One of the first things we do as lawyers when handling a problem loan is to review the loan documents. We do this because we will sometimes find defects in the loan documents that may alter the strategy the bank was going to take in its collection process. Instead of moving to foreclose, for example, a lender might be more inclined to enter into a forbearance agreement with an opportunity to clean up documentation defects. The following are some of the issues we typically ran across while handling problem loans originated during the Recession.
- Term Sheets and Commitment Letters. The use of Term Sheets and Loan Commitments varied dramatically between banks and even within the banks themselves. For example, we found that if a bank did tend to use Term Sheets, the forms oftentimes were ones simply adopted by a particular loan officer, and not used uniformly across the bank.
Why care one way or the other? The problem arises in the use of internal loan approval forms that are inconsistent with the Term Sheet sent to the customer. In many cases, outside counsel attempted to document a loan based on the Term Sheet only to later discover discrepancies between the Term Sheet and the loan approval form. Such discrepancies often resulted in the lender believing that it had certain collateral or certain rights only to find out later on when the loan went into default that it had neither.
The inconsistencies were also fertile ground for borrowers and guarantors to generate defenses and counterclaims based on the documentation not accurately setting forth the deal. The original loan officer may or may not be available (or interested) to answer questions about exactly what occurred when the loan was being negotiated and later documented.
- Signatures. Getting loan documents signed correctly is such an important foundation for enforcing a loan that it was always surprising when we reviewed a package and realized that documents had been signed incorrectly. Signature deficiencies are particularly troublesome when dealing with real estate collateral. For example, a Deed to Secure Debt might state on the front page that the Grantor is ABC, Inc. but when you get to the signature page it is signed by XYZ, Inc. Trying to foreclose on the real property in that situation is, shall we say, somewhat problematic, and can involve, among other things, a suit to “reform” the documents. Not exactly what a special assets officer wants to hear when he or she is expecting a simple, straightforward foreclosure action.
The other common mistake we observed is where the borrower is a particular form of entity, such as a limited liability company, but a person (other entity) signed the document in an incorrect form. For example, for a loan to a limited liability company you would expect to the see the documents executed by the Member or Manager (depending on whether the Operating Agreement provided that the LLC was member-managed or manager-managed); however, the documents oftentimes were executed by someone signing as “Partner.” They may or may not have been the right person to sign the document but the fact that the wrong capacity is shown raises questions about the enforceability of the loan documents.
- Internal Inconsistencies. It is fairly common to see typed references on form documents where the bank was attempting to cross-collateralize or cross-default a note to some other note. Suffice it to say that there are correct ways to cross-collateralize notes and they generally have to do with actually amending the Deed to Secure Debt. That does not seem to be the approach that many banks have taken, possibly either because they want to avoid paying intangible taxes or they have simply done it the wrong way for so long they are convinced it is correct. Regardless of whether it is being done properly to begin with, one must start with a fundamental proposition — the reference to the other note needs to be correct both in connection with its date and its amount.
- Security Interest Defects. One of the fundamental concepts of collateral is that the party pledging the property to the lender must actually grant a security interest in it. For motor vehicles, the owner needs to sign a security agreement, not simply deliver the title to the lender. We have seen numerous files where the bank has a title but nowhere in the file is a document that actually grants a security interest to the lender. Other issues included failing to accurately record the vehicle serial number on a Security Agreement.
- Guaranties. People do not guaranty their own loan. If John Smith is the borrower, it is inappropriate to have John Smith sign a personal guaranty of his own loan.
- Real Estate. Probably the biggest number of errors we have seen involved real estate collateral. They included:
- incorrect description of the real estate collateral such as skipping an entire tract of land;
- failure to have a title examination run in order to insure that the borrower owned the collateral being pledged;
- failure to insure that improved property had access to sewer and water, including necessary easements where necessity;
- encroachments such as roads or power lines affect the proposed use of real property; and
- attempted modifications of Deeds to Secure Debt by using a Security Agreement, a document which was not recorded in the real estate records.
- Training. The biggest risk is that a mistake is made in the use of standardized forms which is then replicated on all subsequent deals. Take the time to have an outside party, such as the law firm you use to document loans, to periodically conduct a Loan Document Audit of the way both new deals and loan modifications are being handled.
- Real Estate. I fully understand the competitive pressures lenders are under to minimize fees paid by borrowers in a loan transaction but I also feel strongly that real estate loan documentation is something that requires the use of outside legal counsel. Lenders should be thinking about who they want to document their day-to-day deals as well as larger, more complex transactions.
- Term Sheets and Loan Commitments. Banks that use Term Sheets and Loan commitments should go to the trouble of drafting a uniform set of forms and then keep them updated overtime. Banks can attempt to manage the process themselves or look to a law firm for assistance. For example, we can provide the Bryan Cave Online Document Portal where loan officers can assess the most recent form of Term Sheet or Commitment Letter. The documents are drafted specifically for each bank in order to accommodate each client’s preference.
- Loan Document Systems. Lenders today have access to many options of preprinted forms as well as computer based documentation systems. Some lenders seek more finely tuned documents, whether from a competitive standpoint or simply because they want forms that better fit the type of deals they are doing.