Posts Tagged 'Workouts'

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.
 
 
 
 

  

 
 

 

Advertisements

Happy Holidays, 2009: CRE is Scrooged

I’ve thought the market was overvalued, and that a wave of foreclosures was coming, for several years.  I was wrong in 2005 and 2006; by 2007 a fair number of folks thought the CRE market was overvalued, but we did not see many defaults, at least here in Southern California.  In 2008, the CRE  market seemed to be generally stuck.  This felt very similar to 1991 — everyone knew values of CRE had fallen, but no one wanted to take action — as if denying reality might make it go away. 

But many of us, including me, have been surprised by how long it has taken for the weakness in the overall economy to affect the CRE market this time, and how long it has taken before an uptick in defaults, workouts and foreclosures.   In some parts of the country, like Michigan and Florida, the wave of foreclosures brought on by falling values has already hit.   But in California, where we have generally seen only limited CRE foreclosures in 2009 (but a lot of modifications), it looks like we’re in the trough of activity looking up at the crest of the wave now.

Just today, in connection with a discussion of a consensual workout of some prominent San Francisco real estate, Bloomberg reports

“Commercial mortgage defaults more than doubled in the third quarter from a year earlier as occupancies fell, according to Real Estate Econometrics LLC.  .  . Property sales financed with commercial mortgage-backed securities plunged 95 percent from a record $237 billion in 2007, according to JPMorgan Chase & Co. “

Bloomberg goes on to quote Moodys, as saying that values “may fall 55 percent from their peak” due to a lack of securitized debt.

 Third quarter 2008 was bad enough:  double that default rate is ugly. 

A drop of CRE values anything like 55% obviously will be even worse news for highly leveraged projects — and could gouge the LTV ratios for even the most conservative lenders.

Probably we’ll see a greater number of underwater owners giving back their properties to lenders, either by deeds in lieu, agreements to not fight foreclosure, or the like.  Often these graceful surrenders are made in  exchange for limiting guaranty exposures.   In the case of CMBS loans, we’re starting to see lots of resales of the property made consensually through a receiver to a willing buyer/new borrower who is willing and able to assume the existing loan, as modified.    These can be fairly simple and effective workout deals, if documented correctly to avoid the traps presented by California law.  We’re also seeing some lenders who don’t want to battle through foreclosures quietly moving to sell their loans to buyers willing to undertake those legal fights in exchange for a discount on the note price.

True to 1991 form, we don’t seem see borrowers or lenders completely capitulating to reality yet:  there’s still a persistent gap (though a diminishing one) between what lenders are willing to sell distressed debt or foreclosed property for, and what buyers are willing to pay.

That’s what we seem to be seeing now, as we go into the holidays.  I’d be interested in hearing whether you are seeing that too — or seeing something different.  Please let us know by posting a comment.

Receiverships Now: Bill Hoffman of Trigild talks

Recently I had the pleasure to talk with Bill Hoffman, of Trigild, which is a receiver based in San Diego that handles receiverships of troubled assets across the country.  I asked Bill to tell us a bit about what he and his colleagues at Trigild are encountering in the current commercial real estate markets they serve.

O’Connor:  What are you seeing in the market now?

Hoffman:  We first saw housing developments, condominium construction and conversions failing in 2008. Also, restaurants started to fail early in this cycle, at a rate worse than lenders believed possible.

Next, shopping centers started to fail early in 2009 and calls on failing shopping center projects are now coming in daily. The pace of these business failures has accelerated rapidly and we don’t see a bottom yet. Calls to our offices on distressed hotels are increasing daily and many of those hotels have already been in default for many months or longer. Some experts estimate that as many as 500 hotels in California are already in default, but awaiting action from lenders and servicers, who are already swamped with other product types. In previous hotel down cycles, it was the smaller independent, often family operated properties that were the early defaults. However, in this cycle higher end, nationally branded hotels have been the first to go down, with current values being far below even the debt amount, and those values expected to decline further. Bigger hotel players are just walking away because there is no near-term likelihood of recovery, and they see no equity returning for many years. With the smaller properties, the franchise is often switched to a lower category, but the luxury branded hotels are much more likely to stay in place, keeping their market presence and avoiding the stigma of “losing” property. The public rarely realizes that it is the franchisee/owner who has failed, and merely connects the failure with the brand name.

As lenders and servicers continue to add staff and begin to get better control over the sudden flood of defaults, we will begin to see earlier action toward foreclosure or bankruptcy.  Few sources in any sector of commercial real estate see a light at the end of the tunnel yet.

Many of the impending loan defaults are not a matter of failing to make regular debt service payments; instead the mortgage is maturing and needs to be replaced. Loans on properties whose values have already shrunk to less than the current debt are not viable candidates for re-financing, especially in this current dry well of financing.

We are also seeing an extraordinary number of “jingle mail” defaults: a property worth perhaps only half of the outstanding debt has no value to the borrower, and property owners are sending keys back to the banks. A side effect of this flood of defaults combined with so many developers, management companies, brokerage firms and other real estate people seeing huge drops in their normal business income, we are seeing a huge increase in people claiming to be qualified to serve as receivers – perhaps 10 times the number of just 2 years ago. We can expect to see a variety of other problems for lenders as a result.

O’Connor:  What do you think you’ll see in the next 6 months to 1 year?

Hoffman:  In next 6 months to 1 year, we think we’ll see 4 – 5 times the number of hotels going into receivership and/or bankruptcy than we did just 12 months ago. Historically, down cycles are slow at the beginning, then speed up once lenders start dumping inventory, leading to even greater discounts in selling prices. Hotels are already being auctioned – a rare disposition method in previous down cycles. We will see unfinished construction of hotels stop, with some simply being mothballed for a few years.

We think the climate for commercial real estate will get worse before it gets better.  Commercial real estate is in trouble all over:  the long spell of increasing occupancies and rates came to a screeching halt, and those loans made on the basis of overly optimistic projections have reversed loan-to-value equations in most asset classes.  Higher end hotels are forced to compete by lowering their rates dramatically without compromising service, with resulting massive losses. Many try to maintain their apparent “rack rate” by offering other discounts – free nights, meal credits, etc.

O’Connor:   In your opinion, what is different about this down cycle as compared to the 1990’s?

Hoffman:  The sudden and dramatic drops in value, with most experts predicting that the bottom is still in the future and will be much deeper.  The consensus also seems to still be extending the predicted date of the bottom, the length on the bottom, and the length of recovery.  Originally, CMBS loans were a vehicle which allowed the RTC to get commercial property back into the hands of owners rather than lenders.  The billions of dollars currently in CMBS loans do not yet have a magic bullet to accomplish that same recovery.  Many commercial borrowers are now dealing with special servicers who did not originate the loans, have no relationship with the borrower, and work under very strict guidelines and regulations which limit the options for resolutions.

Special servicers’ asset managers, like their banking colleagues, are dealing with extraordinary numbers of loans, and many are relatively new to non-performing loans,  sometimes recently moving from the origination side. There is of course a learning curve which further slows the process in dealing with the record volume.  Our staff spends a fair amount of time helping asset managers understand issues of receivership, bankruptcy, franchising, liquor license issues and a full menu of additional factors impacting their jobs.  This includes understanding the costs of maintaining any property, but further complicated for hotels, restaurants, convenience stores, truck stops, water parks and any other real estate project with a business enterprise aspect.

If several lenders are involved in the same project, Trigild often will be asked to serve as the one receiver for all lenders’ security.  This can simplify the process and operation and also dramatically reduce fees and costs. Unlike many other receivers, Trigild has operated hundreds of businesses like those mentioned above, and being able to perform both roles avoids overlapping fees for the receiver to “oversee” the management company.

Another development rarely seen in previous downturns is borrowers cooperating with lenders to have receivers sell property during the receivership, rather than waiting until the end of the foreclosure period, which can be very lengthy.  “The sooner the sale the higher the price” is a given in this economy, and often the borrower recognizes that there will be no equity even in the distant future.  Sales by receivers are becoming more commonplace in many state jurisdictions, and are already recognized in federal rules for receivers.  In the case of CMBS loans, sale by the receiver before foreclosure also allows the servicer to provide some financing from the existing loan.

O’Connor:  What should a lender/servicer seek in a receiver?

Hoffman:  Experience, experience, experience. The number of people claiming to be qualified to serve as a receiver has probably increased 1000% just this year.  There are few if any formal requirements for a receiver in many states, and some management companies, etc. will offer to do the receivership work “free” in order to get the management assignment.  The potential danger to a lender from receiver mistakes can be monumental.  A receiver who involves the lender in decision making for the property can open a claim of lender liability by a disgruntled borrower and cause the lender to end up legally as an owner or owner’s partner, losing its status as a secured lender.  We have seen hundreds of thousands of dollars paid to utilities, vendors, franchisors and other borrower’s creditors which were not receivership estate obligations.  Loss of liquor licenses, gaming licenses and other critical assets are not uncommon with less experienced receivers.

Relatively few lawyers and judges deal with receiverships, and receivership law is very fluid, with no instruction books and few specific rules.  Judges will usually honor the lender’s recommendation of the specific receiver, and show little sympathy for the lender when mistakes are made.  Experienced receivers have earned the courts’ respect and judges rely on those receivers.  A receiver who plans to immediately retain legal and other counsel for advice on how to operate is unqualified.  Most judges will not allow for such immediate professional help without a more specific showing, since they expect the receivers to know the job.

O’Connor:  What distinguishes Trigild as a receiver?

Hoffman:  While Trigild has managed and acted as receiver for traditional real estate (office, retail, multi-family) for 33 years, we are known for our unique ability to act as a receiver for operating businesses, such as restaurants, convenience stores, truck stops and hotels, where the major value is the business enterprise, not merely the real estate.  We field a team of experts who have the experience to operate these businesses, and have done over 1,500.

We have been called upon to take over as many as 100 individual restaurants at one time using our affiliate company, Trigild Associates, as the new employer for sometimes thousands of employees in multiple states. Our staff covers every area of expertise and includes lawyers, paralegals, MBA’s, CPA’s and recognized experts in every branch of commercial real estate.

Finally, we also have a group of skilled real estate agents who are uniquely qualified to direct all aspects of selling these properties, working from our own extensive database and business relationships, and working in cooperation with other brokers through the country.

Enforceability of Guaranties in California

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

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

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

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

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

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

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

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

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

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

[More on sham guaranties later. . . . ]

Workouts 101, Part 6: Lenders’ Negotiations and Documentation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Introduction to California’s one-action and antideficiency rules

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

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

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

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

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


Archives

December 2017
M T W T F S S
« Sep    
 123
45678910
11121314151617
18192021222324
25262728293031

RSS GlobeSt.com’s Top Stories

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


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