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Distressed Note and REO purchases (part 2) | Practical Counsel
« Distressed REO and Note Purchases (part 1)	The Devil’s Triangle of Bank Failure (part 1) »	Distressed Note and REO purchases (part 2)	Published March 15, 2010	Real Estate Finance
Part 1 of this series dealt with representations and warranties that are typically provided in distressed note purchases and distressed REO purchases. This post gives an overview of some of the diligence issues that must be addressed in purchases and sales of (whole) distressed notes. (Other issues arise in the context of sales or purchases of participations in notes, which are not addressed in this post.) Why do due diligence? When a lender chooses to sell, rather than to enforce, a distressed note secured by CRE, it may have made that decision for any one of a number of reasons. For example, the lender’s regulator may have decided that the lender is carrying too many distressed real estate loans, and may have told the lender it needs to quickly rebalance its portfolio. Or the lender may need to improve its liquidity quickly, and may determine it can do so faster by selling one or more distressed notes rather than by enforcing them, then selling the distressed REO after it is foreclosed upon by the lender. Or it may have decided to get out of a given type of lending business, and therefore to sell all its loans in that line of business. It may be rebalancing its risks geographically, or based on changes in the market. Alternatively, the lender may need to improve the overall quality of its portfolio quickly. Or it might be selling to change its yield and duration risks. It might be selling the note due to its merger with another lender. Another reason a lender might sell is because it thinks it will have a tough battle with the borrower to enforce the note, and does not want to commit the time or money. Or the property may carry with it liabilities of one sort or another: for example, foreclosing on a retirement home or a hospital may create public relations problems for a lender; or the lender may simply not want to, or have the resources to, manage certain types of property, such as land not yet subdivided; or a property may have environmental problems that concern a lender. Or, in a declining market, the lender may decide it ultimately can collect more in a fast note sale (or lessen its costs — such as property taxes and other costs it must advance — to hold the declining property) than in a slow foreclosure (and possible bankruptcy). A potential buyer simply does not know why a lender is selling a distressed note, and so it needs to do diligence at two levels to understand and price the risk it is taking by buying the loan: First, it must do diligence to determine the status of the note, the other loan documents, the borrower, any guarantor, and the relationship and actions to date taken by the borrower and the selling lender, because the buyer will be stepping into the shoes of the selling lender; and
Recommended due diligence for distressed note purchases. While it’s pretty straightforward to review a lender’s loan file (assuming a complete loan file can be located), the process for evaluating the underlying collateral can be more complex. To review a loan file, one must carefully read (and preferably also have counsel read) all of the loan documents and all of the correspondence between the lender and the borrower. The purpose of this review is to confirm the basic business terms of the loan (its amount, times and terms for payment, etc.) as well as the legal effects of the loan: that the loan was made and documented properly, that it appears to be enforceable against the borrower and the property, and that the security documents work (create liens against the property that is collateral for the loan, whether personal or real property). It’s usually a good idea to run a litigation search on the borrower to see if it or its principals have a history of litigation — that can be an indication of how hard it might be to enforce the loan. Further, a legal analysis of the likelihood that the borrower has defenses to payment or other leverage (such as a fraud or other lender liability claim) that it could use to oppose the enforcement of the loan should be done by competent CRE counsel. For example, my group has a standard form CRE loan checklist that we use to review loan documentation; it is quite long and detailed, and reminds us to check (and to document in summary form) a wide range of issues that can hamper the enforcement of a CRE loan. After we complete initial diligence for a loan purchase, we provide that checklist (as well as an executive summary of it) to our client, so that it can make its internal determination about what to follow up on. It is not uncommon for an initial round of diligence both to resolve certain issues and to uncover other issues that must be investigated further in order to really understand the risks of enforcing a particular loan. Typically in a loan purchase transaction, the buyer’s lawyer first looks at the lender’s loan file; if there are insurmountable problems in it, then the deal may be terminated before review of the collateral takes place. But if the loan file seems okay, then the next order of business is typically the due diligence review of the real estate collateral securing the loan.
The common goal of all of these questions is to find out precisely what the seller is selling and what the buyer is buying. This sounds simple but is not. The key is to be able to find out about the property while relying only on sources of information that are known to be highly accurate (and, if possible, on sources that carry liability insurance against their own errors). I could go on and on about the specifics of due diligence, but won’t: just understand that in order to know whether it makes sense to buy a distressed CRE note, a buyer must do diligence on the collateral property as well as on the note. Key due diligence provisions in note purchase and sale agreement. In negotiating the due diligence provisions of a note purchase and sale contract, the parties usually have to negotiate several points: (a) the length of time the buyer has to complete its due diligence; (b) whether the buyer can do environmental testing or physical inspection of the underlying property collateral (both are very important, but frequently the would-be note buyer’s access to the property is constrained by the seller/lender, which may itself only have limited rights to access the property; (c) the amount of cooperation during the diligence process that the selling lender must provide; (d) what happens if the buyer completes its diligence, then new information comes up about the status of the loan or the property collateral; and similar issues. These issues and others are typically negotiated in the note purchase and sale agreement; once negotiated, both seller/lender and buyer must comply with those terms.
16 Responses to “Distressed Note and REO purchases (part 2)”
March 16, 2010 at 4:02 pm	I suppose that we real estate lawyers are as prone to get caught up in jargon as those in other technical specialties but, please, when did “diligence” become a verb?
March 17, 2010 at 12:27 am	Thanks for writing, Tom. I appreciate the grammatical advice, which is correct, and have corrected the typo.
March 17, 2010 at 12:32 am	Didn’t mean to give you a hard time. Substantively, it’s a great and very thorough article.
March 16, 2010 at 4:58 pm	Maura, as a loan sale advisor dealing primarily in commercial real estate loans, we are seeing many new entrants into the “we are buyers” of loans field.
The process of buying a loan (properly)is complicated, has numerous moving parts, and the day of closing is quite complex.
We are dealing with buyers ( or would be buyers ) on a daily basis. Frequently I have conversations with people who are new to the space, and quite frankly, some of them just don’t get it!
Hopefully they will have the sense to obtain competent counsel, like yourself, should they be awarded any bids.
Thanks for putting this topic out.
March 16, 2010 at 6:37 pm	Thanks for writing, Barry. Best regards,
propinv001
March 16, 2010 at 7:35 pm	Once again Maura great advice and guidance for people entering into these areas of opportunity. Everyone today is seeking a new opportunity to accumulate and replace the lost assets of the past couple years, and everyone is having to look for new opportunities since the old strategies just are not working in todays markets. But, buyer beware along with opportunity is the old cliche “Risk Reward” You need to educate yourself, do your homework, understand any new investment vehicle, and be prepared to grow and learn as you endeavor into new investment environments. Your advice and guidance is excellent and a great tool for all who read it.
March 17, 2010 at 12:21 am	Thanks for the kind words, Propinv001.
March 17, 2010 at 4:07 pm	Maura
Great article. Ive been advising clients on loan acquisitions since 1993 and today more than ever I am seeing new note buyers complete their own due diligence of loan documents without using legal counsel. They focus on the post purchase period as the time to call in counsel. Some of these transactions include “normal” complexities like intercreditor agreements, mezz lenders with UCC interests, non recourse guaranty, partial construction with mortgagee in posession issues etc etc. Because, as you state there are more buyers than sellers, note investors are shying away from full legal due diligence on the acquisition side to save sunk costs on deals they may later pass on. Interesting times.
March 17, 2010 at 8:00 pm	Why do you think lenders prefer note sales over short sales? What is more common today?
March 18, 2010 at 11:13 pm	Dear Blake:
While this is a matter of opinion, I believe that lenders who prefer note sales over short sales do so because selling a note may be more transparent to the lender, and less conducive to fraud upon the lender, than doing a short sale. There have been a lot of allegations and anecdotal stories about fraudulent short sales. Many lenders are willing to sell a note at a discount, or to do a short sale, but not to the borrower who is defaulting on the loan. \
However, I’m not aware of which avenue to collect “lenders” prefer: in my experience, different lenders have different preferences, some of which relate to their own experiences with loan enforcement, and some of which relate to the lender’s own financial position. Most lenders that I know simply want to have their loans repaid. Towards that end, most lenders will consider various options to determine what the most cost-effective way to get a given loan as close to fully repaid as possible, and will choose to implement the option that brings in the most money for the least expenditure of resources (time and money).
I don’t have access to any data from which I can answer whether note sales or short sales are more common. In my practice, which focusses on California commercial real estate, we are seeing more note sales than short sales, but that may not be true in other practices, or other markets.
March 18, 2010 at 7:51 pm	Enviromental due dilligence is limited to a phase1 because on site examination would be governed by the loan docs.?
March 18, 2010 at 10:30 pm	Dear Greg:
Yes, generally environmental due diligence by a note buyer would be limited to a phase I environmental study because that’s typically what the original lender would be allowed to do under the loan documents.
March 20, 2010 at 1:06 pm	agree with you maura
April 8, 2010 at 9:25 pm	Maura, I am a commercial real estate agent that has been forced into this field by lenders not wanting to go through the foreclosure process (and ultimately sell the real estate) and buyers who think this avenue will bring them a big discount. As I am familiarizing myself with this process and am running into jargon I am not familiar with. Can you explain what is meant by “B K”? As in a buyer of a note is concerned about possible BK on the note or property. My best guess was that this was an abbreviation of bankruptcy or borrower bankruptcy, as this would be an issue for the buyer of the note. Can you provide any insight on this for me?
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