April 03, 2015

Who is your Borrower?

a. Reviewing Financial Statements and covenant

• How to read a financial statement
• Key vocabulary: Cash v. Accrual, Tangible v. Intangible, Book Value v. Estimated Value, and Stabilized Value v. As-Is Value.

b. Think about structure early

• Where is the money? Who does your credit support?
• Underwriting Considerations

One Action Rule- This risk varies by state, but it is of overwhelming importance.

a. The Stated Rule. CCP 726 – “There can be but one form of action for the recovery of any debt for the enforcement of any right secured by mortgage upon real property or an estate for years therein, which action shall be in accordance with the provisions of this chapter.”

b. The Purpose of the Rule. The primary purpose of the one action rule is to force the lender to look to the Collateral first before seeking any deficiency against the borrower. Under this rule, the lender must first exhaust the security before seeking a money judgment. Hartman v. Smith 219 Cal.App. 2d 415 (1963).

c. The Consequences for Violating the Rule.

• The Shield. A borrower may raise the one action rule as an affirmative defense, or in a declaratory relief action against the lender for a stay of any action against the borrower until the lender first exhausts its rights against the Collateral. Western Fuel Co. v. Sanford G. Lewald Co., 190 Cal. 25 (1922).

• The Sword. Loss of security as a sanction against lender. Security Pacific National Bank v. Wozab, 51 Cal 3d 991 (1990). Moreover, even if the borrower fails to raise the one action rule as an affirmative defense, the borrower can subsequently raise it to bar any attempt by the lender to collect against the Collateral. Walker v. Community Bank (1974) 10 Cal 3d 729. This is because a lender’s failure to proceed first against the Collateral will operate as an election of remedies by lender (i.e., sue on the note) and the lender will be deemed to have waived its security interest in the Collateral, including real property.

d. The Practical Effect of the Rule. Lender must proceed first against the Collateral and only upon completion of foreclosure, can the lender seek a deficiency judgment against the borrower (but review relevant anti-deficiency laws (i.e. CCP 580d)).

Anti-Deficiency Laws: Laws that prohibit a lender from seeking a deficiency judgment (e.g. CCP 580d provides that “no judgment shall be rendered for any deficiency on a note secured by a deed of trust on real property in which the real property has been sold by the trustee under the power of sale contained in the deed of trust (a non-judicial foreclosure sale)).

Sham Guaranty Defense

a. The Stated Rule. In order to collect a deficiency judgment against a guarantor, the guarantor “must be a true guarantor and not merely the principal debtor under a different name” Cadle Company II v. Harvey 83 Cal.App.4th 927 (2000).

b. The Purpose of the Rule. The purpose of the rule is to ensure that lenders do not subvert anti-deficiency laws by forcing the true principal into the role of a guarantor. If the guarantor is really just the true principal in disguise (a “sham”), then it is afforded the same protections as the borrower.

c. Tips: Use care in the term sheet and credit write-ups, avoid confusing the borrower and guarantor, expressly provide the primary source of repayment is from borrower, require Borrower financials and prove adequate capitalization of the Borrower through its ownership of the real estate, etc.

Fraudulent Transfers and Tousa

a. Facts: Parent is the 13th largest homebuilder, but it is hit with a $421,000,000.00 judgment. Parent enters deal settlement with Old Lenders of a failed joint venture. Parent funds settlement with Old Lenders from sums borrowed by Parent and Subsidiaries from New Lenders. Subsidiaries were not liable to Old Lenders, nonetheless, the Subsidiaries granted liens on all of their assets to secure the loan from the New Lenders. Parent also has nearly a billion dollars in unsecured bonds, guaranteed by the Subsidiaries. Parent also has a large unsecured line of credit, guaranteed by the Subsidiaries. Housing market crashes and forces Parent into bankruptcy. Subsidiaries sought to avoid the settlement, the new loan and the granting of liens by the subsidiaries as fraudulent transfers. Subsidiaries argued that they received no benefit from the new loan and that the granting of the liens rendered them insolvent. Lenders argued that the subs received reasonably equivalent value by being able to avoid bankruptcy thanks to the new loan. Lenders argued that, in the alternative, the court should apply the savings clause

b. Issue: Was there a fraudulent transfer and if so, should the savings clause apply?

c. Holding: There was a fraudulent transfer and savings clauses are per se invalid under Section 541(c)(1)(B) of the Bankruptcy Code as an impermissible attempt to draft around fundamental portions of the Bankruptcy Code.

d. Reasoning: The subsidiaries did not receive anything for the upstream collateralization so they did not receive any value, let alone reasonably equivalent value.

5. Independence/separateness principles.

a. Cherryland.

Facts:

• Borrower and lender enter into a non-recourse CMBS Loan with a standard carve-out guaranty.
• One carve out required borrower to remain a bankruptcy remote SPE and remain solvent and pay its debts and liabilities from its assets as and when due.
• The market went down causing the collateral’s value to decline to below the amount owed on the loan, resulting in insolvency and the borrower’s default.
• Lender forecloses on the real property.
• Lender then sues the Guarantor, claiming the borrower’s insolvency constituted a failure to maintain Borrower’s SPE status.
• Issue: Was Borrower’s insolvency a breach of the SPE covenants?
• Holding: Yes
• Rationale: Court looked to the four corners of the loan documents and said that they plainly stated that solvency was a SPE provision, so despite Borrower, Lender and everyone else understanding the goal of a non-recourse loan and carve out guaranty, the guaranty became full recourse on Borrower’s insolvency.

b. Michigan Legislature: “A post closing solvency covenant shall not be used directly or indirectly, as a non-recourse carve-out or as the basis for any claim or action against a borrower or any guarantor or other surety on a non-recourse loan.”

c. California Rejects: GECCMC 2005-C1 Plummer Street Office Ltd. Partnership, the California court of appeals refused to say that the carve out guaranty was triggered when borrower went out of business and defaulted under its lease, even though the guaranty said that it would be full recourse where the lease was terminated.

Who is your Borrower?

a. Reviewing Financial Statements and covenants

• How to read a financial statement
• Key vocabulary: Cash v. Accrual, Tangible v. Intangible, Book Value v. Estimated Value, and Stabilized Value v. As-Is Value.

b. Think about structure early

• Where is the money? Who does your credit support?
• Underwriting Considerations

One Action Rule- This risk varies by state, but it is of overwhelming importance.

a. The Stated Rule. CCP 726 – “There can be but one form of action for the recovery of any debt for the enforcement of any right secured by mortgage upon real property or an estate for years therein, which action shall be in accordance with the provisions of this chapter.”

b. The Purpose of the Rule. The primary purpose of the one action rule is to force the lender to look to the Collateral first before seeking any deficiency against the borrower. Under this rule, the lender must first exhaust the security before seeking a money judgment. Hartman v. Smith 219 Cal.App. 2d 415 (1963).

c. The Consequences for Violating the Rule.

• The Shield. A borrower may raise the one action rule as an affirmative defense, or in a declaratory relief action against the lender for a stay of any action against the borrower until the lender first exhausts its rights against the Collateral. Western Fuel Co. v. Sanford G. Lewald Co., 190 Cal. 25 (1922).

• The Sword. Loss of security as a sanction against lender. Security Pacific National Bank v. Wozab, 51 Cal 3d 991 (1990). Moreover, even if the borrower fails to raise the one action rule as an affirmative defense, the borrower can subsequently raise it to bar any attempt by the lender to collect against the Collateral. Walker v. Community Bank (1974) 10 Cal 3d 729. This is because a lender’s failure to proceed first against the Collateral will operate as an election of remedies by lender (i.e., sue on the note) and the lender will be deemed to have waived its security interest in the Collateral, including real property.

d. The Practical Effect of the Rule. Lender must proceed first against the Collateral and only upon completion of foreclosure, can the lender seek a deficiency judgment against the borrower (but review relevant anti-deficiency laws (i.e. CCP 580d)).

Anti-Deficiency Laws: Laws that prohibit a lender from seeking a deficiency judgment (e.g. CCP 580d provides that “no judgment shall be rendered for any deficiency on a note secured by a deed of trust on real property in which the real property has been sold by the trustee under the power of sale contained in the deed of trust (a non-judicial foreclosure sale)).

Sham Guaranty Defense

a. The Stated Rule. In order to collect a deficiency judgment against a guarantor, the guarantor “must be a true guarantor and not merely the principal debtor under a different name” Cadle Company II v. Harvey 83 Cal.App.4th 927 (2000).

b. The Purpose of the Rule. The purpose of the rule is to ensure that lenders do not subvert anti-deficiency laws by forcing the true principal into the role of a guarantor. If the guarantor is really just the true principal in disguise (a “sham”), then it is afforded the same protections as the borrower.

c. Tips: Use care in the term sheet and credit write-ups, avoid confusing the borrower and guarantor, expressly provide the primary source of repayment is from borrower, require Borrower financials and prove adequate capitalization of the Borrower through its ownership of the real estate, etc.

Fraudulent Transfers and Tousa

a. Facts: Parent is the 13th largest homebuilder, but it is hit with a $421,000,000.00 judgment. Parent enters deal settlement with Old Lenders of a failed joint venture. Parent funds settlement with Old Lenders from sums borrowed by Parent and Subsidiaries from New Lenders. Subsidiaries were not liable to Old Lenders, nonetheless, the Subsidiaries granted liens on all of their assets to secure the loan from the New Lenders. Parent also has nearly a billion dollars in unsecured bonds, guaranteed by the Subsidiaries. Parent also has a large unsecured line of credit, guaranteed by the Subsidiaries. Housing market crashes and forces Parent into bankruptcy. Subsidiaries sought to avoid the settlement, the new loan and the granting of liens by the subsidiaries as fraudulent transfers. Subsidiaries argued that they received no benefit from the new loan and that the granting of the liens rendered them insolvent. Lenders argued that the subs received reasonably equivalent value by being able to avoid bankruptcy thanks to the new loan. Lenders argued that, in the alternative, the court should apply the savings clause

b. Issue: Was there a fraudulent transfer and if so, should the savings clause apply?

c. Holding: There was a fraudulent transfer and savings clauses are per se invalid under Section 541(c)(1)(B) of the Bankruptcy Code as an impermissible attempt to draft around fundamental portions of the Bankruptcy Code.

d. Reasoning: The subsidiaries did not receive anything for the upstream collateralization so they did not receive any value, let alone reasonably equivalent value.

5. Independence/separateness principles.

a. Cherryland.

Facts:

• Borrower and lender enter into a non-recourse CMBS Loan with a standard carve-out guaranty.
• One carve out required borrower to remain a bankruptcy remote SPE and remain solvent and pay its debts and liabilities from its assets as and when due.
• The market went down causing the collateral’s value to decline to below the amount owed on the loan, resulting in insolvency and the borrower’s default.
• Lender forecloses on the real property.
• Lender then sues the Guarantor, claiming the borrower’s insolvency constituted a failure to maintain Borrower’s SPE status.
• Issue: Was Borrower’s insolvency a breach of the SPE covenants?
• Holding: Yes
• Rationale: Court looked to the four corners of the loan documents and said that they plainly stated that solvency was a SPE provision, so despite Borrower, Lender and everyone else understanding the goal of a non-recourse loan and carve out guaranty, the guaranty became full recourse on Borrower’s insolvency.

b. Michigan Legislature: “A post closing solvency covenant shall not be used directly or indirectly, as a non-recourse carve-out or as the basis for any claim or action against a borrower or any guarantor or other surety on a non-recourse loan.”

c. California Rejects: GECCMC 2005-C1 Plummer Street Office Ltd. Partnership, the California court of appeals refused to say that the carve out guaranty was triggered when borrower went out of business and defaulted under its lease, even though the guaranty said that it would be full recourse where the lease was terminated.