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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Guest Writer, Laura P. Sims, Winstead PC

(CAVEAT: if this blog seems familiar, it probably is because after we posted it last week, it  "mysteriously" dropped off our site - after I messed up on the posting of March 7.  And I apologize.   So, here it is again!)

This is a series of blog entries [link] 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.

What are the risks involved in delaying the exercise of remedies?

A period of delay between declaration of default and exercise of remedies increases the chance that some action or omission by Landlord or its representatives will be claimed by Tenant as evidence that:

• Landlord has waived the default or
• Tenant reasonably believed (and relied on its belief) that Landlord did not intend to strictly enforce the Lease.

Either one is a bad, bad result.

So, what should you do during any time period when landlord remedies are being deferred (or not exercised)?

Here are some tips:

• avoid sending e-mail correspondence involving discussions of modification of the Lease
• avoid in-person meetings involving discussions of modification of the Lease
• don't accept partial or late cure
• don't promise to forgo exercise of remedies (in other words, don't say "we won't exercise remedies")

Ideally, if rent failure is the issue, then monthly notices of failure to timely pay and demand for payment in full can and should continue during the period of delay - in order to combat any suggestion that Landlord will not strictly enforce its rights.

One final word of warning: at some point, the Landlord will need to get off the stump and act - or waive the default.

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

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As I've noted previously [link to due diligence topics], one big difference between the current commercial real estate melt down and the last big one (in the late 80s) is the amount or level of “structure” in the deals. Like the last time, the debtor\borrower side is “structured” (with a multi-tier borrower and perhaps even a “single purpose” entity); however, unlike the last time, the creditor\lender side also is structured.

A multi-creditor structure greatly complicates decisions covering a possible workout, the remedies to be invoked, and the management, leasing and eventual sale of the collateral (after foreclosure).

Indeed, co-lender disagreements are the most difficult part of this process.  (And one lesson learned is to NOT do co-lender deals in the future; or do them only with similar lenders having similar balance sheets, ownership, investment objectives and criteria, etc.)

Part of the difficulty flows from some confusion, or misunderstanding, on the part of all of us on the technical terms and attributes of the co-lender structure. Since the typical co-lender structure either is a syndication or a participation, I've identified some of the basic terms for those two structures:

• Nature of the creditor’s interest
• Recover of taxes & funding losses; gross up for reserves
• Common law rights
• Insolvency of originator/agent
• Legal opinions
• Assignments
• Enforcement actions
• Amendment (workout) rights
• Waiver rights
• REO decisions (management, leasing & sales)

To help you better understand the difference between (i) a loan that has been syndicated (typically where each lender has its own note and all lenders share the collateral) and (ii) a loan that has been participated (where there is a single, lead lender, and the other lenders only participate without their own notes), here is list of some of the major topics of interest.

(For postings on other co-lender topics, such as A\B Note structures and lender v lender litigation, search the site using the term "co-lender.") 

 (Click on "continue reading" for a table detailing differences on these terms)

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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.

What kinds of default will support termination of the Lease or repossession of the premises?

Most Texas courts (and courts in other states as well) are reluctant to enforce a Landlord's right to terminate a lease or repossess a Tenant's premises in the absence of a specifically negotiated or egregious non-monetary default, if the Tenant is otherwise in compliance with the lease.

By contrast, even a relatively small monetary delinquency will be enforced per the plain language of the lease.

Accordingly, where the lease provides Landlord the right to cure non-monetary defaults and obtain reimbursement of such costs from Tenant as additional rent, it may be expedient for Landlord to exercise such right to cure, so that if and when Tenant fails to reimburse such costs, Landlord can proceed on a claim of monetary default.

However, at least in Texas, non-monetary defaults such as abandonment, voluntary bankruptcy, failure to pay utilities to third parties, and allowing the attachment of liens have provided a basis for exercise of Landlord's more aggressive remedies.

Furthermore, if the lease sets forth termination or repossession as the specific remedy for a given non-monetary failure (such that Landlord is not relying on "catch-all" non-monetary default language), a court is more likely to enforce the parties' negotiated remedy.

• For instance, where Landlord and Tenant have negotiated an obligation for Tenant to open for business by a certain, critical date, with a clearly stated and unique right of termination for failure to perform by such date, the declaration of default and exercise of such termination right should be enforced.
• Conversely, even where a lease requires Tenant to take occupancy or open for business by a date certain, if no specific remedy is stated for that failure, it is unlikely that a Texas court would allow Landlord to terminate the Tenant's lease for such failure, particularly if Tenant occupies the premises or opens for business within a short period following the originally required date.

As a general rule for evaluating the strength of non-monetary defaults as a basis for termination or repossession consider:

1. Whether the breach affects the negotiated bargain between the parties
2. Whether the harm to Landlord is commensurate with the loss a termination or repossession would cause the Tenant
3. And further consider obtaining the opinion of an experienced litigator or real estate attorney before making a final decision about pursuit of remedies

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

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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.

FAQ - Is Landlord required to give notice of all defaults at the same time?

No.

Where multiple defaults exist, some discretion may be used in listing the individual failures, with clear emphasis on monetary defaults and material non-monetary defaults.

A default and demand letter that identifies

• defaults of a . . .
• nature and materiality that would support termination of the lease, or the exercise of rights of repossession if not cured, should suffice . . .
• so long as suitable language (which has been either developed or reviewed by counsel) is also included in the letter to reserve any and all Landlord rights with respect to other defaults, known or unknown, and to disclaim any intent to waive any such defaults.

The third bullet point is very, very important.

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

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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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(This is the last in a series covering the MBA-CREF convention.  In contrast to the first two days [link Day 1] [link Day 2] and our convention "preview" [link], this last posting focuses on the two polar extremes of the convention, and the industry.)

For Chris Nixon [link to bio] and myself, day 3 of the MBA-CREF convention (yesterday, Weds.) was filled with meetings with significant industry players from two distinct groups: special servicing and life insurance companies.

We listened for the answer to one specific question from each group, which for us (and perhaps for you) is “the” question.

• Special servicing: what tips or advice can you give a borrower in 2010?
• Life insurance company: will your loan allocations differ from your 2009 performance? (Read: will we see any “improvement” over 2009?)

Here is our summary of the answers given to us.

Special Servicing Tips

Not surprisingly, the tips were very similar to those articulated at the recent CMSA January Conference [link to 2nd day posting].    However, we heard enough “new” or different answers to craft an expanded list of tips.

True, the answers vary depending upon the particular servicer, the project, the carveout sponsor, the tenants, etc.

But putting it all together, here are the tips:

Do This:

• be nice
• send all information in; be open and transparent
• sign a pre-negotiations agreement
• keep paying cash flow
• have a reasonable, cogent plan BEFORE you contact the lender or servicer (show us that you are in a good city\market, with good tenants, good DSC, etc.) 
• show up with $ (to right size the loan) when you ask for a debt restructure
• default with dignity (i.e., have a "real" default and then be truthful)

Do NOT Do This:

• tell lender or servicer that you're "partners"
• show up with a sham balance sheet
• stiff or abuse your other lenders and the expect us to expect otherwise
• tell lender or servicer that you're a good borrower
• "fish" for information or for terms of a plan that will be acceptable
• cry
• hold lender or servicer hostage
• ask for any of the cash flow (nor a cash flow mortgage)
• fly in on a private jet
• offer a bribe
• rob Peter to pay Paul
• launch off on a religious sermon (caveat: "the special servicer knows that it is going to Hell – every day is Hell")
• ask for any return on the new equity infusion made in borrower 

(For our other postings on CMBS special servicing, use the “search” function on the right side – and search terms such as “special servicing.’)

Life Company Loan Allocations for 2010 (& comparison to 2009)

The message generally was consistent from all our life insurance company contacts:

• in 2009, roughly 30%-45% of the allocation was utilized to refinance the “best” loans\relationships in the portfolio
• in 2009, not all of the allocation was utilized . . .
• but since corporate spread have dramatically dropped in the last 6 months, mortgages are a relative good investment; so . . . 
• there is hope that the mortgage allocation will be fully funded in 2010 . . .
• however, probably the same percentage of the allocation (30%-45%) will be utilized to refinance the “best” loans\relationships in the portfolio . . .
• and, the allocation amount is not near the level seen during recent years
• the limited funds available for new loans will target the narrow bandwidth of the best projects and sponsors (high Debt Service Coverage or DSC; good Loan to Value or LTV; good balance sheet of the sponsor; good tenants; good market position; etc.)
• since large loans to single-sponsor borrowers (and not multiple loans to different sponsors) typically fit this narrow bandwidth, 2010 could be the year of the large loan for many life insurance companies

Add all of this up, and it is clear that with a muted allocation amount and the commitment to utilize a significant part of it to refinance the current portfolio, the total amount of credit available for 2010 from life companies is small (relative to demand). 

The story here reminds me of the message from the CMSA January Conference: the recent CMBS issuances are good news for Wall Street but “no” news (i.e., no help) for Main Street.

The same should be said of the Life Insurance Company mortgage loan allocations: it sounds good, but really?

So, the message from both the CMBS Conference and the MBA-CREF Convention sync very nicely. (As predicted in my earlier posting?) [link]

If the mantra during the ‘90s and ‘00s was “other people’s money” (or “commercial subprime”), the mantra for the new economy is “show me the hard equity” (or “real money for real people”).

Yes, we’re returning to real estate fundamentals.

And since a large percentage of CRE is over-leveraged (a condition that I call "subprime commercial"), we circle back to the tips on special servicing . . .

If you see it differently, or have something to add, please post a comment below.

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As noted in my lengthy postings summarizing the recent 2010 CMSA January Conference in DC [Day 1 link; Day 2 link], over 1,000 commercial real estate professionals attended the conference – roughly 2X more than expected.

Why this unexpected attendance? Answer: All of us are looking for answers amidst the continuing liquidity problems in the CRE Capital Markets. This topic was the sole focus at this conference.  (And it even shows in the number of people "visiting" TTL blog since the Tuesday [Day 1] posting: we show over 1,000 total "hits", of which over 550 are "unique", as of this blog posting.)

 I've received feedback asking for a summary covering a specified set of topics from the two (much, much longer) blogs covering days 1 and 2.  (Keep that feedback coming!)

So, here is that subset of information from the 2010 CMSA January Conference:

INVESTORS FORUM

This forum is for a broad band of CRE debt investors (such as B note holders, mezzanine lenders).

The meeting time was devoted to a survey of the 250+ people in the room. Here are some of the responses: 

• 45% of the voters believe that CRE values will continue to fall in 2010 with no recovery in CRE values until 2011 (this fall is in addition to the 44% fall from 2007 CRE pricing)
• with respect to the 2005-2008 CMBS pools, 37% of the voters believe that the average losses will be in the 11%-15% range (these loses will wipe out bond holder through the "AJ" class)
• 43% of the voters believe that for CMBS loans liquidated in 2010, the average loss severity will be 40%-50% (and 27% believe that the average loss severity will be 50%-60%)
• 69% of the voters believe that annual new CMBS issuances will not exceed $100B until 2013
• for new CMBS issuances in 2010: 50% of the voters believe that issuances will be single borrower transactions; and 33% of the voters believe that issuances will be multi-borrower and large loan structures (with only a few assets); and
• 58% of the voters believe that "old-school" multi-borrower, fixed rate deals will return no sooner than 2012 (or later)

REAL ESTATE FUNDAMENTALS: "THE FACTS OF LIFE"

If the focus on "CMBS 2.0" (which is the "hot" phrase used to describe the "new" CMBS model and market) is a bit too out of touch for me, this session just hammered on the current picture of the CRE market:

• unemployment at historical highs (and still rising)
• retail sales still stumbling
• consumer confidence falling
• "asking" commercial rents falling
• commercial leasing activity (absorption) falling
• CRE sales activity: stagnant
• CRE values -43% from the high in 2007
• huge amount of CRE loan maturities over the next three years, with inadequate sources of credit to pay-off those maturities
• huge shortfall in CRE equity (such that it will not fill gap between the credit available and the looming CRE maturities)
• over 75 funds have been formed to buy distressed CRE debt and properties; but little it has been deployed
• very little CRE has been "re-priced" or "re-set" by lenders or servicers foreclosing or disposing of assets
• we're still early in the CRE recover (perhaps only 25% into the process!) (One interesting comment: remember that valuation adjustment occurs early in the CRE recovery process; so we might be 75%-90% into the valuation adjustment process.)
• importantly: no one on the panel, nor else where in the room, foresees an implementation by the Government of an "RTC style" approach (where the Federal government quickly closes large numbers of banks and thrifts, and then quickly sells the loans and assets at steep discounts – resulting in a "harsh pain" but quick re-pricing of CRE
• unlike the late 80s & early 90s: this time there is no new industry (such at technology) to lead the recovery by increasing employment

BORROWER PANEL: "SURVIVOR"

This panel focused on "how" a borrower could make it through until CRE liquidity returns.

The panel has some advice for borrowers:

• show up with $ if you want to restructure your debt
• if you're in a good city, with good tenants and with DSC (get it?
• Use $ to right-size the loan), then you'll probably survive

It was interesting that while reference was made to splitting up a CMBS loan into an A Note (with good DSC & LTV) and a B Note (representing the "bad" part of the original loan), no one gave any details on the structure (such as the terms of the B Note, the proceeds waterfall between the lender [under the B Note] and the "new" equity [that injected capital needed, in part, to right-size the Note A], the rate of return on the new equity, etc.)

SURVEILLANCE & WORKOUTS: "LET'S MAKE A DEAL'

This panel didn't give any real guidance on terms of workouts, other than to list some basic rules of the game:

Do This:

• be nice
• send all information in; be open and transparent
• sign a pre-negotiations agreement
• keep paying cash flow
• have a reasonable, cogent plan BEFORE you contact the lender or servicer

Do NOT Do This:

• tell lender or servicer that you're "partners"
• tell lender or servicer that you're a good borrower
• "fish" for information or for terms of a plan that will be acceptable
• cry
• hold lender or servicer hostage
• ask for any of the cash flow (nor a cash flow mortgage)
• fly in on a private jet
• offer a bribe
• rob Peter to pay Paul
• launch off on a religious sermon (caveat: "the special servicer knows that it is going to Hell – every day is Hell")
• ask for any return on the new equity infusion made in borrower

It was an interesting day. Much like our experience in Munich – very little clapping at the end of any session (yes, it reminded me a little of the sessions at the EU conference that we attended in October 2008) [link]

In a future posting, I'll cover comments made to us by several elected and appointed Federal officials.

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

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 Our friends at Cantrell McCulloch [link to website] bring to our attention a topic that could literally be a “drag” on your collateral: the valuation given to the collateral by the applicable taxing authorities (public and private).

Taxing authorities could be state, county, city, hospital, school, road and other governmental authorities; and also “private” (not governmental) bodies in instances, for example, where fees are “spread” among multiple lots or parcels pursuant to private agreements (such as deed restrictions).

When you stop and think about it, you’ve probably seen line items in operating budgets for taxes and assessments, but have you stopped to consider whether the borrower has actively protested or tried to lower the valuation that provides the basis for the cost? And, have you (as lender or servicer) investigated and considered your ability to lower valuation PRIOR to taking title to the collateral?

I know, you’re thinking: “surely the borrower has investigated the tax valuation of the property.”

Maybe. Maybe not.

Often, borrowers have much, much larger fires to fight; and devoting a reduced staff to reducing property valuation so as to save money in the FUTURE is, well, not important when the borrower is fighting simply to keep afloat today – and keep the property.

So, my suggestion simply is to add this topic to your workout check list, and include the following as tasks directed at this ticking sound:

• What taxes or assessments cover or encumber the collaterals? Governmental (per a current search of applicable governmental taxing offices)? Private (per a current title report)?
• What valuation has been given to the collateral? (Is it high?)
• How is valuation determined?
• What are the key dates (Due dates? Appeal dates? Etc.)
• Has the owner\borrower contested the valuation? Are written agreements covering valuation in place?
• Is it possible to file a “late” appeal? Are there special conditions for filing a late appeal?
• What input or role does the lender\servicer have in the valuation determination or appeal process? (Under applicable law or regulations? Under the loan documents?)

Todd Franks (with The Cantrell Company) tells me that they have recovered over $100,000 in overpaid property taxes for one loan servicer, after a borrower failed to timely protest their 2008 property tax valuation (in a situation involving Texas real property collateral). His experience is that if the current owner is unsophisticated and\or unfamiliar with the property valuation process, then when the owner is struggling to keep the property and to avoid a loan default or a foreclosure, many owners simply give up on contesting property valuations handed out by taxing authorities. (The result: it is a problem discovered by you AFTER you take title.)

Clearly, this topic qualifies as another one of my “ticking sounds” –  topics inherent in real property collateral that can jump up and bite you during and after a loan falls into distress. (For other “ticking” topics, search this blog using the search term “ticking” in the search box on the lower right side of the page.)

Put this topic on your check list.

And follow up with Todd Frank (at tfranks@cantrellcompany.com) if you’d like to talk with him.

Finally, as always, if you have any questions, comments or practical advice on this topic, please post a comment.

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Just as they did for 2009 [link], our friends at Armstrong & Associates [website] have prepared a 2010 calendar events and meetings for industry associations, legal education events, governmental meetings, etc. -- all focused on bankruptcy and insolvency.

It is a very good list [PDF]

If your focus is on distressed commercial mortgages, then you’ll note that this event is missing from the list: the MBA’s Commercial/Multifamily Servicing and Technology Conference.  It is May 23-26, 2010 in New York City [Link to MBA conference website]

I attended the 2009 MBA Loan Servicing and Technology Conference, and as I typically do at conferences, I posted several blogs covering topics addressed at the conference [day two link].  (Bonus information included several restaurant reviews - how could I be in New Orleans and not mention the food?  Work.  Eat.  Work.  Eat.)

From my perspective, the topics covered by the 2010 conference will sound a lot like the topics at the 2009 conference – unless we have truly significant changes in the regulatory environment and\or in the financial markets, which from my perspective would include changes in the Federal Bankruptcy Code AND Treasury Regulations in support of a covered (mortgage) bond product.  (If you're a regular reader, you know that we're following this topic.)

Here's a "new" topic, however; and it is one that we're suggesting the MBA include in the 2010 Conference: Taking Control of Building Operating Systems Upon Foreclosure or Receivership.

• how does that topic strike you?
• is this a "hot" topic for you?
• for example, how are you dealing with technology issues at building takeover?  Is the server on site? Is removal of the server a non-recourse carve-out event?  Oops - "how" do we "control" the HVAC or the building electrical grid or telephone and data services? (Yes, this is something "new" from the late 80s - technology has impacted building operations; did you make corresponding changes to your loan documents? Is it on your takeover list? How are you dealing with it at takeover?)

My bet is that the MBA will want us to present this topic, and that as commercial office buildings "enter" the workout mix, this topic will jump up and bite us.  (And yes, in 2010 we'll do a few blog entries on this subject as part of our "Ticking Sound" series.)

Also, Kevin Sullivan [web bio] and I will be attending the CMSA's Investor Conference next month [conference flier].  I'll update you on a daily basis while we're in DC at the conference.  It promises to be very, very interesting - given all of the regulatory reform in the winds.

Finally, please comment on any of this.

We hope that you're having a good holiday season.

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On October 30, 2009, the Federal Financial Institutions Examination Council (FFIEC) issued a policy statement that was adopted by the OCC, the Fed, the FDIC and the Office of Thrift Supervision as Guidance on Prudent Commercial Real Estate Loan Workouts (FFIEC's Guidance under the OCC Bulletin 2009-32).  The policy replaced the Interagency Policy Statement on the Review and Classification of Commercial Real Estate Loans that banks have been operating under since November 1995.  (For a copy of the policy statement, see our earlier posting [link].)

OVERALL TONE
The overall tone of the Guidance is to provide prudent but pragmatic guidance on risk assessment, allowing financial institutions in the present environment to actively engage in CRE workouts without undue fear of reclassification by examiners.  For example, the Guidance states:

"Financial institutions that implement prudent loan workout arrangements after performing a comprehensive review of a borrower's financial condition will not be subject to criticism for engaging in these efforts, even if the restructured loans have weaknesses that result in adverse credit classification."

While there are a few hard and fast prohibitions in the OCC bulletin, as a general matter its cornerstone is flexibility and pragmatism in working out distressed commercial real estate credits. Institutions are encouraged to consider both the asset and Borrower/Sponsor capacity for repayment of the credit.

The Guidance establishes protocols encouraging institutions to apply prospective, "forward thinking" to the cash flow analysis of distressed real estate projects.  Additionally, it discourages "second guessing" by examiners on such items as assumed cap rates, lease renewal assumptions, lease-up periods and other forward looking market conditions. The Guidance also reinforces, and in some cases clarifies regulatory and GAAP reporting requirements.

KEY POINTS

The Guidance includes the following key points:
 

• 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 below the loan balance.
   
• In general, renewals of maturing loans to responsible borrowers who, because of the present financial crisis, cannot locate a source of refinancing, should not suffer adverse classification.
   
• Separating a single loan into an "A/B" note structure (with impairment and/or non-accrual hitting the B note only) receives a regulatory "stamp of approval" under appropriate circumstances illustrated in the Guidance.
   
• Troubled debt restructuring (TDR) contains a two-prong test in which both prongs must be met: (a) the borrower is experiencing financial difficulties (examples of what this means are provided in attachment one of the Guidance) AND (b) the lender grants a concession that it would not ordinarily grant except for the status of the real estate and/or economic conditions.
   
• "Fair value" vs. "Market value" - Fair value is still required under impairment situations (pursuant to FASB 114) and for properties deemed to be TDR. "Market value" (i.e. predictable future values) can be considered if consistent with the facts and circumstances of the workout.

• Clarifies Allowances for Loan and Lease Losses (ALLL) calculations utilizing fair value; existing guidance remains in place.
   
• The concepts of "market interest rate" become of paramount importance in: (i) classifying or reclassifying the credit, (ii) going on or off of accrual basis, and (iii) booking losses (examples of what is considered and not considered "market rate" are illustrated in Attachment One to the Guidance).  Market interest rate calculations should:
  
  - Take a forward-looking view at the cash flows, rent rolls and property type analysis
  
   - Be influenced by the credit quality of both the borrower and the real estate
  
   - Be adjusted (positively or negatively) by the existence of quality loan guaranties utilizing current financial information
  
   
• "Interest only" concessions for periods beyond one year in order to allow the property's cash flow to service the debt will be frowned upon, and likely not deemed "market."
   
• Generally "second guessing" by examiners is discouraged and will be viewed as inappropriate in the analysis of certain specified forward-looking circumstances.
   
• Overall, the Guidance encourages bank institutions to be proactive and forward thinking in applying their analytics at the property level.

In summary, the Guidance stresses the need to examine each commercial real estate loan on its own merits; examining borrower, sponsor and guarantor credit and payment capacity, as well as the current and projected quality and durability of asset level cash flows.  The examples contained in Attachment One to the Guidance demonstrate that this process will inevitably involve subjective judgments.  Although there is a definite change of tone, the regulatory construct remains fundamentally unchanged.

It will be interesting to see how banking institutions and their examiners react to the October 30th announcement.  Given the general and subjective nature of the subject matter, and that guidance is provided largely through examples, implementation may well prove to be uneven among banking institutions.

As we move into the next phase and begin to work with the Guidance, we encourage you to share your comments and experiences.

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The “co-tenancy” clause is a lease provision where Tenant A has the ability to take certain actions (such as reduce rent or even terminate the Lease A) if Tenant B does something, such as ceases operations or even terminates Lease B (Tenants such as Tenant A and Tenant B are called “anchor tenants” or “lead tenants”).  

Right now, it has the ability to both maim AND kill a retail center.

What is a Co-Tenancy Clause?
The clause is a lease concession granted by the landlord\borrower in order to attract the all-important anchor tenant to the center (Tenant B) after a “lead” anchor tenant (Tenant A) has already leased space in the center. Since the clause assists in creating the all-important tenant mix, it is viewed as a “good” clause. Rent is good! It’s great when consumers are spending money in the center; which of course, builds value in the center, allowing the landlord\borrower to finance the center. Everybody is happy.

The co-tenancy clause is important in bringing about all of this happiness.

So, the clause is overlooked or even applauded at loan origination when the rent roll and the tenant mix is the focus.

Co-Tenancy Clauses Can Sever a Limb
Of course, that perspective changes when consumers stop spending money. When tenants are no longer happy. When rent is slow-paid (or simply not paid). When tenants are looking at the lease as a major drain on their income statement.

In this economy, Tenant B now might do that “something” (such as ceases operations, or terminates Lease B), with the result that Tenant A will have the ability to invoke its right (under the co-tenancy clause) to reduce rent, to terminate Lease A, etc.
The result will be like losing the arms or legs to the retail center.

So, here are some suggestions:

• Add this clause to your short list of “most dangerous” lease clauses and be sure to flag it during your lease reviews
• As you modify leases, DELETE it from the lease

But wait, there is a new, innovative use of the co-tenancy clause, where it spreads like the flu and then threatens to kill the entire retail center.

Co-Tenancy Clauses Can Kill
Be aware of this new, even innovative, use of the co-tenancy clause:

• Tenant B is in distress and is considering ceasing operations or terminating the lease
• Tenant A learns of this, and starts to consider whether it will invoke its rights under the co-tenancy clause
• Tenants C through G (the other, “small” retailers in the center) learn of this. They meet and for the first time, realize that not only is their economic success tied to Tenant B and Tenant A, but that they should take this collective step with each other . . .
• All tenants, as a collective whole, (Tenants B, A and C through G) approach the landlord\borrower for new rental and lease concessions FOR ALL OF THEM.

This type of collective bargaining is taking place.  It could spread to a retail loan in your portfolio.

It is flu season for landlords. And for lenders and loan servicers. It could kill.

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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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At the September announcement of the REMIC announcements from the US Treasury the IRS, we posted copies of the materials relating to "significant modifications" to CMBS loans.

Last week, Lou Strawn weighed in on his perspective on the significance of these changes.

Today, the Commercial Mortgage Securities Ass'n gives us the industry's "official" perspective in a white paper.

The prediction here is that these REMIC reforms will NOT have a significant impact on the log-jam of distressed loans needing modifcation (in conjunction with a workout).

If you see it differently, or have an experience that you want to explore, please post a comment.

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In September, Keith Mullen posted a blog entry attaching the IRS and Treasury Department's announcement clarifying and expanding the "significant modification" REMIC rules.

The first announcement was the IRS guidelines contained in Rev. Proc. 2009-45, which provides guidance for modifications to certain loans without triggering an IRS challenge to the tax status of the REMIC. The guidance changes the standard under which loans may be modified without triggering the prohibited transaction tax on the income of the trust. Prior to Rev. Proc. 2009-45's current announcement, loans could be modified only if a change in the terms of the obligation was "occasioned by default or reasonably foreseeable default." Rev. Proc. 2009-45 changes this standard and permits a change in the terms to be negotiated if, based on all the facts and circumstances and after meeting the threshold for a qualified loan, the holder or Servicer reasonably believes that there is a "significant risk of default" of the loan upon maturity of the loan or at an earlier date, and that the modified loan will present a "substantially reduced risk of default." Rev. Proc. 2009-45 makes a point of stating that there is "no maximum period after which a default is not per se foreseeable." Previously, Special Service practice was not to entertain a modification for impending "maturity defaults" with maturity dates beyond one year, because maturities beyond one year were not, per se, a reasonably foreseeable default. The guidance is clearly intended to allow Servicers to have greater flexibility in considering "all the facts and circumstances in servicing distressed mortgages." Additionally, those facts and circumstances can come from written factual representations made by the borrower as long as the Servicer "neither knows nor has reason to know that such representations are false." Interestingly, these guidelines will apply to loan modifications effected on or after January 1, 2008.

Additionally, the Treasury Department issued final regulations ("TD 9463") specifically expanding the list of exceptions that will not be considered "significant modifications" of mortgage obligations held by the REMIC. TD 9463 became effective September 16, 2009, with an expanded list of exceptions that include modifications that release, substitute, add or otherwise alter, a substantial amount of the collateral so long as the obligation continues to be "principally secured by an interest in real property."

And lastly, the final regulations clarify that "value retesting" for modifications to satisfy the requirement that the loan principally be secured by real property will not be necessary as long as the fair market value of the interest in real property that secures the loan immediately after the modification equals or exceeds the fair market value of the interest in the real property that secured the loan immediately before the modification. This alternative test is consistent with the general rule that a decline in the value of collateral does not cause a mortgage to cease to be principally secured by real property. Finally, the regulation provided that changes in the nature of an obligation from nonrecourse to recourse or from recourse to nonrecourse are permitted so long as the obligation continues to be principally secured by an interest in real property.

Will the floodgates Open?

As many readers know, there has been an ongoing battle between Special Servicers and borrowers regarding the loan modification process. Special Servicers, needing to be certain that their actions were consistent with Pooling and Servicing Agreements, as well as REMIC regulations, were unwilling to take any significant risk that their Servicing actions would be considered a violation of REMIC rules or of the terms and conditions of Pooling and Servicing Agreements to which they were a party.

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Every downturn and recovery offer opportunities for investors to adapt and respond to changing economic conditions.  Today's climate requires investors to look for commercial real estate opportunities in new and challenging ways.  Investing in distressed assets presents investors with one opportunity for growth as market conditions improve.  Winstead PC and Cohen Financial hosted a webinar covering topics important to implementing an investment strategy in this difficult market.

Did you miss the webcast?
Don't worry, one reason that you follow this blog is to gather information on your own terms, and on your own schedule. 

• Click here to watch the webcast
  
• Click here for a copy of the presentation materials

After you watch this webcast or read the materials, please post comments or questions.
 

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For the next couple of days, I'll be attending the annual meeting of the American College of Mortgage Attorneys (ACMA).  Members of ACMA are a select group of in-house and outside counsel, who are recognized as leaders in commercial real estate finance.

OK, I know:  You're rolling your eyes as your internal big screen pans a view of a room full of (ego laden?) lawyers, sitting in your basic seminar setup, listening to speakers (most by now are far enough up the tech curve to use PowerPoint), and discussing . . . .

Here's where you should wake up to the relevance of it all:  What are the topics that the legal thought-leaders are focusing on?  What has their attention?

I'll admit that some (most?) events like this are grueling for me, but simply because I can't sit still for a stretch of 8 hours.  The content, however, keeps my attention.  And because I think that it might interest you, below is a summary of several of the topics.

A reminder for you:  If you want more information on distressed debt & investments, go to the "Client Resources" tab on our blog homepage.  It contains instructions on how you can access our extranet site, where we have posted 60+ papers, articles and presentations for you to read, download, etc.  It is free.  It is available 24/7.

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Periodically, we alert you of opportunities to participate in online webinars on various topics—from the "comfort" of your own computer.  No travel.  No hassle.

On Wednesday, October 7, Cohen Financial and Winstead PC are hosting a webinar on investing in distressed assets.

Every downturn and recovery offer opportunities for investors to adapt and respond to changing economic conditions.  Today's climate requires investors to look for commercial real estate opportunities in new and challenging ways.

Investing in distressed assets presents investors with one opportunity for growth as market conditions improve.  The professionals at Cohen Financial and Winstead PC will present you with the knowledge needed to evaluate this investment strategy.

During this webinar you will learn:

• How to find distressed commercial real estate assets
• What is involved in the valuation and financing of these assets
• How to buy debt
• How to buy commercial real estate
• The tax issues involve

Investing in Distressed Assets – Webinar

Wednesday, October 7, 2009
11:30am PT/12:30pm MT
1:30pm CT/2:30pm ET
Click here to register (link)

This webinar should interest players from every point or perspective, whether sellers, buyers, special servicers\asset managers, REO\asset managers, or intermediaries.

If you have questions in advance, please post a comment.

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Sick and beyond tired of the inflexibility of CMBS servicers in making needed modifications to CMBS loans that we all know are in the ditch?  Help might be here:

On September 15, 2009, the IRS and the Department of the Treasury issued three pieces of guidance relating to commercial mortgage loans held by a securitization vehicle (a CMBS loan).

• The final rules (see PDF entitled "TD 9463") regarding "Modifications of Commercial Mortgage Loans Held by a Real Estate Mortgage Investment Conduit (REMIC)" include changes in collateral, guarantees, credit enhancement of an obligation and changes to the recourse nature of an obligation.  These rules expand the list of exceptions that will not be considered "significant modifications" of a CMBS loan obligation held by a REMIC.
  
• The IRS also issued Revenue Procedure 2009-45 (PDF), which is a final ruling that describes the conditions under which modifications to certain mortgage loans will not cause the IRS to challenge the tax status of REMICs.  Specifically, note the factor that allows a servicer to take action more than one year prior to maturity.  Furthermore, a servicer is able to rely on information provided by the borrower unless it has knowledge to the contrary.  More importantly, while past performance of the loan is a factor in assessing risk, a "significant risk of default" (based upon a "reasonable" belief standard) can be found by the holder or servicer even if the loan is currently performing (This is great news for principals who are keeping the loan payments current from sources other than rent).
  
• In addition, the IRS and Treasury issued Notice 2009-79 (PDF) and are requesting comments on what additional guidance, if any, is needed regarding modifications of commercial mortgage loans held by investment trusts.

Additional information can be found on the CMSA's Web site (link to REMIC Reform).

Hopefully, these guidelines will allow CMBS loan servicers and borrowers greater flexibility to assess risk and allow for appropriate modifications to CMBS loans.  It is desperately needed.

We know that the public is in no mood to support a "rescue" plan for commercial real estate.  Maybe,  just maybe, "tweaking" the tax code like this will be the approach that will be taken by the government—sort of a "back door" rescue plan for commercial real estate.  However, I believe that it'll take much, much more than tweaks like this one to help commercial real estate to QUICKLY recover.

Kudos to the broad cross section of the commercial real estate industry that worked on this initiative (Mortgage Bankers Association, Commercial Mortgage Securities Association, ICSC, Real Estate Roundtable, and others).

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

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As a baby lawyer, I cut my teeth on collection work.  Any sizeable business law firm has some, and it’s great for training young lawyers.  There is a routine about it, for the most part.  And, while you would often get a lender liability counterclaim in the early 1990’s, those eventually dwindled due to the wisdom of our legislature and courts.

After a couple of years, I graduated to sexier work—fraud, antitrust, trademark litigation and the like.  I would often delegate the promissory note cases, passing work down to the lowest billing rate.  But years ago, something changed.  A banker, who was a good client and friend, mentioned to me that another law firm had gotten a quick judgment, while we were “going through the motions with discovery”.  I realized that I had allowed the means (the routine of collection work) to overshadow the end (the goal of actually getting money for my clients).  That was my wake up call, and I soon rededicated myself to finding the passion in collections.  After all, collecting on a debt that someone owes is a little like waving the American flag in my mind.

I often joke that the bankruptcy system should be abolished, because how could our system of justice allow someone to incur significant debt and then simply walk away from it—no payment plan, no good faith effort, nothing.  I attend creditors’ meetings in bankruptcy court, where, for example, debtors simply charged too much on their credit cards for so long, they can’t see a way out.  They are essentially allowed to walk from their debts as if they never happened.  And in today’s society of debt forgiveness, my guess is they will be given plenty of credit opportunities in the future.

Now, more than ever—I am working with clients that are new to collection litigation.  Many clients have always been able to handle their collections or workouts in-house.  Or perhaps with the number of workouts and collections, personnel are being re-tooled from other areas in the company.  Whatever the reason, clients still see litigation as a necessary evil, the last resort, the worst thing they can do to their customer or client or vendor.  Instead, I argue, they need to see litigation as a workout tool that can effectively and professionally be used as additional leverage and an opportunity to maximize your chance of recovery.  But when is the right time?  After the third broken promise to provide updated financials?  After the fifth late payment?  After the collateral loses half of its value?

This series on collection work will include tips for collecting, when to bring in a litigator, most common mistakes made in collecting and other topics to help you get paid.  Stay tuned for Part I of the series: When can I stop being nice?

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This is the second part of a two-part series laying out a quick checklist covering title insurance issues—and highlighting topics that should be investigated.  This is an important and often overlooked topic.

1. Was UCC insurance obtained (covering attachment, perfection and priority of lender’s security interest in personal property)?  Here are the types of transactions where UCC insurance is important:
   --Factoring credit facilities (where the collateral includes a right to payment or claim covered by a UCC filing).
   --Mezzanine loans (where the collateral is ownership interests in the borrower entity) covered by UCC filings.
   --Asset based credit facilities (for example, where collateral includes inventory and accounts receivable covered by UCC filings).
   --Mixed collateral structures (for example, where collateral includes both real and personal property—such as a hotel or a restaurant).
2. Title insurance polices can contain a long listing of “exclusions” from coverage.  There are items that are not covered by the policy.  These can include the following, each of which can limit the use and value of the collateral: easements; restrictions; use agreements; development agreements.
   --Do these exclusions impact the current use and physical attributes of the collateral?
3. Note that zoning compliance and building code restrictions typically are not included in the basic title insurance coverage.  Therefore:
   --Does the policy contain a zoning endorsement?
   --If “yes,” then what are the terms of the endorsement?
   --Has the current use and physical attributes of the property changed since the issuance of the endorsement?)
   
   Note that a zoning endorsement to a title insurance is a separate and distinct topic from ordinance or law casualty insurance.  Apples and oranges.
    
4. Does the title policy (and endorsements) in the file contain the terms requested at loan closing?
   --For example, if the removal of the “creditors’ rights” exclusion was requested at closing, was it removed (or endorsed “out”) of the policy? A “creditors’ rights exclusion” removes creditors rights issues from coverage of the policy – such as fraudulent preferential transfers.
   
   Note that creditor rights commonly present risks in these types of transactions:
   --Multi-collateral, with separate SPE or “single purpose entity” ownership entities
   --Leverage buyout transactions

If you have questions or a story to share, then post a comment
 

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No surprise at this statement:  When the real estate mortgage nears the ditch, the lien priority of the loan and the status of the title (such as easements, deed restrictions, access rights and lien priority) all come under scrutiny.

One important point of inquiry is the title policy covering the loan.  An “audit” or review of the title policy should be done. 

Here’s a quick (albeit incomplete) list of things that should be investigated (in no order of priority):
 

1. Is there a title policy? (Don’t be shocked if you don’t have a title policy—this is one of those “details” that can get “lost” during the post-closing\servicing process.)
2. If it is a construction loan, was a policy purchased or is a “binder” merely in place? (If a binder, can or should a policy be purchased? Is this possible or even desirable?)
   --What is the current coverage amount?
   --What is the date of the last down-date?
3. Do you need to put the title policy insurer on notice of a possible claim? (Read the title policy for “how” to do this.)
4. Do you have a complete copy of the title policy, the title policy exception documents and the title policy endorsements? (You’ll be amazed at how many loan files fail to contain all of this.)
5. Does the title policy:
   --Continue to cover an affiliate of the lender that takes the title at foreclosure or a transfer 
      in lieu of foreclosure?
   --Correctly describe the insured land?
   --Contain the correct amount?
   --Have the correct title policy form with all endorsements?

The next posting will cover UCC issues, zoning endorsements and creditors rights exclusions.

If you have any questions or some thing to add, please post a comment.
 

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We all love our mother earth, no doubt.  However, if your troubled credit is a real estate construction loan, then you need to add yet another topic to your workout due diligence list: green building laws and ordinances.

• Do you really want to wake up with the title to the property, and only then realize that there is a laundry list of "green building" requirements preventing completion of construction, and perhaps tenants only too happy to terminate their leases due to your failure to comply with those requirements?

This trend truly is a grass roots movement since it germinates at the city and building department level (OK, enough of the alliteration).

I suggest that you investigate this even if the only "construction" at your collateral is tenant finish.  This movement appears to be more than simply new vertical construction.

To give you some flavor on this topic, here's some information on the situation with the City of Dallas:

Dallas' new green building ordinance (PDF) takes effect on October 1, 2009.  The Building Inspection Department developed checklist forms to verify that developers comply with the law. Copies of the following checklists are attached: (i) homes, (ii) commercial buildings less than 50,000 square feet, and (iii) commercial buildings 50,000 square feet or greater.

The checklist will be used by the City of Dallas at both the plan review stage and the building inspection stage.  In addition to submitting the checklist, developers must submit several supporting documents, such as invoices, receipts, diagrams, photographs and product specifications.  In the coming weeks, the City of Dallas will publish additional forms for developers to show the calculations that back-up the assertions made in the checklist.  The architect, engineer or contractor that is responsible for a certain checklist item must sign the checklist.  The City of Dallas will also publish a handbook that should be a practical guide to complying with the new law.

The ordinance is based on Version 2 of the U.S. Green Building Council's LEED program, which has been around for a few years.  The USGBC recently introduced Version 3, but the City of Dallas will stick with Version 2 because people are already familiar with it.

Yes, change is all around us.

Please comment if you're seeing this in your city.

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This is the second posting on this topic (click here for part 1) which addresses the volatile combination: the aging population in America; the real estate industry looking for something to develop; and a lender community that is just now comprehending the value of understanding lease terms as a bedrock topic for the collateral.

The earlier posting addressed “problems” with standard lease boilerplate topics.

Here are some eccentric issues not found in standard office or retail leases:

• Building Name & Signage:  The naming rights of buildings on hospital campuses, together with related building signage, can be a significant source of revenue for the hospital, especially to nonprofit hospitals.  Hopefully all of this is addressed by the lease; and in fact conforms to the actual building names and signage.  So, watch for these provisions; and then determine if they have been violated.
• Prohibited Uses:  Medical office buildings affiliated with a particular hospital may prohibit uses that the hospital deems inappropriate given its particular mission.  For example, many not-for-profit hospital systems are created by faith-based organizations carrying a faith-based mission.  These hospitals may impose restrictions upon tenants relating to elective abortion services, stem cell harvesting from fetal tissue or other practices that violate their faith-based mission.  Also, watch for this issue in any restrictive covenants, if the building is located in a project\campus established by such an organization.  So, watch for these provisions, and then determine if they have been violated.
• Lease Restrictions Imposed by a Hospital:  Because the goal of a hospital system for medical office buildings on its campus is for them to support and create synergies with the hospital, the hospital system may also want to limit the leasing of space in buildings on its campus to only those physicians and physician practices that have staff privileges at the hospital.  This is a matter of convenience for both the hospital and the physician and additionally prevents competitors from occupying space in the hospital campus.  Likewise, the hospital may require that any tenant of a building on the hospital campus be a medical-related tenant (Again, watch for this issue in any restrictive covenants if the building is located in a project\campus established by such an organization).  So, watch for these provisions, and then determine if they have been violated.
• Lease Restrictions – Exclusive & Limited Uses:  Similar to exclusive rights in retail leases, tenants under medical leases sometimes seek to be the exclusive physician in a medical office building providing their particular expertise to patients.  Generally, landlords are also sensitive to the tenant mix on a hospital campus because their success in marketing the building to tenants will be enhanced if more specialties of medical practice are represented, which should enhance patient referrals among the tenants.  So, watch for this provision, and then determine if it has been violated.

Again, once you understand these issues, then the inquiries become:

• Have these been implemented?
• Have they been violated?
• Are these “problems” that you’ll inherit once you take back the property?

Please share your comments, suggestions or questions on this topic.

* Confession: This entry comes from a piece written by my colleagues at Winstead PC, Andy Dow and Allan Katz.   I thank them for bringing this good stuff to our attention.  My contribution is “adding” the workout perspective to it.

 

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Here’s a volatile combination:  the aging population in America; the real estate industry looking for something to develop; and a lender community that is just now comprehending the value of understanding lease terms as a bedrock topic for the collateral.

So, let’s take a quick look at unique issues in leases involving medical uses.  If you didn’t catch these at the loan closing (when lender approved the leases and the lease form), or during servicing following closing, you’ll need to understand this subject BEFORE you foreclose or take title to any collateral containing medical uses.  Indeed, those “standard” provisions create distinctive challenges when applied in a medical lease context.  In addition, medical uses often produce unique issues not found in standard office or retail leases.

“Standard” Provisions aren’t so standard in a medical lease.  Here are a few:

• Compliance with Laws:  Since patients visiting medical facilities are more likely than the general public to have special needs relating to accessibility, the parties should pay special attention to the compliance with laws and accessibility provisions of the lease.
• Landlord Access to Premises:  HIPAA and other federal and state laws regulating confidentiality of medical records and personal health data may necessitate modifications to some typical clauses in standard office leases.
• Environmental Provisions:  Medical tenants also frequently utilize materials and generate waste (such as immunotherapy and chemotherapy agents, biological specimens and the like), which require appropriate disposal to comply with applicable federal and state environmental and waste disposal laws.  Therefore, an absolute prohibition from the utilization of such materials is not appropriate, but the lease should clearly specify rules governing the use of such materials and which party is responsible for their disposal. Finally, surgery centers have their own, unique, environmental issues.
• Utilities & Services:  Medical tenants often have higher utility usage than standard office tenants because many medical tenants have sinks in each examining room and operate X-ray, MRI and other equipment that utilize more electricity than standard office equipment.  The lease should require separate metering of the premises in order to charge tenants equitably, if there are significant variations in utility usage among the tenant base.  In addition, medical uses such as surgery centers will require specialized utilities, including back up power generation.  Finally, medical uses often will restrict or require specialized janitorial services.
• Assignment and Subletting:  This is a topic that the lender\servicer must understand, and be flexible about.  Tenants under medical office leases are often more sensitive to assignment and subletting rights than tenants in other types of leases.  For example, in the case of a lease involving a physician group, the lease should adequately address the tenant's ability to admit new partners into the practice from time to time, as well as accommodating retiring physicians exiting the practice.  And, this topic should be addressed in any lease guaranty-–if there is person liability for the partners (Hopefully, the lease guaranty clearly runs to the benefit of landlord and its successors; and consider the merits in obtaining a confirmation of the lease guaranty as part of your workout strategy).

Once you understand these issues, then the inquiries become:

• Have these been implemented?
• Have they been violated?
• Are these “problems” that you’ll inherit once you take back the property?

The next posting will cover some unique issues not found in standard office or retail leases.  Please add your own comments, suggestions or questions on this topic.

* Confession:  This entry comes from a piece written by my colleagues at Winstead PC, Andy Dow and Allan Katz.   I thank them for bringing this good stuff to our attention.  My contribution is “adding” the workout perspective to it.
 

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Guest Writer - Christopher T. Nixon, Winstead PC

In part 1, I covered the relationship between the loan servicer and the B-note holder, and the role of the B-note holder in making decisions about the loan.  This posting addresses a situation where that the B-note holder no longer can participate in decisions, and the replacement of the special servicer.

Is there any circumstance in which the B-note holder no longer has consultation and consent rights?
Yes, in the event of a Control Appraisal Event, the B-note holder typically loses its consultation and consent rights under the co-lender agreement.  A Control Appraisal Event is typically defined as a reduction in the principal balance of the B-note by appraisal deductions or realized losses to below a certain level (typically 25%; although we have seen percentage levels as high as 50%) of its original principal balance.  In this event, the consultation and consent rights are transferred to the A-note holder under a typical co-lender agreement.

Under the co-lender agreement, may the B-note holder replace the master servicer?
Absent a breach by the master servicer under the co-lender agreement, the B-note holder has no right to replace the master servicer.

Under the co-lender agreement, may the B-note holder replace the special servicer?
The B-note holder may replace the special servicer without cause at any time, subject to certain conditions being met with respect to the replacement special servicer.  However, it is important to note that the B-note holder is responsible for certain costs and expenses incurred in connection with such replacement, and such replacement may cause significant delays and disruption in the servicing of the A/B loan.  Under most co-lender agreements, the B-note holder loses the right to replace the special servicer upon the occurrence of a Control Appraisal Event.

Conclusion:
Because the terms and conditions of co-lender agreements are typically heavily negotiated between the A-note holder and the B-note holder, it is essential for a CMBS loan servicer to review and understand the terms and conditions of the co-lender agreement for the particular A/B loan being serviced.  A failure by the loan servicer to comply with the terms and conditions of the co-lender agreement for the particular A/B loan being serviced may expose the loan servicer to liability to the B-note holder in connection with the servicing of the A/B loan.

If you have any questions, commentary or stories to share, please post a comment
 

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Guest Writer - Christopher T. Nixon, Winstead PC

CMBS loan servicers have duties to a myriad of parties in the servicing of a CMBS loan, including the REMIC trust, the bondholders, and the borrower.  With respect to an A/B loan, a CMBS loan servicer also has certain duties to the B-note holder pursuant to the terms of the co-lender agreement between the A-note holder and the B-note holder.  Because co-lender agreements are typically heavily negotiated during the origination of an A/B loan, CMBS loan servicers should carefully review the co-lender agreement for the particular A/B loan being serviced to fully understand its duties thereunder to the B-note holder in connection with servicing the A/B loan.

What is the relationship between the CMBS servicer and the B-note holder?
A CMBS loan servicer's relationship with the B-note holder derives from the co-lender agreement between the A-note holder and the B-note holder. The co-lender agreement governs the relationship, and sets forth the duties, liabilities and rights of the A-note holder and the B-note holder with respect to the A/B loan.  A typical co-lender agreement provides that the A-note holder will service the A/B loan on behalf of both the A-note holder and the B-note holder.  When the A-note holder places the A/B loan into a CMBS loan pool pursuant to a typical pooling and servicing agreement, the CMBS loan servicer assumes the A-note holder's obligation to service the A/B loan.

What rights does the co-lender agreement provide to the B-note holder in connection with the servicing of the A/B loan?
The co-lender agreement provides to the B-note holder consultation and consent rights with respect to certain major servicing decisions related to the A/B loan.  The B-note holder's consultation right requires the loan servicer to obtain and consider the advice and suggestions of the B-note holder before taking certain actions related to the A/B loan.  The B-note holder's consent right requires the loan servicer to obtain the consent of the B-note holder before taking certain actions related to the A/B loan.

What major decisions require the servicer to consult with the B-note holder?
The provision of the co-lender agreement defining the B-note holder's consultation rights is typically heavily negotiated between the A-note holder and the B-note holder.  Thus, a loan servicer should pay particular attention to this provision of the co-lender agreement to fully understand the scope of the B-note holder’s consultation rights.  Some loan servicing decisions typically requiring B-note holder consultation are:

• Proposals to workout the A/B loan upon a borrower default
• Releases of A/B loan escrow funds
• Lease renewals requiring lender consent
• Mortgaged property alterations requiring lender consent

What major decisions require the servicer to obtain the consent of the B-note holder?
Like the provision defining the B-note holder’s consultation rights, the provision of the co-lender agreement defining the B-note holder's consent rights is typically heavily negotiated between the A-note holder and the B-note holder.  A loan servicer should carefully review this provision of the co-lender agreement given that there is no standard list of major decisions to which the B-note holder is entitled to consent.  Some loan servicing decisions typically requiring B-note holder consent are:

• Foreclosure of the mortgaged property
• Acceleration of the A/B loan upon a borrower default
• Releases of collateral from the A/B loan
• Assumptions of the A/B loan by a third party borrower
• Extensions of the scheduled amortization payments or final maturity date of the A/B loan

If you have any questions, commentary or stories to share, please post a comment.

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National rating agencies, and Standard & Poor's (S&P) in particular, are developing new analytics to be applied to CMBS and RMBS pools originated in the years 2005, 2006 and 2007.  As a preliminary matter, it looks like the new criteria will, when applied to the Triple-A tranches, result in downgrades of a substantial percentage of Triple-A CMBS for the three years of issuances reviewed.  While the details of the analytical changes have not been made public, investors holding RMBS and CMBS, as well as those with a stake in seeing that the securitization industry be revived in some form (such as the CMSA) are naturally inquiring to S&P about the specifics involved in the analytical changes.

It will be interesting to see if S&P is merely changing the stress assumptions for further declines in the market, or if in fact they are adding new criteria from lessons learned along the way in the financial crisis.  Since not all Triple-A CMBS pools have anywhere near the same kind of risk characteristics, perhaps a reexamination of Triple-A CMBS, in order to make meaningful quality risk distinctions between pools, would be a good thing for the market.  However, S&P's decision is likely to add more unwelcome investor confusion to the mix.

As most of you know, the Federal Reserve created the Term Asset-Backed Securities Loan Facility (TALF) to help borrowers and lenders as market participants meet the capital credit needs across a wide range of asset classes, including asset-backed securities (ABS), collateralized by auto, student, equipment, credit card, and small business administration loans.  More recently, commercial mortgage loans including CMBS were added as an asset class eligible for TALF.

On Tuesday, June 16, TALF offered borrowers the opportunity to participate in one of the first CMBS offerings in a long, long time.  The rate available for a loan with an average life of two years was 3.2710% and for five-year, fixed rate loans the rate was 4.130%.  Surprisingly, (or perhaps not surprisingly) even in the present capital starved environment, no loan requests were submitted for CMBS/TALF borrowing execution.  There could be a number of reasons for this, including continued investors current aversion to risk, particularly in this asset class, a continued belief in future weakening of real estate fundamentals, as well as uncertainty about the precise nature of the TALF execution.  At any rate, the last thing mortgage capital markets need is greater uncertainty caused by rating agencies mentioning (but not fully explaining) significant future downgrades of Triple-A CMBS.

This takes us full circle; back to an examination of the fundamental, underlying assumption that criteria can be developed which will adequately assess risk for securitized pools backed by commercial real estate.  Commercial real estate investments as an asset class, poses very unique risks and rewards, and arguably are not susceptible to precise bond ratings.

The problem is that rating agencies have taken on the task of providing "on going surveillance" for these asset classes.  As S&P collects more information about pool performances, their rating assumptions and general market conditions, they are likely facing a growing need to rerate CMBS pools.

Overall, National Recognized Statistical Rating Organizations risk much by stepping out and being active in the present regulatory/political environment.  If they do nothing, they will clearly draw significant criticism.  As the need to regulate rating agencies draws increased scrutiny and the possibility of creating federal oversight of these agencies increases, the rating agency should be very circumspect in changing rating methodology midstream and the effect such actions will have on an already dormant market.  And it's very difficult to see what type of analytics, when applied to CMBS pools, will shed light on what's happening in the market, given the dearth of reliable activity and data.

Perhaps a better approach would be to simply issue surveillance reports that show specifically what analytics have been employed to arrive at the more generalized conclusion that investors can not rely on the present accuracy of the original rating.

CMBS investors as well as rating agency professionals are invited to comment.
 

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Guest Writer: Brenda Brown, Winstead PC

More from ourTough Times FAQs series:

FAQ #4 -  Do I need to reduce the commitment amount after sending a Notice of Default?

• Typically, no – once the loan is declared to be in default, or once the maturity of the loan is accelerated, the lender has no on-going funding obligation – but confirm this in the documents.
• The lender typically is not required to fund current loan allocations or grant new loan allocations.
• Communicate clearly in writing to the Borrower that the lender has no further obligation to the fund and negotiations, inspections, administrations and even making future draws during a draw period (whether under a construction loan or a partial disbursed loan) do not amount to waivers of pre-existing defaults or can be considered obligations for future fundings.

FAQ #5 -  After a Default Notice, should I send statements showing Regular Monthly Interest or statements showing interest at the Default Rate?

• Statements to the borrower should reflect the Default Rate of interest (rather than the prior regular interest rate), late fees, and any other fees due the lender (such as legal fees) – all of which usually do not appear in the "standard" statement.
• So, typically it is best to STOP sending the regular monthly statements.

FAQ #6 -  What else should I put in writing?

• Agreements Regarding Interim or Protective Advances
• Forbearance Agreement

All of these first six questions underscore the fact that the status of the property and the loan must be looked at with current and fresh eyes so that the opportunities for solutions are enhanced, and the risks of encountering questions of waiver are avoided.

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

Please post comments or questions below.
 

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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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This is the second of a two-part series (PART ONE) covering initial due diligence topics for workouts involving co-lender structures, with a focus solely on the participated or syndicated co-lender structure. The series is not a comprehensive listing of possible issues on this topic, but merely a basis template to assist you as you review the co-lender and other relevant loan documents.

Typical Servicing issues:

• how are on all decisions made within the co-lender group on these subjects?
  • waivers and consents
  • default\enforcement (special servicing issues)
  • after enforcement (expenses to protect\preserve, to sell, to complete; title of the property [name of servicer; tenant in common; nominee entity jointly owned]
  • advances, expenses and losses
  • excess recovery
  • is there a buy\sell provision if co-lenders are not able to resolve disagreement?
• what decisions may servicer make without input from co-lenders
• duties of servicer: what must it do (reporting, inspections, etc.)?
• standard of care of servicer
• what if servicer has an equity position?
• rights of co-lenders to examine and copy
• notification rights (when must servicer notify a co-lender)
• fees (primary servicing; special servicing; asset management and disposition)
• future property inspections and reporting (review reports only; or more active role, such as accompany servicer during on-site inspections)

Does the loan seller or originator have any liability?

• contractual duties and warranties
• fiduciary duties

Transfers

• buy\sell for disagreements
• transfers to affiliates
• transfers to third parties (right of first offer?)
• is sub participations\syndication prohibited?

Sharing of payments: on sums paid by the borrower, are payments applied -

• proportionately to all co-lender?
• non-proportionately to co-lenders?

If you have any comments, suggestions or additions to the foregoing, please post a comment.

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1st in a series of 2 postings

Much of the focus in the media on troubled real estate debt focuses on sophisticated debt structures, or on investors holding bonds in pools of loans. This focus, however, misses an important, intermediate player between these two ends of the barbell: the real estate lender.

In several real estate workouts that I’m handling now, the most difficult discussions are not with the borrower or its lawyer. Instead, the difficulty is within the mortgage lender group itself. Indeed, one distinctive in the current workout environment from the late 80’s is the large number of real estate loans involving multiple lenders holding a portion of the same mortgage loan or lien position.

Now, I’m not describing the situation where one lender has the mortgage lien, a second lender has a lien on the ownership interests in the borrower, and perhaps a third lender has an unsecured loan with the entity owning an interest in the entity owning the borrower.

Instead, I’m describing a single mortgage loan or facility that has been syndicated or participated among multiple real estate lenders. While the multiple or “co-lender” mortgage structure is not new to life insurance company lenders (nor to balance sheet lenders), in the last 15+ years the co-lender mortgage structure became widely used by the broader creditor market; and banks, Wall Street (the investment banks) and mortgage funds joined life companies in “structuring” the first-lien position.

This posting is Part One of a two-part series covering initial due diligence topics for workouts involving co-lender structures, with a focus solely on the participated or syndicated co-lender structure. The series is not a comprehensive listing of possible issues on this topic, but merely a basic template for your use as you read the co-lender agreements and related loan documents.

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Guest Writer - Mike Cook, Winstead PC

2nd in a series of 2 postings
(Part 1: The Insolvency Exclusion to Cancellation of Debt (COD) Income;
The Effect of Exempt Assets Under the Carlson Rule)

The Court, having determined that the use of “assets” was ambiguous, pointed out that “[t]he stated purpose of the 1980 Bankruptcy Tax Act was to ‘accommodate bankruptcy policy and tax policy.’” Both Senate and House reports indicate that the proposed insolvency exception in Section 108(a)(1)(B) was intended to ensure that an insolvent debtor outside of bankruptcy (like a debtor coming out of bankruptcy who is accorded a ‘fresh start’ under Federal bankruptcy laws) is not to be burdened with an immediate tax liability.

The Tax Court, however, concluded that although an asset of a debtor may be exempt from the claims of creditors under applicable law, if that asset and the debtor’s other assets exceed the debtor’s liabilities, the debtor has the ability to pay an immediate tax on income from discharged indebtedness. By implication, therefore, the same Congress that decided that it was in the public interest that exempt assets be removed from the reach of creditors so that debtors could obtain a fresh start intended, nevertheless, to impose an income tax on the value of those assets in the event that a taxpayer negotiated a debt settlement with creditors outside of bankruptcy. In effect, the Carlson Court concluded that Congress intended to impose a penalty on taxpayers that handled their financial problems without resorting to the bankruptcy court.

Under the Carlson rule, an individual with substantial exempt assets pays a high penalty for not filing bankruptcy. The opposite viewpoint, however, is that the reason the Tax Court has sided with the government is because the cases from the late 1980s showed the gross disparity in tax treatment that could occur from the differences in exempt assets allowed from state to state. In Texas, a person with substantial exempt assets could successfully take an insolvency position under the old law. It should be noted that only the Tax Court has addressed the issue, and if the economic conditions currently being experienced produce the same quantity of workouts from commercial debt (COD from residential loans is currently excluded from gross income) as occurred in the 1980s, the issue of whether exempt assets should be excluded from the insolvency calculation will surely reach several courts of appeal.
 

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Guest Writer - Mike Cook, Winstead PC

Part 1 of 2

During the current economic crisis, debtors will be negotiating workouts with lenders and if the debtors successfully obtain debt relief, they will also be seeking tax relief from the taxation of COD income. The ability to use the broadest exclusion from COD income, the insolvency exclusion, has been severely restricted in recent years. The relief from taxation of COD income by reason of insolvency of a taxpayer has a common law history, but it was codified in 1980 as Section 108(a)(1)(B) of the Internal Revenue Code. The legislative history of the Bankruptcy Tax Act of 1980 made it clear that a purpose of the statutory insolvency exclusion was to put insolvent taxpayers on the same footing as those who filed bankruptcy, which also excludes COD income from taxation. But recently the Tax Court has penalized taxpayers for not filing bankruptcy; the insolvency exclusion does not now produce the same tax results as does bankruptcy. So are debtors better off filing bankruptcy than entering into a debt settlement with lenders?

When an individual files bankruptcy and is relieved of personal liability, the debtor comes out of bankruptcy with his/her exempt assets and there is no taxation of the relief of liability because COD is not income pursuant to Section 108(a)(1)(A). In the late 1980s, when the banking and real estate industries collapsed in the southwest United States, taxpayers relied on old case law to the effect that their exempt assets were not included in the insolvency calculation. The IRS seemed to back away from its initial litigating position and agreed with the taxpayers’ exempt asset position, but in the 1990s the IRS put taxpayers on notice that its position was that the insolvency calculation should be calculated without inclusion of the exempt assets. The Tax Court subsequently addressed the issue in Carlson v Commissioner, 116 T.C. 87 (2001) and it adopted the IRS’ position.

The Carlson Court noted with some frustration that Congress did not define the word “insolvency” or “assets” as used in Section 108(a)(1)(B) and turned to several dictionaries to find the meaning of “asset.” The court noted three definitions: (i) the property of a deceased person subject by law to the payment of his or her debts and legacies; (ii) the entire property of a person, association, corporation, or estate applicable or subject to the payment of debts; and (iii) the items on a balance sheet showing the book value of property owned. The first two definitions support an exclusion of exempt assets while the third definition supports an inclusion.

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Yesterday (Thursday) was the second, and my last, day of the conference.  As I did with the first day of the conference, I summarize some of the sessions.  So, here's the executive summary:

From a session on bankruptcy issues:

• as reported by the Commercial Mortgage Securities Ass'n in its press release, the bankruptcy court in the General Growth Property bankruptcy issued a good ruling on Wednesday.  The ruling recognized the integrity of the special purpose vehicle (or single purpose entity; also called "SPE") utilized by GGP in the ownership of each mall in its portfolio. (Recall that many GPP malls are owned by a SPE subsidiary of GGP.)
• for detail on the importance of the SPE structure to the commercial mortgage lending industry, and for an understanding of the structure itself, take a look at the brief filed by the CMSA in the case.
• briefly, the debtor-in-possession financing recognized the validity of the SPE structure: it did NOT place a lien on each mall (which are owned by separate SPEs) and the first-lien holders of each SPE-owned mall were given a first-priority lien on the cash collateral from their mall collateral
• next step of interest in the case: the hearing on the bad faith filing issues.  Was it proper for the solvent SPE to be included in the bankruptcy of the parent GGP?

From a session on the challenges in complex transaction structures:

• one of the first tasks in handling a distressed loan is identifying the parties and their issues.  For example: (1) who\what are the creditor & borrower issues? (2) who\what are the co-lender issues? (3) and if there is a separate servicer, what are the terms of the servicing agreement? The answers: find the documents.  Read the documents.
• the many, varied structures of the credit stack present challenges simply in understanding the relationships between all of these parties.  Here is a short list of common structures: 1st lien & mezzanine debt (with one or more mezz debt positions; and each mezz debt could have all of the following structures); A note and B note (and the A note might be securitized); A1, A2 and A3 note (and the A1 note might be securitized); "true" participations of any of these notes (if not securitized); etc. Some of these credit stack structures will give you a head ache.  And often the borrower has NO knowledge of them - although a sophisticated borrower might recognize some of the clues pointing to a complicated credit stack.
• for credit stacks that include securitized debt, the rating agency faces multiple challenges: (1) post-closing surveillance (in that it often does not have access to loan documents covering discrete loans in the credit stack); (2) issuing confirmation letters ("no down-grade letters") can be problematic for the same reason; (3) intercreditor agreements and loan documents might not comply with rating agency requirements
• special servicers in securitized loan pools are being changed by the controlling class holders and the B note holders.  This can result in two different special servicers: one appointed by the controlling class holders for the entire pool; and a second by the B note holder as to the notes that it has first-risk loss.  Another complication, of course, is that the special servicer must be approved by the applicable rating agency.  And to further complicate it all, often the intercreditor agreement(s) have a higher rating standard than the standard required by the rating agency monitoring the pool.
• some of the credit stacks are so complicated, that it is difficult for the servicer to determine "who" should receive notice of a change in servicing (or "who" should receive any other notice).  One answer is to follow the money: if the master servicer is the paying agent for the pool, the servicer's treasury group has contact information.
• against this complicated back drop, borrower's often communicate to the incorrect lender! And have difficulty in indentifying "who is who" among this confusing group of players.
• in a prior posting, we commented on the question of whether a borrower should intentionally default a loan that has been put in a securitized pool.  The panel noted these dire consequences for a borrower in special servicing: (1) default interest will accrue; (2) late fees will accrue; and (3) workout land is NOT "borrower friendly" - and if borrower does not obtain its desired result, there is no "free pass" back to the safety of master servicing.
• for loans with "springing" lock box features: borrowers are refusing to do the paper work to create lock boxes.  This results in a covenant default under the loan, which triggers a transfer of the loan to special servicing.  Also, on several loans, local banks (who have long-standing relationships to the principal behind the borrower) have closed dormant, "springing" lock box deposit account - which is a real problem when the lockbox "comes to life" and the master servicer attempts to implement the lockbox structure.

From a session on loan surveillance:

• each point of the mortgage compass is requiring more and better information: bond holders, rating agencies, federal and state regulators, investment committees, etc.
• loans are being reviewed more often (even monthly)
• all of this is a major difference from the late '80s & early '90s
• what are some of the warning signs of a loan going "bad"? (1) exhausting a debt service reserve (recall: this type of reserve was used when a project was not stabilized); (2) exhausting a contingency line item (in a construction loan); (3) change in ownership of any portion of the credit stack (this is often difficult to monitor); (4) low utilization\occupancy of space by tenants; and (5) ___________
• surveillance needs to have a "forward" looking component, such as: (1) future lease rollover; (2) local market information and trends (new construction of competing projects; tenants looking for space; etc.); (3) sponsor level debt information (amount; maturities; etc.); (4) free rent and rental rate trends in the market; and (5) _________
• use "free" resources available on-line
• one problem for servicers: each lender seems to have their own, unique reporting form
• one lesson in this "new" economy: real estate really is unique.  Thus, people need to understand and evaluate each tenant, project, market and principal.
• one panelist briefly mentioned the all-important "mortgage experience adjustment factor" - which is a risk-based capital concept governing insurance companies who hold commercial mortgage debt.  Some time in the near future we'll blog on that mind-boggling concept - and the draconian effect that it has upon insurance companies and their mortgage portfolios.  It is horrible.

This is my last posting on the conference.  It met my expectations.  Everyone agreed: it was the "best" servicing conference in years - undoubtedly because this is the worse real estate market in years.

Today it is back to the office, and the nitty-gritty of workout world.

Please post your comments, suggestions or questions below.

P.S.: back to the restaurant review thing - although there are "cooler" places to go in New Orleans, if you stay at the Hilton Riverside (the conference hotel), then you're immediately adjacent to the Riverwalk Marketplace mall.  The Crazy Lobster (504.569.3380) is a free-standing bar and restaurant on the Riverwalk.  It is a good place to catch a breeze and a change of pace.  Like many places in NO, it has live entertainment in the evenings.  We escaped the conference for several lunches at the Crazy Lobster.  It is a short (100 yards?) walk from the Hilton.  (And yes, it is a GPP mall - and probably owned by an SPE.) (See discussion above on GPP and SPEs.)

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The first day of the 2009 MBA's Commercial/Multifamily Servicing and Technology conference has ended.

It has been a long day, filled with attending panel presentations and meetings with people over meals, in the halls and at receptions.  It started at a 7:30 breakfast and ended @ 10p (when I refused to join a group that headed toward B___n Street).

Attendance this year seems down by @ 40%-50% from prior years.  Indeed, several companies told me that they would not be attending this year.  And many companies seem to have sent only 1 or 2 people this year; instead of the usual 4 or 5.

It is late, and if I don't get this down-load out soon, tomorrow will hit with more panel presentations and meetings - and I'll "lose" these data points.  They are in the order collected by me during the day - and so they are NOT ordered by relative importance.  Here is the down-load  (remember, this is a blog and not a thesis or brief; and it is very late).

(One other preliminary and important thought: if your boss requires that you prepare a memo on the conference, consider this permission to cut'n paste as you wish . .  . . )

From the opening general session:

• during the next 2-3 years, the commercial mortgage finance industry will focus on servicing & asset management, which will be the new front line for the industry
• unemployment remains a key leading indicator of the performance of real estate as an asset class (and since unemployment is expected to increase, it will take several years for the asset class to recover)
• while defaults presently are @ 3%, some predict that the default rate will increase to 6%; consequently, special servicing will become busier, and the need for greater transparency will be increased (in order to support better decision making) (Note the Fitch report described below.)
• one speaker articulated five areas of focus for the industry: (1) greater transparency (with "real time" property performance data); (2) the need for high quality and detailed physical asset condition inspections; (3) greater focus on customized business plans for each asset, which points to the need for more expertise by special servicing; (4) the increase in defaults will strain human resources at companies (and require greater recruiting, more training and better integration); and (5) companies must be better at understanding macro trends and changes

From a session on developments in Washington, DC:

• expect more changes and experimentation by policy makers
• accounting issues include: (1) FASB 140 (true sale changes); (2) FIN 46(r) (balance sheet consolidation with the "primary beneficiary" of securitization vehicles); and (3) FASB 157 (fair value); all due to "FASB's perceived suspicion" of real estate structures
• REMIC reform will take a back seat to other issues at Treasury
• Single Purpose Vehicle (or single purpose entities) and separateness covenants: the General Growth Properties bankruptcy will be an initial stress test of this "bankruptcy remote" structure; although one panelist labeled the GPP structure as "SPE light with bad cash management."  Another panelist called the GPP case simply "bad facts, which should not be followed by other situations."  (This last point puzzles me: a clever borrower might view the GPP case not as "bad facts" but as a "helpful road map.")
• One panelist expects to see a new securitization in 3rd or 4th Q of 2009.  Wow.  Given all of the accounting and structure "issues" detailed during the day, anticipated increase in the default rate, etc. - a securitization in 2009 would be . . . well  . . . wow.
• Federal limits on executive compensation are a huge problem for investors; and are chilling the market by impeding companies from participating in Federal programs
• Terrorism insurance needs to be addressed . . . but the Executive Branch needs to cut programs - not increase the funding of them.
• Welcome to the "Age of Regulation"

From a panel session on dealing with troubled securitized loans:

• even life companies are starting to see their mortgage portfolios in distress (so they are focusing in-ward on their portfolios; and not outward to refinance CMBS loans)
• the demand for new commercial mortgages exceeds the supply
• long term, fixed rate interest mortgages are limited in amount
• property values are difficult to establish
• debt service coverage & loan-to-value criteria are very conservative (and thus underwriting is tough)
• CMBS structures do not offer refinancing (with only a limited ability to extend)

From a panel session on today's servicing challenges:

• servicers are surprised that subordinate lenders do not understand their rights (relative to the rights of the first-lien secured lender)
• communication among the lenders in the credit stack can be "challenging" (Wow; that was an understatement.  I've seen some deals where the disparate balance sheets and agendas of the lenders present the biggest hurdle to resolving a distressed project.  The project and the borrower can almost be an afterthought)
• valuation is a huge problem: every party at every point of the debt stack and the equity stack needs a good\reliable value in order to make decisions.  No value=No decisions=No peace
• as reported by Fitch Ratings in an April 29, 2009 special report, CMBS special servicing volume increased by more than 5.0X in the 15 months ending March 31, 2009 (from $4.6B at 12/31/07 to $23.7B at 3/31/09).  And these figures do not address distressed bank debt, nor distressed life insurance company debt.  More wow.

Taken together, I come away from the day with much the same impression as I did on that day three session at the EU conference last fall: no one is clapping.

Time to go to bed.

If you have your own comments, or follow up questions, please post a comment below.

P.S.:  Returning to the eating theme from my posting on Tuesday, and before I get some sleep -  here's another good restaurant in New Orleans: Herbsaint Bar and Restaurant.  This is the second restaurant recommended to me by a New Orleans native.  I now understand.  It is very, very good.  Not as fancy as Nola; much more stylish than Jacques-Imo's. And not in the French Quarter. Together, all three restaurants will pull me back to New Orleans.

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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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Following up on my earlier posting covering impossibility performance as a possible defense to performance\pay-off of a loan at loan maturity -

As everyone knows, yesterday the #2 owner of malls in the U.S. (General Growth Properties) filed for bankruptcy.  Here's link to a blog on seekingalpha.com that contains copies of GPP's 8-K and the voluntary filing, and some interesting commentary about the situation.

From my perspective, the GPP filing simply might be the logical and ultimate outcome of an impossibility of performance "defense" or perspective - with the important twist that GPP is simply too big to assert the defense in each of the states where it does business.  In other words, the combination of (i) an "impossible market" and (ii) a huge, multi-jurisdiction business footprint simply forced it to file BK.

Here are portions of the blog posting that lead me to this perspective:

• This is not a typical Chapter 11 as the reason for reorganization is not due to a company that cannot pay bills, credit markets have cause extenuating circumstances.  Because of that, the "usual outcome" some assume must be discounted and other options receive more weight.
• There is legal precedent in 11 for equity remaining whole
• [The COO on CNBC states]:
  
  * Rent are stable
  * NOI up
  * Not negotiating leases
  * Occupancy strong

Please post your thoughts, comments or perspective.

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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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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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The Wisconsin Bankers Association reports on a Wisconsin bill that could foretell things to come, if the "new" economy continues to slide:  laws that protect the wage claims of workers at the expense of existing liens held by others.

Briefly, this Wisconsin statute recognizes the rights of employees (subject to certain exceptions excluded by the statute) to enforce a wage claim lien as a "super priority" lien even against pre-existing liens.  Currently, there is a $3,000 per employee cap amount. However, legislation has been introduced in Wisconsin to remove the cap.

Why should you care (unless you're hibernating in the frozen tundra of Wisconsin)?

• It points to the importance of knowing the local law. When you exercise remedies, your first move should be to hire qualified, experienced local legal counsel who know the bumps in the local road – and who stay current on the most recent changes and trends.
• Expect pro-borrower changes to the law. Look for it. The prediction here is that we're going to see more and more of these types of pro-borrower laws in the near future – most certainly as the public becomes frustrated with the economy, the role lenders played in the financial melt down, the public "investment" in banks, _________ (you can fill in the blank). So, be on alert for changes to the default and foreclosure process.

Indeed, even in the State of Texas, a bastion of caveat emptor and "free" markets, we're seeing pro-borrower changes.  Last fall, the Texas Attorney General proposed consumer-friendly changes to residential foreclosure laws – including requiring lenders to give longer cure periods, to contact the consumer by phone or in person (as a condition to starting the foreclosure process), and a time period to vacate the residence after foreclosure.

This is just one way that this real estate down turn will be different.  Change is coming.

This will be a different tough time.

Please give us your comments, questions, predictions or incite to changes in your state.
 

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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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(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)

It is no surprise that the convention is markedly different from previous years.  Everything has changed (unfortunately that's almost NOT a terrible understatement): lenders have a new focus (and those with "real" investment allocations to lend are few in number), servicers are under scrutiny in the face of looming defaults, and mortgage bankers are seeking ways to serve (read "save") their best borrowers.

Kudos to the MBA for directly addressing these changes and challenges.  The sessions were informative.  The discussions were frank.  Too bad attendance at the convention is down.

Here are some of the topics, observations and comments:

• Servicing is servicing.  While servicing CMBS clearly has unique twists and challenges (such as the servicing standard of care, "tension" among the investor classes, etc.), portfolio lenders and CMBS servicers share many common hurdles in dealing with troubled loans.  (My next post will address some frequently asked questions about dealing with troubled CMBS loans.)
• The erosion of credit and value is a critical challenge.  Yesterday's debt service coverage and loan to value definitely is not today's story.
• The stack of first lien mortgage, mezzanine debt and even holding company leverage, which I affectionately call the "Other People's Money" mantra of the "old" economy, is yesterday's story and today's headache.  In prior conventions, sessions focused on these "tools" of the finance market.  This convention didn't even mention it - for good reasons: we're now dealing with the hangover.
• It is difficult to identify the correct asset disposition strategy when relative values are difficult to determine - values seem to change weekly.  In all sectors (products) and markets, appraisal valuations are problematic.
• Life companies are placing greater emphasis on debt service coverage, with less reliance on loan to value measures.
• The ability of borrowers to pay off a loan at maturity (the inability to pay is called a "maturity default") is under question due to the fear that community and regional banks are tapped out in their ability to place mortgage debt on their balance sheets.  And since these loans are limited term floaters, with equity pay-downs and guaranty agreements, they are only a temporary "fix" to the larger credit problem.  In other words, the boomerang remains in the air.
• Generally, the strategy of CMBS servicers and portfolio lenders is this: extend (if possible), wait and increase surveillance.  However, an extension has a price: new underwriting of the market, the project and the sponsor, with an extension fee, new reserves, lock box structures, amortization, etc.  An extension needs to make sense.
• Regulatory reform is coming.  For the life company, this means possible changes to risk-based capital (and the dreaded "mortgage experience factor") and possible "opt in" Federal licensor.  For the CMBS servicers, this means possible REMIC reform (again) addressing seller financing, control over the special servicer, etc.
• The need for greater information flow.  For the life company, this plays out in rating agencies asking for loan level information - like the information available in CMBS pools.  This second guess is totally new for life companies.  (For years, I periodically ask my life company clients: do you want outside counsel to prepare a loan and property summary like the ones we prepare when we close a CMBS loan? The prediction here is that the time has come for this change.)  For CMBS servicers, investors are asking for even more loan level information.  They've learned that they can not simply "trust" the certificate rating - they need to understand the current status of each loan in the pool (beyond the data contained in the current investor reporting package).
• Note sales are problematic.  On the CMBS side, they have slowed, with a wide gap between the bid and the ask price.  It was noted that there exists a correlation between AAA CMBS spreads and the volume of note sales.  Thus CMBS prices need to stabilize in order for loan sales to increase.  On the portfolio lender side, the risk-based capital rules literally rob the portfolio of the ability to craft loan restructures that place the lender in a position to increase its yield (and profit from a rebound in the market).
• Life company underwriting is now a return to the basics: 1.50x minimum debt service coverage; maximum 55% maximum loan to value (slightly higher for multifamily); shorter term; avoid hotels; beware of retail and "transitional" projects (which is a problem for banks seeking takeouts for construction loans); closely examine employment base of local market; scrutinize debt maturities of the principal; consider the use of lock box and SPE structures; less reliance on appraisals (due to valuation challenges) and more reliance on debt service coverage; etc.

This convention has been "rich" - not in the sense of money being thrown at deals (as in prior years); but rich in information, determination and the resolve to navigate these challenges.

The unspoken mantra seems to be: we can do tough times.

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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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Evicting "unwanted" residential tenants is a tough, tough subject.  This piece by Mark Edwards at Concurring Opinions is worth reading.

There is a "human element" in these tough times, which Mark terms as the tension between legality and social responsibility.

It is a topic that is much discussed in workouts involving apartments. Indeed, it is the point where the lender (or servicer) shifts from viewing it as a "project collateral" (the lender perspective) and starts to understand it as an "apartment community" (the owner\investor perspective).

Often, we expand the workout team to include community relationship people, including governmental relationship people for the lender.

Please give us your questions, thoughts or suggestions on this subject by posting a comment.
 

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The existence and continuation of title insurance coverage is an important issue in every workout and real estate collateral recovery plan.  (Recall the earlier posting on construction loan policy binders).

The recent bankruptcy filing by LandAmerica Financial Group has focused many of us on this basic issue.

This announcement from the American College of Mortgage Attorneys (of which I am a member) should be of interest to you or others on this important question.

As you may know, LandAmerica Financial Group, Inc. and LandAmerica 1031 Exchange Services filed for Chapter 11 bankruptcy protection last week. Fidelity National Financial, Inc. has entered into an agreement with LFG for Fidelity to acquire Commonwealth Land Title Insurance Company, Lawyers Title Insurance Corporation, LandAmerica NJ Title Insurance Company and United Capital Title Insurance Company.

According to representatives of LandAmerica and Fidelity, the transaction is expected to close by the end of this year. The Bankruptcy Court has scheduled a hearing for December 16, 2008 at which time the motion to approve the sale will be heard. During this transition period, Fidelity and Chicago Title have entered into Reinsurance Agreements with Lawyers Title, Commonwealth, United Capital and LandAmerica NJ Title in order to allow customers and agents to rely on the financial strength of Fidelity and Chicago. Below are links to a press release regarding the reinsurance and copies of the reinsurance agreements.

The announcement of the reinsurance agreements has been posted by Fidelity National at http://www.investor.fnf.com/releasedetail.cfm?compid=fnt&ReleaseID=350993.

You may read online the reinsurance treaties between:
 

• Fidelity and Lawyers Title at
  http://www.fntg.com/pdf/lawyerstreaty.pdf
• Chicago Title and Commonwealth and United capital at http://www.fntg.com/pdf/commonwealthunitedtreaty.pdf
• Chicago Title and LandAmerica NJ Title at
  http://www.fntg.com/pdf/landamericanjtreaty.pdf

If you or others have any questions or comments, please contact me.  I hope that this is helpful.

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If you did not make the Builder Finance Workout seminar, don't worry. 

• Click here to view a video of the seminar
   
• Click here for a copy of the seminar materials

We post this for your personal use or for use as part of your company's training program.  After you watch this video, please post your comments or send us your questions, so that we (and other readers) may respond.

We'll keep you advised of our future public speaking engagements; and we'll endeavor to do a digital "capture" to make them available to you.

To help us in looking around the workout corner (or into the next ditch):

• What other commercial credit products do you see as near term problems (as the next wave of distressed commercial debt)?
• What other seminar topics do you find of value or interest?

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In the "good times," competition for the business often forced the construction loan originator to look for ways to trim costs or fees for the borrower. While this approach may have been prudent at the time, it can result in unintended consequences and a trap for the unwary during the workout or foreclosure process.

One example of this is title insurance. As part of landing the deal, many construction lenders might have agreed to "save" the borrower money by NOT requiring the borrower to purchase a loan title policy. (A loan title insurance policy insures the priority of the deed of trust or mortgage that secures the construction loan [subject, however, to specified conditions, limitations and exceptions to coverage]).

Instead, the lender would obtain a title insurance "binder," which has a nominal cost when compared to the cost of a loan title policy. A title insurance binder merely commits the title insurance company to issue a loan title policy upon the payment of the full premium (once again, subject to specified conditions, limitations and exceptions). More importantly, title insurance binders are limited in time. In other words, after a specified time period, the title binder is no good – even if a lender is prepared to pay the premium.

A construction lender would rationalize this approach by pointing to the "contingency" line item in the construction loan budget. The thought was that if the construction lender needed to buy a loan title policy in the future, it could fund the policy premium from the contingency in the budget.

One problem in this approach is that the topic of title insurance falls "off" the radar screen during the life of the loan in that few lenders track this topic. Indeed, as a performing loan sours, other issues fog the screen on this issue. And the contingency line item is utilized for other purposes.

Here are some suggestions for your workout process:

• Audit your loans to determine which ones only have title policy binders; whether the binders have lapsed; and the premium cost to purchase the loan title policy
• Confirm that your loan documents give you the right to purchase title insurance (as part of the debt). If they do not, make this a term to be included in any workout agreement
• Do all of this BEFORE you foreclose because delaying the purchase until after foreclosure will prevent you from adding the premium cost to the debt
• Carefully consider the name of the insured under the title policy and your ability to continue the coverage of the policy for affiliate entities (that will hold title to the collateral after foreclosure)

If you have other suggestions or any comments or "war stories" of your own, please post a comment.
 

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Guest Writer – Nelson Block, Winstead PC
(3rd in a series of 3 postings)

The strategies:

Be realistic
Borrowers sometimes suffer from terminal euphoria, believing that current market conditions will change, the business climate will improve, a new investor can readily be found, or the company can be sold quickly. Jump these hurdles quickly. Be prepared for difficult times.

Avoid surprising the lender
If there is going to be bad news, the borrower gets a jump ahead by being frank with the lender about adverse business results. This course builds credibility and trust, and creates an impression that management knows its business.

Plan ahead
The lender probably receives disappointing news about business performance much better if it is accompanied by a plan identifying the problems and outlining solutions. Even an outline of issues may be helpful. If management is not certain what action to take, the lender may have ideas or suggest outside experts who can offer experience and expertise. Accurate, current financial information is vital.

Understand the options
If the business cannot resolve its problems with changes to its business plan, assume that the lender will act to resolve them. The company’s options include, in descending order of desirability: move to another lender, wind down sufficiently to regain profitability, wind down to generate enough cash to pay off the loan, liquidate, or have the lender liquidate.

Get the loan in line
Often, asset-based lenders maintain the right to reduce advance ratios and strengthen eligibility requirements for collateral. If the business continues to require more money than its borrowing base justifies, the lender may use these tools to ratchet down the loan until the business’s performance is again in line with the amount advanced on the loan.

Maintain the initiative
Lenders know that everyone benefits when the borrower runs its business, even in a workout or liquidation. The company’s management knows the business better than the lender, and is in a much better position to understand issues, see problems and implement necessary changes. Lenders will try to take a role of approval, rather than proposal, during the workout.

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Guest Writer – Nelson Block, Winstead PC
2nd in a series of 3 postings

When market conditions worsen, the business’s deficiencies can outstrip the accumulation of assets that supports new loans.  Assume that on January 1, the borrower’s accounts receivable are $100,000, and the lender, using an advance ratio of 75%, lends $75,000.  The borrower uses the $75,000 to pay employees, taxes, rent, utilities and purchase inventory.  But adverse market conditions cause business to fall off, and on April 1 accounts receivable are only $80,000.  During the intervening 90 days, unless the company’s management was farsighted (and assuming it already adjusted for annual seasonal changes in business), it purchased the same amount of inventory and kept the same number of employees.  Moreover, the borrower’s non-payroll fixed costs – taxes, rent and utilities – have stayed the same.  So, on April 1, the borrowing calculation is 75% of $80,000, or $60,000, but the borrower still requires $75,000 to operate.

The typical pressures of business loom larger in a downturn.  The borrower, which needed daily working capital when it obtained the loan, is now strapped and using cash quickly. Management was already under stress from the many issues facing it when it took out the loan, and now confronts all those problems plus two more – a troubled business and a lender that wants to get paid sooner than expected. Time, which was short during any business day, is even more precious now, as the company’s management spends more time analyzing its business problems, dealing with employees (one of the most difficult and worrisome activities in a workout), putting off creditors, and meeting with the lender.  Certain strategies work well in such situations. See the next posting for a list of strategies.
 

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Guest Writer – Nelson Block, Winstead PC
1st in a series of 3 postings

While the experts argue about whether we are in a recession, or whether the Houston area is immune to it, those of us in business need to prepare for the challenges of an economic downturn and what to do about it. An important aspect of that analysis is what to do about your loan. Sometimes during the life of a loan, the borrower’s performance may be impaired or, just as importantly, may be viewed by the lender as impaired. Warning signs of a distressed loan include weakened cash flow, decreasing accounts receivable, rising costs, and build-up of inventory. In a revolving credit loan, where the amount of the loan varies as a function of the borrower’s collateral, poor economic performance translates into a loan covenant default because the borrower is not in compliance with its borrowing base.

How can a default arise in a revolving line of credit, where the amount of money advanced only increases when the borrower’s assets increase? The default often occurs because the loan anticipates cash flow. The borrower only sought a loan because its accounts receivable do not pay quickly enough to supply a reliable source of regular working capital. Its monthly cash needs were not being met by the payment of its accounts receivable.
 

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Whether it is in management contracts, space leases, or the underlying partnership agreements, lenders should be very wary of contractual relationships that their borrowers have with parties related to the borrower.

Most loan documents allow the lender to terminate management contracts, whether with related entities or not. These should be carefully reviewed. Additionally, many times, the borrower has related entities entering into leases of portions of the security under either favorable or questionable terms. All of these "sweetheart" contracts should be carefully reviewed as part of the workout process.
 

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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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