ATTORNEY PROCEDURES FOR ACQUISITION OF DISTRESSED LOANS

The Opportunity Funds have been hiring attorneys for acquisition and management of their business line involving the purchase of performing and non-performing debt.  Many attorneys have found that crossing the line between the role of attorney and management has been a rewarding and smooth transition.  I am not advocating a replacement of the attorney in the debt acquisition process.  It is absolutely necessary to engage an outside attorney In the business line of purchasing performing and non-perfuming debt, if not for any other reason but to receive a valid opinion letter and have a sufficiently rated malpractice insurance carrier involved in the transaction.

For purposes of this Procedures Manual I call this group  the Commercial Discount Loan Department (“CDL”) and the mission statement would be to acquire non-performing commercial mortgage loans with balances in excess of $5 million.  Most Opportunity Funds utilize a team or group consisting of one CDL Acquisitions Person or Acquisitions Officer, a CDL Asset Manager and a CDL Market Analyst.

The concept is to identify loans that are collateralized by over-leveraged but well maintained income producing properties with positive cash flow prior to debt service.  The process of sourcing the loan or loan portfolio is not discussed here.  This Procedures Manual assumes a loan or loan portfolio has been targeted for acquisition and begins with the procedure subsequent to making that determination.

The CDL Loan Acquisitions Procedure can be separated into three main areas: Due Diligence, Property Valuation and Asset Pricing.

DUE DILLIGENCE

Pre-Bid Due Diligence

The first step after sourcing a possible acquisition is to perform a preliminary review.  The objective of this review is to determine whether the individual loan or loan portfolio’s characteristics meet your Groups standards:  Determinations for each Group varies, however see the following:

  • Average loan balance;
  • Property  type;
  • Property location;
  • Local market conditions;
  • Estimated Loan To Value ratio;
  • Estimated Debt Service Coverage ratio;
  • Vacancy percentage;
  • Loan Status (performing, sub/non-performing); and
  • Seller’s motivation.

If it is determined that the loan or loan portfolio meets the preliminary acquisition criteria, a Confidentiality Agreement (usually supplied by the Seller) is executed by Buyer and returned to the marketing source. As soon as it is available, the proposed Loan Purchase Agreement (usually supplied by the Seller) will also be reviewed by outside Legal Counsel and by an Asset Manager to determine the scope of due diligence that is required and allowed prior to bid submission.

Upon receipt of the signed Confidentiality Agreement, the loan Seller will provide additional information about the loans.  In some cases, the information will include rent rolls, historical operating statements, appraisals, title reports, legal counsel correspondence and loan documents.  In other cases, the information will be limited to Borrower names and property addresses

On-Site Due Diligence

The very first step is the for the Market Analyst is to identify and contact real estate brokers and/or appraisers in the market area of the subject property and obtain rent/sale comparables and brokers price opinions (“BPO”) for each property in the portfolio.  The Market Analyst will also begin preparing a market study for each market and submarket within the portfolio.  This will assess area economic data, employment trends, absorption rates and market rental rates on a macro and micro basis.

The on-site due diligence review is designed to fully compile information regarding the loans that are being offered for sale and the collateral securing the loans.   The Acquisitions Officer will inspect every property in the portfolio in accordance with the inspection standards described below and the Financial Analyst will review all of the loan files and documentation available regarding the loans being offered for sale.  To the extent possible, the on-site due diligence review of the loan files will always include the following:

  • Review of all legal counsel and collateral documents relating to the loans;
  • Review of all litigation files relating to the loans;
  • Review of all correspondence files relating to the loans;
  • Review of historical income and expenses for each property securing the loans including a review of all available operating statements and financial statements;
  • Review of all leases for each property;
  • Review of all title insurance policies, title updates, surveys and tax status reports for each property;
  • Review of recent appraisals for each property;
  • Review of all engineering and environmental reports for each property;
  • Review of all credit reports, financial statements, partnership agreements and any other information relating to the organizational strength and structure of the Borrower.

The on-site due diligence team will review the information described above, verify data previously provided and gather additional information not previously made available by the loan Seller, which is necessary for pricing or which impairs a loan’s value.

The on-site due diligence team will also identify any Legal documents, pleadings or correspondence that will require further review by CDL’s Legal Counsel.  Verifying legal legitimacy is paramount to the process.

The scope of the on-site due diligence inspection and the information required prior to bidding on a portfolio may be expanded depending upon the representations, warranties and due diligence provisions of the proposed Agreement of Sale for the subject loan portfolio.  In some instances, an Agreement of Sale will include a post-bid due diligence period to review legal counsel documents, title status and to perform engineering and environmental studies.  Under these circumstances, outside experts will not be retained until after Buyer’s bid is accepted by the Seller.  Outside experts may include: a) local counsel to review loan documents, b) environmental and engineering consulting firms (the decision to retain outside environmental and engineering firms will vary based upon the quality and dates of the reports provided by the Seller) and c) a title insurance company to update the title report and provide a down dated title insurance endorsement. If the proposed Agreement of Sale is on a “where is as is” basis without representations and warranties, engineering and environmental experts may be retained prior to the bid depending upon the date and quality of reports already in file.  Prospective sales which do not permit post-bid due diligence are not favored and therefore will only be done on a very selective basis.  It is CDL’s preference to avoid incurring unnecessary fees for outside consultants until a bid is won or offer accepted.  Bids with “where is as is” Agreements of Sale will generally not be pursued unless: a) the security for the loans appears extremely strong, b) an exit strategy with a high likelihood of success can be identified, c) the property is of a type which Buyer is confident it can submit a competitive bid and d) the loan files contain engineering, environmental, title and legal counsel documents which provide a preliminary indication that the property and loan meet Buyer’s underwriting criteria.

To the extent possible, efforts will be made to determine the level of deferred maintenance at each property and the estimated costs of repairs.  The scope of this portion of the due diligence review will vary based upon the post-closing representations, warranties, put-back provisions and due diligence opportunities afforded under the Agreement of Sale.

Property Valuation

After completing the on-site due diligence inspection and the property inspection, the information compiled will be analyzed to determine collateral value for each property.  The property valuation process utilizes a variety of tools, many Funds utilize ARGUS real estate valuation software program and others have developed their own Excel Spreadsheet. The sources of information used to determine value include:

  • Current and historical operating statements;
  • Appraisals in file;
  • Broker Price Opinions;
  • Rent and Sales comparables;
  • Industry statistics and reports regarding operating expenses such as those compiled by the Institute of Real Estate Management (“IREM”);
  • Leases; and
  • Deferred Maintenance observed during site inspections or described in structural reports, environmental reports and correspondence found in the loan files.

The Financial Analyst will develop a projection of stabilized net operating income and cash flows, taking into account any perceived lease rollovers, anticipated tenant improvement costs and leasing commissions.  Based upon this projection, an estimate of  net cash flow available from the property will be established for property valuation.  Prior to selecting a final underwriter’s value, the cash flows and market values estimated by the underwriter will be compared on a line item basis to all other estimates of value available from the due diligence process, including the BPO, appraisals, market comparables and general industry and regional statistics.  The Financial Analyst will then reconcile all of the available value information and recommend a final value. The final value and all of its underlying assumptions must then utilize the experience of the Acquisition team.

Asset Pricing

Loan portfolios will be priced by establishing an appropriate purchase price for each loan by projecting possible resolution outcomes and timelines based upon numerous factors.  These factors include property value, current net operating income, stabilized net operating income, the likelihood and complexity of bankruptcy and foreclosure and the amount of deferred maintenance and unforecloseable liens that attach to the property in question.

After completing the on-site due diligence inspection, the Acquisitions Officer should attempt to determine global assumptions that will be used to initially price the loans.  Global assumptions are made with respect to a variety of factors including:

  • Buyer’s required rate of return for each of the major resolution alternatives;
  • Bankruptcy and foreclosure costs and timelines;
  • The amount of cash collateral a lender would expect to receive from a property prior to foreclosure;
  • Loan restructure guidelines; and
  • Marketing timelines and closing costs.

These assumptions will be used to determine a preliminary price for each loan in the portfolio.

The preliminary market valuations developed for each property will be calculated into a preliminary price for each asset.  After this preliminary price is calculated, the Acquisitions Officer and Financial Analyst responsible for each loan will review the scenario and cash flows projected and consider them in conjunction with the information that was gathered during the due diligence review.  In determining whether the price and scenario used is advisable for the loan, the underwriters must consider all correspondence, title updates, engineering reports, appraisals and litigation files that may provide information regarding the potential resolution of the loan.

The price of all loans is determined by examining the five most probable loan resolution scenarios.  Each of the following scenarios are considered:

  • Default;
  • Delayed Default;
  • Performing;
  • Restructure; and
  • Cram down.

For every loan, the Acquisitions Officer and Financial Analyst initially underwrite and evaluate the price for Scenario 1 to establish a “worst case price”.  Recognizing that a Lender can always attempt to negotiate a restructured loan with a Borrower, the underwriter then contrasts the Scenario 1 and then should attempt to establish a “best case price” Obviously, if your underwriting is good then somewhere in between is the “probable price” that one would pay if the loan was restructured in accordance with certain pre-selected parameters.  Another scenario should be considered by the underwriter based upon pre-established debt service coverage ratio parameters that will be established for each pool.  The underwriter will should be sure to know the bankruptcy laws in each Market and whether the loan or portfolio of loans include certain characteristics which would make a bankruptcy cram down likely.

Closing Procedures

Pre-Bid

Pre-Bid is defined as the time period prior to the Seller accepting the bid.

Most funds establish a chart of possible loan sale acquisitions on which Buyer may bid as most loan portfolios are sold on the open market.  Obtaining an under the radar pool of loans is preferable but most of the loan sales are marketed by open bidding. But to be successful the Group should utilize a chart for planning purposes only. The chart will include a description of the type of property, location of the city/town, property size, name of the issuing title insurance company, date of the title policy and the unpaid principal balance of the loan. Often, if the Group believes that its chances to obtain the pool they may want to obtain pre-bid preliminary information to the appropriate title insurance, environmental and structural consultants to obtain get a better idea of the time frames needed to complete the due diligence process.

Loan Sale Agreement

The negotiations for the Loan Sale Agreement (the “Agreement”) are not normally done prior to the pre-bid time period but occasionally, a Seller will want certain provisions especially if the loan pool contains a mixture of property types, then the Seller wants to make sure that they are not wasting their time with a bidder who ultimately will not close the deal.  The biggest fear for most Loan Seller is that the bidder chosen does not close the deal.   In those special occasions the Agreement would be first reviewed by Legal.   After the Agreement has been approved by Legal, Acquisitions would go through the preliminary pricing process. Often in some less than competitive open market Loan Sales the Buyer who presents the best (most specific) review of the potential Loan Sale Agreement.

Pre-Closing Actions

Pre-closing is defined as the time period from notification of winning a bid to the closing date.

Required Documentation:

Most Funds have a process that includes providing what is often called a Credit Commttee Book that is used to present the possible acquisition and therefore they may compile and complete the following documents (the “Pre-Closing Documents”):

  • Closing checklist;
  • Bid letter;
  • Confidentiality Agreement;
  • Deposit Agreement;
  • Credit Committee Book; and
  • Due Diligence Deposit Wire Advice; and
  • An experienced closing coordinator is extremely important to the process.

The closing coordinator will assist in developing  to developing a Pre-closing Checklist and Litigation Summary to a) fully capture all information pertinent to each loan, b) assist in the loan closing and c) help formulate a loan workout strategy.

Closing Checklist

Although the information will vary from loan to loan, a Closing Checklist will include information such as:

  • All original loan documents and modifications to each specific loan;
  • Recording information;
  • Title insurance information;
  • Property insurance and carrier information;
  • Verification of any taxes owed on the property;
  • Environmental and structural report information; and
  • Any items needing immediate post closing attention.

This form will serve as the foundation for the closing and set-up processes.  During loan closings, this form is intended to fully summarize the documentation.

Litigation Summary

A Litigation Summary should be made for each loan that is non-performing (the “Litigation Summary”). Non-performing includes loans in default, foreclosure and/or bankruptcy.

The Litigation Summary will contain the following information, if available:

  • Delinquent Loans
  • Date of default
  • Date of Demand Letter
  • Date Notice of Default was filed
  • Borrower response, if any Foreclosure
  • Date foreclosure action was filed
  • Type of foreclosure (judicial/non-judicial)
  • Date answer filed by Borrower
  • Name/address of Trustee, if selected by Seller
  • Date of Trustee sale, if available
  • Name/address of Receiver, if appointed
  • Name/address of Attorney, if engaged by Seller
  • If assignment of rents exercised Bankruptcy
  • Date petition was filed
  • Type of bankruptcy (7,11,13)
  • Cash collateral status
  • Attorney engaged by Debtor/Seller
  • Status of chapter, if available

Closing Document Preparation

The appropriate closing/transfer documents to be executed at time of closing should include, but not be limited to the following:

Bill of Sale/General Assignment:  Generally, the Agreement requires the Seller to prepare this document.  The draft is to be reviewed by the Closing Coordinator.

Assumption Agreement:  Generally, the Agreement requires the Seller to prepare this document.  The draft is to be reviewed by the Closing Coordinator.  Once the form has been reviewed and approved, the execution copy is to be executed by the Managing Directors of CDL.

Allonge:  Generally, the Agreement requires the Seller to prepare the allonge. The draft is to be reviewed by the Closing Coordinator.

Grant Deed:  Generally, the Agreement requires the Seller to prepare this document.  The draft is to be reviewed by the Closing Attorney and title insurance company prior to closing to ensure that the document is in recordable form.

UCC Financing Statement:  Generally, the Agreement requires that the Seller prepare this document. The draft is to be reviewed by the Legal r and forwarded to the title insurance company to ensure that the document is in recordable form.

UCC Assignment:  Generally, the Agreement requires that Buyer prepare this document.  The document will be drafted by the Closing Coordinator and will be reviewed by  the title insurance company to ensure that the document is in  recordable form.

Settlement Statement:  The Seller generally prepares this document. The Buyer should assist the Seller in calculating the closing adjustments so that there are no surprises at Closing and an agreed upon the settlement statement prior to the execution of the Closing. .

Assignment of Leases and Rents:  Generally, the Agreement requires that the Seller prepare this document.  The draft is to be reviewed by the Legal and forwarded to the title insurance company to ensure that the document is in a recordable form.

Other transfer documents as needed.

Legal Counsel should review and discuss the drafting of the standard closing documents with the Acquisitions Officer.

Servicing Notification

The closing coordinator will usually provide the Asset Manager with a copy of the Loan Sale Agreement, after first highlighting the provisions regarding payments, proration’s, credits and other adjustments.  The closing coordinator must always obtain the contact information of the Seller’s servicing contact.

Post-Bid Due Diligence

The due diligence period is defined by the terms of the Agreement.  The post-bid due diligence period, if any, varies for each acquisition.  Generally, the due diligence period commences from the date that Buyer’s purchase offer is accepted by the Seller.  The due diligence period may terminate on the date of closing or extend beyond the closing date.  If the due diligence period terminates at time of closing, an adequate time period should be made to complete the following assessments.

Environmental Assessment and Building Condition Surveys

If the terms of the Agreement allow Buyer to conduct environmental assessments and building condition surveys, the Closing Coordinator will contract the appropriate consultants to conduct the necessary assessments at the property sites and prepare a report of their findings (the “Report”).  Generally, the Agreements require that the assessments be conducted after the bid is won.  Once the assessment(s) are completed, the consultants are to provide drafts to the Closing Coordinator for review and comment  The Closing Coordinator shall distribute the final Reports to the Asset Manager and the CDL Legal Counsel.

If the Reports raise any unexpected issues, the Closing Coordinator will bring them to the attention of the Acquisitions Officer and possibly Legal. The Legal Counsel should determine a) whether additional assessment is required and b) whether the issues are covered by the representations, warranties or other provisions included in the Agreement.  If it is determined that the issues give rise to a claim against the Seller under the Agreement, all members of the Group should meet to discuss with Legal Counsel to determine a recommended course of action.

A Building Condition Survey may be ordered for each loan depending upon the terms of the Agreement, the age and the condition of each property.  A Survey may not be necessary if the  Seller has provided Buyer with a satisfactory recent Building Condition Survey Report.

A Phase I Environmental Report must always be ordered for all sites, if allowed under the terms of the Agreement.  Most Buyers can rely on a recent Phase I report provided by the Seller, given that this prior Phase I assessment was conducted within one year from Buyer’s due diligence and provided that no material contamination or evidence thereof was reported.  The Phase I assessment must comply with the ASTME – 94 guidelines which are the current industry standard.

Title Insurance

The appropriate title insurance company to conduct a title search for each property securing the individual loan acquisitions.  The title search will be conducted from the date of the existing title insurance policy or from date the Borrower acquired the property.  Upon completion of the title search, the title insurance company(s) will issue a title commitment or preliminary report on title for each property securing the individual loan acquisitions.

Any inconsistencies between the title commitment or title report and the due diligence information should be dealt with depending on the Loan Sale Agreement.  The closing will only occur once the title issues have been resolved.

Upon closing of the loan acquisition, the closing coordinator should instruct the title insurance company to issue either a date-down endorsement and all other necessary endorsements to the original title policy or a new title policy.  Whenever possible, the closing coordinator should order a date-down endorsement.

At a minimum, the date-down title insurance endorsement insures a) that the Lender has a valid first (if appropriate) mortgage lien against the property as of the date of the assignment of the mortgage, b) that the assignment of the loan is valid and enforceable and c) that Buyer is now the policyholder under the Seller’s loan policy

UCC-1 Search

Once the bid is won, Legal should contract with the appropriate UCC Search Company. This consultant will conduct the uncertified UCC-1 searches at the state level. The results of the UCC-1 search include a copy of the face page of the filed UCC-1 financing statements.  The Closing Coordinator will work with Legal Counsel or Acquisitions Officer to resolve any problems which are revealed  as a result of the UCC-1 search.

Other due diligence will be determined on a case by case basis, based upon the particular characteristics of the loan portfolio and the proposed Agreement.

Certification

The Closing Coordinator will conduct document certification prior to closing. Document certification usually includes verifying the following:

  • Seller has in its possession all original collateral, loan documents and title policies/endorsements;
  • Title policies are endorsed for each loan modification;
  • Document Legal descriptions;
  • See that all documents are original;
  • See that document pages are not missing; and
  • See that documents are properly executed and notarized.

Any issues arising from the certification process must be resolved prior to closing.  Once all issues are resolved, the closing coordinator will be authorized to close the loan acquisition.

Closing

Based upon the results of any due diligence, the closing coordinator will attend the closing and the loan portfolio purchase funds most likely be requested from a lender.  Prior to closing,  the Buyer should have a wire authorization for the funds that are required to close.

With most Lenders the funds will not be released  until the closing coordinator completes the following:

  • Takes an inventory of all original loan documents to be delivered to Buyer;
  • Review, box and seal all expected original documents and files;
  • Ensure the delivery of the specimen title insurance policy/endorsement and a closing protection letter; and
  • Oversee and review the draft settlement sheet that has been prepared by the Seller.

Upon completion of the foregoing, the Lender will notify the Buyer Legal to release the wire transfer authorization form and authorize the wiring of funds from Buyer to the Seller.

Post-Closing

Once the loan acquisition has closed the Closing Coordinator will:

Coordinate with the title insurance company(s) and UCC company(s) for the recording of the assignment documents;

Coordinate with the Asset Manager to ensure the timely delivery of the Seller’s loan documents to Buyer;

Prepare a closing binder that may include the following:

  • Credit Committee Binder
  • Credit Committee Minutes
  • All Wire Advances
  • Deposit Agreement
  • Confidentiality Agreement
  • All Executed Closing Documents
  • Settlement Statement
  • Assignment Documents
  • Assumption Agreements
  • Escrow Agreements
  • Title Insurance Endorsements or Policies

Ensure that all original documents are imaged and stored in the vault;

When delivering original documents to the Custodian of the vault, the Closing Coordinator will prepare an inventory of said documents.  The Custodian of the vault must acknowledge receipt of the documents and the Closing Coordinator will retain the written acknowledgment;

Ensure that the CDL Financial Analyst receives copies of all UCC Statements;

Coordinate with Acquisitions to ensure that the Asset Managers receive all of the due diligence and closing documents; and

Prepare a memo describing all of the deadlines and significant issues relating to the Purchase and Sale Agreement.  The memo will be distributed to the Managing Directors of CDL, the Director of Acquisitions and CDL Legal Counsel.

It is probable that the Closing Coordinator will obtain environmental reports, engineering reports, title work, UCC searches and other products from various vendors in the course of the acquisition and/or management of assets. 

LOAN SET-UP/POST CLOSING PROCEDURES

Set Up

After closing is completed, all closing documents and loan files will be immediately sent to Buyer by overnight delivery.  Additionally, the Closing Coordinator will coordinate with the Seller to obtain the appropriate servicing records.

The closing documents and loan files will be sent to the Buyer vault Custodian.  The vault Custodian will immediately:

  • inventory and image all original collateral documents;
  • place all original collateral documents in the vault; and
  • place all loan files in a segregated area for Asset Manager review.

Immediately after closing, the Closing Coordinator will upload the servicing data onto Buyer’s commercial loan servicing system and perform the following tasks:

Send a welcome letter to the Borrower with respect to Buyer’s acquisition of the loan including payment instructions;

Prepare a loan set-up worksheet  for the Asset Manager’s review and approval with a tickler system for significant dates, to include:

  • Loan payment due dates and grace periods;
  • Tax payment due dates;
  • Insurance payment due dates;
  • UCC filing/continuation dates;
  • Evidence of insurance/submission of financial statement dates; and
  • Interest Rate change dates; and, on an on going basis prepare monthly billing statements for all borrowers.

The Asset Manager will perform the following post-closing tasks to complete the transfer to Buyer:

Review the closing documents received against the documents itemized on the Closing Checklist.  All discrepancies will be noted and communicated to the Closing Coordinator; and

Establish working loan sub-files for each loan to include:

  • Correspondence
  • Closing Checklist
  • Title Insurance
  • Insurance
  • Tax Information
  • Appraisals
  • Engineering
  • Environmental
  • Leases, if appropriate
  • Action plans
  • Loan histories and payment information
  • Verify the correctness of the Loan Setup Worksheet and loan servicing information prepared by CLS;
  • Image and/or archive appropriate non-collateral documentation;
  • Order appraisals, environmental and engineering reports, as required, for individual loans; and
  • Provide CLS with any special payment posting instructions.

Lender’s Rights & Remedies

The Asset Manager will review all loan documentation and complete a Rights and Remedies Checklist.  The Asset Manager will review the loan files to verify compliance with all covenants of the loan documents.  The Asset Manager will regularly monitor and enforce these rights and remedies.

Property Summary/Action Plan

Within the first 30 days of loan acquisition, the Asset Manager will prepare an Action Plan for each asset.  The  plan will be updated, where required, to reflect any changes in the anticipated loan resolution strategy.

Treasury Projections

The Asset Manager shall formulate a Treasury Report and provide the  Director of Acquisitions Buyer’s with the projected cash flows and resolution period for each loan.  Upon receipt of this information, the Director of Acquisitions will escrow the cost of funds to be utilized for each loan.  The Treasury Report will be updated and sent to Treasury on a quarterly basis.

LOAN RESOLUTION PROCEDURES

General Guidelines

Due to the complexity and wide variety of issues that may occur with respect to a delinquent commercial loan, each loan acquired will be individually analyzed to determine the optimum resolution strategy.  Chapter 11 bankruptcy filings and potential cram-downs will be options for many Borrowers on loans acquired by CDL.  Although the likelihood of a Chapter 11 filing and its associated costs and timing are evaluated by related due diligence analysis, there can be no guaranty of the Lender’s results in a Chapter 11 filing.  As a result, no legal actions or negotiations will take place with respect to any commercial loan until local counsel, CDL Legal Counsel and the Director of Acquisitions have been consulted.

Pre-Negotiation Letters

Asset Managers will secure, in standard form, a Pre-Negotiation Agreement from all Borrowers prior to entertaining any discussions with the Borrowers or their agents to modify the terms and conditions of any loan (the “Pre-Negotiation Agreement”).

by Anthony Palazzo
General Counsel and Attorney at Law