The SCOTUS has recently decided to hear an appeal to consider whether junior mortgage liens, which are out of the money, on chapter 7 debtor’s homes may be voided simply because there is no equity in the home to attach to the junior lien at the time of the bankruptcy filing.  The effect of a win by the debtor would be to permit bankrupt individuals to wipe out junior mortgages in chapter 7 when the senior lender’s lien debt is greater than the value of the home.

home underwater

In bankruptcy, a secured creditor’s claim is considered to be bifurcated for the purposes treatment under a plan (see chapter 11 or 13 usually).  More simply, when the secured claim exceeds the value of the collateral, the secured claim equals the collateral value and the portion of the debt above the collateral value is considered to be unsecured.

In a chapter 13 bankruptcy case (an individual’s version of chapter 11), some secured claims may be stripped downie, the secured portion is reduced to the collateral value.  Similarly, in chapter 13, junior lien holders who’s debt is behind a senior lien debt which is greater than the collateral value may be stripped off (rendered unsecured entirely).

In chapter 7, there is no plan treatment, and thus the distinction between debt is trumped by the general rule that a lien rides through bankruptcy, and thus – regardless of the valuation of the collateral – the secured lender is entitled to its entire secured claim against the property.  The debt is generally not enforceable against the individual, through, after discharge.  The SCOTUS has ruled in the past that a chapter 7 debtor may not strip down a lien.

However – the code section that provides for the distinction between the secured vs. unsecured portion of the debt also states that the lien of a purported secured creditor is “void” if the underlying claim is not an allowed secured claim.

Here is the issue:

  • A couple of chapter 7 bankrupt debtors in Florida have claimed that a junior lien which is junior to an already underwater senior lien is not a “secured creditor” and thus has no allowed secured claim (ie, there is no secured portion of the claim).
  • Thus – they argue – the second lien on their residential mortgage is void under the law because it is not a secured claim.

The Bankruptcy Court agreed with this argument over the objection of Bank of America, who is the junior lien servicer/holder.

BofA, seeing that this might be a little bit of a nationwide issue, promptly appealed two of the rulings to the SCOTUS, which has not yet heard the appeals.

The effect on residential lenders will be a little different depending on their respective position in the lien stack:

  1. The issue to be determined is of some consequence to senior lien holders because, if the junior lien is voided in a chapter 7 on undersecured collateral, the senior lien holder may have a little more flexibility in deciding whether to negotiate or take back the home.
  2. For junior mortgage holders, the issue is of greater consequence.  While the junior lien may have been out of the money at the time the bankruptcy was filed, the house may appreciate in value before the senior lender forecloses or the borrower sells.

Once the SCOTUS rules on the pending appeals, the ruling will affect the treatment of junior chapter 7 mortgage holders nationwide.

(As a side note, I missed last week’s post because I was in trial.  I would also like to thank the folks at Apple, Inc. for the traffic viewing the last post.  Swing by anytime.)

It is said that when the debtor files bankruptcy the debtor is in a fish bowl.  The reason is simple:  the debtor in bankruptcy is required to make honest and sworn disclosure of all manner of financial and operational information on request and at regular intervals per the bankruptcy code.  Often, new and exciting liabilities and obligations are discovered by the lenders when their borrower files bankruptcy.  The policy behind this is obvious.  Moreover, rarely does a debtor find itself in bankruptcy because it was too honest.  However, sometimes this statutory preference for sharing collides with the real need to keep trade secrets, secret.

Apple Fish Bowl

Many of you probably heard of the Apple, Inc. vendor who filed bankruptcy.  The vendor, who is GT Advanced Technologies, Inc. and affiliates, made the screens for Apple phones.  The bankruptcy filing made the news because of the stunning possibility that anything related to Apple could be in financial peril.

The screens are technically difficult to make, but Apple sold over 10 million IPhone 6 phones in the first week.  Compare that to reports of Amazon Fire Phone sales of 34 thousand after two weeks.

As it turned out, the sheer scale of endeavor was too much for GT.  Also, it turned out that Apple requires, what some may call, significantly one sided contract provisions.

Two of the many things the contracts between Apple and GT required were:

i.            Attempt to make a bankruptcy remote entity, and

ii.            Keep Apple’s secrets, secret.

As it turns out, it only kind of worked.

For confidentiality, Apple’s terms provided that GT would be liable for $50 million in liquidated damages for each occurrence of disclosure by GT of protected information.  The information protected from disclosure was extremely broad and included disclosing “the nature of their business relationship” and the terms of the contract itself.

For the bankruptcy remote entity, it filed bankruptcy also.  It was faced with the specter of the enormous burden of the liquidated damages, among other things.

In a typical bankruptcy, GT would be required by law to disclose many parts of the business relationship with Apple on a regular basis, typically monthly as well as the terms of the agreements.  The potential for liquidated is therefore large.

However, the wayward debtor is not without salvation.  The bankruptcy code also allows the Court to “protect an entity with respect to a trade secret or confidential research, development, or commercial information;…” upon request.

Piece of cake, right?

Nope. The Bankruptcy Judge in GT didn’t feel that the information provided to him under seal was worthy of protection – notwithstanding the $50MM liquidated damages – and ordered the majority of it to be made public.  So – the information that was provided to the Court to justify the secrecy was in turn simply filed on the docket for all to see after the Judge made the ruling.

If you were interested in the business relationship between Apple and GT and their sapphire screens, unprecedented attempt to meet demand and ultimate downfall – it’s on the docket.  I should note, though, when I checked there was nothing of a purely technical nature.  Thus, the ruling is more a bench mark for expectation of what may actually be confidential in bankruptcy.

For borrowers, this is clearly a difficult path to thread.  For investors, this is a cautionary tale of how to protect your value.  For lenders, this provides some backstop to the idea that all trade secrets will be secret in bankruptcy.  Of course, if the borrower’s income exists because of a trade secret and it becomes public, you might not be getting paid back.

In re GT Advanced Technologies, Inc., et al., case no. 14-11916, pending in the United States Bankruptcy Court for the District of Delaware

In an earlier posting, I reviewed the OCC’s new Commercial Real Estate Lending handbook .  The purpose of the handbook is to give parenting – I mean guidance – on risks inherent in commercial real estate lending.  On legal topics, the handbook takes a mind-boggling approach: it swings from legal light, to “I know it when I see it,” to neglect.   Even with this inconsistency, my main complaint with the handbook is that, with a few exceptions, it misses the opportunity to give bank examiners and lenders guidance on important legal topics.  Based on this, I give the handbook a gentleman’s C.  (One reader followed up with me, and gave it a D.)  As we all know, guidance often comes in a list (starting with your first “star chart” on the kitchen refrigerator). The OCC lending handbook needs a “star chart” on important legal topics.   In this posting, I’ll identify and list some of the legal topics that create risks in commercial real estate lending.  Of course, this is “not an exhaustive listing” – and you ou can add to the list (or chart) by commenting below. Topics in the list are not described in detail.  The value in the list is the indentification of some (but not all) of the more prominent legal issues, when little or no guidance is offered in the OCC Commerial Real Estate Lending Handbook.  The goal is NOT perfection – it simply is about being better. Fortunately, legal lists do not need to be created.  They are everywhere.  One place to start is by looking at topics covered by key legal education providers or by legal organizations at their annual meetings.  I’ll start with two of my favorites. At the annual meeting of the American College of Mortgage Attorneys, members (actually, “Fellows”) present papers and discuss legal issues of immediate importance to lawyers working on real estate finance transactions.  This is a top-notch group.  If they identify the following legal topics as important, then . . . this list is a good list.  Here are a few of the topics from the recent annual meeting (no priority order and with my comments in parentheicals):

  • credit enhancement tools: letters of credit (currently in disfavor); earnout provisions (stay away from subjective triggers); guaranty agreements (choice of law and service of process provisions are important); and master leases (you’re better off with a guaranty)
  • intercreditor agreements (never, ever use the “standard” form – craft it to the deal)
  • ground leases (approval of any changes to the ground lease by the mortgage lender)
  • golf course loans (a trap for the inexperienced; and be sure to include websites and other technology rights in the collateral package)
  • Islamic Shiriah loans (a trap for the inexperienced)

Recently, I’ve been speaking on legal technology at the University of Texas Law School’s Mortgage Lending Institute.  This annual seminar draws accomplished speakers on a wide variety of important real estate lending topics.  Again, here are a few of the topics presented at the seminar (no priority order and with my comments in parentheicals):

  • construction lending (lien waivers; payment and performance bonds; and full-funding conditions)
  • tenant subordination agreements (might not be needed if already addressed in the lease; lender will NEVER accept liability for anything arsising prior to lender acquiring full legal title to the project)
  • impact of oil, gas and other mineral interests (merely relying upon local drilling ordinances could be risky)

Every list, of course, should end with a statement that “this list is not an exhaustive listing.” In future postings, I’ll list other topics.  Right now you can locate other topics by using  the “search” function (near the top of the page) to look for information and my perspective on other issues. If you want to dig even deeper, “click” on the “Resources” tab (near the top of the page) for instructions on accessing Winstead’s on-line training and presentation materials. Again, use the comment field below to list some of our favorite topics.

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.

Provisions in commercial mortgage loan documents,  where a particular state law is “selected” as the governing law, can drive a deal into a ditch, and take a good (or growing) lending relationship into the emergency room.  In many situations, this topic is a good example of over-thinking, and perhaps over-lawyering.

  • Simply stated, which of these two thinkers gets it right on using (or not using) choice of law provisions in a typical commercial mortgage loan?

  The choice of law topic is a very intellectually rich subject for lawyers.  Much is written about it.  Entire books.  It is a class topic for an entire semester in law schools.  It is a wonderful topic for lawyers.  It “invites” debate and discussion.  And confusion. However, lawyers who go to war over the “choice of law” provision (in commercial mortgage loan documents) are the poster child for those who argue for simplicity in contracts, and who view lawyers as deal inhibitors, and as creators of all things complicated. My perspective is that in the typical mortgage loan, there is no legitimate reason for this provision to be the subject of discussion.  There is no “choice” in choice of law.  The approach should be simple –

  • the mortgage loan documents should be governed by the law of the state where the project (the loan collateral) is located

Here are a few reasons supporting the two perspectives on this: Choice of Law Should NOT be the Law of the State Where the Project is Located

  • Quality Control: Mortgage lenders need to know that their loan portfolio has consistent terms (subject to the exception below).  Thus, all of the loans should apply the laws of a single state.
  • Easier to Manage: Using the laws of a single state makes it easier for loan servicing to make decisions.
  • Exceptions (creation & enforcement):  Of course, local state law must govern the creation of liens and the enforcement of remedies.  So, the choice of law must always have this exception.
  • He (She) Who Has the Gold Makes the Rules:  The loan is the lender’s money, and if a borrower wants to use it, then the borrower simply needs to do as told – accept this approach and close the loan.  The lender must be obeyed (if the borrower wants the money).
Choice of Law SHOULD be the Law of the State where the Project is Located
  • Quality Control:  In our age of technology, surely “quality” can be controlled by smarter uses of technology (for collaboration, reporting, etc).  Keep a list.  Share it.  Also, legal opinions on choice of law provisions (that select the law of another state) can be very expensive.  Let’s not lose track of this important point: the lender needs to lend money; and if the choice of law provision inhibits the deal, or increases legal fees or mucks up the closing process and experience, then the result could negatively impact the Lender’s ability to handle future loans from the borrower, or from others in the local market.
  • Easier to Manage:  Again, we’re well into the information age.  Access to laws of the 50 states is not difficult.  Collecting and sharing information about state law should not be a problem.  Again, let’s not get side tracked . . . the lender needs to lend money.
  • Exceptions: if and when the loan goes bad, taking the “exceptions” approach (where one state’s law governs some topics and another state’s law govern other topics) injects a level of complexity into an “already” bad situation.  Dealing with a troubled loan is difficult, and now it becomes even more challenging because the lender, the borrower and then the courts must become experts at implementing the choice of law provision.  Indeed, how is injecting this complexity a “good” thing?   Will a court handling the case correctly apply the law (as selected under the loan documents)?
  • He (She) Might Have the Gold But . . . No One Wants It:  Again . . . the lender needs to lend money.  Also the market understands that our system of governance allows States to have differing laws.  So, “why” should a lender try to “unify” them in a lending platform?  Does the market actually reward a lender for doing so?
Selecting the laws of the state (for all topics) where the project is located just makes sense.  And cents.
A simple thought.
Please share your thoughts below.

       

Lenders are refreshing their mortgage loan documents with provisions based on the “lessons learned” during the recent (continuing?) economic experience.  One change is to add a service of process provision. The change is based on this basic lesson learned: when the tough times hit, borrowers and guarantors sometimes are hard to find. A few simply disappear behind gated communities, on yachts, or regularly move from one remote estates to another – maybe intending to make it difficult for the lender to give them required legal notices of litigation or foreclosure (referred to as “service of process“).

Hide and Seek – in style
Or maybe this simply is a desire to get away from the stress of it all – leave the train wreck (1913 State Fair Trains Collide) for the lawyers.  Or perhaps just a final surrender to the wanderlust whisper. In response, many lenders now bake into their loan documents a provision where the borrower (and the guarantor) agree that legal notices (or service of process) will be given to a designated person (or company), who will accept those notices. So far, I haven’t had a borrower object to the provision. If you’re tired of spending money and wasting time in an adult version of hide and seek (or simply not wanting someone to do what you can’t do), then consider adding a service of process provision in your standard forms of documents for:

For other “lessons learned,” click this link (or use another search term). If you have comments, or your own suggestions, please comment below – then board your yacht or follow your wanderlust.

Acceptance by commercial real estate lenders of a partial payment in full satisfaction of the loan (as a “discounted payoff” – a “DPO”), prior to the maturity of the loan, is a topic that receives little “public” attention.

Here are a few reasons why we hear so little about this topic, and the challenges in actually paying off a commercial real estate loan at a discount (prior to maturity):

  • Confidentiality: many payoff agreements require the borrower and the purchaser (if different from the borrower) to NOT disclose the payoff
  • Segmented lender market: not all lenders are alike (life company; CMBS servicer; bank; mortgage REIT; etc.), and each type of lender has different regulatory constraints.  So, there is no “one size fits all.”  And, even within each lender type, each lender has its own balance sheet, loan allocation and credit policy limitations
  • Debt stack: the existence of multiple debt layers, and a debt holder who might not be “happy” with the payoff amount offered to it.  Complicated debt structures make a discounted payoff very, very difficult.  Indeed, combine this point with the second point (the “wrong” lender), and  . . .  difficult can be impossible

A DPO could be a sound business decision for a lender.  For example:

  • Accepting less than full payment on the loan could be a better economic decision than incurring the costs in exercising remedies, and then owning, reviewing and managing property (often called real estate owned or “REO”)
  • The  loss incurred by the lender (by being paid less than the full loan amount under the DPO) is less than “loss” of capital caused by the loss reserve for a bad loan on its books (bad loans are also referred to as “impaired” loans).  Impaired loans trigger increases in a capital reserves, which for some types of lenders (such as life insurance companies and the “mortgage experience adjustment factor” [or MEAF]) is an amount well in excess of the loan amount
  • Impaired loans generate intensive management reviews (another cost)
  • A DPO can close quickly and efficiently, typically much quicker than a deed in lieu of foreclosure
  • If lender is in sound financial conditions, and already has recognized the loan loss, the quick loss inherent in the DPO is a non-event

In a future post, I’ll cover some of the details in a DPO.

If you have other thoughts or experiences in this, please comment below.

 

It’s always good to have the “big picture” in one hand as you deal with the troubled loan with your other hand.

Previously, we’ve touched on preliminary tips and steps, and even some tips on the “art” of dealing with a mucked up deal and with “less than friendly” people – and don’t overlook the glossary of terms.

In addition to the “decision tree” laying out a typical “time line” or process of a distressed commercial real estate loan, here is a short check list of topics that a lender or servicer might consider as elements of a successful modification to the loan:

  • add lender rights or remedies (including addressing new laws or court decisions) (look at the “market trends” topic on the right side of the page)
  • waivers of claims and defenses (including disclaimer of any interest in reserves or escrow accounts)
  • new reporting requirements (“flash” reporting on a monthly basis)
  • changes to lease approval rights, location of tenant security deposits and tenant letters of credit
  • new or additional collateral, including direct deposit of rent by tenants into a lock box account controlled by the lender (or servicer), and new reserves or escrows (for tenant finish and leasing commissions on future leases, for capital repairs, and for debt service)
  • new recourse events and even new guarantors – and eventually, making the loan full recourse and with a full payment and performance guaranty
  • direct reporting by the property manager and leasing agent to the lender (or servicer), with tougher approval standards on the part of the lender (and servicer) (including the ability of the lender to require the replacement of the manager or agent)

If you have other items to add to this list, please comment below.

 

Train wrecks draw a crowd.  Look at this old film from the 1913 California State Fair (click the text).
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Unfortunately, many co-lender structures (secured by distressed commercial real estate) look exactly like this train wreck.
 
 
 
Why?
  • Some lenders used a co-lender agreement without considering the basic nature or perspective of the agreement – whether the form was “pro-buyer” or “pro-seller”
 
Co-lender agreements contain different approaches and terms depending upon the perspective or desired result of the party with the negotiating leverage.  On numerous, fundamental topics, a pro-buyer agreement heads in a different direction than a pro-seller agreement.
 
 
 
Each type of agreement (or different perspective) is a different train track. By not recognizing that a different colender agreement should be used if you were selling or buying interests in a loan, some lenders simply boarded the first train (i.e., the first or only form in the file) without asking the conductor (i.e., a lawyer or someone with some expertise) “where “the train was headed.
 
 
 
Sure, there were pressures at the turnstile to quickly buy the loan.  We all heard the “if you don’t buy, there’s a long list of people behind you who will buy.”
 
 
But I’m focused on sellers who used the wrong form.  Lenders who took the attitude of “I use this form when I buy, so it should be acceptable to my buyers.  I need to quickly sell this loan interest.”
 
 
This is an untold subplot of our larger CREF liquidity pile up.  It is the tangled mess of many commercial real estate, colender structures (from participations to syndications of the loan).
 
 
It is part of the answer to these questions:
  • Why is the colender group having so many problems in making decisions when the loan is under distress?
  • Why the delay, from the co-lender side, in resolving a distressed loan when the borrower has a perfectly acceptable solution?

The delay might be more basic than lenders with different balance sheets and different regulatory environments. Some lenders treated the colender agreement as if it was a LSTA form (which are used in trading loans not secured by commercial real estate). Unfortunately, LSTA standardization does NOT exist in the world of commercial real estate finance.  There is no recognized “one size fits all” form of co-lender agreement in commercial real estate finance. Yes, this one falls into the “lessons learned” category. But unless and until you bake this lesson into the core knowledge base and process of your organization, the train wreck will be repeated at the next commercial real estate downturn. If not, we’ll all stand around and watch the train wreck. If you have a comment or a story to share with us, please post it below.

So much of dealing with distressed commercial real estate is an “out of the box” experience. But my use of the phrase “out of the box” is extremely nuanced:

  • change your thinking; and
  • change the box (the property), too.

Here’s an approach that goes out of box and then reverses field to “remake” the box – Bob Burton at Common Interest 360 has an interesting thought for increasing the value of under-valued improved real property, whether ownership still is with the borrower or is with the lender (or servicer) after a foreclosure or deed-in-lieu of foreclosure:

Sure, this approach is tied to:

  • local demand for specific uses
  • the physical andor operational attributes of the property, and
  • it probably includes spending money to make changes to the property itself or to building services (such as HVAC, etc.)

So, this “out of the box” by “remaking the box” requires some creativity. But, what’s “new” about creativity in dealing with distressed commercial real estate? However, if parts of the property could be put to a different use (turning it into a “mixed use” project), yet these parts share basic structural components or building services, then it is simply smart to consider a condominium structure. For example, if there is a demand for traditional office or medical office, could the second story retail, or the rear of the shopping center be converted into those uses; and would converting ownership of that area be more valuable if it was a separate ownership structure?  In other words, make these areas into a “medical office building” but clothed as a separate condominium unit; with the balance of the project being a separate retail condominium.  Create a condominium structure with two units: retail unit; and a medical office unit. The result could be new value – indeed, a present of sorts.     Take a look at your property. Then wander over to Common Interest 360, and consider subscribing to it. Kudos to Bob.  He gets it. If you have any comments or questions, please do so below.