Good Times for Lenders

On occasion I have thought that a chapter 11 bankruptcy case is somewhat analogous to a trip on a plane in a few ways. Among other analogous events, consider checking a bag and then forgetting to pick it up on the conveyor belt after the flight lands. It would be easy enough to do – as the bag is riding in the cargo hold, perhaps it was simply forgotten.  If that has ever happened to you, it likely you went back to pick up the bag from the airport.  On the other hand, in a chapter 11 bankruptcy case, if the debtor-in-possession doesn’t pick up all of its assets when it exits bankruptcy, it will lose them forever.

luggage

To understand how a cause of action could just go away after plan confirmation, it is helpful to understand the legal distinction between the original entity which filed bankruptcy and the debtor-in-possession, or DIP.

I. The Bankruptcy Estate is Something Separate

When any bankruptcy case is filed, an estate (not unlike a trust) is immediately created and all of the assets of the entity are immediately and automatically transferred to the estate pursuant to the bankruptcy code.

  • When the bankruptcy case is filed as a chapter 7 liquidation, a 3rd party is appointed to manage and liquidate that estate for the benefit of the creditors.
  • In a chapter 11 reorganization bankruptcy case, the estate is usually managed by the filing entity- the DIP, which is given possession of the estate to administer for the benefit of the creditors.

As a practical matter, a typical chapter 11 bankruptcy case looks like business as usual by the debtors prior management, but legally, the debtor is acting as a trustee over the bankruptcy estate which was created upon filing.

The distinct, but parallel, existence of the estate from the DIP is important when considering the effect of confirming a chapter 11 plan.  When a chapter 11 plan is confirmed, one of the effects is to re-vest assets into the debtor who will then operate under the plan going forward.

The rub is: anything that is not transferred out of the estate to the debtor does not belong to the debtor.  This is where the cause of action issue comes up.

 II. Take it or Leave It

A cause of action (or perhaps an affirmative defense) is an asset of the debtor before filing bankruptcy and it remains so during bankruptcy.  As an asset of the estate, it must be transferred under the plan to the debtor in order for the debtor to use it after confirmation of the plan.

Among others, the Fifth Circuit has held that if a cause of action is not specifically and unequivocally reserved and transferred to the debtor post plan confirmation, it will not belong to the debtor post confirmation.

More simply, if the confirmed plan does not sufficiently identity a cause of action which will leave the estate and be given back to the debtor after plan confirmation, that cause of action functionally disappears.  So, if the DIP doesn’t take the cause of action, it leaves it.

III. The Recent Case

The recent Rossco Holdings v. McConnell case in the Fifth Circuit provides a good excuse to write about the topic.  The opinion was entered last week.  In the case, post-confirmation chapter 11 debtors sued their alleged attorneys for malpractice in connection with the bankruptcy case.

The attorney/defendants moved to dismiss the lawsuit asserting that the confirmed plans of the plaintiffs did not transfer the causes of action from the DIPs to the debtors after confirmation. Therefore, the plaintiffs would have no right to bring the lawsuit.

The Fifth Circuit agreed and affirmed the dismissal of the lawsuit because the plaintiff/debtors did not specifically enough transfer the claims back into the debtor from the estate and therefore they no longer existed.

IV. Things to Consider

 The first thing to consider if you are a lender, is that if you are being sued by a post-confirmation debtor you should review the plan to see if the plan properly transferred the claim from the estate into the post-confirmation debtor.

Additionally, the opinion also denies a couple of the plaintiffs’ arguments simply because they were raised too late in the proceedings – particularly with regard to choice of law.  In short, the plaintiffs attempted too late to argue that 9th circuit law (which is more favorable for the plaintiff than 5th circuit law) applied and thus waived the argument.

In summary: All of the assets of the pre-bankruptcy debtor are along for the ride once in bankruptcy.  However, if a cause of action is not properly transferred by the DIP to the debtor upon exit, that cause of action will not belong to the post-confirmation debtor.

The opinion is here.

A good piece of advice I once received when I was younger was: “Don’t write an email you wouldn’t want copied to the cover of the New York Times”.  In the past, it would take days of depositions in a lawsuit to get a handle on what someone said or thought to prove a legal point.  Now, emails (combined with searching techniques) can provide a first person narrative usually by people who have no inclination their email conversations will be exhibits in an unexpected and un-filed lawsuit.  Sometimes, and entire lawsuit comes down to one email.  That was the case in a recent 5th Circuit opinion.

 

Credit: Unknown
Credit: Unknown

The Lawsuit

The lawsuit itself is fairly interesting if you follow the litigation surrounding the WaMu collapse and takeover by JPMorgan Chase Bank.  The lawsuit concerns a developer who was contracted by WaMu (pre-takeover) to acquire land, build a WaMu location and then rent it to WaMu for 20 years.  Prior to acquiring the land but while the developer was under contract, WaMu was taken over by the FDIC.

There has been significant litigation concerning the WaMu leases since the takeover and assignment to Chase which I don’t intend on getting into here.  In fact, the lawsuit is worthy of its own blog post for those of you interested in this “obscure but heavily litigated” matter (as the 5th Circuit put it).  Among one of the more interesting holdings is that the FDIC can be held liable for negligent misrepresentation because “it is reasonable to rely [on the statement] when the federal agency which oversees the banking industry…tells you that your banking lease may be lawfully rejected”.

The Email

In any event, the purpose of this post is to illustrate that a lawsuit and its appeal can boil down to one single email.

The email in question was sent by an executive of the developer to Chase requesting that the lease be rejected quickly so that the developer could cut its losses and be done with it.  The developer, having relied on the FDIC’s representation that the lease could be rejected, believed that rejection was the only outcome.

As it turns out, the FDIC was wrong.  In fact, the agreement between WaMu and the developer was assumed by Chase. When the developer figured it out, he sued Chase for damages for breach of contract (as opposed to being stuck with nothing when the FDIC repudiates a lease).

In the 5th Circuit opinion, the Court of Appeals quotes the email directly five times in support of its holding that there was not mutual termination, which was one of the two issues on appeal.  (The developer won the appeal).  There is no other evidence directly cited by the 5th Circuit to support its holding.

In short, the entire case has now been determined based primarily on one email an executive sent out in the ordinary course of his day.  There is no legalese in the cited portions of the email.  In fact, the executive didn’t use the proper legal terms for what he was requesting from Chase and the FDIC.   I haven’t spoken with the executive, but I think it’s a safe bet that he did not write the email thinking the 5th circuit’s opinion would one day turn on a few quick sentences.

The take home lesson here is likely already known by everyone reading this.  You have no doubt heard this over and over again.  Don’t write an email you would not want to be public.  This post is to illustrate that even the most mundane of emails may win or lose a lawsuit you have no inclination will be filed.   In short, you never know when your last email will be the one pasted into a Federal Appeals Court opinion.

Central Southwest Texas Development, LLC v. JPMorgan Bank, NA, et al., case no. 12-51083, pending in the United States Appeals Court for the Fifth Circuit.  Opinion Entered March 2, 2015.

If you are anything like me, you enjoy discussing bankruptcy and litigation issues at social gatherings.  It’s basically like being the Most Interesting Man in the World , except the opposite of that.  Or, at the very least it will end a conversation with someone you didn’t want to speak with. With that in mind, below I have compiled the first annual Cocktail Party Talking Points.  Please use them as you see fit.

RetroCocktailParty

The Energy Bubble.  With the Saudis keeping the pedal to the metal on production while the US is in the midst of an energy boom, the cost of oil and gas has tanked.  With margins burning off, the E&P firms who had been surviving of cheap liquidity may be in for a correction.  Read about it on Bloomberg.

Radio Shack is still Kicking Along.  The beleaguered tech retailer Radio Shack continues its attempt to not default on its various lines of credit and stave off bankruptcy.  As it attempts to cut $400MM annually from the budget, the retailer must obtain lender consent to close stores.  Meanwhile, the company’s credit default swap spread is at 144%.  Read about it on CNBC.

East Cleveland Considers Bankruptcy.  The city of East Cleveland, which is a suburb of Cleveland, is “on the verge of collapse” according to the Ohio state auditor.  While the city is relatively small, the emergence of another municipality on the brink of bankruptcy is a reminder that municipalities are still in trouble and the economy has been slow to work through their financial issues.  The city will decide whether to file bankruptcy in Q1 2015.  Read more about it on Reuters.

The Fed Ups the Capital Requirement for 8 Largest Banks.  Under the new Fed guidelines, “the eight largest U.S. banks would need to have an additional capital buffer of between 1% and 4.5% of their risk-weighted assets, based on the relative threat a bank poses to the financial system as calculated by the Fed.”  According to Janet Yellen, this rule “would encourage such firms to reduce their systemic footprint and lessen the treat that their failure could pose to overall financial stability.”  The biggest impact is expected to be on JP Morgan which faces an apparent shortfall of $21B.  Read more about it on the Wall Street Journal.

That Argentina thing is Still Going on.  Earlier this year, Argentine defaulted on bonds governed under US law and has been embroiled in lawsuits both before and after.  It’s still going on.  To further its troubles, Argentina made a bond offering under is local laws and raised about 10% of the $3B being offered.  Notwithstanding, the Argentina Economy Minister presented the participation as evidence of investors’ confidence in Argentina.  Read more about it on Bloomberg.

And finally, a palette cleanser…

California Family Judge gets mean.  In California, ex-state family law judge Healy was admonished (which is a sever finger-wagging at in legal speak) for telling a mother accused of drunk driving that she didn’t “understand the beatdown that was coming…”.  After discussing the drug and alcohol use by the husband and wife, the Judge wondered aloud if “they’re trying out for Jersey Shore.”  The Judge summed up the wife as a “total human disaster”.  Finally, in another hearing, the Judge informed the mother that her daughter would no doubt end up as a “hooker” based on the mother’s attitude.  Formal document is here.

Have a happy and safe holiday.  Look for my next post in January 2015.

Over the last few weeks, I’ve commented on the new version of the OCC’s Commercial Real Estate Lending Handbook (I give it a gentlemen’s C); and I listed a few legal topics that deserve some guidance from the OCC. “Guidance” could even merely be a list of important topics (ending with a warning that the list is NOT an all-inclusive list). I expect legal issues to be identified and put on the “check the box” list by the OCC  – with the banks expect to check the box. The "Blank" List   Unfortunately, instead of leading the class by at least listing legal issues associated with risks in commercial real estate lending, the OCC implicitly affirms those banks that under value and under utilize legal counsel.  (Let’s resist the temptation to comment on “why” this takes place.) Fortunately, some banks are very good at identifying and monitoring legal issues. Several of them do this by a simple two step process:

  1. List key legal provisions in loan documents
  2. Instruct legal counsel to report, in writing AND PRIOR to closing, if these provisions are altered

Here is a sample list (it is NOT an exhaustive or all-inclusive list):  legal counsel must report (in writing) any changes, from the bank’s standard form, in loan document provisions that cover the following –

  • grace period, late charges and default interest
  • prepayment, lockout and yield maintenance
  • transfer restrictions (due on sale) provisions
  • subordinate financing (due on encumbrance provisions)
  • material deviations in, or deletions of, the remedies provisions (unless required under the governing law of the state in which the collateral is located)
  • recourse provisions
  • environmental provisions
  • taxes and insurance premiums escrows
  • any reserves or other escrows
  • granting clauses or form description of collateral contained in such granting clauses (unless required under the governing law of the state in which the collateral is located)
  • casualty or condemnation provisions
  • addition of a provision allowing a release of collateral (unless expressly provided for in the credit approval)
  • lender approval process relating to amendments, renewals or termination of major leases (or new leases)
  • cooperation provisions, including use of any future technology required by lender (such as on-line reporting and delivery of required materials and information)
  • WARNING: __________ [this list is not “all-inclusive” and you should revise it as needed]

My suggestion is that every bank (or other lender) take this approach.  Surely at some point, the OCC will view this simple approach as a key to safe and sound banking practices. Please share you comments below.                

Last month, the Office of the Comptroller of the Currency published the Commercial Real Estate Lending handbook (August 2013).  The 128 page handbook gives guidance to bank examiners and bankers on risks inherent in commercial real estate (“CRE”) lending.  It replaces a 95 page version published in 1995 (and revised in 1998). For this new school year and since commerical real estae lending is increasing in the “recovering” economy, I expected the OCC’s CRE lending handbook to grade-out with an “A+.” Instead, it is a solid, gentleman’s “C.” Make that a fraternity “C.”

Your Company is in this picture, too!
And probably make that a “C” for your company, too.   Like the OCC’s handbook, in many companies there is a disconnect or chasm between the business platform and legal issues undergirding the platform.  The “C” grade is NOT limited to the OCC and the banking sector. The OCC’s Commercial Real Estate Lending handbook takes an inconsistent approach in the role or importance of basic legal issues as a subset of risk management.  The approach swings from:

  • “legal light”: a few topics list legal issues and mention lawyers, but the topics are limited in number –
    • in the context of environmental risks,  handbook lists specific legal issues (p. 71)
    • the term “counsel” appears 5 times:
      • in the review of (ground) lease documents  (p. 53)
      • in assessing environmental risks (p. 70)
      • in the review of loan docs and other agreements “to determine if the improvement” comply with applicable laws and restriction (p. 104)
      • in the review of takeout agreements (p.107)
      • in the review of completion insurance bonds (p. 108)
  • “I know it when I see it – but you have to guess what I see”: some topics include the use of the phrases “legally bound” and “legally enforceable,” but with no guidance on “how” an examiner or banker is to verify or arrive at these legal conclusion (assuming the examiner or banker is not an experienced commercial real estate lawyer) –
    • what do these phrases mean or require?  They are not defined in the Glossary (Appendix C). Are legal opinions required? Does this require hiring a lawyer? If “yes,” this sidesteps the reality that most Companies are seeking ways to spend LESS money on lawyers.
    • similarly, the handbook contains references to “appropriate” loan documentation and “loan documentation policies.”  Again, what do these phrases mean or require?  Broad generalizations give no guidance on loan document provisions, and are not helpful in addressing or mitigating risk.
  • neglect: most topics simply do not include any reference to anything legal –
    • maybe for purposes of the OCC handbook, legal issues simply are outside the scope of the OCC handbook.  If this is the OCC’s approach, then legal issues should be disclaimed, with no mention of legal issues.
    • one of my problems with this “neglect” approach is that it denies reality.  Legal issues are part of the DNA of safe and sound lending, and risk management.  Banks and the OCC acknowledtge this by spending millions of dollars on legal services.  Indeed, guidance might even help to control legal fees.

My expectation was that the handbook would give lists of “no” change provisions, or a list of legal topics that need to be addressed (with the ability of a bank to explain any deviation from the provisions or list). Clearly, either I misunderstand the uses of the handbook, or the OCC missed an opportunity to give more meaningful guidance. Perhaps the gentleman’s “C” is too gentle. In future posts, I’ll describe a few of my favorite “no-no change” provision, and give an overview on current legal topics covered at several recent seminars. Please post your comments and perspectives below.

The July 2013 issue of the “Mortgage Banking” magazine focuses on the Consumer Financial Protection Bureau (or “CFPB”).  The coverline  is this: “CFPB – A Powerful New Overseer.” Why my interest in this issue and coverline? In the past, commercial lenders (and their lawyers) blissfully ignored anything involving consumer lending.  We quickly distanced ourselves from any meeting involving discussions of consumer loan documentation, compliance audits, data collection (and access), and the byzantine consumer lending regulations. Residential lending was . . . but not really . . . but really . . . the “other side” of the lending family. This is changing. The residential obsession (on rules, lending policies, data collection and compliance inquiries) will radically change commercial lending.  It is more than a shadow on the wall. In every industry meeting attended by me in the past year, anticipating the impact of the CFPB upon commercial lending is a top-tier topic.  Although not a formal agenda item, the discussions are not “if” this will occur – the discussions are “when?” Leaders (on the commercial lending side) are anticipating the need to adopt some of, if not mirror, the CFPB requirements.  This will require new lending rules and lending policies, with requirements for expansive loan level data, rich data  mining and new compliance policies and procedures – with the ability to alter procedures and generate “new” reports upon demand (or at least quickly). Here are some of the drivers behind extending CFPB principals to commercial lending:

  • Other governmental authorities and industry regulators will perceive value in the CFPB approach (“since they’re digging into this on the consumer side, why aren’t we doing the same on the commercial side?”)
  • Investors will demand similar treatment (“why can’t the commercial side have the same focus on policies, rules, loan level transparency, and all that stuff – which we’re paying for”)
  • Supporting technology tools already are available (“what’s so hard about modifying these new tech tools for commercial investments?”)

No one questions whether the shadow is real. The focus is “when” will the shadow push the residential table into the same room as the commercial table. (Or maybe it’ll be the other way around.) No more distancing ourselves from Cousin Eddy – we’re going to eat a lot of meals together. Please post your comments below.  

In many cities, urban growth now fills the farmland that once surrounded Navy and Air Force airfields.  Real estate development and finance near Navy and Air Force runways, however, requires special attention to a special set of restrictions called “AICUZ.”  These Department of Defense regulations severely restrict land located near military runways.  It is easy to overlook (or overfly) them in your review of real estate title, because they sometimes are implemented as zoning restrictions – and typically not expressly listed in the real estate title commitment or report. Think of AICUZ as “stealth” or hidden restrictions on the development and use of real property. As an Air Force brat, I literally lived under the sights and sounds of the F-86 Sabre, the F-101 Vodoo, the F-4 Phantom and the B-52 Stratofortress, with an occasional U-2. They were LOUD, but as Air Force brats, we barely noticed them.  (Ok, you always stopped to watch the U-2s).  (And yes, since Dad worked in base ops, I did sit in the cockpit of a U-2.) However, we did stop one day when the sound of an approaching F-101 didn’t have the usual rhythmic pulse.  The sound stopped us as the bird wobbled overhead, and then over the ridge line toward the runway. Almost immediately after the plane disappeared (on what Dad called “final approach” to the runway), the pilot popped up over the ridgeline (sitting in his seat), his parachute deployed, he lifted off the seat, next came a muffled explosion, and then a black cloud.     In a few minutes, a helicopter raced toward the spot where the parachute disappeared. We jumped up and down – we were part of the action!  Of course, no one believed any of this the next day at school. Today, reviewing title as part of financing a project will never has us jumping up and down – unless you fail to discover the AICUZ restrictions associated with the neighboring military airbase. Here’s how the City of Virginia Beach describes AICUZ: “The purpose of the AICUZ (Air Installation Compatible Use Zone) Program is to protect the health, safety and welfare from noise and hazards through compatible development in the airport environment. The program was instituted by the Department of Defense to address the problem of land development surrounding military air installations. It provides for the development and implementation of a plan to determine those land areas for which development should be significantly influenced by the operation of the airfield. These land areas are then designated as the AICUZ for that installation.” This depiction of the AICUZ south of the runway (at the Joint Reserve Base) in Fort Worth will help you understand the impact of an AICUZ: Fort Worth AICUZ at Joint Reserve Base (Thanks to Elizabeth Solender for bringing the Fort Worth AICUZ to my attention.) Next time you’re dealing with real property located near a military airfield, don’t overlook AICUZ restrictions. Missing AICUZ restrictions could be a “hard landing” for the profitability of your project. It could even turn the investment into a ball of smoke. If you have experience in dealing with AICUZ restriction, please comment below.

Most commercial real estate loan documents give meaning to the phrase “real estate is old as dirt.”  Why? Because just as dirt doesn’t change, commercial mortgage loan documents largely ignore the impact of technology on the physical attributes, use and operations of the property.   Take another look at your mortgage loan forms with these questions in mind, and ask yourself if the forms are “as old as dirt.” My bet is that you won’t like the answers to the question.  (Yes, it’s even embarrassing.) Do your mortgage loan documents cover:

  • third party (or “cloud”) documents storage?
  • require lender consent to any use of electronic (eSign) documents with tenants and vendors?
  • address use or surrender of internet or social media tools (such as websites, Facebook, etc.) upon a loan default?
  • turnover of hardware and data used in the operation of the property?
  • due diligence (check list items) on technology contracts used in the operations, marketing or leasing of the property?
  • continuation of these contracts following foreclosure (or deed in lieu)?
  • what kind of new defaults and remedies are needed?
  • annual listing of technology contracts and third-party services?
  • using e-mail as a permitted method of giving “notice?”
  • require a borrower to cooperate if and when lender implements new technology tools (such as online reporting)?

Of course, this is not an exhaustive list.  My list seems to grow every few weeks. I recently spoke on this topic at the Texas Bar Advanced Real Estate Drafting Course, and later this summer, I plan to do a webinar series on this topic. If you have questions to “add,” please comment on them below.

The combination of 4 speaking engagements and working on 4 new (or revived) lending products buried me during the last several months.  Fortunately, I’ve navigated the course, and it is a new year.  It is time to take a look back at 2012, and step out with some comments on 2013. New commercial real estate lending started to come back in 2012.  Finally. Here are my observations on the distinctive attributes of this come back, and my prediction of what it will look like in 2013: Lessons from 2012:  

  • Tough Love: Loan documents are longer, and tougher.  Lessons learned from the tough times now are included in many base commercial real estate forms.  (I’ll comment on these in the future.)
  • Rose Colored Glasses: Unfortunately, the “return” of lenders (and liquidity) to the market and the expectation of borrowers looks like this – a train wreck.  Parked in the workout group during the tough times, loan originators return to loan production with fresh memories of tough loans characterized by inadequate underwriting, bad documents and inadequate personal liability.  On the other hand, the strongest borrowers are flush with cash and are willing to place it into the project, with the expectation that the lender will reward the wise decision with reasonable terms and limited personal liability.  These different perspectives collide during negotiations of the loan documents.  It is not pretty.
  • Fewer and Newer:  In comparison to 2007, there are fewer lenders in the market.  However, many “new” lenders are entering into new commercial real estate finance markets.
  • Something for Almost Everybody:  Yes, some real estate products remain tough to finance (office, retail); but over the last half of 2012 I worked on a broad range of commercial real estate –

– unsecured (registered) notes to a regional grocery chain – forms for a new (production) single family builder program (multiple states) – construction loans for senior living projects (multiple states) – permanent loans (multiple states) (office and retail)

Prediction for 2013  

  • More of the same.  Not flood waters more; but a steady, gradual improvement.

Over the next week, I’ll comment on my 2012 experience with distressed commercial real estate, and then the growing (and latent) impact of technology on investing in (and working with) commercial real estate. I hope that 2012 found you improved over 2011. Happy New Year.  

As commercial real estate lenders, life insurance companies have a unique approach on dealing with potential losses or loan loss reserves in their mortgage loans holdings.  Unlike bank mortgage lenders, who apply their risk based capital requirements on a loan level basis, life insurance companies use an approach that applies at the portfolio level (called the “mortgage experience adjustment factor” or “MEAF”).   In 2013, this probably will change – and life insurance companies will use a “loan level” approach.  This should give more liquidity to the commercial real estate market.

Bad loans go to the penalty box
MEAF takes a mind-bending approach in determining the amount of capital that must be set aside (as a loan loss reserve) for a bad commercial real estate loan.  Under MEAF, loss reserves are based on a formula that “includes a moving eight month moving ratio of company to industry experience with minimum to maximum limits.”  (Instructions for Life Risk Based Capital Formula (MEAF) risk based capital).  This comparison of company losses to the industry means that a few of bad loans could generate (via the formula) a total loss reserve well in excess of the actual losses from those few bad loans. This plays out as follows (and has been the story for life company holdings of commercial mortgages over the past few years):

  • they avoid recognizing defaulted commercial real estate loans
  • they hyper monitor loans in tough markets and over the last couple of years prior to maturity
  • for loans that could go into default, or be tough to refinance at maturity, life companies will sell the loan PRIOR to either event – even if the sale is at a loss (i.e., not at par)
  • recognizing that the MEAF approach has a draconian effect, the NAIC set floors and ceilings on the MEAF formula during 2009-2012

Why the incredible low number of defaulted loans on the part of life insurance companies in recent years?  MEAF is part of the answer. The suggested approach will be similar to the process used to assign capital charges to corporate bonds. With cost of funds for banks at an all-time low (i.e., zero and almost zero), it will be interesting to see  whether this change (if it is passed by the NAIC and adopted by the states) will at least partially level the playing field for life insurance companies, as they compete with banks for the best commercial loans.  At the very least, it could level the playing field at the investment committee in a life insurance company (as mortgage lending competes with corporate bonds for investment allocations).  And it could mean more liquidity for the commercial real estate market. It also will mean the “end” of the “deals” for those who have been buying these loans from life insurance companies. Please share your comments and perspective below.