Our friend, Dan Rubock, just inked an interesting and timely piece entitled, “Key pillars of loan structural quality are eroding, especially in single-borrower deals.” As usual, Dan’s views at Moody’s are worth considerable attention. That piece focused on bad-boy carve-out guaranties, the quality of borrower financial information, property release provisions, qualified transfer provisions and cash sweep triggers. While reasonable professionals can differ on both the incidence and the impact of the deterioration of these deal features, the point is well taken that the deterioration of legal structural features in CRE lending is often a canary in the mine for… excessive exuberance. I’ll put off litigating Dan’s points for a future time, but this got me thinking about all that we do in legally structuring loans for the capital market.
Much of the playbook for capital markets CRE lending was established at the dawn of this business. At that time, Dechert was outside counsel to S&P and for good or ill, Dechert was responsible for much of the early architecture of CRE documentation and legal underwriting. While these criteria have been periodically tweaked over the years and adapted to changes to the underlying CRE lending market, the original architecture is still pretty much in place.
I would posit that it is an industry failing that we haven’t really given legal underwriting a thorough rethink in 30 years. Here’s a start.
Let’s talk opinions and particularly the non-con and true sale.
Now for a bit of context. Think of the unshakable grip that Hippocratic medicine had on doctors right up to the beginning of the modern era. Why look to understand disease if you already know beyond peradventure that everything bad was due to an imbalance in one of the four humors? Bleed ‘em, starve ‘em or send him to the country (if rich enough). It’s probably fair to say that absent such an unshakable faith in the brilliance of the great masters of antiquity, someone might have noticed that it’s not a terrific idea to eat where you shit? (The main stream media assures me that it is no longer a problem to use that earthy Anglo-Saxon word in papers of general circulation anymore, so I feel empowered… although perhaps it’s only okay to use in articles about Mr. Trump?) Did you know that Rome, a basket case of a city during medieval times, had the lowest death rate of any major city in Europe from the Black Death? Why? Because they still had a sewer system from Roman times. No one connected the dots. In more modern days, think about my poor father, suffering at the hands of a well-meaning and well-educated wife, with skinless chicken, no eggs, bacon or red meat for 40 years because of the received wisdom that dietary cholesterol lead to heightened levels of blood cholesterol. It turns out there never was any data to support this, and plenty to conflate it; but no one noticed.
Okay, I’ve gotten a fair way off piece here, but this is relevant to the opinion question we’re after. So at the risk of my immortal professional soul, let me ask whether non-con (and true sale) opinions really make any sense in rated securitizations today.
From the various cyclical downturns I’ve been through in my professional life, I can distill my loan default experience into one simple rule: If I’ve got some human being on the hook, I’m likely to win. But we don’t do principal and interest guaranties in structured finance, do we?
Why? Because the non-con opinion is the rosary beads of the capital markets. We do non-cons between related buyers and sellers, between parents and subsidiaries and sometimes among other more arcane pairings required by someone or other in a transaction. Anyone read these things? They start with a statement of the facts (useful) then proceed over the next forty pages to regurgitate long-settled case law, make a pretty simplistic nod to good facts or bad facts and end with a short opinion that uses the word would which we all know means should, and moreover we all know is almost meaningless because if wrong, then everyone is wrong and the opinion is worthless.
Anyone read the actual case law recently? Substantive consolidation, treating the assets and liabilities of two separate juridical entities as a single entity for bankruptcy purposes happens rarely. And the case law screams out substantive consolidation, like porn, is something you know when you see it. Those few cases where substantive consolidation was actually ordered, it was blindingly obvious. Think of seven hundred cabs in a fleet where each cab was separately incorporated but ran by a single manager with a single bank account, etc. Of course they should be consolidated.
As to the ordinary interconnectivity and transactional activity between legally separate entities in business today, the risk of substantive consolidation is, I would propose, slight.
So why do we view a guaranty, even a partial guaranty, of repayment of principal and interest on a loan as an existentially bad fact for opinion purposes? Show me the case where an entity with multiple contractual undertakings and obligations (think leases, management agreements, supply contracts, etc.) was consolidated because a single obligation was guaranteed by a parent or related party. Show me. Intellectually, it makes no sense that such a limited guaranty would cause the juridical entities to be viewed as illusory but the market sayeth we shall not render a good non-con opinion in the presence of such a guaranty.
The ratings agencies require “will” level opinions and because of the entirely reasonable liability concerns of the bar, non-con opinion practice has created guardrails around opinion liability that are so wide of the bleeding edge of reality that you can barely see them from the center of the road. Hence, no guaranteed debt.
And look at what the lenders have given up. We can’t even ask for a guaranty and we know, with certainty, that guaranties from real live human beings have a very material impact on the likelihood and severity of default.
We tolerate this tradeoff because it is relatively costless in capital market transactions. That’s because in the rating model, which we all embraced, guaranties of unrated parties are largely not credit positive. Moreover, the absence of a non-con opinion at least in larger deals, is definitively credit negative. Don’t know about you, but I’d take Warren Buffet’s personal guaranty, the unrated gentleman that he is, over the finest, prettiest opinion on the planet. But if I lose the guarantee, get a pretty opinion and my deal fares better, that’s where I go.
We need to rethink this. The trade-off seems at least debatable if not entirely irrational and this is a debate the industry should have (particularly as this Goldilocks expansion is long in the tooth and a cyclical downturn is certainly ahead of us somewhere, putting a much sharper point on questions of collectability). Moreover, these damn opinions are an expensive nuisance. Why kill a tree and print the same 50-page opinion and make law firms twist their knickers over hypothetical liability on these opinions on every single deal? What are we accomplishing?
The only arguments in favor of the non-con opinions that I can see is that they are a due diligence exercise where a lawyer who worries about his professional rump susses out the salient facts in the relationship between a borrower and related parties. Can’t this be done just as well with a borrower certification (assuming, of course, we receive a payment guaranty)? The facts are the facts and we rely on borrower and deal party certifications on all sorts of matters of import in commercial lending. Give us a borrower certificate regarding the key facts and then we could all stare at them and decide whether consolidation is a real risk or not. And we can price it if it is.
And don’t get me started on true sale opinions. True sale, the first cousin of the non-con, is another exercise in kabuki theatre. We need to know the facts and a certification from an issuer/sponsor party should accomplish that, then people could make a judgment. Does anyone think that an opinion of law with a would somewhere in the last paragraph actually is a credit enhancement feature of the deal? (Regrettably, someone does think that an opinion matters and that’s the accountants. In order for the accountants to get to a GAAP true sale, they need a legal opinion or other evidence that the deal has achieved legal isolation. Can’t we work out with them what “other evidence” is without having to drop a 50-page book on their desk which goes through the same exercise as we do in the non-con?). We all write the same opinion on the same facts. Remember the standard of these opinions is negligence. If everyone writes the same opinion, even if it’s wrong, it ain’t negligence.
Okay, I am trying to be a little controversial here, but there is something to be said for thinking afresh about how we support high quality loans that will support bonds in a structured finance environment. I remember talking to one of my life company clients years ago who had given up on the practice of asking for borrower organization and enforceability opinions as an unnecessary deal expense on middling to small loans. I asked why. The answer was that the company had looked at 30 years of lending experience and had actually mapped all non-performing and defaulted loans against the reasons of why the loans defaulted and discovered that not in one case was the issue the valid existence of the entity or enforceability of the loans. Hmm. But we still ask for it?
We should be mindful that we’re giving up real, demonstrable value to get non-con opinions. Are we really making a good trade?
Before I close, let me assure my readers that I am indeed a card-carrying member of the herd (moo) and notwithstanding the musings set out above, I am still going to require these opinions, so don’t wave this commentary in my face. The market is the market and until the market moves, the opinions will remain an integral part of the loan closing process. But, assuming by the time you read this I haven’t been marched out of the CREFC fort and been dishonorably discharged from the profession, this is a dialogue that I think we should pursue. Thoughts?