One Person's Distress is Another's Opportunity: A Buyer's and Seller's Guide to Nonperforming Loans

When commercial loans are close to default or are in default, banks traditionally turn to the standard workout playbook. Typically, this means pursuing asset-recovery strategies such as workout agreements, liquidating collateral or exercising their rights as creditors on loans classiied as nonperforming or distressed. In the past two years, however, an increasing number of banks have turned to another option: selling nonperforming loans to third parties.

Sales of Distressed-Loan Portfolios Likely to Remain High in 2012
In the wake of the inancial crisis, banks have faced the pressure of increased capital and loan-loss reserve requirements, which are driven by defaults on previously performing loans and the decline in the value of real estate held as collateral for loans. These factors make asset sales attractive, as the sales not only offer a quicker way to achieve a recovery than workouts and foreclosures, but can also free up capital for making new loans that would otherwise need to be held in reserve.

Participants in lending markets and professionals servicing such participants should expect this trend to continue. A record of more than $360 billion in commercial real estate debt is scheduled to mature this year. This debt will be a major driver in the sale of loan portfolios in the coming years, as more than $1.3 trillion in commercial real estate debt is scheduled to mature between now and 2015. Further, an estimated 60% of the loans scheduled to mature in that time are underwater. Because real estate values are likely to remain depressed, refinancing these maturing loans will be challenging.

At the same time, banks will continue to look for opportunities to make new loans to companies gaining confidence as the economy recovers, necessitating moves to free up capital. As a result, maintaining balance sheets will remain an important objective for major financial institutions and community banks alike, making additional sales of distressed-loan portfolios an attractive option.

European banks, facing even more stringent capital-ratio requirements, will also continue to dispose of their distressed-loan portfolios, creating acquisition opportunities in the U.S. markets. Pressure from regulators to raise capital drives these asset sales by European banks and, as a result, many of the assets being sold are less risky or even currently performing loans and other profitable assets, making them attractive to domestic banks.

Sales of nonperforming or distressed loans also create investment opportunities for hedge funds, opportunity funds and REITs. These types of private investors have long sought to invest in risky debt portfolios at the right price, and the current market presents them with the desired opportunity.

The negotiations and documentation of a loan-sale agreement (or a loan-portfolio sale agreement) are critical parts of the sale process. Although sellers and buyers pursue different objectives within documentation, they generally should expect to see certain provisions in a loan sale agreement.

From the Seller's Perspective
Typically, the seller's counsel prepares the loan-sale agreement. The seller will — and should — try to limit his liability. As a result, a seller will insist that a loan-sale agreement limit the representations and warranties the seller makes with respect to the portfolio. These representations and warranties will likely be limited to the seller's ownership rights in the portfolio and its authority to sell the portfolio to the buyer. A seller may also insist on including a speciic disclaimer of any recourse to the seller, as well as a release of any claims or damages against the seller arising in connection with the acquired loans after the closing date. To the extent that the seller will endorse any promissory notes to the buyer, such endorsements are likely to be without any recourse, representation or warranty. To constitute an effective disclaimer of the typical transfer warranties, the seller should be sure to include speciic disclaiming language in any endorsement of promissory notes evidencing the distressed loans.

After the parties execute a sale agreement, the buyer will be entitled to some time for due diligence before the transactions close. The seller should expect the buyer to require certain disclosures, documentation and cooperation from the seller as part of the buyer's due diligence process. Thus, the seller should be prepared to provide payment histories with respect to the loans, copies of the applicable loan documents and assurances that the seller is holding the original loan documents (particularly the promissory notes). Additionally, if the seller has undertaken any legal action to collect on any of the loans, the seller should be prepared to provide a detailed report as to the status of those proceedings.

From the Buyer's Perspective
Buyers must be cognizant of the steps that sellers will take to limit their liability. Many loan-sale agreements will include a buyer's express acknowledgment and agreement that the loans are being sold on an “as is, where is” basis, with no representations, warranties or recourse. However, it is in a buyer's interest to negotiate a carve-out from such blanket disclaimers with respect to a seller's liability for actual fraud or intentional misrepresentation in connection with the sale itself.

As a consequence of the lack of representations and warranties from the seller, the buyer's due diligence becomes the main (and often the only) source of protection. Thus, buyers should look for these red flags:

1. Restructuring Agreements: Sellers might not expressly disclose restructuring agreements, which may release any obligors or collateral or modify the repayment terms, during negotiation. These agreements, however, could seriously undermine a buyer's chances of recovery on a loan post-sale.
   
   
2. Environmental Issues: Although most lenders routinely conduct Phase I Environmental Site Assessments on commercial properties securing their loans, it is possible that issues have arisen during the life of the loan. This is particularly true when a borrower in default may have attempted to reduce costs by cutting back on compliance with environmental laws, or in cases where a property has been vacant. Environmental problems can impose signiicant costs on a buyer and can severely impair the value and marketability of collateral.
   
   
3. Defenses Raised in Litigation: Buyers should be familiar with any defenses and counterclaims that defaulting borrowers or guarantors have asserted against the seller in litigation. These borrowers and guarantors may now be able to assert those same defenses and counterclaims against a buyer. To the extent a buyer has notice of pending litigation, the buyer will likely be subject to those defenses and counterclaims. As a result, buyers should seek the advice of counsel in analyzing any such defenses and counterclaims, which, if successful, could signiicantly restrict a buyer's ability to collect on the loan.

As these considerations demonstrate, a carefully drafted sale agreement and familiarity with the loans being sold is critical to ensuring a successful asset sale. And, as the sale of distressed loans continues to increase in the U.S. and globally, it is important for inancial services and legal professionals to be mindful of both perspectives.

Inez M. Markovich, a partner at Deeb Blum Murphy Frishberg & Markovich, PC, headquartered in Philadelphia, PA, concentrates her practice in the areas of commercial finance transactions, debt restructuring, business reorganization and bankruptcy, creditors' rights and financial services regulation. She routinely represents commercial banks, leasing companies and other financial institutions in all aspects of secured lending, asset-based lending, syndicated lending, commercial leasing and creditenhancement transactions. She has also played significant roles representing secured creditors in a variety of complex bankruptcy matters.

David P. Dean, an associate at Deeb Blum Murphy Frishberg & Markovich, PC, focuses his practice primarily on commercial litigation, workout and creditors' rights. Ms. Markovich and Mr. Dean may be reached at (215) 563-0500 or via e-mail at imarkovich@dbmfmlaw.com and ddean@dbmfmlaw.com respectively.