

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

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

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

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

The five options are:

1. open bank assistance;

 2. management change;

 3. purchase and assumption transactions;

 4. receivership; and

 5. depositor payoff.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is the FDIC and what does it do?  

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

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

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

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

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

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

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

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

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

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

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

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

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

  

 
 

 

Distressed REO and Note Purchases (part 1)

As more borrowers default on commercial RE loans, more lenders are starting to sell either the defaulted notes or, after foreclosing on the property securing the loan, the REO (real estate owned) properties.  These deals are typically “as is” deals, subject only to certain negotiated representations and warranties from the lender/seller to the buyer. 

I thought it might be useful to outline some of the typical representations and warranties we’re seeing in these deals; and also to set forth a reminder about the due diligence that should be done by buyers so they know what they are getting, and don’t just become knife catchers.  In today’s post, I’ve outlined typical reps and warranties.   I’ll outline typical due diligence issues in the next post.

First, at the risk of stating the obvious, there’s a big difference between buying foreclosed REO and buying a distressed note.   If you’re buying REO property, the borrower has already been foreclosed upon, and therefore you as buyer will not have to either foreclose the loan or take the risk that the borrower will file for bankruptcy.  If you are buying a note, however, you as buyer are taking those risks.  This means that a buyer of a note must take additional precautions and do additional diligence in order to make sure that the distressed note is actually worth what the buyer is willing to pay for it.

One way to determine the value of a distressed note, is to evaluate the market value of the underlying real estate collateral, then to take a discount from that in the amount estimated to reflect the likely cost to enforce the loan (possibly all the way through a borrower bankruptcy), adjusted by the likelihood that the borrower (and guarantors, if any) will fight the foreclosure.  This requires both a business and a legal analysis — the latter to determine if there are any defects in the loan documents that would make the loan harder or easier to enforce.

In purchases and sales of distressed REO, the terms of the deal are basically like other purchases and sales of real estate, with a few exceptions.  The seller of REO, typically a lender which has foreclosed upon the property, will not usually make a lot of representations about the property because it is not as knowledgeable as the typical seller — the lender’s position is usually that it made a loan, and will make representations about its ownership of the loan, but not about the underlying real property.  So most sellers of REO will generally represent and warrant as follows:

1.  that the lender/seller has the authority to enter into the sale of the REO, and that the agreement to sell the REO is enforceable against it;

2.  that no interests in the REO have been previously conveyed to others by the lender/seller;

3.  that there is no litigation concerning the REO  other than as disclosed in writing in an exhibit to the purchase and sale agreement;

4.   that the information provided by the lender/seller is true, complete and correct to the extent it has been created by the lender/seller (note that a lender/seller will usually provide copies of third party reports, such as environmental reports, but expressly will not accept liability for their accuracy — buyers need to either engage the provider of such original reports for downdates of them so that they can rely on such reports, or to have new reports done for them); and

5.  other representations typical in CRE purchase and sales agreements may be included.

If a distressed note is being sold, rather than REO, additional representations of lender/seller may include:

6.  that the lender/seller has provided to the buyer copies of all of the contents of its loan file, including all loan documents, modifications and copies of all correspondence relating to the loan;

7.  that the lender/seller is selling the whole loan (or, if the sale is of part of a loan, what part);

8. that the lender/seller owns the distressed loan, and has not conveyed any interests in it to any third party (except as disclosed in writing in the agreement).

In both REO and distressed note sales, there may be more representations and warranties running from the buyer to the lender/seller than in a typical CRE purchase agreement.  In a sale of REO property, in addition to the standard representations that the purchase contract is enforceable against the buyer and the buyer’s signatory has the authority to execute the contract,  the following representations may be included:

1. that buyer has investigated and completed its due diligence on the property, and will rely only on that diligence in electing to purchase the property;

2.  that the buyer expressly agrees its purchase of the REO is “as is, where is”;

3.  that the buyer complies with the Patriot Act;

4.  that the buyer is not an insider or affiliate of the lender/seller.

Sometimes in distressed note sales, a buyer will also represent that it is a sophisticated investor, and can bear the risks of purchasing a distressed note.  These lists of representations are not exhaustive, but should give you an idea of the sorts of reps you’ll typically see in these deals.

Next post:  Due diligence needed for purchases of REO and distressed CRE notes.

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.


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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.