As banks look for opportunities to free up their balance sheets from the ongoing financial, managerial and regulatory burdens of problem loans, some examine opportunities for selling the problem assets to loan purchasers on terms that may, or may not, be advantageous to the selling institution.
In the current environment, selling institutions are often under intense regulatory (and shareholder) pressure to “clean up” their balance sheets. Prospective loan buyers sense and understand that pressure and have been known to take advantage of the situation to secure the credits at a bargain-basement price, with terms that sometimes provide a virtual guarantee of collection and little, if any, actual risk to the buyer.
There are loan sales and there are loan sales. Terms vary widely, and as always, the devil is in the details. Transaction terms of course reflect allocation of a variety of risks. How the loan sales are conducted, how they are priced, and the various terms and conditions of loan sales can make the cure worse than the disease unless the selling institution takes care to thoughtfully negotiate and document terms that make sense for their particular situation.
While each transaction is unique, some of the more common issues and traps for unwary sellers are discussed briefly below.
Before proceeding with any prospective buyer, it is important to secure a strong confidentiality agreement with covenants regarding customer and selling bank information, restrictions on use of the information provided to the buyer, and non-solicitation covenants. A well-worded “letter of intent” also may be useful in establishing a protocol and certain transaction terms early before much time is expended and before asset quality erodes further.
Exclusivity and Due Diligence
Some loan buyers take advantage of pressured institutions and, early on, suggest a high “estimate” price to be followed by an “exclusive” due diligence review period. As the due diligence period drags on (and is often extended), regulatory and shareholder pressures mount, problem loans get worse, and the seller misses other sale opportunities due to the “exclusivity” clause. The buyer’s apparent initial optimism sometimes becomes one of increasing skepticism followed by a significantly reduced price. Kind of like the initial used car trade-in “estimate” before visiting with the sales manager. Before long, the initial “estimate” is long gone, replaced by a much lower price and terms that sometimes leave the selling institution in the position of a guarantor of recovery, despite the lower price (which should reflect risk). Sellers are often worn down by this time and ready for almost anything to get the loans off of their books. Even if accepting a low-ball price, however, sellers need to undertake a careful review of the other terms of the sale agreement before entering into a transaction that could leave the seller in a worse position than if no transaction had occurred.
Initial proposed sale agreements often include a buyer “put” which enables the buyer to require that the seller repurchase loans for a variety of reasons. At that point, sellers need to examine whether they would be in a better position by retaining the loans and continuing with workouts. Intervening issues may (and often do) arise with regard to treatment of the loans (and borrowers) by the buyers and the seller can be left holding the bag with a “lender liability” problem to boot. Regulators and auditors also may require continued reserves against these credits in the event that they return to haunt the seller. While buyer “puts” may be necessary in certain circumstances, providing buyer “puts” after a due diligence period can provide post-sale headaches for selling institutions. Buyer “put” options also may adversely impact the ability of the seller to characterize the transaction as a “true sale” for a variety of accounting and regulatory purposes, and they may require maintaining further reserves. Non-recourse transactions are typically the preferred seller vehicle for ridding the seller of the problem loans once and for all.
Seller Representations and Warranties
Despite buyer due diligence opportunities, many sale agreements provided by buyers contain extensive seller representations and warranties (including as to collectibility of the underlying debt, borrower creditworthiness, document sufficiency, etc.) that result in a virtual seller guarantee of the underlying credits. “As is, where is” is of course typically the preferred seller position, particularly after buyer due diligence and pricing, with minimal seller representations and warranties. Buyers know they have sellers in a precarious position with regard to reputation risk and regulatory scrutiny, and they may take advantage of the relative bargaining power. Anything that increases the potential that the loans may ultimately return to the selling institution, by exercise of a buyer “put” resulting from breach of a seller representation and warranty or otherwise, reduces the desired goal of getting rid of the problem loan forever.
Pricing and Expenses
While pricing may vary depending on the value of the credit and the underlying terms of the transaction (including whether the seller agrees to the referenced buyer “put” option), selling banks are in the best position to know the true value and whether pricing is appropriate. Buyers may in some instances tend to take advantage depending on the level of pressure and desperation of the selling bank. Sellers may consider obtaining professional assistance in determining pricing for the assets particularly in light of potential shareholder and regulatory questions with regard to value received.
Transaction costs in loan sale transactions can be significant, including preparation of transfer documentation, filing and recording fees, title searches, customer and contractor notices, lease and other collateral assignments, tax pro-rations, and legal fees. Loan sales are document intensive, and the sale agreement should take those costs into consideration and allocate as appropriate.
If available, payment for the loans sold should be received up front, not in reliance on ongoing buyer solvency. While buyers can rely on the regulated environment and audited financial statements of banks to provide comfort with regard to the bank’s solvency and creditworthiness, bank sellers typically don’t have the same comfort with regard to non-bank buyers. Sellers may want to consider requiring buyer escrows, letters of credit or other guarantees of buyer performance.
Avoiding Unintended Consequences
Care must be taken to ascertain that the transaction does not bring unintended consequences such as inadvertent violations of selling bank (or holding company) debt covenants, participation agreements, shareholder agreements, requirements of governance documents or collateral pledges (such as selling loans pledged for FHLB lines). Sellers must determine whether third-party notices, consents or approvals are required for the transactions, or whether there are limitations on transfer that may apply. Ongoing funding may be required for commitments under construction loans, letters of credit and other lines, which must be addressed if such credits are to be included in the loan package.
Seller Due Diligence
Sellers should require (and follow up on) buyer references and, as always, be wary of deals that seem too good to be true, particularly with aggressive up-front “estimates” followed by long “exclusivity” periods and blanket seller representations and warranties. Given the typical circumstances, buyers can be in a position to drive negotiations from a position of strength that result in deals which in reality, still leave the selling institution holding the bag.
Regulatory and Professional Involvement
The terms of proposed transactions should be carefully reviewed with relevant regulatory agencies and the sellers’ accounting, tax and legal professionals to make certain in advance that they will receive the desired regulatory and accounting treatment. Depending on the nature and size of the transaction, prior regulatory notices and/or approvals may be required, and buyer state licensing may be an issue particularly when consumer loans are involved. Entering into a binding agreement with terms that result in undesired (or unforeseen) regulatory, accounting, tax or legal treatment can be avoided by making certain that appropriate agency personnel and professional advisors are in the loop early and often and are in agreement with the institution’s planned treatment of the transaction.
Post-closing Issues and Seller Reputation Risk
Keeping in mind that these loans typically represent deals that were once desirable (loans are always good when they’re made....), how the loan buyer treats borrowers (who may well still be in the community) can reflect on the selling institution. Troubled borrowers also can sense distress and vulnerability and may raise “lender liability” and other loan management issues and claims with regard to not only the buyer for post-sale activities but also the selling institution for pre-sale activities. Post-sale loan management and collection activities by the loan buyer can have a very real impact on the business and the reputation of the selling institution, its management and its board. Sellers may wish to secure indemnification from buyers for post-closing issues and activities involving the loans and the buyer’s post-sale treatment of the loans and borrowers.
Sellers also may consider securing post-closing confidentiality obligations for the buyer with regard to further use of transaction and customer information, as well as post-closing commitments regarding non-compete and non-solicitation obligations. Sellers also may wish to limit or prohibit subsequent loan resales by buyers.
Problem loan sale transactions, done correctly, can provide important and needed relief to the selling institution. While most loan buyers in the market are reputable, there is the occasional buyer who may attempt to take advantage of seller weaknesses and pressures to engage in a transaction that ultimately may not be in the best interests of the seller. In many if not most situations, lenders are not looking to sell the credits unless they are in a difficult situation already. Taking care to do it right the first time will save real headaches and cost in the long run.