Tough Times for Lenders : Financial Services Lawyer & Attorney : Winstead Law Firm : Finance, Banking, Bankruptcy

(This is the second posting in a series on this topic) (first posting)

Now that the United States Covered Bond Act of 2010 (H.R. 5823) is out of committee, covered bonds are attracting interest of the broader financial services community.  I view covered bonds as a "must have" product for the US commercial real estate finance market.

So, more of you are asking . . .

Can you give me a quick description of covered bonds?

Brief Description: A covered bond is a recourse debt obligation of the bond issuer (where the bond issuer\original lender has a continuing interest in the performance of the loans), which is secured by a pool of assets (such as commercial mortgages). The holders of the bond are given additional protection in the event of bankruptcy or insolvency of the issuing lender: the pool is NOT included in the bankruptcy or insolvency action.

Moody’s Summary of Covered Bonds: While Moody’s has been covering EU covered bonds for years, it  has not attempted to educate the US investor market on covered bonds. Recently, however, it issued a short (5 pages), plain language, well-written guide to covered bonds.  Although Moody's “A Short Guide to Covered Bonds” appears to be available upon payment of a fee, the Covered Bond Investor gives us the subheadings in the guide:

• Covering the Continent Since 1789: A Default-Free Success Story by Any Name
• What Makes a Bond "Covered"?  - A Quick Course in Dual Recourse
• Benefits to the Covered Bond Investor
• Benefits to the Covered Bond Issuer
• How Covered Bonds Compare to Mortgage Backed Securities
• Covered Bond Risks and Moody's Rating Approach
• Four Main Drivers of a Moody's Covered Bond Rating
• Is the Time Ripe for U.S. Covered Bonds?

Clearly, Moody’s is getting the market “ready” for a covered bond product in the US – undoubtedly with an eye toward the passage of H.R. 5823.

Perry Hill Summary of the Moody’s Report: Edward Murphy at the Economic Legislation blog gives us a nice description of the typical attributes of statutory covered bonds. 

Here is his description of the four basic elements of covered bonds, when created by statute:

1. the bond is issued by (or bondholders otherwise have full recourse to) a credit institution that is subject to public supervision and regulation;
2. bondholders have a claim against a cover pool of financial assets in priority to the unsecured creditors of the credit institution;
3. the credit institution has the ongoing obligation to maintain sufficient assets in the cover pool to satisfy the claims of covered bondholders at all times (this is the "skin in the game" component that is the topic of some debate on the CMBS loan product); and
4. in addition to general supervision of the issuing institution, public or other independent bodies supervise the institution's specific obligations to the covered bonds. 

Other good resources exist for a description of covered bonds, including the Covered Bond Investor.

In the next couple of postings, I’ll cover some of the pros and cons of covered bonds.

If you have other helpful summaries of covered bonds, please post them below.

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Recall that on July 28, the US House of Representatives Financial Services Committee approved H.R. 5823, the “United States Covered Bond Act of 2010,” which now is on the floor of the House for a vote (but not yet scheduled for a vote). This means that legislation on covered bonds (H.R. 5823) is currently eligible for further consideration and a possible vote by the full House of Representatives in this Congressional term.

My perspective is that covered bonds will be an important and fundamental product for the much-needed, “new middle-tier” CREF lender position on the finance spectrum, as described by me in anther posting (see my “call” for this new group of lenders).

I've offered up at least 5 reasons “why” covered bonds are a viable structure and an important product for bringing liquidity into the commercial real estate market.

So, how can you “follow” H.R. 5823 and if passed into law, will banking regulations need to be changed?

How To “Follow” H.R. 5823?

The Internet and my favorite technology tool (Google Reader) make it easy to follow the legislation and to learn about covered bonds. Here are my suggestions:

• OpenCongress “collects” (or aggregates) news and blogs on H.R. 5823 at this link
• The Library of Congress tracks Bills at this link (simply search for H.R. 5823)
• Follow the Bill in your Google Reader (I give you instructions on "how" to set up Goggle Reader here)
• Closely follow sites like covered bond investor
• Purchase PLI's book on covered bonds
• Follow it here at TT4L

If Passed, Will Bank Regulations Need To Be Changed?

In addition to needing new legislation, implementing covered bonds will require change in some features of American banking regulations   The FDIC already has addressed this issue: covered bonds could affect potential recovery for the Federal Deposit Insurance Corporation (FDIC) when a bank fails. In 2008, the FDIC issued Financial Institution Letter (FIL)  FIL 73-2008, which clarified its obligations to the holders of covered bonds if an FDIC-insured institution is placed in FDIC receivership or conservatorship.  Of course, other bank regulations probably also will need to be changed.

This is the first in a series addressing covered bonds.  With H.R. 5823 out of committee, and with an economy that continues to limp along, covered bonds probably will become a reality for us.  It is time to understand them, so that we can use them as one way to lift out of these troubled times.

If you have other resources addressing covered bonds, please tell us about them below.

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Recently the IRS corrected a mistake inadvertently created by it in September 2009, when it made changes to the REMIC rules governing changes to CMBS loans.  One result of the 2009 change was that partial releases, expressly contemplated in the CMBS loan document, must pass the “principally secured by real estate” test for qualified mortgages at the time of the partial release (see Section 860G(a)(3)(A) of the Internal Revenue Code and Section 1.860G-2(a)(8) of the Income Tax Regulations).

Failing this test could result in the CMBS pool losing its status as a REMIC, which would have horrible consequences to the tax-free status of the CMBS trust.

Thus, the loan servicer was placed in a no-win situation: the borrower had a right to a partial lien release under the loan documents; yet doing so would violate REMIC rules and the servicer's agreement (in the servicing agreement) to comply with REMIC rules.  (Loss of tax-free status for the trust = heads roll at the loan servicer).

The borrower, of course, was not interested in the loan servicer's problem; it simply wanted the benefit of the bargain (see CMBS gripes of borrowers).  (Sounds like a personal problem of the loan servicer.)

The IRS' new Revenue Procedure 2010-30 gives guidance on this problem and details how the IRS will provide relief for loan modifications of CMBS loans that are “grandfathered qualified mortgages” and “qualified pay-down transactions.”

The Revenue Procedure provides that a partial lien release will be a "grandfathered modification" if:

• it occurs by operation of the terms of the debt instrument, and
• the terms providing for the lien release are contained in a contract that was executed no later than December 6, 2010.

The Revenue Procedure defines a "qualified pay-down transaction" as a transaction in which a lien is released on an interest in real property and which includes a payment by the borrower resulting in a reduction in the adjusted issue price of the loan by a qualified amount.

So, if the CMBS loan expressly permits a partial release of a portion of the property upon the payment of a partial release price (all as expressly specified in the loan documents), then the CMBS loan servicer may go forward with the partial release.

This is good news.

Nice to have good news.

It is interesting that the IRS does not address this request: dropping the requirement for a  retesting of collateral released when a loan is in default.  This request was made by industry organizations in order to give CMBS special servicers additional flexibility as they deal with defaulted CMBS loans.

If you have a war story on this topic, or simply want to comment, please post it below.

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I know that the subject of flood insurance has little "glitz" and that the narrow focus here is on co-lender deals (my other postings on this topic), but if -

• you're in a multi-lender loan (participation, syndication, etc.)
• with federally regulated lending institutions
• where any portion of the real estate collateral is in (or even near) a flood plain

. . . then this announcement by the Loan Sale Trading Ass'n (LSTA) should interest you.

Recently, the LSTA has published the final version of the “Market Standards for Flood Insurance Processes in Syndicated Lending”. 

The federal laws and regulations regarding flood insurance come into play when any of the co-lenders is a federally regulated institution.  Briefly, the regulations mandate that lenders obtain certain flood documents and impose a requirement and a time frame for force placement.

The LSTA guidelines establish procedures for the administrative agent (or lead lender) covering the following topics:

• obtaining documents which evidence compliance with such laws and regulations
• adequate monitoring by lenders in the syndicate of such compliance.

So, if your distressed loan is in (or even near) a flood plain, and if you're a federally regulated lender (or if any other lender in the co-lender group is federally regulated; or if you might be selling the paper or the collateral after the co-lender group takes ownership), then these standards are important to you.

Note also: to what extent will these standards "influence" the broader servicing community and standard of care?

You can bet that these standards will be used "against" the lead or agent bank by other co-lenders in the deal.  Ignoring these standards could be a breach of the servicing obligations or standard of care.

If you have an example of this, or a similar situation, please comment below.

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(More from the “Watch for Change” series . . . .)

I’ve warned you to be on the lookout for new laws and ordinances affecting distressed real estate, the foreclosure process (special notice periods to apartment tenants) and the operation of the property after foreclosure (such as green building laws). 

In May of 2009, I warned you about the movement in several states to require lenders to register a loan before it is foreclosed.

The City of Los Angeles isn’t waiting for the California legislature to act: effective July 8, 2010, lenders foreclosing on residential property in the City of Los Angeles must comply with a new foreclosure registration ordinance.

Here’s a brief description of the ordinance furnished to me by Steve Bloom and Craig Welin of the Frandzel Robins Bloom & Csato law firm (in a news alert prepared by Bob Benjy):

Residential property means:

• Single-family homes
• Residential condominiums
• Apartments and duplexes
• Raw land zoned residential
• Mixed-use properties containing residential uses
• Partially completed (under construction) residential projects

Registration requirements & penalties:

• register within 30 days of recording a Notice of Default and Election to Sell Under Deed of Trust (referred to in California as the “NOD’)
• possible annual fee for each property
• monetary penalties for failing to comply are stiff: $250 per day, and up to $100,000 per property

Requirements for inspections, maintenance and securing the property:

• inspections: at recording of the NOD and weekly thereafter (Danger: this could give rise to liability claims against the lender and also to mortgagee in possession liability – and may force the lender to seek the appointment of a receiver to do the required maintenance, inspections, etc.)
• the lender and trustee area required to maintain the property and keep it secure (Danger: squared - see prior bullet point [where the bullet is in a gun held by the lender and pointed at the lender's foot])
• once the NOD is recorded, the requirements extend to successor lenders, and include property covered by a deed in lieu of foreclosure
• stiff penalties exist for properties that are not inspected, maintained or secured
• hot-lines are established for citizens to report violations

Be alert for the possibility that this type of ordinance will be considered or adopted by your city. If your city contains a significant number of foreclosed homes, and if the LA program receives favorable publicity, then this type of ordinance probably will be on the agenda of your favorite city.

Be prepared.

If your city or state has a similar ordinance or law, please briefly describe it below. 

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Negotiation agreements or discussion agreements are a fundamental building block, or (for some lenders) the starting line, for dealing with distressed debt and investments.  Typically, when a loan is in imminent default or actually in default, a workout, restructure or settlement of a loan will not get off the ground until this agreement is signed by the borrower, any guarantor and the lender.

In two prior postings, I've covered the "why" and the "when" questions: why are they needed? when are they used?

Now we get down to the nitty, gritty details of content: what terms can they contain?

Of course, different lenders and loan servicers take very, very different approaches on the content of a negotiation agreement.  This is where a simple concept ("let's agree to not use anything we say or furnish against each other") can become much, much more complicated in that some lenders view this agreement as the opportunity to confirm or agree upon a lengthy list items.  Other lenders want to keep this letter agreement short - so that they can quickly start discussions.  And, of course, the content of the agreement may vary depending upon the particular situation.

So, these items can be few in number, or they can be large in number - with some items significant enough such that this agreement itself becomes the "pre-workout" of the actual workout.

With that landscape in place, here is a list of topics (in no priority order) sometimes covered in negotiation agreements.  Again, whether an item is used in a negotiation letter turns on the approach taken by the lender (or loan servicer), and the surrounding circumstances.

• Basic statement: confidential and inadmissible (this is covered by me in the earlier posting)
• Status of the loan documents: agree they are enforceable; agree on a list of them (in other words: "Here is the list of the loan documents and don't tell me that we've agreed on something else in some other document, e-mail or cocktail napkin")
• Outstanding balance of the loan
• Admission of default (or no admission of default)
• Acknowledge receipt of notice letters
• Non-wavier of rights and remedies (all rights and remedies reserved)
• Forbearance or delay in exercising rights or remedies
• Acceptance of partial payments not a waiver of full payment
• No party bound until a formal, written agreement (in other words: "don't hold me to what I just said; we don't have an agreement until we've dotted every 'i' and crossed every 't.') Warning: the execution of a negotiation agreement is no excuse for not being careful and smart in your oral communication (see my postings on oral communication)
• Termination of discussions & any forbearance (at any time, by any party, for any or no reason)
• No transfer or pledge of any assets (in other words: "don't use this time to empty out your financial cupboard by giving your good stuff to your other creditors")
• Limited waiver of claims (each party waives any claims relating to the negotiations or discussions; but the waive does not extend to obligations under the loan)
• Other loans not covered by these discussions
• No one can nor should rely upon any statement or action undertaken during the discussion period
• Borrower and Guarantor agree to use reasonable efforts to furnish requested information
• Borrower and Guarantor to pay all of Lender's expenses (including legal counsel)
• Borrower and Guarantor acknowledge they are represented by counsel
• Waiver of jury trial as to any claim arising out of the negotiation agreement
• Authority of each party to enter into the negotiation agreement.

This is a long list; and the list could be longer.

I personally favor the use of a short negotiation letter - so that the parties can quickly enter into discussions.

If you have items to add to this list, or if you want to comment on your approach, or if you want to give us your "war story" on this topic, then please post your comment below..

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This is the second posting on this topic.  The first posting covered the topic of "why" a negotiation agreement is used.  And it generated some interesting comments on LinkedIn (see below).  Now, let's get to the question of -

• When should a negotiation letter or agreement be used?

The answer to this question runs the entire spectrum:

• Before a default;
• After a default;
• Right be before remedies are first used
• After the delivery of current financial and operating statements
• As a requirement of any discussion or communication between the parties

In almost every defaulted loan or investment, there comes a point when frank discussions are needed between the parties (beyond discussions between the lawyers) in order to possibly settle the dispute, and often this can only occur if the content of the discussions will NOT be used "against" any party.

• Where do I see lenders and servicers lined across this spectrum?

All across the board: perhaps because this is a topic where the content of the agreement can control the use of the agreement.  In other words, the negotiation agreement itself can be so onerous, so detailed, so long . . . that no one (in their right mind or with the advice of legal counsel) should sign it . . . unless they have no choice.

Yes, a simple concept can be made complicated by addressing too wide a range of topics.

And yes, some lenders keep it simple; and other lenders want to address the wider range of topics - at any cost and at any consequence.

These comments (from a discussion of this topic on LinkedIn) focus on this "problem" with negotiation agreements:

• "A sophisticated borrower will never sign one unless his lawyer emasculates it. However, I have found it useful with less sophisticated borrowers, where there are lender liability issues lurking in the credit file or loan documents or in email messages."
• "I hate those pre-negotiation letters, and I've never used one. First, the terms and conditions of the letter are like throwing down the gauntlet even before you've started negotiating. Without having even started out of the gate negotiating a deal there's already negative energy and posturing. Its absurd to me to negotiate how the parties are going to negotiate. The borrower knows he's already backed into a corner, so how much further into the corner do you suppose you can push?"

In my next posting on this topic, I'll cover provisions in negotiation agreements - some of which are no-brainers and others that can be problematic.

If you have a comments or a war story, please post it below.

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I'm often asked "do I really need to get a 'negotiation' agreement before we start discussions with the other side about the distressed or defaulted loan [or investment]?"

The answer is simple: Yes.

The challenge to the question, and in my crafting of the answer, is this word: simple.

This posting will be the first in a short series on negotiation agreements.  This posting will cover "why" they should be used.  Future postings will cover "when" to use a negotiation agreement, and the topics that could or should be included in the agreement.

Judging simply by the length of some of these agreements, this topic can be turned into a larger than life experience (and made more complicated than it needs to be).  I'll try to keep it simple.

Why the need for a negotiation agreement?

Before we step into the nitty gritty details of the topics that could be covered by this agreement, we need to step back and ask "why?" should we even have it.  This agreement is all about these basic or key concepts - and they are the most common reasons or answers to the "why do I need it" question:

• Pre-Workout Agreement: If the borrower and lender can't agree on the topics in this agreement, then chances are slim that they will agree on any thing substantive about the distressed loan or investment.  In other words, if they can't quickly come to terms on the ground rules of the discussions, then there is no reason to talk about a possible workout or negotiated settlement - so get on with the war.
   
• Confidential & Inadmissible:  The key element or concept in this agreement is this - the parties agree that whatever is said, read or discovered will not be used against the other party.  This agreement often has these elements in it:
  • the discussions constitute settlement discussions and are privileged in the same manner as a settlement offer in litigation.  However, some use this agreement for broader purposes beyond the restrictions on admissibility contained in Rule 408 of the Federal Rules of Evidence or in similar rules of evidence used by state courts - so they add the following elements to the agreement . . . 
  • information from the discussions shall be inadmissible for any purpose whatsoever in any judicial or similar proceeding or in any litigation or other proceeding involving any of the parties (including for the purpose of evidencing culpability, weakness of position, admission of liability or otherwise evidencing any admission of obligations due and owing to or from any party)
  • information from the discussions shall not be disclosed (except for reasonably necessary disclosures to principals, investors, shareholders, limited partners, members, representatives, attorneys, accountants, advisers, consultants, prospective purchasers of and/or participants in the loan and their respective representatives, attorneys and advisers and as required by law, including pursuant to a judicial administrative procedure)
  • information from the discussions shall not be used, admissible or disclosed by any party as a defense or counterclaim in any action or proceeding

• Careful, Careful: But let's not be too naive - this topic comes up in the context of a real dispute between adults, which means the information exchanged or obtained under the "protection" of a negotiation agreement will effect behavior; and perhaps even motivate each side to source or locate the same information from other sources.  So be careful what you disclose, and what you say (see postings on oral communication).

If you have any thing to add, or a war story (with names changed, of course), please post a comment below.

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This is a series of blog entries in which we provide some quick answers to lenders' frequently asked questions (FAQ).

Although I can NOT quantify this statement, we're seeing more and more commercial real estate go into bankruptcy.  Of course, these typically do NOT involve CMBS loans; probably because those loans typically have a "non-recourse carveout" that brings personal liability to the individual sponsor, key principal or owner of the borrower, if the borrower files for bankruptcy.  So, unless that person's financial condition is independently insolvent, the individual owners "behind" commercial property (that is financed with a CMBS loan) generally strive to avoid bankruptcy. 

But then, during the '04 to '07 "hot" production years, there seemed to have been a tendency to even NOT require an individual to be personally liable for this topic.  Instead, the non-recourse carveout party was an entity (such as the operating company).  So, these types of CMBS loans will be like bank loans to entities, or any loan that doesn't have an individual with liability upon a bankruptcy filing: bankruptcy is a viable option.   (I know, I know:  . . . then there is the General Growth Properties bankruptcy filing - but that case is a topic beyond the scope of this posting.)

In any event, we're seeing an up-tick in bankruptcy filings involving commercial real estate owners. So, our FAQ series will focus on some common bankruptcy questions.

FAQ #42 -  What happens if the borrower files bankruptcy?

• Upon a borrower's filing of bankruptcy, an automatic “stay” immediately takes effect. The automatic stay prohibits all actions that may be taken against a borrower or its assets. This effect increases the costs and fees and dramatically delays a lender from foreclosing on the loan's collateral.
• Here is a glossary of helpful terms used in bankruptcy.

FAQ #43 - How can Lender (servicer) proceed in spite of the “automatic stay”?

• The lender as a secured creditor, may file a request with the court for relief from the prohibition of the automatic “stay”.
• In a Chapter 7 case (look at the glossary [above] for a definition), a secured creditor will likely want to file a lift stay motion as early case as possible in order to obtain stay relief as quickly as possible.  A stay relief motion may require at least twelve to thirty days' notice.  Therefore, if a secured creditor wants to obtain stay relief to pursue repossession or foreclosure, it is important that it file a motion for stay relief as early as possible to avoid any further delay.
• Occasionally, a secured creditor is able to negotiate with the Chapter 7 Trustee to reach an agreement whereby the Trustee will administer the secured creditors' collateral in exchange for a portion of the proceeds of such collateral to be distributed to unsecured creditors. 

To read the entire Tough Times FAQ series, please click here.

Two things should be kept in mind. First, none of these questions can be answered in a vacuum. Questions should be considered with a thorough review of the file and an interview with appropriate loan officers. And secondly, many of the questions are worth revisiting from time to time because subsequent events will impact the answers.

If you have thoughts, war stories, suggestions or questions on this topic, please post a comment below.
 

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