Political leaders in the United States and other countries where distressed loans are weighing down the balance sheets of important lending institutions are considering many solutions to loosen the resulting credit crunch. The focus recently has centered on creating “bad banks” to acquire such loans or providing incentives for private investors to do so. It’s an easy process in concept, but, as with any transaction, far more complex in actual application, particularly where there are large numbers of loans. This article breaks down the deal process into four segments (negotiation, due diligence, transfer, and post-transfer), and addresses the issues that arise at each step.
As with any transaction, the parties should first agree on the primary goals and key business terms of the deal in a letter of intent (LOI). Creating a detailed road map for the transaction, with input from real estate, finance, tax and securities lawyers, makes drafting the asset transfer agreement proceed far more efficiently. The LOI can establish the general allocation of risks as between the seller and buyer, and the asset transfer agreement can then fill in the necessary detail, preferably based on at least initial due diligence with respect to the loans and the commercial properties, but with an understanding that any issues that surface in the due diligence process will need to be resolved in the final agreement. With large portfolios, or in the case of a deal that must close very quickly, the seller should give the buyer access to the loan files immediately, preferably via an easy-to-use electronic data room. Note that seller files often are incomplete, so, promptly after a seller decides to transfer assets, it should start obtaining copies of loan files from its own records and the records of originating counsel, custodians and servicers. As discussed below, due diligence often is the most grueling part of getting to closing.
Due Diligence Phase
Once the asset transfer agreement is signed, the parties should prepare a detailed due diligence and closing checklist, and buyer’s counsel should prepare a template for abstracting the loan documents to identify key issues and loan terms. Of course, loan documents won’t reveal much about the current state of each loan, so the seller should provide current servicing reports and valuations to enable each loan to be properly categorized. Among the various issues to review, buyer’s counsel should focus on the following:
Inventory the types of assets being transferred.
The first question is, what kinds of loans are being transferred? Are they whole mortgage loans, participations in mortgage loans, mezzanine loans or participations in mezzanine loans? Are they in default, and has the lender initiated remedies, such as foreclosure or taking the mortgaged property by deed-in-lieu? Is there evidence supporting lender liability claims? Are there future funding obligations? Of course, each loan document should be catalogued, and missing documents should be requested. Critically, different types of loans will have different transfer requirements (as discussed in more detail below), and those transfer requirements will drive the structure of the transaction and, in some cases, the structure of the transferee.
Identify all types of collateral.
To ensure proper transfer, the due diligence process also should focus on the types of assets securing repayment, starting with the real property, but also including escrow accounts, reserve accounts, operating and similar accounts, letters of credit, bonds, personal property and other similar types of collateral. Identify what kinds of assets there are, where they are being held and in whose name they are issued. Servicers or custodians may be the best source of this type of information, and the buyer should require the seller to authorize direct contact with those parties.
Identify future funding or other future obligations of the lender.
If the loan is a construction or renovation loan, the lender likely will have future funding obligations. In some instances, the amounts required to be funded in the future might be escrowed or held by a depository bank, or they may be in the form of a letter of credit. Any escrowed amounts or accounts with depository banks should be transferred to the transferee concurrently with the transfer of the loan. Once unfunded future funding obligations are identified, the parties should determine whether the transferor or the transferee should be responsible for them, and this decision should be reflected in the transfer documents. As discussed below, the assignment of such obligations may be subject to transfer limitations.
Chart the notice and consent provisions.
Buyers and sellers each have a stake in identifying to whom prior or concurrent notice of a transfer must be given (e.g., servicers, custodians, depository banks and ground lessors) and from whom prior consent to a transfer must be obtained (e.g., rating agencies, hotel franchisors and, sometimes, borrowers). Since third-party consents can be the most time-consuming, they should be requested as soon as possible.
Check for transfer restrictions.
While unusual in loan agreements between a borrower and a single lender, more complex loan structures, including participation agreements, co-lender agreements and intercreditor agreements, almost always contain transfer restrictions. For instance, if a participation interest in a mortgage loan is being transferred, it is likely that the transferee will have to meet the definition of a “Qualified Transferee” (QT) or a “Qualified Institutional Lender” (QIL) under the applicable provisions of the participation agreement. A loan with future funding obligations typically will include similar restrictions on the transfer of those obligations. If other loans secured by the same property have been securitized, rating agency confirmation may be required, and rating agency confirmation or consent of the senior lender or participant sometimes can be an alternative to meeting the QT or QIL requirements; however, obtaining these may be time-consuming. While typical QT or QIL provisions require certain levels of capital surplus and total assets and sometimes require that the transferee be regularly engaged in the business of owning commercial real estate loans, these provisions are contractually driven and vary widely. Some require the transferee to be a “U.S. Person,” essentially a U.S. taxpayer.
Order Title and UCC searches.
Another critical element of the due diligence process is ordering title searches for each of the real properties that serve as collateral under the mortgage loans and UCC searches on each of the entities pledged as collateral under the mezzanine loans (depending on the transaction, title and UCC searches may be appropriate in all cases). The searches are a long lead-time item, and may be costly and time-consuming to review, but only by actually reviewing the UCC and/or title searches can one be certain that collateral underlying the loans has not been further encumbered.
To prepare for closing, the parties should agree on the proper method of transfer for each type of commercial real estate loan.
Whole mortgage loans.
Transferring an interest in a whole mortgage loan typically requires endorsing the original note over to the transferee and delivering physical possession of the note to the transferee or to a custodian on behalf of the transferee. All of the transferor’s interest in the remaining loan documents should be assigned to the transferee; if the documents are to remain with an existing custodian or servicer, the related agreement should be assigned to the buyer, and appropriate notice sent to the custodian or servicer of the buyer’s interest. The buyer also should record an assignment of mortgage and assignment of leases and rents in the land records where the real property is located (including a substitution of the trustee under the deed of trust, if applicable), to put third parties on notice of the assignment. In most jurisdictions, transfer or recordation tax will not be payable on recording an assignment, but local counsel should be retained to confirm this and other closing issues. Also, if a UCC-1 financing statement has been recorded in the land records as a fixture filing, or filed with the secretary of state where the borrower is organized, each should be assigned via a UCC-3 that includes the identity of the new secured party. Co-lender arrangements should be handled in a similar fashion, although depending on the relative rights of the note being assigned, a recorded assignment may not be appropriate.
If a junior participation interest is being transferred, the rights of the participant vis-à-vis the borrower are derived through the rights of the senior participant, so an assignment need not be recorded. If a certificate evidencing the participation exists, the certificate should be reissued in the name of the transferee, and physical possession of the new certificate and the participation agreement should be delivered to the transferee or a custodian on behalf of the transferee. If there is a participation register, the custodian of the register should be instructed to create a record of the assignment. The participation agreement, and all of the transferor’s rights and obligations, should be assigned to the transferee.
In the mezzanine loan context, when the loan is secured by a pledge of equity in the borrower, the original note should be endorsed and delivered to the transferee or a custodian on behalf of the transferee, and a UCC-3 financing statement must be filed in the location where the original pledge of the membership or other equity interests has been perfected by filing. The transferor also should assign its interest in the mezzanine loan documents and any intercreditor agreements to the transferee.
As discussed above, notices to third parties should be timely delivered, and some notices may need to be sent as much as 30 days in advance. Proper files should be maintained, showing evidence that delivery of the notice occurred in accordance with the requirements of the loan agreement. The content of the notice will depend on how the loans will continue to be serviced after closing, but should contain, at a minimum, any new payment instructions and the transferee’s name.
Title insurance/UCC insurance.
The existing lender’s title insurance policy should run to the benefit of the transferee by virtue of its existing terms. Title searches will reveal whether there are any encumbrances recorded between the date of the original loan and the transfer, but unless there are tax liens or mechanics liens (in some jurisdictions), the priority of the lien will not be affected by such junior encumbrances. Obtaining an endorsement to the existing policy may be costly, but has the benefit of insuring that the assignment instrument has been properly recorded and that the mortgage is vested in the buyer.
If there is no UCC insurance policy for a mezzanine loan, one should be obtained. The UCC search on the borrowing entity will be critical to determining whether the borrower’s owner has subsequently pledged or encumbered its interest in the borrower, but, as in the title insurance context, a new policy, or an endorsement to an existing policy, would insure the UCC-3 amendment.
Structure of transferee.
The structure of the transferee will be driven by internal corporate and tax priorities and commercial considerations, and possibly, as discussed above, by whether the transferee is required to be a QT or a QIL. While it is unusual for an entity to be required to qualify to do business in a state merely by virtue of the fact that it holds mortgage loans in that state, state requirements vary. If there are future funding or other ongoing lender obligations under one or more loans in a state, however, the buyer may need to register to do business in that state, and some states may require the buyer to be licensed as a mortgage lender in respect of such activity. In addition, if loans are in default and will be foreclosed soon, the buyer should form a wholly owned, special-purpose entity to take title to the foreclosed property and qualify that entity to transact business in the state in which the property is located.
Loan servicing and location of documents.
How and by whom the loan will be serviced after closing are critical considerations, as these issues will affect the content of the closing notices and, most importantly, how the buyer will manage the loans going forward (most likely, these days, this will involve more than simply receiving loan payments).
Borrower’s insurance; bank accounts.
Notice must be sent to the borrowers to have their insurance policies updated to reflect the identity of the transferee. These notices can and should be sent by the servicer (if there is one). Accounts held by the depository bank also should be updated to reflect that the accounts are being held for the benefit of the transferee.