Selling Problem Loans: Cash for Clunkers
As financial institutions look for opportunities to free themselves from the ongoing financial, managerial, and regulatory burdens of problem loans, selling the problem assets can be an attractive solution. On close examination, however, the terms of the sales of these assets may or may not be advantageous to the selling institution.
In the current environment, selling institutions are often under intense regulatory (and shareholder) pressure to "clean up" their balance sheets. Prospective loan buyers sense and understand that pressure, and they have been known to take advantage of the situation to secure the credits at a bargain-basement pricing, with terms that sometimes provide a virtual guarantee of collection and little, if any, actual risk to the buyer.
There are loan sales, and there are loan sales. Terms vary widely, and as always, the devil is in the details. Transaction terms, of course, reflect a variety of risks. How the loan sales are conducted, how they are priced, and the various terms and conditions of the sale can make the cure worse than the disease—unless the selling institution takes care to thoughtfully negotiate and document terms that make sense for their particular situation.
While each transaction is unique, some of the more common issues and traps for unwary sellers are discussed briefly below.
Confidentiality
Before proceeding with any prospective buyer, it is important to secure a strong confidentiality agreement with covenants regarding customer and seller information, restrictions on use of the information, and non-solicitation. A well-worded “letter of intent” may also be useful in establishing a protocol and certain transaction terms early in the process, before much time is expended and before asset quality erodes further.
Exclusivity and Due Diligence
Some loan buyers take advantage of pressured institutions and, early on, suggest a high "estimate" price to be followed by an "exclusive" due diligence review period. As the due diligence period drags on (and is often extended), regulatory and shareholder pressures mount, problem loans get worse, and the seller misses other sale opportunities due to the "exclusivity" clause. The buyer's initial apparent optimism sometimes becomes increasing skepticism followed by a significantly reduced price, much like the initial used car trade-in "estimate" before a visit with the sales manager. Before long, the initial "estimate" is long gone, replaced by a much lower price and terms that sometimes leave the selling institution in the position of a guarantor of recovery, despite the lower price (which should reflect risk). Sellers are often worn down by this time, and ready for almost anything to get the loans off their books. Even if accepting a low-ball price, however, sellers need to undertake a careful review of the other terms of the sale agreement before entering into a transaction that could leave them in a worse position than if no transaction had occurred.
Buyer "Puts"
Initial proposed sale agreements often include a buyer “put,” a stipulation of the agreement that enables the buyer to require the seller to repurchase the loans for a variety of reasons. Sellers need to examine whether they would be in a better position by retaining the loans and continuing with workouts or by going forward with the sale. Intervening issues may, and often do, arise with regard to treatment of the loans (and borrowers) by the buyers, and the seller can be left holding the bag with "lender liability" problems to boot. Regulators and auditors may require continued reserves against these credits in the event that they return to haunt the seller. While buyer "puts" may be necessary in certain circumstances, providing buyer "puts" after a due diligence period can provide post-sale headaches for selling institutions. Buyer "put" options may also adversely impact the ability of the seller to characterize the transaction as a "true sale" for a variety of accounting and regulatory purposes, and may require maintaining further reserves. Non-recourse transactions are typically the preferred seller vehicle for ridding the seller of the problem loans once and for all.
Seller Representations and Warranties
Despite buyer due diligence opportunities, many sale agreements provided by buyers contain extensive seller representations and warranties (including collectability of the underlying debt, borrower creditworthiness, document sufficiency, etc.), which result in a virtual seller guarantee of the underlying credits. "As is, where is" is typically the preferred seller position, particularly after buyer due diligence is complete and pricing has been established with minimal seller representations and warranties. Buyers know they have sellers in a precarious position with regard to reputation risk and regulatory scrutiny and may take advantage of the relative bargaining power. Anything that increases the potential of a loan ultimately returning to the seller by exercise of a buyer "put," resulting from breach of a seller representation or warranty or otherwise, reduces the desired goal of getting rid of the problem loans forever.
Pricing and Expenses
While pricing may vary depending on the value of the credit and the underlying terms of the transaction (including whether the seller agrees to the referenced buyer "put" option), selling banks are in the best position to know the true value of the loan and whether the pricing is appropriate. In some instances, buyers may tend to take advantage of the seller, depending on the seller’s level of pressure and desperation. Sellers may consider obtaining professional assistance in determining pricing for the assets, particularly in light of potential shareholder and regulatory scrutiny with regard to the value received.
Transaction costs in loan sales can be significant and may include fees for preparation of transfer documentation, filing and recording, title searches, customer and contractor notices, lease and other collateral assignments, tax pro-rations, and legal work. Loan sales are document intensive, and the sale agreement should take those costs into consideration and allocate as appropriate.
Buyer Payment
If available, payment for the loans should be received up front, not in reliance on ongoing buyer solvency. While buyers can rely on the regulated environment and audited financial statements of the seller to provide comfort with regard to the seller’s solvency and creditworthiness, sellers typically don't have the same comfort with regard to non-bank buyers. Sellers may want to consider requiring buyer escrows, letters of credit, or other guarantees of buyer performance.
Avoiding Unintended Consequences
Care must be taken to ensure that the transaction does not bring unintended consequences, such as inadvertent violations of the selling institution’s (or holding company’s) debt covenants, participation agreements, shareholder agreements, requirements of governance documents, or collateral pledges [such as selling loans pledged for Federal Home Loan Bank (FHLBank) lines]. Another unintended, but sometimes unavoidable, consequence is that the sale process may create a de facto value for the loans that regulators and auditors find compelling.
Sellers must also determine whether third-party notices, consents, or approvals are required for the transactions, or whether limitations on transfer may apply. Ongoing funding may be required for commitments under construction loans, letters of credit, and other lines, which must be addressed if such credits are to be included in the loan package.
Seller Due Diligence
Sellers should require and follow up on buyer references and, as always, be wary of deals that seem too good to be true. Sellers should be particularly cautious of deals with aggressive up-front "estimates" followed by long "exclusivity" periods and blanket seller representations and warranties. Given the typical circumstances, buyers can drive negotiations from a position of strength, which can result in deals that, in reality, still leave the selling institution holding the bag.
Regulatory and Professional Involvement
The terms of proposed transactions should be carefully reviewed with relevant regulatory agencies and the sellers' accounting, tax, and legal professionals to make certain, in advance, that they will receive the desired regulatory and accounting treatment. Depending on the nature and size of the transaction, prior regulatory notices and/or approvals may be required and buyer state licensing may be an issue, particularly when consumer loans are involved. Entering into a binding agreement with terms that result in undesired or unforeseen regulatory, accounting, tax, or legal treatment can be avoided by making certain that appropriate agency personnel and professional advisors are in the loop early and often, and are in agreement with the institution's planned treatment of the transaction.
Post-closing Issues and Seller Reputation Risk
Keeping in mind that these loans typically represent deals that were once desirable (loans are always good when they're made), how the buyer treats borrowers, who may well still be in the community, can reflect on the selling institution. Troubled borrowers can also sense distress and vulnerability, and may raise "lender liability" and other loan management issues and claims with regard to not only the buyer for post-sale activities, but also the selling institution for pre-sale activities. Post-sale loan management and collection activities by the loan buyer can have a very real impact on the business and reputation of the selling institution, its management, and its board. Sellers may wish to secure indemnification from buyers for post-closing issues and activities involving the loans and the buyer’s post-sale treatment of the loans and borrowers.
Sellers may also consider securing post-closing confidentiality obligations for the buyer with regard to further use of transaction and customer information, as well as post-closing commitments regarding non-compete and non-solicitation obligations. Sellers may also wish to limit or prohibit subsequent loan re-sales by buyers.
Conclusion
Problem loan sale transactions, performed correctly, can provide important and needed relief to the selling institution. While most loan buyers in the market are reputable, there is the occasional buyer who may attempt to take advantage of seller weaknesses and pressures to engage in a transaction that ultimately may not be in the best interests of the seller. In many if not most situations, lenders are not looking to sell the credits unless they are in a difficult position already. Taking care to do it right the first time will save real headaches and cost in the long run.
Jeffrey E. Smith is a partner in the Bricker & Ecker banking and financial services group, a Columbus, Ohio-based law firm. Jeffrey has over 25 years of experience in complex financial institution and general corporate matters, including transactional regulatory compliance and “troubled institution” issues, both as in-house legal counsel for large financial services organizations and in private practice.
Copyright 2009 Jeffery E. Smith
These materials may not be reproduced, in whole or in part, without the prior written consent of the author and acknowledgement of it source and copyright. The materials are intended to inform about legal matters of current interest and are not intended as legal advice. You should not act on the information contained herein without the advice of professional legal counsel.