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

Guest Writer, Laura P. Sims, Winstead PC

This is a special series of blog entries in which we provide quick answers to lenders' frequently asked questions related to tenant leases (FAQ). Leases are "the" whole point of income producing property—and this series is pointed to the simple goal of helping you protect the basic value building block of your collateral—which are the leases. Of course, 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 secondly, many of the questions are worth revisiting from time to time because subsequent events will impact the answers.

Is Landlord required to exercise its remedies and/or mitigate damages immediately once a default is declared under a commercial lease?

• No, Landlord is not required to immediately exercise its remedies under a commercial lease.

Assuming the original demand letter protected Landlord's rights with respect to exercise of remedies, Landlord is entitled to the immediate exercise of all available remedies or, at its election, to delay the exercise of some or all remedies until a later, more suitable date.

In rough economic times, Landlords may have concerns that compete with the traditional process of repossession or termination of the lease (or terminating the Tenant's right of possession without terminating the lease itself).
 

• For instance, where a mixed-use or retail development is still within its initial lease-up phase, it might be prudent for Landlord to allow a Tenant occupying a prominent location within the development to remain in operation, particularly through a holiday or other critical period, notwithstanding the existence of an event of default.  (Note the discussion of a forbearance agreement below.)
• Even in an office context, where "dark space" is less of an immediate concern, a Landlord might still be inclined to delay termination of a lease in favor of repossession or even to delay taking any action in order to avoid negative press coverage surrounding the exercise of remedies.

For a commercial lease in Texas, under applicable Texas law and absent an express agreement to the contrary, a declaration of a default does not give rise to an obligation for Landlord to mitigate damages.  A duty to mitigate arises (in Texas) only when Tenant has abandoned the premises and ceased the timely payment of rent or the Lease provides otherwise.

As such, Landlord is not triggering any additional burdens by completing the process for establishing an event of default and Landlord may, within reason, delay further action pending resolution of competing factors.

Even if termination or repossession are delayed, Landlord should make prompt inspection of the premises and address any immediate repair or maintenance concerns. Application can also be made of the security deposit to cover current deficiencies or Landlord expenses, subject to the specific terms of the lease.

Also, if the the relationship with the defaulting Tenant permits this approach and in the appropriate circumstances, the Landlord should consider entering into a forbearance agreement with the Tenant.  This agreement will expressly recognize the default, it will set forth the Landlord's agreement to NOT exercise remedies for a specified time, and it will confirm the Tenant's agreement to perform (on a going-forward basis) the terms of the lease - again, for a specified time.  After the time period ends, then the Landlord may exercise its remedies.

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

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Have you checked your boilerplate lately? There is no longer anything standard about the "standard" language in financial services contracts. Whether you are drafting or litigating origination documents, workouts or settlement agreements, you won’t want to miss this seminar (on Thursday, February 25, in our Dallas office)! Otherwise, you could be litigating in an unfriendly forum, fighting over representations made before the loan documents were signed, or find yourself without adequate remedies when the other side defaults. Learn how to minimize your risks and strengthen your position by effective negotiation and drafting.

The seminar brochure [download] is attached.  And here's a short version of the agenda and session topics:

• 11:30 - 12:15: registration and lunch
• arbitration clauses
• forum selection clauses; venue and choice of law provisions
• indemnity clauses
• remedy provisions
• jury waiver provisions
• merger clauses
• panel discussion: The View From 10,000 Feet (I'm "on" this panel.)
• 4:30 - 5:30p: reception

We know that these topics are "hot" ones - we're dealing with them as we handle distressed investments.

Our seminar speakers include a former Texas Supreme Court Judge, litigators currently handling CRE finance litigation, and workout lawyers.

Who should attend?  This seminar is for any professional who regularly negotiates, drafts or litigates financial services contracts, including in-house counsel, transactional lawyers, special assets and workout professionals and litigators. If you deal with contracts on the front end or after the fighting starts, this program is for you.

I know that this blog announcement is late; but since space is limited (and we're paying for the food at lunch and then drinks at the closing reception), we first offered this one to clients.

However, we have a limited number of "extra" spaces.  And you're invited.

If you'd like to attend, please send (ASAP) an e-mail with your contact information to:

• mlee@winstead.com

Directions to our offices, and parking instructions, are on the brochure.

If you're in Fort Worth\Dallas tomorrow, please consider coming.

I'll enjoy the opportunity to meet you.

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Guest Writer, Laura P. Sims, Winstead PC
This is a special series of blog entries in which we provide some quick answers to lenders' frequently asked questions related to tenant leases (FAQ).  Leases are "the" whole point of income producing property - and this series is pointed to the simple goal of helping you protect the basic value builidng block of your collateral - which are the leases.  Of course, 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 secondly, many of the questions are worth revisiting from time to time because subsequent events will impact the answers.

FAQ - What lease provisions are most important when determining the existence of a default and/or providing notice of a default?

In addition to the specific provision(s) which is the basis for the default, a thorough review should be made of provisions regarding events of default, remedies and notices, as well as all correspondence for purposes of determining if waiver or modification allegations may exist or if notice requirements or addresses have changed. 

Be aware that certain operational defaults may be addressed in provisions of the lease other than the default and remedies section, such as continuous operation clauses and surrender obligations, and the remedies for breach may appear with the operative language rather than being mentioned by name in the list of events of default. 

In order to avoid any alleged defense against claims for payment or performance, and to give the guarantor an opportunity to cure the default, copies of all default correspondence should be delivered to any lease guarantor (even if not required under the terms of the guaranty or the Lease notice provision). 

Also, requirements to provide notice to lenders and other third parties may appear in ancillary documents, such as Subordination, Non-Disturbance and Attornment Agreements, and thus a review of the entire Lease file is strongly recommended.

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

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Not all assignments are created equal.  Houston Bankruptcy Judge Marvin Isgur recently reminded us of the differences in his August opinion in In re Amaravathi Limited Partnership, 2009 WL 2432315.

The court studied the issue of when the post-petition rents from an income producing project— in this case apartments—still constituted “property of the estate” of the project owner even though they had been assigned to a lender and placed by the debtor into the lender’s lockbox.  The judge, a former bankruptcy practitioner and an executive with an apartment developer prior to attending law school, gave a cogent analysis of the issues, and held that the post-petition rents are property of the estate and cash collateral that may be used by the debtor in a chapter 11 proceeding.

The court described the three kinds of assignments of rents commonly found in Texas real estate loans:

• The collateral assignment, which is a basic lien, and requires some action by the lender to “activate” its right to the rents
• The absolute assignment, in which the lender is given legal title to the rents with a license back to the debtor for the purpose of collection with the proviso that the lender acquires the right to receive the rents automatically upon a default
• The true assignment or “true sale,” which is accompanied by a pro tanto discharge of the debt or purchase obligation in an amount equal to the amount of rent received

In determining the rights of the parties under an assignment of rents, the parties’ description of the kind of assignment is not controlling, there is a presumption that the grant is of a collateral assignment, and courts will look to the parties’ rights under the loan documents in determining what kind of assignment has been created.

The court held that even in the case of an absolute assignment, the debtor retained an equitable interest in the rents, that this interest sufficed to make post-petition rents property of the estate, and that post-petition rents were cash collateral, which could be used subject to providing the lender adequate protection and other appropriate safeguards following notice and a hearing.

What’s a lender to do?

• In each transaction, discuss with your attorney the benefits of having an absolute assignment of rents rather than a collateral assignment.
• Make sure your documents permit you to move quickly, and in several different ways, if you have to revoke the borrower’s license to collect rents. These rights should include the right to collect rents from tenants directly, in person or via a lockbox, and the right to ask a court to appoint a receiver.
• Regardless of what kind of assignment you have, police your collateral, especially after default, and move quickly if the borrower is not cooperative.

If you have any questions, comments, or your own example, then please post a comment.

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

FAQ #7 - Should I pay the property taxes prior to foreclosure?
Taxes and Escrows: Escrows may be in your possession and available for tax payments.  Taxes should typically be paid prior to foreclosure in order to add them to the loan deficiency amount--unless it is your plan to sell at the close, subject to taxes to a third party.

FAQ #8 - What other legal issues or hurdles should I consider in proceeding with foreclosure
Each state's law governs when and how a lender proceeds with foreclosure.  The following questions should be considered:

• Is there an anti-deficiency statute or single cause of action rule?
• What are the mechanics lien filing periods?
• What are the content and timing requirements for sending notice of default and acceleration?
• How does my course of dealing affect the existence of the default?

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

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This past Friday (October 31, 2009), the Federal Financial Institutions Examination Council (website) released a major policy statement giving guidance, and articulating general principals, for the distressed commercial real estate debt market.

The report is a "must" read: PDF.  (Footnote #1 to the report lists the Federal & State Regulators - visit the FFIEC website for the complete list.)

The introductory paragraphs and the Article I "Purpose" statement contain some very, very interesting (even bold) statements:

• " . . . financial institutions and borrowers may find it mutually beneficial to work constructively together"
• "The regulators have found that prudent CRE loan workouts are often in the best interest of the financial institution and the borrower."
• "Financial institutions that implement prudent loan workout arrangements after performing comprehensive reviews of borrowers’ financial conditions will not be subject to criticism for engaging in these efforts even if the restructured loans have weaknesses that result in adverse credit classifications."
• " In addition, renewed or restructured loans to borrowers who have the ability to repay their debts according to reasonable modified terms will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount that is less than the loan balance (emphasis added)."

This is a must read for everyone involved in CRE.

This is very different from the regulatory guillotine used in the late 80s & early 90s.

And the policy statement should have major implications - and undoubtedly will influence regulatory bodies such as the NAIC (which loosely governs commercial mortgage investments by life insurance companies) (website) and other "unregulated" financial institutions.

Please post your comments.

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(More from our "Watch for Change" series . . . .)

As you know, the "new" economy is prompting a wide range of new laws and ordinances, all of which present opportunities for the unwary to trip up and mess up in the collection process.

This posting will interest you if any of your collateral involves residential real property.

While this posting is written from a Texas perspective, the concept applies to all states—because the new Federal law applies to all states.

Thanks to Vince Marino of Winstead PC for this information, which was published in the Houston Business Journal on July 17, 2009.

If you have any questions or comments, please post them.

New Federal Foreclosure Law Gives Residential Tenants 90 Days to Vacate

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Guest Writer: Brenda Brown, Winstead PC

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

Without further ado:

FAQ #1 -  The Borrower is how far behind – now what?

• Analyze the entire situation: the collateral, the loan documents, the file, any co-lender or intercreditor agreements, financials on the parties, the market - in other words, the entire picture. Act like you're about to own it.
• Consider restructuring – But send a "Discussion Letter" – to help avoid waiver of lender's rights under the loan documents
• Determine whether a default – as defined in the loan documents – has occurred. If so, consider sending Notice of Default and Notice of Acceleration.
• Generally Borrower has "terminal euphoria" and no reason to change unless it is in default.

FAQ #2 -  What if the default was not a monetary default?

• "Default" vs. "Event of Default" – check defined terms in the loan documents.
• Look for Grace / Cure Periods to see if expired.

FAQ #3 -  What can I do besides calling a default?

• Alternatives to calling a default include à Restructure (i.e., amend the loan documents so the borrower is no longer in default – if the borrower's financial deterioration is not too great)
• Simple Notice of Default à Just to create a written record that it exists and is continuing.

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

Please post comments or questions below.
 

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I know that this is the "tough times for lenders" blog, and our focus generally is on distressed debt.

However, we can't ignore another perspective for "tough times" for lenders: the failure of the lender.  (OK, bank failure>"tough times")

So, let's take our focus off the asset side of the balance sheet (the investments) and take a look at the bigger picture: the regulatory insolvency of an FDIC insured bank.

The borrower of course has its own investment to protect, and perhaps a project to complete; or a business to run.  In the late 80s, few borrowers had the resources to track the solvency of the lender.  However, the internet-age allows everyone to follow a plunging stock price, read blogs (like this one) and monitor the final hours of a favorite lender.  Indeed, everyone is doing it.  (I don't intend to be disrespectful - it simply is an attribute of Marshall McLuhan's global village.)

When the bank (finally) fails, typical questions include:

• Who should the borrower call?
• How can the borrower get the next loan advance?
• What happens when the FDIC sells the note?

One place to start the process of finding answers to these questions is on the FDIC's website, which has web pages addressing these and related questions.

It is at least a place to start.

If you have other suggestions or resources, please post a comment.

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More on our "Watch For Change (at the state house)" series (prior postings on new business tax; new foreclosure fee) . . . .

I suspect that many state and local authorities soon will be requiring lenders to register a loan BEFORE the loan is foreclosed.

Yes, another foreclosure trip wire.

Recently, a representative of MERS (the electronic note registry used extensively with residential mortgage note and to a lesser extent with commercial mortgage notes securitized in CMBS pools) told me that MERS is being used in new ways - most notably, several cities (such as Chula Vista, CA) are using the registry to "track down" and identify owners, servicers and managers of foreclosed single family houses.

He also tells me that several states (VA & CA, for example) have pending legislation requiring all foreclosed property to be registered in a database for use by governmental authorities (data points for the registry include ownership, servicer, property manager, etc.).  (I'm tracking down information on this.)

• Why? Thousands of homes have been foreclosed, and sit vacant and unattended.  And the public wants them to be kept secure, yards mowed, pools serviced, etc.  No one wants a meth lab, or a party house, as your newest next door neighbor.
• Why not?  Public officials want votes, so they're looking for ways to "please" the public without spending public funds.

However, since most commercial mortgage notes are NOT registered with MERS, it will NOT be a data-ready tool for use in tracking down commercial lenders after foreclosure (one caveat: some CMBS notes have been registered in MERS).

. . . yet. I predict that this will catch on in state legislatures across the nation - making registration a requirement before foreclosure.

If you can give us some information on this, or if you have any questions or comments, please post a contact.

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Guest Writer - Nelson Block, Winstead PC

3rd in a series of 3 postings
(Part 1: Establishing a Security Interest in Receivables)
(Part 2: Funds in Deposit Accounts and the Account Control Agreement)

In order to capture checks sent in for payment, the lender will often create a lockbox account, usually at the bank where the borrower does business. The lockbox agreement provides that all envelopes addressed to the borrower that are received at a post office box under the bank’s control – the lockbox – will be opened and checks deposited in a special account which is either set up with the lender or covered by an account control agreement. Letters and other items received in the lockbox are sent to the borrower.

In addition, account debtors are notified to pay their accounts by mailing their remittances to the lockbox. This arrangement is “full notification,” as distinguished from an agreement with the borrower to only notify its customers after an event of default. Lenders refer to this full notification feature, coupled with the lockbox and deposit account, as “dominion of funds” because the lender now has a security interest, as well as some measure of control, over the entire process by which the borrower’s cash flow is received.

Once received, the lender may wait for one to three days before crediting the loan balance in order for the checks to go through the clearinghouse process. Borrowers sometimes contract for these clearing periods, or “float days,” for a time that is longer than may actually be required for checks to clear, permitting the lender to continue to charge interest on the loan balance. Once the cleared funds are credited to the loan, the lender will be in a position to advance fresh funds upon the purchase of inventory or the creation of new accounts receivable.

If you have any unusual experiences or stories on these topics, please post a comment.

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Guest Writer - Nelson Block, Winstead PC

2nd in a series of 3 postings
(Part 1: Establishing a Security Interest in Receivables)

But the ordering created by the filing of financing statements only provides protection when the collateral is accounts. When the customer who owes on the account – the “account debtor” – pays by sending the borrower a check, the filed financing statement does not perfect the lender’s security interest in the funds represented by the check once it has been placed in the company’s bank account. At that point, the nature of the collateral changes and, unless the proceeds are “identifiable cash proceeds” which can be traced by the lender, the lender must have a security interest in the bank account. If the lender is the bank where the account is maintained, then the creation of a security interest will be sufficient to perfect. Usually the bank lender’s documents will also contain a right of set off, which is not a security interest but gives the lender the right to take the funds in the account upon a default in the loan. If the lender is not the bank where the account is maintained, then in addition to the lender’s security interest, it will need an account control agreement. This is a three-party document signed by the lender, the borrower, and the bank where the account is maintained. The most significant feature of the account control agreement is the bank’s agreement to honor payment instructions only from the lender, not from the borrower, after the lender has given written notice to do so.

Next: Lockbox Accounts, Full Notification and Dominion of Funds

If you have any unusual experiences or stories about deposit accounts and control agreements, please post a comment.

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Guest Writer - Nelson Block, Winstead PC

1st in a series of 3 postings

A business’s accounts receivable are one of its most valuable assets, not only to the business but to its lender. In an ongoing business, the continual turn of accounts receivable on a frequent basis make them a reliable source of revenue and, therefore, of collateral support for financing the business.

The steps necessary to secure the lender in its position in the receivables are sometimes confusing to the business owner. Here are the steps by which a lender obtains its secured position in its customer’s accounts.

In the case of businesses which sell inventory, the receivable is created when the inventory is sold on credit. The Uniform Commercial Code (“UCC”) governs security interests in inventory, accounts receivable and other kinds of personal property. It provides that a lender establishes or “perfects” its position against other creditors by filing a financing statement (form UCC-1) stating the type of collateral with the proper filing officer – the Texas Secretary of State’s Office for entities formed under Texas law. The first creditor to file a financing statement has first priority. In such cases, the process of gaining collateral in the “accounts” (the UCC term for accounts receivable) begins even before the inventory is sold. Between a lender who has a secured position in inventory and its proceeds filed before a lender who has security in accounts, the inventory-and-proceeds-secured lender takes priority over the accounts-secured lender.

Next: Funds in Deposit Accounts and the Account Control Agreement

If you have any unusual experiences or stories about securing a lien on account receivables, please post a comment.

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I've commented before on the need to closely monitor "changes" in your state legislature.  I've highlighted pending legislation in South Dakota on commercial loans by life insurance company; and pending legislation in Wisconsin lifting the limit of the state's wage lien law. 

This trend will continue as the economic "crisis" continues.  It probably is bred by several factors:

• states searching for more money (who doesn't need more money now?);
• politicians becoming more populist (who doesn't want to keep their job?); and
• _____________ (you can fill in the blank).

Even Texas seems to be joining this movement, which is somewhat shocking, because generally, on many topics, Texas embraces "caveat emptor" - everyone should take care of them self.  ("This is a big state and everyone needs to be a big boy.")

Recall that in an earlier posting, I mentioned the Texas Attorney General's proposal to give Texas residential consumers a mandatory 45 day cure period on mortgage defaults.

Well, the Texas legislature now joins the movement. Earlier this month, legislation was introduced in both the Texas House (where it is in committee) and in the Texas Senate to impose fees on lenders as they post mortgages for foreclosure.

These fees will be used to fund civil legal services for indigents in Texas - if the legislation becomes law.

The importance of my comment is NOT to predict whether this legislation will become law, nor to debate the need for civil legal services for the poor.  The importance is that these pieces of legislation clearly substantiate the validity of my "factors" listed above: state politicians are looking for money and for votes.

But why is it important for all of us to monitor these trends?

• these laws will increase the cost of doing business; and
• these laws will be "trip wires" for us as we deal with distressed debt (in that they will cause delay, and will be a possible source of much pain if we forget them)

No doubt, dealing with distressed debt will just keep being more and more difficult.

Please post a comment if you are seeing similar trends in your state.

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By Guest Writer – Christopher T. Nixon, Winstead PC

CMBS Master Servicers typically lack the ability to modify a CMBS loan to preemptively address a potential loan problem. A CMBS borrower frustrated with such inability may elect to purposefully default on the loan to circumvent the restrictions placed on the Master Servicer and force the transfer of the loan to the Special Servicer. The borrower's expectation is that the Special Servicer will have the ability and agree to modify the CMBS loan to address the potential loan problem.

Risks:  If it is apparent to the Special Servicer that the borrower intentionally defaulted on the loan, the Special Servicer may elect to accelerate the debt and pursue foreclosure of the real estate collateral. The Special Servicer may determine that an aggressive foreclosure of the defaulted loan will maximize recovery for the bondholders as compared to attempting to negotiate a loan workout with an untrustworthy borrower acting in a manner detrimental to the economic interests of the REMIC Trust in which the CMBS loan is pooled.

Potential Solution:  Rather than taking the inflammatory step of defaulting on the CMBS loan to reach the Special Servicer to address a potential loan problem, a borrower should consider discussing the potential loan problem with the Master Servicer. If the Master Servicer determines that the loan problem constitutes a "reasonably foreseeable default," the Master Servicer may have the ability under the Pooling and Servicing Agreement (PSA) to transfer the loan to the Special Servicer at that time (without waiting for an actual loan default to occur) to address the loan problem. A Special Servicer may be more inclined to consider a loan modification as compared to a foreclosure if the Master Servicer and borrower present the loan problem to the Special Servicer at this stage. The effectiveness of this approach will largely depend on the quality and sophistication of the Master Servicer and Special Servicer. Given the current bad economy, Master Servicers are increasingly aware of the need to proactively discuss borrower loan problem concerns and to involve the Special Servicer early in such discussions.

Tips for the Borrower:

• Be honest about the potential loan problem when discussing it with the Master Servicer.
• Provide sufficient information to the Master Servicer for it to objectively determine that the potential loan problem constitutes a "reasonably foreseeable default."
• Do not create a potential loan problem merely to seek economic concessions from the Special Servicer. The borrower should have a sincere concern that a loan default is likely to occur if the loan problem is not promptly addressed.
   

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(This is part of a series of postings from the 2009 MBA-CREF convention in San Diego.) (Trends; Arriving;  Day One; Day Two; Day Three)

My time at the convention has been a series of "firsts" for me:

• "live" blogging on Day Two during the Opening Session talk by Paul Begala of CNN and Tucker Carlson of MSNBC (thereby cementing, and forever embracing, my "inner geekness")
• after experiencing the credit crisis first hand in the EU last fall (Before; Day 1, Day 2, Day 3, Day 4 & Last Day), I completed the high-level credit crisis perspective by immersing myself in it here at the MBA-CREF conference - after years of drinking from the "frothy" side of the real estate finance cycle
• finally, this is the second blog entry for today - the last day of the convention.  I've never done two of these in one day.  (. . . need to find a hobby.)

But don't think that I've saved the "best" for last; because there is a "positive" side to the new economy.  There is opportunity in chaos and change.

However, I am continually approached by people concerned about the inability of CMBS borrowers to locate financing to refinance their CMBS loan.  Notwithstanding efforts by the CMSA and the MBA to educate the industry on this product (such as their brochure explaining CMBS debt), much confusion and misinformation exists about CMBS loans.

So, this last entry will focus on a session here at the convention that addressed the myths of CMBS servicing . . . . "click on" to read on . . . .

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Once a month, our regular group of authors discuss topics that we view as being of interest (the "hot" topics) in the commercial loan workout arena.  We then hash out a list of what we'll write on for the next month.

Identifying "hot" workout topics can be a dangerous thing for lawyers.   Yes, we -

• are active in industry organizations (such as the several committees with the Mortgage Bankers Association and working on creating workout data standards through MSMO 
• give workout seminars to clients and at legal industry meetings, and
• now handle an increasing number of workouts and bankruptcies every day . . .

BUT as "outside" counsel,  we're keenly aware that we are not privy to all of the discussions (both formal and informal) that you, the front-line participant, are having on this growing topic.  (There you have it: that long sentence proves I'm a lawyer - which is the reason why we need your help.)

While we believe that we're generally in touch with the market, we understand that we still remain "outside" legal counsel.  So, we're looking to you for the "inside" scope on topics of interest.

- Do you have any topics that you'd like us to address in Tough Times?

Please post a comment to give us some guidance.

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As noted in our recent posting on this subject (The Very Dark Side), the Concurring Opinions Blog  addressed a volatile topic: evicting residential tenants after a real property foreclosure of a single-family residence.  In this posting, we suggest this topic has more relevance to commercial lenders and servicers than you might initially think; and we suggest some tips.

Clearly, most commercial mortgage lenders do not have this type of product (single-family) in the portfolio.  Or if they do, it is a million-dollar home occupied by an executive who is not a tenant, and definitely not a sympathetic figure in the new economy.

So, does a commercial mortgage lender or servicer care about this topic? Why should you care?

The prediction here is that the time will come when evicting a small business owner, or evicting families who occupy abandoned property (or a model home), or evicting laid-off workers occupying an abandoned warehouse or factory will gain the attention of the local media.

If this starts to sound like your portfolio, then here are a few tips:

• Realize that foreclosure and the process of taking possession will be much different than your typical commercial collateral foreclosure. For starters, you should notify a broader group of people in the foreclosure process. For example, contact your community relations or governmental relations group, and include them in decisions made during the foreclosure process. In turn, they will reach out to local community organizations and governmental agencies.
   
• As soon as you have the legal right to directly communicate with the occupant, contact them to discuss the process and options available to them, including local community and governmental resources. In other words, be a resource of information for the occupant.
   
• Consider entering into a short-term lease arrangement (as a bridge to finding a replacement tenant) in order to give the occupant time to find new housing. (As to laid-off workers occupying the collateral - I'm still chewing on that one.)
   
• If the collateral is an affordable housing project, examine the title records to verify rental and other restrictions that burden the project.

Taking back the collateral is tough enough. And getting it back while managing media coverage only makes it worse.

If you have any other suggestions or questions, please post a comment.
 

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In two prior postings (Part 1) (Part 2), I briefly described each concept and the advantages of both. In this third and final posting, I'll briefly contrast the disadvantages of both.  So, here we go (with the expectation that you'll add to this listing):

Disadvantages of Foreclosure

Major disadvantages of a foreclosure include the following:

• Receipt of a foreclosure notice by a borrower could encourage the borrower to file for bankruptcy. Filing for bankruptcy halts all foreclosure proceedings and could impact the likelihood that the lender will be fully repaid for the money it loaned to borrower.
• Most notably in the case of a non-judicial foreclosure, strict compliance with all statutory requirements is required or else the borrower may have the foreclosure overturned, and the lender may then become liable to the borrower for damages associated with wrongful foreclosure. Lender's liability may extend to junior lien holders if they were not properly notified of the foreclosure sale.
• Depending upon the law of the relevant state, a non-judicial foreclosure may take more time than a creditor is willing to accept.

Disadvantages of a Deed-in-Lieu

Deeds-in-lieu have a few serious disadvantages, some of which can be contracted around, however:

• Unlike with foreclosures, a deed-in-lieu does not alter or affect other lien holders to the property. The lender takes the property, along with all encumbrances. If there are senior lien holders with "due-on-transfer" rights, the lender would immediately become liable for paying off those claims. If the borrower is the senior lien holder, the borrower takes the property subject to all, if any, junior liens. At least in foreclosure, the liens junior to the those of the foreclosing party are cleaned-up.
• At a foreclosure sale, if there is a deficiency between the sale price of the property and the balance due on the loan, the lender can go after the borrower for the deficit (subject, however, to applicable state law limitations). With a deed-in-lieu, no market-value is set for the property, unless it is expressly set forth in the terms of the agreement. The need to agree upon value points leads to the next subject.
• Negotiations of the terms of the deed-in-lieu agreement (such as the valuation of the property if a deficiency will be agreed upon) may take more time than initially anticipated. Some of this might be mitigated by the use of a non-binding term sheet covering the terms of the deed-in-lieu agreement; however, there is no assurance that the existence of a term sheet in fact will "speed" the negotiations of the deed-in-lieu agreement (in that some parties simply insist upon negotiating).

If you have any suggestions or questions, please post your comments.

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2nd in a series of 3 postings

In a prior posting, I briefly described each concept.  The more difficult task is contrasting and comparing them.  So, here we go (with the expectation that you'll add to this listing):

Advantages of Real Property Foreclosure

Major advantages of a foreclosure include the following:

• The one overwhelming advantage of foreclosure (whether judicial or non-judicial), when compared to a deed-in-lieu of foreclosure (to be discussed in more detail below), is that a foreclosure proceeding clears or extinguishes all liens that are subordinate or inferior to the lien held by the foreclosing lender.
• Sometimes the cost to undertake a non-judicial foreclosure may be less than the costs of a deed-in-lieu transaction (in that a deed-in-lieu can include title insurance premiums, significant legal fees if the agreement is negotiated, etc. – although some of this may be mitigated by the use of a term sheet in the deed-in-lieu process).

Advantages of a Deed-in-Lieu

Deeds-in-lieu have several advantages over foreclosure proceedings as a means of obtaining some measure of repayment for a lender from a defaulting borrower:

• Accepting a deed-in-lieu allows the lender to obtain ownership of the property without the costs and delays associated with judicial and non-judicial foreclosure. (Note: in a future posting we'll discuss other agreements that allow the lender access to the property WITHOUT obtaining the title.)
• Since a deed-in-lieu is a voluntary conveyance by the borrower, the parties can agree upon the amount and related terms of any deficiency (and thus avoid a dispute as to the valuation of the property), together with a full release of any claims against lender.
• Again, since a deed-in-lieu is a voluntary conveyance by the borrower, the lender has a great deal of leverage in terms of conditioning its acceptance. The lender can condition acceptance of the deed-in-lieu upon such things as receiving a complete and accurate copy of the borrower's financial statements, tax records, leases, service contracts; construction plans and contracts, sales contracts, etc. In other words, this may be a better "turnover" of the property to the lender. (However, a "friendly" non-judicial foreclosure can achieve the same result.)
• Unlike a foreclosure, a deed-in-lieu is a private transaction that does not involve publication or court filings. Thus, with a deed-in-lieu, the borrower can avoid adverse publicity, which may also minimize the impact on property valuation.
• Accepting a deed-in-lieu of foreclosure avoids all the problems with the foreclosure process, such as the possibility of post-foreclosure attacks on the sale as a wrongful foreclosure.
• Note that accepting a deed-in-lieu structure does NOT mean that the lender's lien (or space leases) will be released or extinguished. Indeed, the lien (and space leases) may be "preserved" or "kept alive" by expressly making the deed-in-lieu subject to those interests (so that such interests will expressly continue). This will permit the lender to foreclose at a later date if, for example, there are mechanics' liens that need to be extinguished (which are subordinate to the lien). Note that use of this structure depends upon this important consideration: is the lien absolutely superior to other objectionable or problematic title matters (such as M&M liens)?

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1st in a series of 3 postings

This is a first of three postings on these two (2) concepts. The first posting will briefly describe each, the second posting will list some of the advantages of each, and the third posting will cover some of the disadvantages of each.  Note that this series is not intended as a comprehensive discussion of these topics. (For example, this series will not address related topics such as trapping rents, redemption periods, legal limitations on deficiencies, the use of deficiency agreements, laws that limit or prevent a creditor from ignoring its security, laws that prohibit a creditor from bringing more than one action to exhaust its security, nor laws that limit recourse against a guarantor – look for other postings on these topics.)

The following is a brief description of a foreclosure and a deed-in-lieu of foreclosure:

Real Property Foreclosure
Foreclosure is the legal proceeding whereby a defaulting borrower is stripped of its interest in real property in order to satisfy debts owed to a lender. These are debts that were originally secured by the real property. In a judicial foreclosure proceeding, the lender files a motion in state court seeking a foreclosure decree. The lender must prove that the borrower is in default on a valid note. Generally, the court will then appoint a trustee to notify all interested parties of the pending foreclosure sale. The trustee will carry out the sale and disburse the proceeds under strict court supervision. In many states, judicial foreclosure is the only means of foreclosing on real property. Because judicial foreclosure is a court proceeding, it can take months if not years to complete.

A limited number of states permit a non-judicial foreclosure (such as California and Texas). A non-judicial foreclosure is one where the foreclosure is conducted with little to no court supervision. Meaning, the interested parties are notified, the sale is conducted, and the proceeds disbursed without court supervision. Typically, the ability to conduct a non-judicial foreclosure is not a statutory or constitutional right; it is a contractual right that must be specifically granted by the borrower to the lender in the loan documents. Because a non-judicial foreclosure does not involve a court proceeding, the process is easier and faster to complete than a judicial foreclosure.

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Foreclosure of real property and disposition of personal property are governed by different bodies of law. Real property foreclosure sale varies dramatically among the states. Personal property disposition is governed by each states' versions of Article Nine commercially reasonable disposition.

Texas Real Property Foreclosure
Section 51.002, et seq. of the Texas Property Code defines the minimum statutory procedure that must be satisfied to properly foreclose upon real property. In addition to the minimum statutory requirements, the deed of trust executed by the debtor-mortgagor details the agreed contractual terms and conditions for foreclosure of real property.

Personal Property Disposition in Texas
Article Nine of the Texas Business and Commerce Code defines the minimum statutory procedures that must be satisfied to foreclose upon personal property. In addition to the Article Nine requirements, the security agreement executed by the debtor-mortgagor defines the contractual terms and conditions for foreclosure of personal property. Generally, personal property disposition must be commercially reasonable.

Comparison of Texas Foreclosure Procedures for Real property and Personal Property
Real property and personal property foreclosures are dramatically different. Real property foreclosures are conducted on the first Tuesday of each month between the hours of 10:00 a.m. and 4:00 p.m. at the courthouse door in the county in which the real property is located, with a notice posted at the courthouse door, personal notice to the debtor, and filing of the notice with the county clerk, all 21 days before the foreclosure sale. These requirements are defined by § 52.001 of the Property Code and are unique to Texas law. Personal property foreclosures are conducted under § 9.504 of the Texas Business and Commerce Code, which generally requires a commercially reasonable sale. The requirements of Article Nine of the Texas Business and Commerce Code are followed, with some minor variations, by all states except Louisiana.

Thus, real property foreclosures in Texas are very defined and structured procedures unique to Texas law which do not require the sale to be commercially reasonable. On the other hand, personal property foreclosure sales are not structured by statute, but they must be commercially reasonable as to every aspect of the disposition, including method, manner, time, place, and terms. The apparent conclusion is that although the legislature has specifically defined the procedures that must be followed to dispose of real property, personal property may be disposed of in any manner the secured party elects, as long as the sale is in all respects commercially reasonable.

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Mortgagor's Interest: No Right of Redemption
Before the sale is actually consummated, the mortgagor is entitled to pay the amount of indebtedness at any time, and, if there is a dispute concerning the amount, he or she may pay into the registry of the court the amount alleged due and halt the sale. Once a valid sale is consummated, however, the mortgagor has no right of redemption. The mere fact that negotiations between the mortgagor and the mortgagee were pending while the sale was held does not constitute an irregularity sufficient to set aside the sale. After the foreclosure sale, the mortgagor's ownership of the property has been transferred to the successful bidder, and the mortgagor may face a deficiency suit from the mortgagee.

Junior Lienholders
Following the valid foreclosure of a senior lien, junior lienholders do not have a right of redemption, and their liens, if not satisfied from the proceeds of the sale, are extinguished. There is an exception to this rule in the case of property which may be removed form the real property without material damage to the land, the improvements themselves, and surrounding improvements.

Purchase at Foreclosure of Inferior Lien
If a lien inferior to the first lien is being foreclosed, the trustee distributes proceeds to the inferior lienholder and executes a trustee's deed in favor of the successful bidder. If there are excess proceeds available, they will be distributed to inferior liens or, alternatively, if there are no inferior lienholders, to the mortgagor of the foreclosed inferior lien. Of course, the successful bidder at a junior lien foreclosure takes title subject to prior liens and must service the prior liens in order to prevent loss of the property by foreclosure of the prior liens.

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Most modern real estate loan documents will include a separate "Absolute Assignment of Leases and Rents." What is the purpose for this and why is it worded this way? The answer lies in the history of the law surrounding collateral devices.

The Lien Theory
Most states follow the "lien theory" of mortgages. While the roots go way back in our common law, the basic concept is simple. The borrower owns the collateral and is entitled to operate it to make a profit without interference from the lender – until an event of default occurs in the loan documents. While this concept seems relatively simple – it can lead to some sticky questions, particularly with an otherwise non-recourse loan situation where only the collateral (both the real estate and the cash it generates) is the source of repayment.

Notice Requirements
Mortgages and Deeds of Trust often address leases and rents as an addition to the overall collateral package. In respect of the "lien theory," many states hold that the debtor is entitled to all rents earned until some event of default and notice from the lender. Absent some other documentation, rents earned before the notice are the debtor's and the lender is not entitled to them. The issue of when a debtor received such notice cutting off its right to hold rents becomes an important issue, both as to rents in the door and those coming in the future.

"Absolute" Assignment Documents
Real estate lending lawyers began to draft around this problem. The Absolute Assignment of Leases and Rents provides that the debtor makes an absolute (as opposed to collateral only) assignment of the rents for so long as the debt remains unpaid. The debtor is typically granted a "license" to collect and spend the rents until a default occurs, resulting in the automatic termination of the license. If the device works, the intent is to avoid the ambiguities arising around the time of default and to provide a bright line allowing the lender to capture more of the rent.

How Absolute is Absolute?
Most courts will respect this arrangement reached between sophisticated parties, but the concept has not been well tested in the stressed environment we may be entering. If the assignment was absolute, what is the effective principal of the loan or – what was the effective consideration paid for the loan (the de facto interest amount). If the assignment was absolute, how did the debtor and borrower treat this disposition on their respective tax returns at the time the loan closed? Questions abound.

What to do?
Send those notices of default as soon as you know you need to in order to trigger the traditional lien theory right to receive rents – and argue for more under the absolute assignment.
 

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You've reached agreement in concept with your borrower for a debt workout. The borrower will deliver the keys (and title) to the collateral, the noteholder doesn't intend to pursue recourse liability carveouts (or has agreed to forego pursuit of any claims) and you want to accomplish all of this in short order. There are several key documents and provisions you will want to work with to close your deal.

Deed in lieu of foreclosure
The quickest way to transfer title to the noteholder in a consensual workout is a deed in lieu of foreclosure. Legally, this has the effect of accomplishing what the noteholder/mortgagee could accomplish through the power of sale reserved in the mortgage or deed of trust – but without the notices, time delays and attendant costs.

If you are certain your lien interest is a first priority perfected lien interest, you are in good shape. If there is any chance you have lien priority issues, you should consider things further. Potential lien priority issues typically will involve property tax and other tax liens and mechanics and materialmen's liens (especially as to removable improvements). In that event, make certain your settlement documents include warranties and representations to the effect that there are and will be no lien claims arising based on the period of time the debtor held title. But remember, you already had a note obligation from the borrower that wasn't honored – chances are a claim for breach is going to be little consolation.
 

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Promissory Note
Historically the owner and holder of negotiable instruments, bearer instruments, etc. have been very important in contractual financial relationships. However, promissory notes contain repayment obligations of the maker that may be contractually limited. Confusion exists as to the legal necessity of "holder and owner" legal requirements. The new structured financial instruments have caused concern about the owner/holder status in various contractual relationships. The primary applicability of owner and holder status relates to enforcement of the promissory note by the holder against the maker. However, many structured financial instruments are non-recourse as to the maker of the obligation. If the promissory note is non-recourse, the secured party must look to other sources of repayment.

Deed of Trust Contractual Real Property Source of Repayment
In Texas the deed of trust and Property Code §51.0001, et seq., define the legal requirements for selling real property collateral by foreclosure, and applying the sale proceeds against the unpaid promissory note. Property Code §51.0025 allows a mortgage servicer to administer the foreclosure of property without requiring the mortgage servicer to be the owner and holder of the promissory note. The contractual right to foreclose is found in the deed of trust and Property Code §51.00025 allows the mortgage servicer to administer the foreclosure sale.

Personal Property Security Interest
Like the contractual deed of trust, the foreclosure of personal property may be exercised in accordance with the security agreement and Article 9 of the Texas Business and Commerce Code. The disposition of personal property is pursuant to the contractual security agreement and Article 9.

Guaranty
Guaranty is a contractual relationship between the guarantors and the contractual payees of promissory notes. Like deeds of trust and personal property security instruments, guarantys are another source of repayment of contractual payment obligations.

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