Due Diligence for Lenders With Distressed Assets
Article by Robbin Newman
Robbin Newman is a Partner at Holland and Knight
It is important for lenders – and their special asset/portfolio management teams - to take inventory of lenders' real estate collateral. This is especially true now that lenders have scaled back on new loans and are focused on managing their real estate collateral portfolios due to potential or pending loan defaults by borrowers. Such inventories include reviewing permits, licenses, zoning and land-use approvals, leases and other due diligence that, if neglected, could result in devaluation of the collateral.
The following discussion and checklist are designed to assist in the carrying out of this due diligence (with particular attention to Florida law).
Land Use, Zoning and Development Approvals
Review of approvals is particularly important where a given real estate loan was a bridge loan or development loan to fund the development costs for the proposed project. This includes any and all land use, zoning and development approvals required to permit the development of the proposed project. Since the lender's exit strategy for the payoff of this type of bridge or development loan was typically to occur by the closing on a new construction loan, this exit strategy will be impeded if attention is not given to the milestone dates for obtaining, and as applicable, maintaining, the project entitlements and approvals. This is of particular importance now: borrowers may have run out of their own funds and, due to a potential or pending default, the lender may have been unwilling to fund any further development costs with disbursement of loan funds. Notwithstanding that the lender may not want to invest more money into a defaulted loan, the alternative is for the lender to be left with "keys" to a vacant parcel that was on the road to vesting of entitlements, and ends up lacking entitlements. If the loan did not initially include a timeline and critical dates for the borrower to satisfy certain zoning and land use approvals, then it is important to immediately obtain this information, whether from a cooperative borrower or directly from the controlling governmental authorities. It is possible that the borrower is 75 percent or even 90 percent along the path to vested entitlements, which could greatly improve the value of the lender's collateral – even more than the potential cash outlay that would be necessary to obtain the necessary remaining entitlements.
One example would be a case in which a plat approval is pending for the subdivision of certain Florida real property – and in conjunction with the pending plat approval, there may be approved density, use, easement, traffic and other similar entitlements that will all be lost if the plat is not recorded in a timely fashion. Typically, it is extremely difficult, if not impossible, to obtain an extension for the time for recording of a plat. It is possible that with an additional expenditure of $10,000 (for example only), the plat could be completed and recorded, preserving many important approvals that ultimately will revalue the vacant property much more than the $10,000 spent to complete the plat work and send the plat to recording. Similarly, there may be permits that have been obtained by the borrower for development or construction purposes that will be void – and either not renewable or subject to further procedures before state or local agencies, if the permits are not kept current. This could be anything from a site work permit, to a water management permit, to permits issued by the Environmental Protection Agency. If a milestone date timeline with action notes was not prepared at the time of closing or thereafter, it would be prudent to immediately assemble all of this information and calendar all critical dates for action required; the aim is to obtain or maintain entitlements that will add or preserve value to the real estate collateral.
Title Updates
When a loan is subject to a potential default or is in a pending default, it is always a good idea to request a title update to review the current status of title, and to see if any liens have been filed against the property. If the lender is not getting paid, there is a good chance that others engaged to do work for the property for a development or construction loan also have not been paid. Where any of these liens are recorded after the lender's mortgage, under Florida law they will be junior and subordinate, and may be foreclosed by the lender if the loan is accelerated at the time of a default and a foreclosure action is filed by the lender. Notwithstanding the junior priority of such liens, it is possible that some of these contractors could be necessary to carry out any land use or zoning approval work that is needed for obtaining or maintaining entitlements as described above. In such a case, notwithstanding that the lien is subordinated to the lender's mortgage, the lender should first look at its loan documents to see if these contracts were collaterally assigned to the lender as additional security for the loan, and if so, whether any consents to assignment were obtained from those contractors whose contracts were not assignable absent such contractors' consent.
This can be particularly important in terms of the cost to the lender for asking a lienor to continue to do work for the lender if necessary to obtain or maintain a zoning entitlement. For example, even though the borrower may owe a civil engineer $10,000 that is also the subject of a filed mechanic's lien, a properly drafted consent delivered at the time of the loan closing may provide that even though the loan is in default, the engineer is required to continue to work for the lender as of the date of written notice to the engineer to resume working, and in such event the lender is only obligated to pay for charges incurred on a going-forward basis. This could be very key to the lender if there are multiple contractors who have filed liens, yet are necessary to continue with a project to preserve entitlements or to complete site work that must be completed pursuant to an issued permit.
As a result, lenders should do a review of their loan documents to see what assignments and what consent documents were obtained in order to facilitate contractors resuming work for lenders on a going-forward basis. In addition to searching for recorded liens, it is also a good idea to make sure that the borrower has not violated the loan documents by recording other encumbrances (i.e., covenants, restrictions or even a junior mortgage), or by conveying a partial interest in the real estate collateral to a third party.
Letters of Credit
If letters of credit were issued in connection with the loan closing, it is advisable for the lender to take inventory of any and all such documents. One reason is to make sure that the issuing bank is still in business and is not subject to FDIC control; the latter could mean that further inquiries are required in the event that a drawdown on the letter of credit becomes necessary. Another reason is to make sure that if the letter of credit was renewable, the renewals took place with payment of any required fees. In the event that the lender holding the letter of credit has changed its name or has merged or been acquired, the letters of credit should be reviewed and addressed so they can be issued in the name of the current lender.
Condominium Properties
With respect to condominium properties, lenders should be kept apprised of the status of pending sales, association assessments and collections, pending lawsuits, service contracts, and property management and maintenance of association documents. If the loan is at the stage of a potential default or a pending default, there are many moving parts to the operation of a condominium property that will ultimately need to be addressed. Before the loan gets to this stage – when the borrower may not be amenable to cooperating with the lender – the lender's portfolio/asset management team should take inventory of the information in the lender's files relating to the condominium and the condominium association; the aim here is to be prepared in case further action is taken, whether by foreclosure or deed in lieu of foreclosure. If the loan was a construction loan for constructing the condominium project, then management of potential liens and contractor claims, as well as assessment of liability for construction defects and as a potential "successor developer" if the units are taken back by the lender in a subsequent foreclosure, are additional issues that should be considered at this early stage so appropriate steps in due diligence can be taken.
Insurance and Property Taxes
Although property insurance is customarily addressed in the loan documents with provision for the lender to require evidence of insurance and to obtain insurance if the borrower fails to keep insurance in place – especially in the State of Florida where insurance is difficult to obtain in rated areas subject to high hurricane rates of coverage – the lender should take inventory sooner rather than later to make sure of the status of the insurance policies that protect the real estate collateral. For example, is the premium going to come due at a time when it is possible that, due to slowed loan payments, the borrower may not have the money to pay the premium? What is the notice period to the lender prior to the insurance company cancelling the insurance policy? How much may the lender have to be prepared to advance to keep the insurance current if the borrower fails to do so? This assessment of insurance costs will be helpful to the lender in determining how much of a budget may be required to cover certain necessary operating costs of the property if the loan goes into default and the borrower claims it is unable to make payments of any operating expenses.
In Florida, ad valorem real estate taxes have priority over any recorded first lender mortgage; the lender's title policy will always show ad valorem real estate taxes as an exception to title. Because the failure to pay real estate taxes not only results in issuance of a tax sale certificate that includes penalties and interest for redemption once the taxes are paid, but also could lead to issuance of a tax deed so that some third party may acquire title to the lender's real estate collateral without obligation to pay the mortgage, it is very important that the lender's asset management team make sure that the lender's information is provided to the applicable property appraiser's office so that all notices of publication and matters relating to payment of any unpaid taxes are delivered to the lender.
Retail, Hotel and Office Properties
With retail, hotel and office properties that have ongoing tenants, income and operation expenses, the lender should make sure that its files are current and updated with respect to tenant leases, service contracts, management contracts, operating statements, rent rolls, security deposits and similar operational information that will be necessary to have in the lender's possession if the loan goes into default. After closing, there often are different or additional service contracts, management agreements and new leases that are not forwarded to the lender, even though the loan documents require such information. It could be the lender's portfolio management team made a demand but no response was timely provided, and that during this follow-up period the loan's status is beginning to change. It is especially important to make sure that all leases and rent rolls are current including security deposit information. One reason is possible future ownership of the asset; another is that if a foreclosure action will be filed, the lender will need to know who all the tenants are, and whether or not their lease is subordinate to the recorded lender mortgage (only junior interests may be foreclosed). Furthermore, there may be subordination, non-disturbance and attornment agreements that preclude the joinder of certain tenants, and perhaps some of these agreements were either post-closing items or first arose after closing. It is best to gather all of this information before it is time-critical for review by the lender and its counsel.
The following is a checklist summary of the information discussed above:
Due Diligence Real Estate Asset Management Checklist
1. ____ Review status of pending, applied-for land use approvals, including development orders, zoning-variances, rezoning or special exceptions, site plans, plats
2. ____ Review status of approved land use approvals with expiration dates and what may be required to keep those approvals active
3. ____ Review status of pending, applied-for permits for site work, building, construction, environmental, water management
4. ____ Review status of approved permits for site work, building, construction, environmental, or water management with respect to expiration dates due to failure to commence work under the permits, or work stoppage under the permits
5. ____ Review title search for liens and encumbrances recorded against the property
6. ____ Review loan closing documents for assignment of contractor documents and consents to assignment from contractors
7. ____ Determine if any letters of credit are in loan file; review status and issuing bank, and conform to name of current lender
8. ____ Regarding condominium properties, review status of sales, pending litigation, property management and service contracts, leases, condominium association assessments and documents
9. ____ Regarding insurance, review status of property and commercial liability policies, renewal dates and time frame for notices of cancellation for non-payment; confirm renewal payment premiums if to be paid by lender
10. ____ Regarding real estate taxes for Florida properties, check status of payment of taxes, and whether tax certificates and/or tax deeds have been issued
11. ____ Regarding hotels, retail and office properties, review rent rolls, security deposits, operating statements, leases, SNDA agreements, service contracts
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
Wednesday, July 22, 2009
Tuesday, July 21, 2009
Title-Insurer Fees Draw Scrutiny
By JAMES R. HAGERTY
The U.S. title-insurance industry faces increasing pressure from regulators to justify the fees charged to consumers for ensuring they have clear ownership of their homes.
For most people, title insurance is just another mysterious fee they must pay when they buy a home or refinance a mortgage. Unlike some of those fees, though, title charges aren’t negligible. They range from several hundred to several thousand dollars—and last year totaled more than $10 billion for the title industry. Lenders insist on the insurance to protect them against the possibility that a taxing authority, another creditor or a disgruntled heir may have a claim to the property, among other risks.
As falling home prices tempt more people back into the housing market in some parts of the country, politicians and regulators are raising questions about whether they may be paying too much for this protection. “There’s no transparency,” Delores Kelley , a state senator in Maryland, said in an interview. She introduced legislation that created a commission to study the title-insurance industry in Maryland. That panel is due to make recommendations about possible regulatory changes by December.
In Pennsylvania, Attorney General Tom Corbett earlier this year successfully campaigned against a push by the title industry for increases in regulated rates. New Mexico’s legislature this year enacted a law that will allow price competition among title insurers, previously required to charge standard prices set by the state insurance regulator. That kind of fixed-price regime continues in Texas.
A bigger potential threat to title insurers comes from the Obama administration’s proposed Consumer Financial Protection Agency. The new regulator would oversee a wide variety of financial products, including title insurance, which is now regulated mainly at the state level. That would open the door to more federal oversight.
Rather than shopping around, most people accept title-insurance choices made for them by a real-estate agent, mortgage company or builder. Cathy Pearson, an elementary school teacher who recently bought her first home, in San Clemente, Calif., says she accepted as “a given” the title insurer chosen by real-estate agents involved in the transaction. Like many buyers, Mrs. Pearson didn’t feel she had time to question all the details.
Avoiding Fee Traps
Early in the process of buying a home or refinancing, let your real-estate agent and lender know you will select your own title insurer.
Research title-insurance costs online and check whether there are fees on top of the premium.
If you are refinancing, make sure you get the discount that often applies to such transactions.
Before submitting a loan application, ask the lender to disclose in writing the total fixed-dollar fees that would apply to you. Insist that these agreed-upon fees then be specified in the loan “lock” statement setting the rate and other terms.
Yet people advising home buyers often have conflicts of interest. Some real-estate brokers, mortgage firms and builders own firms that act as agents for title insurers. Federal and state laws bar title insurers from giving kickbacks to real-estate agents, mortgage firms or others for funneling business toward a particular title company, but enforcement is spotty. In recent years, regulators have fined title companies for various alleged violations of laws against inducements to steer business toward a title agent. The inducements have included entertainment, trips and help with marketing.
Typically, 80% or more of the premium goes to the title-insurance agent, with the rest going to the insurer. Agents often handle the task of searching through and analyzing public documents, sometimes going back many decades. But in many states, consumers pay separate fees to the agents for that research, on top of the premiums.
Charges vary widely around the country. In Texas, for instance, the current cost of basic title coverage for a $250,000 home-purchase loan is $1,644. That is supposed to include the cost of searching for and examining title records and related tasks, Texas insurance regulators say, but they warn that title agents sometimes tack on unjustified fees. In Iowa, the costs of similar coverage—including fees for lawyers and title researchers—range from around $500 to $800. Unlike the rest of the nation, Iowa has a state agency that provides title insurance.
The industry so far has fended off a class-action lawsuit, filed in early 2008, charging title insurers with illegally fixing prices at unreasonably high levels in New York state. A U.S. District Court judge for the eastern district of New York dismissed that suit last month. It has been appealed to the U.S. Court of Appeals for the Second Circuit.
The American Land Title Association, or ALTA, a trade group for insurers and agents, rejects suggestions that title insurance is overpriced. “Nobody’s getting rich” selling title insurance, says Kurt Pfotenhauer, the ALTA’s chief executive officer.
The ALTA opposes the Obama plan to include title insurance as a product to be regulated by the proposed consumer-protection agency. “Regulation of local transactions by Washington bureaucrats is a recipe for frustration and malfunction,” says Mr. Pfotenhauer.
State regulators are striving to show they are on top of the issue. A working group of the National Association of Insurance Commissioners is devising plans under which title insurers and agents would provide financial data to help regulators determine whether premiums are reasonable. The working group is also looking at ways to help consumers shop effectively for title insurance.
Jack Guttentag, a finance professor emeritus at the University of Pennsylvania’s Wharton School who provides mortgage advice on the Web site www.mtgprofessor.com, advises home buyers to shop for title insurance online and to do so early in the home-buying process. When refinancing, borrowers should make sure they are getting the discount for title insurance that often applies on such transactions, says Mr. Guttentag.
The pressure on title insurers comes at a time when they are struggling to adapt to the plunge in transactions that has accompanied the housing bust. The four biggest title insurers—units of Fidelity National Financial Inc., First American Corp., Stewart Information Services Corp. and Old Republic International Corp.—all reported losses for 2008. Together, they account for more than 90% of the market. They distribute their insurance through thousands of title agents nationwide.
The big title insurers may face more price competition. Entitle Direct Group Inc., of Stamford, Conn., last year began selling title policies online. Timothy Dwyer, chief executive officer and founder of the company, says Entitle aims to undercut other insurers by at least 35%.
Morgan Stanley's Albatross: Real Estate
By AARON LUCCHETTI and ANTON TROIANOVSKI
In Atlantic City, N.J., construction on a 47-story casino project financed by Morgan Stanley is moving along despite the gambling industry's slump. The bad news: The 1,900-room hotel and other glitzy amenities won't be finished until the developer can raise $700 million.
Morgan Stanley's exposure to commercial real estate is one of the reasons why analysts expect the New York company to report on Wednesday a net loss of $555 million, according to Thomson Reuters. That would be the firm's third quarterly loss in a row, even as rival Goldman Sachs Group Inc. revels in the record profit it reported last week.
Morgan Stanley has been pinched by bad real-estate bets, like the partially completed Revel Casino in Atlantic City, N.J., shown here in January. Much of Morgan Stanley's red ink will come from an adjustment to borrowing costs and paying back the Troubled Asset Relief Program. But bulking up on commercial real estate when times were good also is taking a bite out of the bottom line now. Morgan Stanley, before hedges, had about $18 billion in such exposure in its institutional securities unit as of March 31, less than many large commercial banks but double the size of Goldman's bets.
Commercial real estate is "still a cloud over" Morgan Stanley, says Brad Hintz, an analyst at Sanford C. Bernstein & Co., who expects "modest" write-downs that could dog the firm until the economy rebounds. Credit Suisse analyst Howard Chen says he expects as much as $300 million in write-downs at Morgan Stanley's institutional unit from commercial real estate.
In the federal government's stress tests, Morgan Stanley faced potential losses of 45% on its commercial real-estate loans under the worst-case economic scenario, the steepest percentage of any financial institution that underwent the tests. In the institutional unit, Morgan Stanley already has sharply lowered the carrying value of its commercial loans and securities to about 50 cents on the dollar, and hedges have helped the firm generate gains on its holdings in recent quarters. The company has said its net exposure, or potential losses if defaults occur, was $4 billion in the first quarter.
Meanwhile, much of the $1.5 billion in losses in Morgan Stanley's asset-management unit in past year came from commercial real-estate investments.
Morgan Stanley is essentially the sole backer of the Atlantic City casino project, where construction by closely held developer Revel Entertainment LLC began in 2007. Morgan Stanley wanted to bet on casinos, but its exposure deepened when Revel wasn't able to line up financing.
Morgan Stanley's investment could total at least hundreds of millions of dollars, though the project isn't expected to significantly affect this quarter's earnings. The casino might open in mid-2011 if Revel can get financing by year's end, says Joel Simkins, a Macquarie Capital analyst.
Morgan Stanley has more than $2 billion in exposure to its Crescent real-estate portfolio of office buildings, resorts and other properties, while taking steep write-downs in MSREF VI International, an $8.8 billion commercial real-estate fund.
Separately, Morgan Stanley said Monday that it hired hedge-fund manager Jack DiMaio, 42 years old, to run a big part of its bond- and currency-trading operations. The move reflects Morgan Stanley Chairman and Chief Executive John Mack's dissatisfaction with the bond-trading unit's recent results. Roberto Hoornweg, now the firm's head of interest rates, currency and credit, is leaving Morgan Stanley, a person familiar with the matter said. Mr. Hoornweg declined to comment.
After Mr. Mack became CEO of Credit Suisse First Boston in 2001, he renegotiated downward contracts that previously guaranteed Mr. DiMaio and his bond-trading team roughly $300 million when the group threatened to defect to a Barclays PLC unit.
Zombie Loans Raise Hurdles For Deed-in-Lieu Transactions
By Jeffrey B. Steiner and Jason R. Goldstein
July 15, 2009
In an earlier article, we examined certain equitable defenses that borrowers may avail themselves of when fighting a lender's enforcement of remedies.1 These equitable defenses, we posited, were more likely to be made when a lender pursued a foreclosure action in reliance on a non-monetary default as opposed to plainly objective payment defaults. While recognizing that lenders would be better positioned in a litigation if they waited for a payment or maturity default, some lenders, we noted, would be unwilling to sit by, unable to take control of a troubled property while waiting for a monetary default which may take months or years to occur in some cases. This unique aspect of the current crisis and the prevalence of loans that are objectively bad but not yet in payment default has yielded a new, widely used term, "zombie loans." This article will explore the use of deed-in-lieu transactions as a method of dealing with zombie loans as well as the possible hurdles a lender may face when choosing a seemingly logical remedy to take control of a troubled property.
Zombie loans have dominated recent discussions in both real estate finance industry journals and conferences alike. The term refers to mortgage loans that while generally considered performing, since the property cash flow or other reserves cover the cost of operating the property and the payment of debt service, are in fact destined for default at a foreseeable later date when, at maturity, the debt service reserve runs dry or the property owner will be unable to refinance the impending balloon payment due to tightening credit standards and depressed real estate values. In the event the property securing the zombie loan is supported by good tenants and is otherwise decent asset quality, one school of thought suggests that the maturity date on such loan should simply be extended until the credit crisis resolves and the loan can be properly refinanced. On the other hand, a loan that is being kept afloat by large interest reserves (providing longer-lasting debt service coverage, perhaps, due to historically low interest rates) or is secured by a property that is otherwise troubled may better be dealt with on a more immediate basis, even prior to the occurrence of an actual default.
One suggested resolution for these zombie loans is the deed-in-lieu of foreclosure, a transaction in which the parties to a mortgage loan forego the time and expense of foreclosure litigation by having the mortgagor transfer title directly to the mortgagee or mortgagee's designee in satisfaction of the mortgage debt. Mortgage borrowers and their principals normally receive additional inducement to complete the so-called "deed-in-lieu" in the form of a release from guaranty obligations. The deed-in-lieu is generally considered a positive resolution to a troubled mortgage transaction and has been looked upon favorably by courts from a public policy perspective as it reduces the use of already scarce judicial resources.
Subsequent equitable attacks on a deed-in-lieu, whereby a borrower asserts some sort of fraud, duress or unfair bargaining power claim, rarely carry much weight in the commercial context where the interested parties enter into a consensual agreement, are represented by counsel, are savvy to the relevant business issues, and normally receive the additional consideration of releases from guaranties and the like. Furthermore, any such defenses may generally be dispensed with by examining the totality of the circumstances and demonstrating that the mortgagee's taking of title was all but inevitable whether by deed-in-lieu or a more lengthy foreclosure effort. Presumably, any mortgagor that reasonably believed there to be any equity remaining in its asset would protect its interest at nearly any cost and would consequently refuse entering into a deed-in-lieu to obtain the lender's release of the borrower, thereby defeating such equitable defense. The more common equitable defense lies in a common law doctrine having its origins in 17th century English common law, the equity of redemption.
The spectre of the equity of redemption in the context of a deed-in-lieu transaction has largely been the dominion of academic scholars. Commentators and courts have examined the timing of a deed-in-lieu as it relates to the original mortgage transaction in order to determine whether the deed was essentially given to the lender in escrow at the time of closing (impermissible)2 or as part of a subsequent separate transaction after the occurrence of an event of default (acceptable).3 Secondly, questions of independent and adequate consideration must be considered since courts cannot rely alone on an argument that but for the mortgagor's agreement to give a deed-in-lieu, the mortgagee could have proceeded to foreclosure at once.
In response to concerns about consideration, lenders must undertake a well documented evaluation of the property's value, including complete property financial reports and appraisals of the property, demonstrating that the amount of debt being forgiven by the lender as a condition of the deed-in-lieu is in excess (often by considerable amounts) of the property's current value. Several commentators have also recommended that mortgagees condition a deed-in-lieu transaction on the mortgagor's delivery of an "anti-clogging affidavit" executed by the mortgagor and affirming such party's understanding that the arrangement will not clog the equity of redemption.4 The affidavit should address the sophistication of the parties, that the borrower was adequately represented by counsel, the voluntariness of the transaction and lack of duress, and that the borrower received independent, fair and bargained-for consideration. Title companies requested to insure a deed-in-lieu transaction may request additional certifications as well.
The review of these equitable concerns gets somewhat more complicated in the context of a deed-in-lieu given in connection with a zombie loan that is, by definition, not yet in default. While the financial inquiry detailed above made at the time of the deed-in-lieu transaction may show the loss of all borrower equity in a property, there is no way to properly value the property in the future when the default of the zombie loan in question is ultimately expected to occur. Furthermore, in the bankruptcy context, other creditors may be able to assert that the deed-in-lieu constituted a fraudulent transfer subject to attack under Section 548 of the Bankruptcy Code and any applicable state law. We acknowledge that the advent of special purpose covenants limiting a mortgage borrower's permitted indebtedness should mitigate the ultimate risk of attack in bankruptcy, however, current events suggest that bankruptcy-remote does not translate to bankruptcy-proof and there still exists some concern of other creditors asserting claims in a borrower bankruptcy.
Other than a properly completed foreclosure under applicable state law (whether judicial or non-judicial foreclosure), the U.S. Supreme Court concluded in the case of BFP v. Resolution Trust Corporation5 that any conveyance of real property may be reviewed to determine whether a fraudulent transfer has occurred. Bankruptcy courts have held, notably in In re Main,6 that an evidentiary hearing would be required to determine whether Chapter 11 debtors received reasonably equivalent value at the time they transferred any real property subject to a mortgage or deed of trust in satisfaction of indebtedness due and owing by them to the holder of such mortgage or deed of trust, for the purpose of determining whether the deed-in-lieu transfer was fraudulent. In the case of determining whether a borrower under a zombie loan completed a deed-in-lieu for reasonable equivalent value, however, the question is whether the court should examine the value exchanged at the time of the deed-in-lieu transaction or rather at the time of the future default, when foreclosure was all but inevitable. Without strong if any relevant case law regarding the unique issues raised by zombie loans, counsel for lenders planning to take a deed-in-lieu as a resolution for such a loan must guide their clients carefully through the equitable risks.
In reality, not all zombie loans are equally problematic in the context of determining whether reasonably equivalent value was exchanged in connection with a deed-in-lieu. For instance, an argument that the anticipatory determination of value was ultimately prejudicial to other creditors and therefore constitutes a fraudulent transfer will have less strength if the anticipated maturity date is only one or two quarters in the future. However, a creditor may argue that it was prejudiced when a borrower waived its right to extend maturity pursuant to an extension option whether or not the extension required payment of a fee by the borrower. While one may reasonably determine that capital markets and property valuations will not change in the immediate future, longer range predictions are more questionable.
Furthermore, simply because there is no equity remaining in the property at the time a borrower under a zombie loan offers up a deed-in-lieu may not be sufficient to protect the transaction from attack in bankruptcy. Prior to accepting a deed of lieu in anticipation of a loan default in the future, lenders should look to current financial reporting provided by borrowers to determine whether a key tenant's decision to vacate the property or other property conditions will ultimately support the loss of all borrower equity both at the time of determination and in the future.
We note that while mezzanine loans are distinct from traditional mortgage loans, they do share certain characteristics such as ultimately looking to real property as collateral. Acknowledging the lack of relevant case law on point, lenders should be wary of courts sitting in equity that may deem a mezzanine loan an equitable mortgage or hold that a mezzanine borrower is entitled to the same equitable rights as mortgagor. Cautious lenders negotiating the equivalent of a deed-in-lieu of a mezzanine loan should head the same cautions and follow the same procedures as if the mezzanine loan were a mortgage loan. Thus, if a court draws the parallel between mezzanine loans and mortgage loans, the lender will be able to point to the default to show that there was no clog on the equity of redemption.
Deeds in lieu offer a valuable tool in dealing with troubled mortgage loans. In most contexts, the consensual nature of the transaction coupled with the dire economic realities that push a borrower into such a resolution will normally provide solid protection from later equitable attacks. Still, in light of current conditions and the diversion of market realities from the context in which deeds in lieu were previously examined by courts, lenders should be cautious before accepting a deed-in-lieu on a zombie loan that has not yet been called in default.
Jeffrey B. Steiner and Jason R. Goldstein are members of DLA Piper. Kira L. Mineroff, a summer associate with the firm, assisted in the preparation of this article.
Endnotes:
1. Jeffrey B. Steiner and Jason R. Goldstein, "Dealing with Equitable Defenses to Foreclosure," NYLJ, March 18, 2009.
2. Kirby v. Tricker, 265 AD 149 (N.Y. App. Div. 1942).
3. Verity v. Metropolis Land Co., 248 AD 748 (N.Y. App. Div. 1936).
4. John C. Murray provides an example of an anti-clogging affidavit from in the appendix of his article, "Clogging Revisited," 33 REAL PROP. PROP. & TR. J. 279 (1998-1999).
5. BFP v. Resolution Trust Co., 511 U.S. 331 (1994).
6. Main v. Brim (In re. Main), 75 B.R. 322 (Bankr. D. Az. 1987).
By Jeffrey B. Steiner and Jason R. Goldstein
July 15, 2009
In an earlier article, we examined certain equitable defenses that borrowers may avail themselves of when fighting a lender's enforcement of remedies.1 These equitable defenses, we posited, were more likely to be made when a lender pursued a foreclosure action in reliance on a non-monetary default as opposed to plainly objective payment defaults. While recognizing that lenders would be better positioned in a litigation if they waited for a payment or maturity default, some lenders, we noted, would be unwilling to sit by, unable to take control of a troubled property while waiting for a monetary default which may take months or years to occur in some cases. This unique aspect of the current crisis and the prevalence of loans that are objectively bad but not yet in payment default has yielded a new, widely used term, "zombie loans." This article will explore the use of deed-in-lieu transactions as a method of dealing with zombie loans as well as the possible hurdles a lender may face when choosing a seemingly logical remedy to take control of a troubled property.
Zombie loans have dominated recent discussions in both real estate finance industry journals and conferences alike. The term refers to mortgage loans that while generally considered performing, since the property cash flow or other reserves cover the cost of operating the property and the payment of debt service, are in fact destined for default at a foreseeable later date when, at maturity, the debt service reserve runs dry or the property owner will be unable to refinance the impending balloon payment due to tightening credit standards and depressed real estate values. In the event the property securing the zombie loan is supported by good tenants and is otherwise decent asset quality, one school of thought suggests that the maturity date on such loan should simply be extended until the credit crisis resolves and the loan can be properly refinanced. On the other hand, a loan that is being kept afloat by large interest reserves (providing longer-lasting debt service coverage, perhaps, due to historically low interest rates) or is secured by a property that is otherwise troubled may better be dealt with on a more immediate basis, even prior to the occurrence of an actual default.
One suggested resolution for these zombie loans is the deed-in-lieu of foreclosure, a transaction in which the parties to a mortgage loan forego the time and expense of foreclosure litigation by having the mortgagor transfer title directly to the mortgagee or mortgagee's designee in satisfaction of the mortgage debt. Mortgage borrowers and their principals normally receive additional inducement to complete the so-called "deed-in-lieu" in the form of a release from guaranty obligations. The deed-in-lieu is generally considered a positive resolution to a troubled mortgage transaction and has been looked upon favorably by courts from a public policy perspective as it reduces the use of already scarce judicial resources.
Subsequent equitable attacks on a deed-in-lieu, whereby a borrower asserts some sort of fraud, duress or unfair bargaining power claim, rarely carry much weight in the commercial context where the interested parties enter into a consensual agreement, are represented by counsel, are savvy to the relevant business issues, and normally receive the additional consideration of releases from guaranties and the like. Furthermore, any such defenses may generally be dispensed with by examining the totality of the circumstances and demonstrating that the mortgagee's taking of title was all but inevitable whether by deed-in-lieu or a more lengthy foreclosure effort. Presumably, any mortgagor that reasonably believed there to be any equity remaining in its asset would protect its interest at nearly any cost and would consequently refuse entering into a deed-in-lieu to obtain the lender's release of the borrower, thereby defeating such equitable defense. The more common equitable defense lies in a common law doctrine having its origins in 17th century English common law, the equity of redemption.
The spectre of the equity of redemption in the context of a deed-in-lieu transaction has largely been the dominion of academic scholars. Commentators and courts have examined the timing of a deed-in-lieu as it relates to the original mortgage transaction in order to determine whether the deed was essentially given to the lender in escrow at the time of closing (impermissible)2 or as part of a subsequent separate transaction after the occurrence of an event of default (acceptable).3 Secondly, questions of independent and adequate consideration must be considered since courts cannot rely alone on an argument that but for the mortgagor's agreement to give a deed-in-lieu, the mortgagee could have proceeded to foreclosure at once.
In response to concerns about consideration, lenders must undertake a well documented evaluation of the property's value, including complete property financial reports and appraisals of the property, demonstrating that the amount of debt being forgiven by the lender as a condition of the deed-in-lieu is in excess (often by considerable amounts) of the property's current value. Several commentators have also recommended that mortgagees condition a deed-in-lieu transaction on the mortgagor's delivery of an "anti-clogging affidavit" executed by the mortgagor and affirming such party's understanding that the arrangement will not clog the equity of redemption.4 The affidavit should address the sophistication of the parties, that the borrower was adequately represented by counsel, the voluntariness of the transaction and lack of duress, and that the borrower received independent, fair and bargained-for consideration. Title companies requested to insure a deed-in-lieu transaction may request additional certifications as well.
The review of these equitable concerns gets somewhat more complicated in the context of a deed-in-lieu given in connection with a zombie loan that is, by definition, not yet in default. While the financial inquiry detailed above made at the time of the deed-in-lieu transaction may show the loss of all borrower equity in a property, there is no way to properly value the property in the future when the default of the zombie loan in question is ultimately expected to occur. Furthermore, in the bankruptcy context, other creditors may be able to assert that the deed-in-lieu constituted a fraudulent transfer subject to attack under Section 548 of the Bankruptcy Code and any applicable state law. We acknowledge that the advent of special purpose covenants limiting a mortgage borrower's permitted indebtedness should mitigate the ultimate risk of attack in bankruptcy, however, current events suggest that bankruptcy-remote does not translate to bankruptcy-proof and there still exists some concern of other creditors asserting claims in a borrower bankruptcy.
Other than a properly completed foreclosure under applicable state law (whether judicial or non-judicial foreclosure), the U.S. Supreme Court concluded in the case of BFP v. Resolution Trust Corporation5 that any conveyance of real property may be reviewed to determine whether a fraudulent transfer has occurred. Bankruptcy courts have held, notably in In re Main,6 that an evidentiary hearing would be required to determine whether Chapter 11 debtors received reasonably equivalent value at the time they transferred any real property subject to a mortgage or deed of trust in satisfaction of indebtedness due and owing by them to the holder of such mortgage or deed of trust, for the purpose of determining whether the deed-in-lieu transfer was fraudulent. In the case of determining whether a borrower under a zombie loan completed a deed-in-lieu for reasonable equivalent value, however, the question is whether the court should examine the value exchanged at the time of the deed-in-lieu transaction or rather at the time of the future default, when foreclosure was all but inevitable. Without strong if any relevant case law regarding the unique issues raised by zombie loans, counsel for lenders planning to take a deed-in-lieu as a resolution for such a loan must guide their clients carefully through the equitable risks.
In reality, not all zombie loans are equally problematic in the context of determining whether reasonably equivalent value was exchanged in connection with a deed-in-lieu. For instance, an argument that the anticipatory determination of value was ultimately prejudicial to other creditors and therefore constitutes a fraudulent transfer will have less strength if the anticipated maturity date is only one or two quarters in the future. However, a creditor may argue that it was prejudiced when a borrower waived its right to extend maturity pursuant to an extension option whether or not the extension required payment of a fee by the borrower. While one may reasonably determine that capital markets and property valuations will not change in the immediate future, longer range predictions are more questionable.
Furthermore, simply because there is no equity remaining in the property at the time a borrower under a zombie loan offers up a deed-in-lieu may not be sufficient to protect the transaction from attack in bankruptcy. Prior to accepting a deed of lieu in anticipation of a loan default in the future, lenders should look to current financial reporting provided by borrowers to determine whether a key tenant's decision to vacate the property or other property conditions will ultimately support the loss of all borrower equity both at the time of determination and in the future.
We note that while mezzanine loans are distinct from traditional mortgage loans, they do share certain characteristics such as ultimately looking to real property as collateral. Acknowledging the lack of relevant case law on point, lenders should be wary of courts sitting in equity that may deem a mezzanine loan an equitable mortgage or hold that a mezzanine borrower is entitled to the same equitable rights as mortgagor. Cautious lenders negotiating the equivalent of a deed-in-lieu of a mezzanine loan should head the same cautions and follow the same procedures as if the mezzanine loan were a mortgage loan. Thus, if a court draws the parallel between mezzanine loans and mortgage loans, the lender will be able to point to the default to show that there was no clog on the equity of redemption.
Deeds in lieu offer a valuable tool in dealing with troubled mortgage loans. In most contexts, the consensual nature of the transaction coupled with the dire economic realities that push a borrower into such a resolution will normally provide solid protection from later equitable attacks. Still, in light of current conditions and the diversion of market realities from the context in which deeds in lieu were previously examined by courts, lenders should be cautious before accepting a deed-in-lieu on a zombie loan that has not yet been called in default.
Jeffrey B. Steiner and Jason R. Goldstein are members of DLA Piper. Kira L. Mineroff, a summer associate with the firm, assisted in the preparation of this article.
Endnotes:
1. Jeffrey B. Steiner and Jason R. Goldstein, "Dealing with Equitable Defenses to Foreclosure," NYLJ, March 18, 2009.
2. Kirby v. Tricker, 265 AD 149 (N.Y. App. Div. 1942).
3. Verity v. Metropolis Land Co., 248 AD 748 (N.Y. App. Div. 1936).
4. John C. Murray provides an example of an anti-clogging affidavit from in the appendix of his article, "Clogging Revisited," 33 REAL PROP. PROP. & TR. J. 279 (1998-1999).
5. BFP v. Resolution Trust Co., 511 U.S. 331 (1994).
6. Main v. Brim (In re. Main), 75 B.R. 322 (Bankr. D. Az. 1987).
Associated Press updated 1:49 p.m. ET, Fri., July 17, 2009
WASHINGTON - Construction of new U.S. homes rose in June to the highest level in seven months as builders rushed to pour foundations for homes that must be completed by the end of November for first-time buyers to take advantage of a special tax break.
The Commerce Department said Friday that construction of new homes and apartments jumped 3.6 percent last month to a seasonally adjusted annual rate of 582,000 units, from an upwardly revised rate of 562,000 in May.
It was better than the 530,000-unit pace economists expected, and was the second straight monthly increase after April's record low of 479,000 units.
"This was the most positive housing report in ages," wrote Patrick Newport, an economist with IHS Global Insight.
Homebuyers are being attracted by lower prices, and first-time buyers can also take advantage of a tax credit worth 10 percent of the purchase price, with a cap of $8,000, which was included in the federal stimulus package.
"The largest spark...has been the looming deadline," said David Crowe, chief economist for the National Association of Home Builders. His trade group said Thursday that the confidence level of builders has risen to the highest level in nearly a year.
Shares of major homebuilders rose on the news with Beazer Homes and Hovnanian Enterprises up about 5 percent in midday trading. The broader stock indexes, meanwhile, were little-changed Friday after Bank of America and Citigroup became the latest banks to report big second-quarter profits but also weakness in their loan portfolios.
Over the past three years, the collapse in the housing market led to soaring loan losses, a severe banking system crisis and the longest recession since World War II. Even with the better-than-expected figures, the pace was still 46 percent below last year, and analysts don't expect a quick rebound. That's because companies are still shedding jobs and home prices are falling.
"There's still a long way to go before one wants to declare anything that begins to look like a strong recovery or success," said Rebecca Blank, undersecretary of commerce for economic affairs.
The Federal Reserve this week projected that the national unemployment rate, currently at a 26-year high of 9.5 percent, will pass 10 percent by the end of the year. Unemployment has already passed that mark in 15 states and the District of Columbia last month, according to federal data released Friday.
The rate in Michigan surpassed 15 percent, the first time any state has hit that level since 1984.
Most Fed policymakers said it could take five or six years for the economy and the labor market to get back on a path of long-term health. To get there, consumers must return to a regular spending groove and housing prices need to start rising again.
The jump in housing starts last month reflected a more than 14 percent rise in construction of single-family homes, the largest monthly increase since December 2004. Construction of multifamily units — a particularly volatile part of the market — fell nearly 26 percent from a month earlier.
Meanwhile, applications for building permits, seen as a good indicator of future activity, rose almost 9 percent in June.
WASHINGTON - Construction of new U.S. homes rose in June to the highest level in seven months as builders rushed to pour foundations for homes that must be completed by the end of November for first-time buyers to take advantage of a special tax break.
The Commerce Department said Friday that construction of new homes and apartments jumped 3.6 percent last month to a seasonally adjusted annual rate of 582,000 units, from an upwardly revised rate of 562,000 in May.
It was better than the 530,000-unit pace economists expected, and was the second straight monthly increase after April's record low of 479,000 units.
"This was the most positive housing report in ages," wrote Patrick Newport, an economist with IHS Global Insight.
Homebuyers are being attracted by lower prices, and first-time buyers can also take advantage of a tax credit worth 10 percent of the purchase price, with a cap of $8,000, which was included in the federal stimulus package.
"The largest spark...has been the looming deadline," said David Crowe, chief economist for the National Association of Home Builders. His trade group said Thursday that the confidence level of builders has risen to the highest level in nearly a year.
Shares of major homebuilders rose on the news with Beazer Homes and Hovnanian Enterprises up about 5 percent in midday trading. The broader stock indexes, meanwhile, were little-changed Friday after Bank of America and Citigroup became the latest banks to report big second-quarter profits but also weakness in their loan portfolios.
Over the past three years, the collapse in the housing market led to soaring loan losses, a severe banking system crisis and the longest recession since World War II. Even with the better-than-expected figures, the pace was still 46 percent below last year, and analysts don't expect a quick rebound. That's because companies are still shedding jobs and home prices are falling.
"There's still a long way to go before one wants to declare anything that begins to look like a strong recovery or success," said Rebecca Blank, undersecretary of commerce for economic affairs.
The Federal Reserve this week projected that the national unemployment rate, currently at a 26-year high of 9.5 percent, will pass 10 percent by the end of the year. Unemployment has already passed that mark in 15 states and the District of Columbia last month, according to federal data released Friday.
The rate in Michigan surpassed 15 percent, the first time any state has hit that level since 1984.
Most Fed policymakers said it could take five or six years for the economy and the labor market to get back on a path of long-term health. To get there, consumers must return to a regular spending groove and housing prices need to start rising again.
The jump in housing starts last month reflected a more than 14 percent rise in construction of single-family homes, the largest monthly increase since December 2004. Construction of multifamily units — a particularly volatile part of the market — fell nearly 26 percent from a month earlier.
Meanwhile, applications for building permits, seen as a good indicator of future activity, rose almost 9 percent in June.
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