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Buying a Loan-to-Own Series, Part 2

By Natalie Dolce

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Muller

Part 2 of 2

SAN FRANCISCO-Three experts at Manatt, Phelps & Phillips LLP recently spoke with GlobeSt.com about buying a loan-to-own, how to account for the risks and how to know what you are buying. Check out the first article in the two-part series titled: “Buy a Loan to Own, and Price it Right.” In this article, the Manatt team takes a deeper look into a borrower’s actions, such as opposing foreclosure and filing for bankruptcy protection.

Buying a loan to own creates tension between the point of the exercise—getting your hands on the property—and every lender’s obligation to act in good faith, says Clayton Gantz, a partner in Manatt, Phelps & Phillips’ San Francisco office. Lenders—whether those who originated the loan or later holders of the note—have been found liable to borrowers, or borrowers have established defenses or counterclaims, based on fraud, duress, breach of fiduciary duty, unfair business practices, and breach of the terms of the loan agreement, he says.

“Lenders since medieval times have attempted to keep properties in lieu of repayment of the debt, giving rise to long-established rules protecting the borrower’s ‘equity of redemption’—the right to free the property of the mortgage by repaying the debt,” Gantz says. “In many states, including California, the courts have established a ‘covenant of good faith and fair dealing,’ which is implied into every contract.

Therefore, he says, “note buyers are well advised to keep their intentions to themselves, lest their actions in the workout and foreclosure process be viewed in an unhelpful light.” And, as with all lenders, he explains, “note buyers should be careful to make no misrepresentations, not to imply that they are willing to consider a workout if they’re not, to refrain from giving the borrower advice or exercising undue control over the borrower or the asset (which may be particularly challenging if cash management rights are being exercised), to be sure not to thwart attempts by the borrower to cure defaults, and otherwise to behave in a way that will be later viewed as fair.”

This market has already seen several very large, seemingly very good, acquisitions of loans and loan portfolios by buyers eager to own the underlying properties, Gantz points out. “Years from now, the ones who will be looked back on as the geniuses will be those who were able to put together a good team to evaluate the costs and risks lurking in these deals and underwrite their bids accordingly.”

Is the borrower going to oppose foreclosure?

According to Tom Muller, a partner in the real estate and land use practice group, some key questions to think about are what kind of people are managing your borrower, do those people have a reputation for filing lawsuits at the drop of a hat or do they work cooperatively with the current noteholder to transition the property in an orderly manner? “Even if your due diligence discloses no borrower claims or offsets, that doesn’t prevent a litigious borrower from raising them after you’ve bought the note,” he says, “and while you may well ultimately prevail in the lawsuit, the legal fees and time spent litigating will wreak havoc on your pro forma.”

He also points out that it is important to keep in mind that “borrowers may behave very nicely while their lender is a bank with whom they have several other loans outstanding, but may not feel compelled to be so compliant when you buy the note.” And, he adds, “be sure you are very careful when exercising your remedies under the loan documents and any guarantees-the law contains traps for the unwary, and is not all that friendly to lenders.”

Is the borrower going to file for bankruptcy protection?

The threat of bankruptcy hangs over all transactions in the distressed asset arena. A bankruptcy filing can tie up the property for a long time and result in very substantial legal fees for protecting your rights as a creditor in the bankruptcy case, says Muller.

Probably the most important change in bankruptcy law for real estate lenders since the real estate recession of the 1990s was a provision making it much more difficult to tie up real property held in a single asset company in bankruptcy for a long time, Muller explains. “Difficult, but not impossible, and the benefit of this change, at best, is to allow a foreclosure to proceed after ninety days if the borrower has not come up with a plan of reorganization,” he says.

“Bankruptcy can also thwart your intentions to own the property, as the property can be sold out of the bankruptcy case by order of the court without your consent as a secured lender, though your claim under the loan documents-to the extent the property was worth enough to secure it-should be protected,” Muller continues. “But your idea of ‘protected’ may be a bit different from the court’s, especially if the borrower is able to come up with new money to help finance his recovery plan and you get ‘crammed down’—forced to remain as a lender with a stretched-out loan at an interest rate the court deems fair.”

Since the possibility of bankruptcy is an unavoidable risk, Muller says that note buyers should carefully evaluate the likelihood that the borrower will file for bankruptcy protection. If the property is worth much less than the face amount of the loan the note buyers are buying, then it may not be worth the borrower’s time and energy to file for bankruptcy protection, he explains, adding the “filing can also trigger recourse under nonrecourse carve-out guarantees.”

Muller points out that some key questions to think about surrounding the bankruptcy topic are: Is the borrower fond of litigation, or trying to leverage for release from a guarantee?; and is the property deeply underwater, but held in a company with many other distressed properties so that the borrower is going to be forced into bankruptcy anyway?

Is the loan seller giving you any protection?

According to Steve Edwards, a partner in the Orange County, CA-office, the answer to this question is probably not. “Particularly because the market today is largely set by large institutions such as the FDIC, few sellers will offer representations, warranties, or repurchase remedies to make it up to you if the loan isn't all you hoped it would be,” he says. “And if you do get some post-sale protection, it is likely to be subject to baskets, caps, and time limits.” While there may be some negotiating room here, he explains, “you are not likely to get much, so you should underwrite and price as if the seller will offer you no protection.”

Until recently, Edwards explains, “most note buyers who were interested in acquiring the underlying collateral would not let that be known, as it was viewed as somewhat unseemly.” However, he points out that “bankruptcy court opinions in the past few years have made it clear that even making a loan with the hope of thereby becoming owner of the collateral or borrower is not necessarily inappropriate.”

Categories: West, Distressed Assets, San Francisco