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BUYING AND SELLING A COMMERCIAL REAL ESTATE SECURED LOAN IN DEFAULT

Martin M. Fleisher Scott H. Olson

Sedgwick, Detert, Moran & Arnold LLP

The authors express grateful appreciation to Victoria H. Paal, Sedgwick, Detert, Moran & Arnold LLP, for her assistance and input.

If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.

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I. INTRODUCTION

In these uncertain times, opportunistic investors are buying defaulted commercial real estate secured loans in record numbers. Among others, a number of major banks, rather than foreclosing these loans and suffering adverse publicity, are selling them into the market at a significant discount to “vulture” and other funds, to individual investors who are willing to speculate in troubled loans. With the volume of troubled commercial real estate loans skyrocketing, many believe the worst is yet to come. Delinquencies in the commercial mortgage-backed securities market skyrocketed more than 500 percent in October, 2009 from a year ago, with California reportedly topping the U.S. Numbers released December 7, 2009 by RealPoint Research show more than $32.6 billion worth of loans are in default as compared to $5.4 billion in October 2008.2

According to Foresight Analytics, there are approximately $1.4 trillion of commercial mortgages, of which approximately $770 billion will mature in the next five years.

As ever, the purchase price for a defaulted loan is the constant theme, and each fact or observation in this article has varying impacts on reaching an acceptable price for the loan given the risks and rewards and intentions of the buyer. If the seller is a federally regulated financial institution, then the first focus should be on the recently issued Guidelines for regulators analyzing and evaluating loans in trouble.

First, this article briefly addresses significant new regulatory guidelines for federally regulated financial institutions in dealing with loans in default and loans which are undersecured. Next, the article discusses the types of due diligence associated with a buyer’s (including investor’s) considerations for acquiring a defaulted loan for investment, restructuring or foreclosure purposes. Inherent in many of the due diligence issues are the contractual restrictions and other provisions impacting the valuation of a defaulted loan and the risks if the documentation is missing key provisions or contains mistakes. Lastly, the article focuses on the effect of a borrower’s chapter 11 bankruptcy on holders of secured real estate loans, strategic considerations for secured

2. CB Richard Ellis, Capital Markets Newsletter, December 7, 2009. California,

Texas and Florida account for a third of the defaults in the mortgage-backed securities market, but the cities with the most delinquent loans are Las Vegas with $1.6 billion, followed by Phoenix with $1.5 billion and New York with $1.2 billion. The defeasance of mortgaged-backed securities is beyond the scope of this article.

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creditors when borrowers file for bankruptcy, including whether to elect to have the full amount of the claim treated as secured, and potential bankruptcy challenges to creditors with real estate secured debt.

II. NEW REGULATORY GUIDELINES FOR BANKS

Defaults and bankruptcies by major tenants, plummeting rents and rent rolls, diminished operating cash flow, and long delays in renting and selling commercial properties, and the corresponding drop of loan to value ratios and debt service ratios have created a crisis and opportunity in the commercial real estate loan market. With the mark-to-market requirements, even performing loans have crossed the line into technical defaults based on the failure to satisfy the initial loan-to-value covenants. Financial institutions have been compelled to require the borrowers for performing loans to invest additional equity at a time when many of the original owner/investors do not have liquid capital.

In response to this situation, on Friday, October 30, 2009, the regulators (consisting of Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS), and the Federal Financial Institutions Examination Council (FFIEC) State Liaison Committee) issued new guidelines (the “Guidelines”) allowing banks to keep loans on their books as “performing” even if the value of the underlying properties has fallen below the loan amount.3 In general, the Guidelines are designed to encourage workouts and restructurings rather than foreclosures. The Guidelines especially target loans which are coming due with little or no prospect of obtaining refinancing because of severely declining property values even though the underlying projects may be producing sufficient cash to service the debt. As of December 2, 2009, over 110 banks have failed.4

Among the more important aspects of the Guidelines, loans to creditworthy borrowers which are restructured and not in default will not be reclassified by the regulators as “high risk” solely because the value of the collateral is less than the balance of the loan.5 This alleviates the regulatory pressure to find additional Tier 1 capital to cover the shortfall

3. Policy Statement on Prudent Commercial Real Estate Loan Workouts, Policy Statement No. FIL-61-2009 (Oct. 30, 2009).

4. Cite to Bank Failure numbers (see Foresight Analytics). 5. See, Guidelines at p. 1.

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of the value, and thereby incentivizes lenders to engage in “prudent” restructurings and modifications. Nevertheless, the Guidelines, when combined with the relaxed accounting standards in 2008 which allowed banks to avoid marking the value of the loans down to reflect their true current market value, may ultimately contribute to currently masking the underlying bleak economic realities and deferring a bubble of bad real estate loans. The regulatory approach also has the effect of tying up bank capital in questionable loans rather than a resumption of lending on new projects.

III. DUE DILIGENCE AND MAJOR CONTRACT ISSUES

A. Due Diligence Steps

1. Strategic Considerations

In considering the purchase of an existing loan in default, the buyer must consider whether it intends to workout the loan, foreclose on the collateral and if permitted by law, pursue a deficiency against the borrower, or possibly accept a deed-in-lieu of foreclosure. Additionally, if permitted by law, the lender may seek a deficiency judgment against or settlement with, the guarantor. The intentions of the potential buyer will vary the focus of which factors should be emphasized during the due diligence process and which may be ignored or given a low value.

The decision of which strategy to implement may depend upon how long a borrower can delay the lender in litigation, whether in state court or in a bankruptcy proceeding. An enforcing lender may face lawsuits over deficiencies (both the availability and amount), lender liability claims, preference claims and fraudulent conveyance claims. Even though the purchaser may not have personal liability for any lender liability claims against the selling lender, the mere assertion by the borrower could color the buyer’s perception of the borrower as a person or entity too difficult to “buy.” The borrower or guarantor may also challenge whether the loan documentation is proper and whether the liens and security interests granted in them have been duly and timely perfected. This type of litigation can take months or longer to litigate to gain the right to go to a foreclosure sale, only to have the borrower file a Chapter 11 proceeding at the end. Some lenders will immediately seek a receiver to take possession and control of

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an income producing property to wrest control of the property and the money from the borrower pending resolution and foreclosure. All of these factors must be considered by a prospective loan purchaser.

2. Review of Loan Files

The first step for a buyer is to seek to review as many of the selling lender’s files as possible, including of course, the full set of loan documentation and any appraisals. Of course, the Buyer will want to have its own appraisal, environmental report and other building condition studies.

The files may contain attorney-client privileged correspon-dence, internal analyses of the borrower’s financial condition, internal audits (if permitted to be shown outside the seller by applicable law), and the collateral value, and strategy memoranda. There may also be a closing memorandum detailing the list of closing documents and perfection, filing and recording details which can be very useful. In addition, there may be an organizational chart showing the relationship among the players. In all events, a careful seller will have counsel review the files first to segregate out such confidential materials. Among the documents which must be reviewed are the following, some of which are dependent upon whether the property is an office building, a shopping center, hotel or resort, apartment complex, incomplete single family subdivision, condominium development, mixed use project, research and development, or warehouse, and construction or permanent financing:

• Loan Agreement

• Promissory Note

• Deed of Trust or Mortgage (recorded copy)

• Assignment of Rents and Leases (recorded copy)

• Guaranty (payment and/or completion, limited or full, debt service)

• Security Agreement (for personal property assets of the project)

• UCC Financing Statements, amendments (filed copies)

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• Deposit Account Control Agreement (to control the cash flow of the borrower)

• Pledge Agreement (equity in borrowing entity)

• UCC,6 Federal and State Tax, and Federal and State Judgment Search Report

• Title Insurance Policies and Copies of Recorded Documents identified in policies

• Evidence of Zoning Classification

• ALTA (if available) Survey

• Collateral Assignments (Construction Contract, Management Agreement, Liquor License, Architect’s Agreement, Engineer’s Agreement, Environmental Consultant Agreement, Permits, and Development Agreements)

• Environmental Reports

• Soils Report

• Structural Engineering Report

• Letters from Consultants allowing reliance on reports.

• FIRREA Appraisal (The Financial Institutions Reform Recovery and Enforcement Act of 1989, Public Law No. 101-73, 103 Stat. 514 (August 9, 1989))

• Non-Disturbance and Attornment Agreements

• Subordination [Non-Disturbance] and Attornment Agreements

• Estoppel Certificates from Tenants

• FIRPTA Affidavits ((Foreign Investment Real Property Tax Act (Internal Revenue Code Section 1445))

• Letters of Credit

• Subordination Agreements (debt subordination or lien priority subordination or both)

• Participation Agreements

6. The UCC financing statement search should show the seller’s filings so that the

priority of the security interest perfected by the filing of such statement(s) should be determinable.

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• Intercreditor Agreements

• Inventory of Furniture, Fixtures and Equipment

• Rent Roll and Copies of Leases

• Ground Leases

• Opinion Letters7

• “Side Letter” agreements (agreements which contradict or waive some provision of the loan documents)

• Post-closing agreements and agreements identifying documents not yet signed or not yet delivered)

3. Execution of Non-Disclosure Agreement

Secondly, the seller should have the prospective buyer execute an appropriate non-disclosure agreement in which the buyer agrees to return all originals and duplicate copies of the file if the deal does not go forward. If the seller is a financial institution, seller’s counsel should make sure the disclosures comply with customer privacy laws. Additionally, the seller should check the loan documentation to determine if there are any contractual restrictions on disclosing the borrower’s tax returns, financial statements, and other confidential information, and determine if there is a list of assignees (buyers) the seller has agreed to exclude from the list of potential buyers of the loan. In some cases, an influential borrower may have negotiated for the right to approve any assignee of the original lender. Obtaining the borrower’s prior written consent would be an important step.

4. Considerations for Forbearance or Workout Agreement

If a lender is even remotely considering the sale of the loan, then it must be careful before entering into any forbearance or workout agreement with the borrower because of the economic and practical decisions typically contained in those types of agreements. For example, if the lender agrees to a reduced interest

7. Although legal opinion letters are not necessarily assignable to a loan buyer, a

review of such opinions is important because it may reveal an unexpected legal issue that confronted the seller at the time its loan was made as well as useful information regarding loan structuring issues and enforcement procedures.

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rate, a revised amortization schedule, or revised stated maturity date, or release of some security, or a waiver of existing defaults, it can have a direct impact on the marketability of the loan, again depending on the intention and timing of the prospective buyer to hold the loan or to enforce it.

On the other hand, having a recent reaffirmation of the loan agreement (and the guaranty by the guarantor) and a waiver and release of any lender liability claims by the borrower and guarantor (as well as a representation that the borrower has no offsets to the loan or counterclaims against the seller) in a well-drafted forbearance agreement or workout agreement can increase the attractiveness of the loan to a buyer. Further, if there are drafting or perfection issues in the original loan documents or guaranty, these can be addressed in the forbearance or workout agreement and reduce the potential discount to the sales price of the loan.

B. Due Diligence Checklist

For purposes of this article, we have assumed that the prospective buyer will be purchasing the loan for investment and not for immediate foreclosure. Even if the loan is intended for immediate foreclosure by the buyer, many of the same steps should be taken to ensure that the buyer is not opening itself up to counterclaims for lender liability and other causes of action by the borrower.

For example, it is somewhat common for a lender which has just accelerated a loan and commenced the foreclosure process, to be notified by the borrower that the lender has breached some type of obligation to the borrower such as a written or oral commitment to continue to provide funding or to provide refinancing of the existing indebtedness.8 In response to the waive of lender liability lawsuits in the 1980s and 1990s, a number of states have adopted additions to their statutes of fraud to require commitments to lend to be in writing. For example, California Civil Code Section 1624(g) provides that any “…contract, promises, undertaking, or commitment to loan money or to grant or extend credit, in an amount greater than one hundred thousand dollars ($100,000), not primarily for personal, family or household purposes, made by a person engaged in the business of lending or arranging for the lending of money or

8. See, Commercial Nat. Bank of Beeville v. Batchelor, 980 S.W.2d 750, 131 Ed.

Law Rep 536 (Tex. App. Corpus Christi 1998).

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extending credit” must be in writing to be enforceable. Similarly, the Illinois Credit Agreements Act, 815 ILCS 160/0.01 et seq., provides that a debtor may not maintain an action on or in any way related to a credit agreement (which is defined to include a commitment to lend money for business purposes) unless the agreement is in writing, expresses a commitment to lend money, sets forth the relevant terms and conditions, and is signed by the debtor and the creditor.9 Under the statute of frauds in many states, the writing can be satisfied by emails.10 Nonetheless, borrowers continue to assert such arguments in the hopes that a court will accept a bad faith argument, estoppel, or some form of tortious conduct such as misrepresentation. If there is any suggestion of some sort of refinancing or workout commitment, then the buyer would be well-advised to interview the seller’s employee responsible for the relationship and any relevant emails.

1. Contents of Loan Files

The lender’s loan file should contain the loan application, the list of closing documents required to close the loan, all borrower and guarantor financial statements and tax returns, loan application, required disclosures (if any), loan covenants and lending and other debt ratios, periodic loan covenant and loan compliance certificates, budgets, sources and uses of loan proceeds, sources of equity, identification of all investors in the borrower entity, and the correspondence with the borrower and any guarantor, indicating previous defaults and corresponding waivers and nature of the defaults and cures. Of course, one of the most important documents in the files may be the notice of default by the seller to the borrower, the nature of the defaults (money, performance of an obligation, failure to pay taxes or insurance, insolvency, etc.) and to whom the notice was sent and by what means. As noted below, the notice provisions of the loan documents must be strictly observed, and if there is a guarantor, notice must be given to the guarantor with observance of the timing and method of notice.

In addition to the lender’s files, a prospective buyer should obtain and review each of the following documents with a focus on the particular highlighted provisions within each. These

9. La Salle Business Credit, Inc. v. Lapides, 2003 WL 722237 (N.D. Ill.) 10. Electronic Records in Global and National Commerce Act, 15 U.S.C. 7001(c) et

seq.

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documents (included in the list above) must be carefully scrutinized by buyer’s counsel to determine if there were any errors in the loan documents or missing documentation based on the scope and nature of the collateral. The following analysis will focus only on the primary “real estate” related documents.

a. Promissory Notes

There are a variety of ways in which the preparation and execution of a note can create ambiguities if not enforcement problems.

(1) Signatures

Under Sections 3-402(a) and 3-402(b)(1) of the Uniform Commercial Code, if a borrower is a non-individual (i.e., a corporation), and the person signing the note indicates that he or she is signing the note in a representative capacity (i.e., president or vice president), the individual signing the note is not personally liable on the note, and the named borrower is liable if the document and the signer were duly authorized by the borrower to execute the note by the particular person signing the note. However, if a note is simply signed by an individual with no representative capacity indicated, then under Section 3-402 of the Uniform Commercial Code, the person signing the note (and not the arguably represented party, i.e., the borrower) is liable on the note. If the buyer does not qualify as a “holder in due course” under Section 3-302 of the UCC (in which case only the signer is liable), then representative must prove that the original parties did not intend the representative to be liable on the instrument (see, Section 3-402(b)(2)).11

Further, the buyer must determine that the borrowing entity duly authorized the execution and delivery of the note (and the other loan documents) by appropriate action and resolutions. For example, the buyer should review the articles or certificate of incorporation and bylaws, or partnership agreement, or limited liability company

11. See Federal Deposit Insurance Corporation v. Woodside Construction, Inc., 979

F.2d 172 (9th Cir. 1992), for an excellent discussion of these issues.

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operating agreement, to determine how many signatures are required to bind the legal entity and whether the entity has the power to borrow money and grant liens and security interests. Also, by appropriate resolutions (or certificates), the borrowing entity must authorize the person or persons actually signing the loan documents by name or by title. Failing such authorization, an unauthorized signature is ineffective to bind the represented entity (borrower) under Section 3-403(a), although it may be later ratified.

If the relevant organizational documents require two signatures to bind the entity (i.e., president and secretary), then under Section 3-403(b), if one of the two signatures is missing, the represented entity (borrower) is not bound.12

(2) Other State Law Requirements

Some states require particular legends on notes to be enforceable. For example, the State of Washington requires the following: “The creditor shall give notice to the other party on a separate document or incorporated into one or more of the documents relating to a credit agreement. The notice shall be in type that is bold face, capitalized, underlined, or otherwise set out from sur-rounding written materials so it is conspicuous. The notice shall state substantially the following: “Oral

12. Note that under Section 3-416(a)(2), a person transferring an instrument for

consideration warrants to the transferee, among other warranties, that all signatures on the instrument are authentic and authorized. However, to qualify for the benefit of such warranties, the buyer must prove that the instrument is a negotiable instrument under Section 3104 of the UCC, which is not always a simple matter, especially if the terms cannot be determined from the “four corners” of the document. If a note’s interest rate is based on the prime rate or the London Inter-Bank Offer Rate, not all of the terms are within the “four corners” of the instrument and the note may not be negotiable. See, FDIC v. Hershiser Signature Properties, 777 F.Supp. 539 (E.D. Mich. 1991) (holding that the fact that the note contained a variable interest rate did not render it non-negotiable; the rate was tied to a readily ascertainable commercial index such that the interest could be readily calculated, so the note contained a promise to pay a “sum certain”6); but see Taylor v. Roeder, 234 Va. 99 (1987) (finding that a note providing interest at 3% over Chase Manhattan Prime, adjusted monthly, was not a negotiable instrument since the current interest rate could not be determined from the face of the note; changes in this conclusion should be made by the legislature, not the courts).

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agreements or oral commitments to loan money, extend credit, or to forbear from enforcing repayment of a debt are not enforceable under Washington law.”13

Other states, such as Florida, require an indication of whether the note was executed outside the state for documentary transfer tax purposes.14

(3) Interest Rate

The first inquiry must be whether the stated interest rates are within the usury limits of the state law governing the transaction (assuming that the choice of that state’s laws are valid in the first instance). For national banks and other federally chartered lenders, this is not an issue.15 For state-chartered banks and non-bank lenders, however, this is a real issue.

Sometimes a lender offering London Inter-Bank Offer Rate (“LIBOR”) options, may not actually invest in the LIBOR market, but simply measure the interest rate by the LIBOR market. Accordingly, the manner in which the applicable interest is computed may not be accurately described in the note. Also, the note may provide for LIBOR contract breakage fees if the note is prepaid or if there is a default prior to the stated maturity date. These types of provisions can lead to a Racketeer Influenced and Corrupt Organizations Act16 claim based on alleged interest overcharges.17

Some states focus on the purpose of the loan as the basis for their usury laws.18 Be certain that there is a usury savings clause which automatically reduces the effective interest rate to the maximum lawful amount in the event the stated interest rate or formulaic iteration causes the rate to exceed the maximum rate allowed by applicable

13. Wash Rev. Code 19.35.140. 14. Florida Statutes, ch. 201 et seq. 15. See, 12 U.S.C. § 385. 16. Chapter 96 of Title 18 of the United States Code, 18 U.S.C. § 1961–1968. 17. Sundance Land Corp. v. Community First Federal Sav. and Loan Ass’n, 840 F.2d

653 (9th Cir. 1988). 18. Illinois Compiled Statutes, Chapter 800 et seq.

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law.19 Also beware of post-default interest rate provisions which impose interest “at the highest rate allowed by applicable law.” At best the phrase is ambiguous and the highest rate may depend on the indentity of the lender or the borrower, and/or the purpose of the loan.

(4) Default

See the discussion, in Section C.2.i below, in connection with due diligence in reviewing loan agreements.

(5) Statute of Limitations

Attention must be paid to the statute of limitations for enforcing notes. Although Article 3 of the UCC is generally more uniform among the states than other Articles of the UCC, it is critical to check the relevant state’s version of Section 3118 for the applicable statute of limitations. In California, for example, a holder has six years from the stated maturity date (or date of acceleration) under Section 3118 in which to commence an action to collect the note. (Different rules apply to demand notes). Although there is a ten year statute of limitations for a deed of trust with a stated maturity date (and sixty years for a deed of trust without a stated maturity date in California), the deed of trust secures the payment of the note.20 If the note is no longer enforceable, then it should follow that the security for the note is no longer enforceable. California Civil Code Section 2911 provides “that a lien is extinguished by the lapse of time within which an action can be brought upon the obligation.” However in Nicolopulos v. Superior Court (Bourgeois, Real Party in Interest), 2003 Cal. App. LEXIS 226, the California appellate court could not ascertain the maturity date from the deed of trust itself and therefore permitted the exercise of the power of sale in the deed of

19. In some states, the question of usury is based on the purpose of the loan, i.e.,

business purposes, to what kind of entity is borrowing the money, i.e., corporation (Illinois), and in some states, it depends on whether the lender itself has an appropriate license to exceed the stated statutory maximum rates (California).

20. California Marketable Title Act, Civil Code Sections 882.020-882.040.

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trust even though the underlying obligation may have matured more than ten years previously.

(6) Recourse or Non-Recourse

Is the loan transaction recourse to the borrower or non-recourse or limited recourse (for the so-called bad boy acts, such as fraud, misappropriation of funds or insurance proceeds, waste, and the like)? If at all recourse, does the borrower have the financial ability to respond to a claim or does the guarantor? Most real estate borrowers are organized as single purpose entities meaning they own only the particular project. This is done for a variety of reasons, chief among which are to insulate the principal’s equity from other assets owned by the principal. E.g., if the principal defaults on the loan on this project, it won’t affect its ownership of the other projects it may own. Another major reason is the attempt to make the entity bankruptcy-proof so that a lender will lend to this entity without worry about the principal’s (or sole shareholder’s or sole member’s) other financial dealings adversely affecting the borrowing entity.

The advantages of a single purpose entity may have shifted in a significant way because of several key holdings in In re General Growth Properties, Inc., et al., Case No. 09-11977, pending in the United States Bankruptcy Court for the Southern District of New York. In that case, the court consolidated the parent and approximately 200 subsidiaries that filed Chapter 11 together, despite the fact that each subsidiary was a bankruptcy remote, single purpose entity that owned a shopping center. Most of these separate subsidiaries had separate loans secured by its particular shopping center and many of which loans were fully performing. The court, on procedural grounds only, consolidated approximately 200 subsidiary shopping center entities (owned by the parent) for Chapter 11, for cash flow administration purposes. These cases bear serious study.21

21. On May 14, 2009, Judge Gropper entered an order granting General Growth

Property’s (GGP) motions to use net cash flow generated from properties encumbered by secured debt, and approved a $400 million debtor-in-possession loan from a group of lenders. In granting the motions, Judge Gropper stated that those measures were “necessary to prevent substantial harm to the Debtors’

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The court’s ruling has been positively received by the collateralized mortgage backed securities community and has been viewed as affirming the sanctity of single purpose entities. Note that the issue of whether the single purpose entity debtors could or should be substantively consolidated was not before the court. The various filings were procedurally consolidated only. The value of the non-consolidation opinions that inhabit the loan closing binders in countless real estate finance transactions has not yet been tested, but may be very soon.

2. Loan Agreement

The loan agreement typically contains the following provisions which a prospective buyer must review and evaluate with counsel:

a. Commitment to Lend

Although most loan agreements provide that any obligation to make advances under a line of credit cease upon a default, the buyer needs to check the precise conditions relating to any future obligation to make advances, and when and if the borrower has any right to cure the existing defaults in order to compel the lender to make additional advances. If all of the obligations to make advances have been satisfied by the borrower, but the seller still refuses to make advances (for example, on an incomplete construction project), the seller could be facing a lender liability lawsuit for the refusal to make the future advance, which lawsuit could embroil the buyer. A close review of the seller’s correspondence file should reveal a potential issue as well as the representations and warranties (i.e., no pending or threatened litigation or

estates that would otherwise result if the Debtors fail to obtain the [DIP] financing contemplated herein to preserve the Debtors’ assets and continue their operations.” However, Judge Gropper also ordered that the single purpose lenders were entitled to adequate protection of their interests in their respective prepetition collateral. The court ordered, among other things, that to the extent of the diminution in value of their prepetition collateral (as determined by the court), the single purpose lenders are entitled to postpetition perfected first priority liens on funds in GGP’s main operating account and intercompany claims among the Debtors based upon the property-specific net cash that flows into the Debtors’ centralized cash management system.

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claims) by the seller in the actual assignment agreement between the seller and the buyer.

The privity of the lien securing the payment of such future advances must also be analyzed. Are the advances obligatory (and therefore share the same priority as the initial advance) or are they discretionary (and possibly be subordinate to intervening liens) under applicable state law? Are the advances necessary to protect the priority of the lien, such as real estate taxes, or not?

b. Budget

If a construction loan, the buyer should seek an updated line item budget to determine where the shortfalls occur and the use of the contingency.22

c. Interest Rates

The buyer should determine what loan interest rates are available to the borrower pre and post-default and the adjustment mechanisms between and among interest rate selections. In particular, the buyer should note the post-default “default interest rate.” (The amount and conditions of payment of the late charge should be ascertained.) In particular, is the late charge a penalty or a valid liquidated damages clause under applicable state law.23

22. Construction loans for incomplete projects present a range of additional issues

beyond the scope of this article. However, in today’s environment, it is not uncommon for a construction lender to cease advances when the loan is materially out of balance (i.e., the remaining undisbursed loan funds are insufficient to cover the cost of completion without additional funds from the borrower or guarantor or investors), insufficient pre-sales of condominium or fractional interest units which are a condition precedent to further advances, work stoppage, permit issues, subcontractor defaults, sureties failing to honor payment or performance bonds, shortage of construction materials, defective work requiring replacement, environmental issues, and a variety of other construction-related issues. The decision of a construction lender to cease funding is a major one in view of the well-understood principle that an incomplete project may have less value than the raw land on which it is located.

23. See, California Civil Code, § 1671.

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d. Prepayment

Some loan agreements treat a default and acceleration as a prepayment event, triggering the payment of the prepayment penalty. If a buyer is counting on the collection of a prepayment penalty under a default circumstance, it needs to consult with counsel as to the enforceability of the provision under applicable law. Some lenders have asserted that, in the absence of such provision, a borrower could intentionally default on the loan to avoid a prepayment “lock-out period” or the imposition of a prepayment penalty provision which has not yet expired under the loan documentation.24

e. Taxes and Insurance Impounds

The buyer should determine if there are such impounds required, and if yes, but not yet implemented, whether the existing defaults trigger the impound requirement. If there are existing impounds, they would typically be transferred to the buyer along with the loan. The seller should verify balances for the buyer.

f. Syndicated Loan

If the loan to be acquired has been syndicated, such situation raises a host of issues which are beyond the scope of this article. Essentially, the buyer would be acquiring “pieces of the loan” from each syndicate member or perhaps buying the position of one or more syndicate members but not the entire loan. The assignment agreement should clearly indicate that the seller holds 100% of the loan at the effective date of transfer to the buyer.

g. Warranties and Representations

These provisions (and accompanying schedules) should be reviewed to alert the buyer of any exceptions to the stated warranties and representations. For example, environmental

24. See, In re Skyler Ridge, 80 B.R. 500 (Bankr. C.D. Cal. 1987); In re Kroh Bros.

Dev. Co., 88 B.R. 997 (Bankr. W.D. Mo. 1988), and In re A. J. Lane & Co., Inc., et al., 113 B.R. 821 (Bankr. Mass. 1990).

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exceptions, tax issues, litigation and other material information will be an important factor in gauging risk and price. Similarly, determining the zoning status of the property is essential, especially if there is a casualty and the property cannot be rebuilt as is.

h. Separate Tax Lots

The loan agreement should indicate whether the property is comprised of one or more separate tax lots and whether any portion of the property is located within a tax lot which contains land not covered by the deed of trust or mortgage.

i. Events of Default

The various events of default should be reviewed and the specific events of defaults creating the present default should be identified to make sure that the actual events fall within the precise definition, and that all required notices have been given and applicable grace and cure periods have expired without a cure. If a seller relies on an “insecurity clause”25 as the sole basis of declaring a default under the loan documents and as the basis for accelerating the maturity date of the note, the risk of litigation increases dramatically. Similarly, if the precipitation default is a transfer of a portion of the equity ownership in borrower, the buyer will have to evaluate whether the event materially impairs the risk to the lender and constitutes an enforceable event of default.

j. Remedies

Counsel for buyer should review the remedies provisions to make sure they are complete and current. For example, for

25. An insecurity clause allows the lender to accelerate the maturity date of a loan

when the lender has grounds to feel insecure with regard to the borrower’s ability to repay the loan or with regard to the value of the security for the loan. The Uniform Commercial Code allows a secured party (or seller or buyer) to provide for the option to accelerate the payment or performance of an obligation at will but requires that the determination be made in good faith. Under Section 1-208 of the UCC, the burden of establishing the lack of good faith is on the party against whom the power has been exercised. This is a commercial law, not real estate law concept and is a risky basis for accelerating a loan in the absence of any other default.

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a hotel property which has both real and personal property aspects, the remedies provisions should adequately cover the mixed collateral provisions of the Uniform Commercial Code and a unified sale under Section 9-604 of the relevant version of the Uniform Commercial Code. Such provisions give the buyer greater flexibility and protection in the event the buyer winds up in a foreclosure proceeding with the borrower.

k. Notices

Particular attention should be paid to the notice provisions to identify mandatory methods of notice and when such notices are deemed to become effective.

l. Forum Selection

The forum selection clause should be reviewed to determine any required forum, although typically, but not always, the forum will be the locale of the real estate collateral.

m. Jury Trial Waiver

Most states will permit a pre-dispute waiver of jury trial if it is properly set forth in the loan documents. Some states, such as California, have prohibited pre-dispute jury trial waivers even among commercial parties and even if clearly set forth in the documents.26 In states permitting non-judicial foreclosures, this may not be particularly relevant unless applicable state law permits a deficiency to be collected and the borrower is still solvent. However, where the borrower is a single purpose entity and there is a solvent guarantor, this is definitely a factor to consider in time and costs, and the absence of such waiver may be affect the price offered by the buyer for the loan.

n. Alternative Dispute Resolution

Many loan documents, especially construction loan agreements, require mediation and possibly arbitration of certain types of issues. This is simply one more factor the buyer must consider in acquiring a loan in default. For example, if the selling lender stopped funding a construction

26. See, Grafton Partners L.P. v. Superior Court, 36 Cal.4th 944 (2005).

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loan because of construction quality issues, those types of issues might have to be resolved through the alternative dispute resolution procedures.

3. Deed of Trust and Title Insurance Policy

a. Legal Description

The legal description contained in the recorded deed of trust should (1) track the survey exactly, and (2) match the legal description in the survey, which should match the legal description in the title policy. Check to see if there is an ALTA title endorsement form 116.1 insuring that the legal description in the survey matches the title policy. Also, if more than one legal parcel is encumbered, check for an ALTA endorsement 116.4, which insures the contiguity of such parcels and verifies that fact on the survey.

b. Title

Review the title of the document to see if it is also a security agreement, fixture filing and assignment of leases and rents. If so, make sure the operative grant language is contained in the document. For example, if it is also intended to be a fixture filing under the UCC, it must state that it is to be effective as a fixture filing near the top of the document so that the recorder can take notice of it. Also, it must conform to the requirements of Sections 9-502(a) and (b) to qualify as a fixture filing.

c. Document Legends

Some states require legends at the top of the deed of trust or mortgage if the lien secures a variable rate of interest, or if the lien is subordinate to another lien. For example, the following is a typical California header: CERTAIN OF THE PROPERTY COVERED BY THIS DEED OF TRUST CONSISTS OF GOODS THAT ARE OR WILL BECOME FIXTURES UPON REAL PROPERTY. ACCORDINGLY, THIS DEED OF TRUST ALSO CONSTITUTES AND IS FILED AS A FIXTURE FILING UNDER STATE OF CALIFORNIA COMMERCIAL CODE

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SECTION 9502(a) AND (b), AND SHALL REMAIN IN EFFECT AND BE EFFECTIVE AS A FIXTURE FILING UNTIL RELEASED OR SATISFIED OF RECORD OR THE EFFECTIVENESS OF THIS DEED OF TRUST, SECURITY AGREEMENT, FIXTURE FILING AND ASSIGNMENT OF RENTS OTHERWISE TERMINATES. TRUSTOR’S ORGANIZATIONAL NUMBER IS ________, AND TRUSTOR IS THE OWNER OF THE PROPERTY ENCUMBERED HEREBY.

THIS DOCUMENT SECURES FUTURE ADVANCES WHICH MAY BE MADE PURSUANT TO THE LOAN AGREEMENT (AS DEFINED IN THIS DOCUMENT) OR THIS DEED OF TRUST.

THIS DOCUMENT CONTAINS PROVISIONS FOR A VARIABLE INTEREST RATE AND SECURES, IN PART, THE [CONSTRUCTION] LOAN WHICH MAY BE MADE PURSUANT TO THE LOAN AGREEMENT (AS DEFINED IN THIS DOCUMENT) OR THIS DEED OF TRUST OR CERTAIN OTHER LOAN DOCUMENTS.

If the lien of the deed of trust is to be subordinated to another lien, California Civil Code section 2953.2 requires the word “SUBORDINATED” (in at least 10-point bold type) followed by a description of the security instrument, i.e., “Subordinated Deed of Trust.” Further, an 8-point bold type statement must immediately follow which states: “NOTICE: This subordination agreement (“may result” or “results” as appropriate) in your security interest in the property becoming subject to and of lower priority than the lien of some other or later security instrument.”

d. Description of Secured Obligations

Review the description of the obligations secured to make sure it comprehensively describes every type of indebtedness, payment obligation and performance obligation in the transaction, and future advances to protect the lien of the lender. Determine if any nonobligatory future advances will have priority over a lien recorded after the seller’s deed of trust or mortgage, out prior to the future advance.

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e. Scope of Grant Language

Review the “grant” language to make sure it (1) contains a trustee’s power of sale (in states where permitted), (2) comprehensively describes the security, including all of the real estate and improvements, easements, other real estate interests (gores, incorporeal heriditaments, etc.), and fixtures.

f. Security Interest

Does the deed of trust contain security interest grant language sufficient in scope to cover present and future fixtures and UCC types of collateral for the particular type of project? Is there a separate security agreement? If yes, make sure the remedies in the deed of trust and the separate security agreement are consistent in terms of enforcement against the types of collateral involved in the project.

g. Impound Accounts

Does the deed of trust require tax and insurance premium impound accounts before or after the occurrence of a default? (See comment in Section C.2.e., above, in analyzing the loan agreement.)

h. Casualty Insurance Provisions

What happens if there is a casualty event? Is the holder of the note required to allow the borrower to use the proceeds to rebuild the improvements? Does that remain the situation after the occurrence of a default? Some states require that the lender allow the use of the casualty proceeds for rebuilding if the lender’s security is not impaired. Section 2924.7(b) of the California Civil Code provides that the mortgagee may control the disbursement of the proceeds of a casualty loss regardless of whether its security interest has been impaired. Interestingly, the provision tells the courts how to interpret the new statute so as to prevent lenders from applying the insurance proceeds to the debt and prevent rebuilding. Specifically, Section 2924.7(b) states:

“The Legislature hereby declares that this act is not intended to abrogate the holding in the case of Schoolcraft v. Ross [citation omitted] insofar as it provides that a lender may not prohibit the use

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of insurance proceeds for the restoration of the security property absent a showing that the lender’s security interest in the property has been impaired.”

i. Transfers in Violation of Deed of Trust

Most deeds of trust contain a provision prohibiting the trustor from an outright transfer of the property without the prior written consent of the beneficiary (lender). However, most commercial deeds of trust describe a host of other acts that effectively prohibit the transfer of interests in the ownership entity holding the property and classify any such transaction as an event of default. A typical clause reads as follows:

As used herein, “transfer” includes (a) the direct or indirect sale, transfer, conveyance, assignment, mortgage, encumbrance, hypothecation or other alienation of the Property, or any portion thereof or interest therein by Trustor, whether voluntary, involuntary, by operation of law or otherwise, (b) the execution of any installment contract, sales or assignment agreement, deed or similar instrument affecting all or a portion of the Estate or the Premises, (c) granting of an option to purchase any portion of or interest in the Estate, (d) the creation of a lien or other encumbrance on the Leases or the Estate or any part thereof or interest in the Property, (e) the sublease or assignment of all or substantially all of the Premises or the Estate; and (f) a Change of Control (as defined in the Loan Agreement).

The critical issue is whether any single transfer event is so material as to impair the lender’s security and whether a court would agree with such assessment if the borrower seeks to restrain enforcement based on such default.

j. Leases

Some lenders require a separate assignment of rents and leases so that the assignment can be separately enforced without having to foreclose the deed of trust. In all cases, the assignment should be an absolute assignment with a license back to the trustor to collect the rents and to enter into leases until the occurrence of a default. The intent is to make the assignment present and absolute to avoid arguments in a bankruptcy proceeding that the assignment is contingent upon a default and therefore possibly an avoidable preferential transfer in bankruptcy. Depending on the type of property involved,

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most lenders specify the level of economics required for a proposed lease to be approved. This protection is significant if the buyer intends to engage in a workout of the loan rather than an enforcement of the loan documents. Such provisions should mandate the borrower require subordination and attornment protections in each lease of premises at the property. Such rights can also be very helpful in the event the buyer seeks a receivership of the property so that the receiver has such protections and has the power to require subordination and attornment provisions (and if necessary, to grant non-disturbance agreements), as well as tenant estoppel certificates.

k. Suretyship/Guaranty Waivers

If the trustor is not the borrower, but a related third party that is granting a lien on its property as additional security for the payment and performance of the loan obtained by the borrower which loan buyer is acquiring, then the buyer is well advised to make sure that the deed of trust contain appropriate surety/guarantor waivers.27 Without such waivers, the trustor would retain all of its surety/guarantor defenses under the deed of trust and the buyer would then need the consent of the third party pledgor to each agreement (changing any material aspect of the underlying documents) entered into by the borrower with the buyer as the assignee lender. Of course, it may still be prudent to obtain such consent so that any changes to the risk undertaken by the trustor (or any guarantor) is expressly agreed to, and the buyer does not chance a full or partial loss of the particular pledged collateral or full recourse to a guarantor.

27. In California, the distinction between sureties and guarantors has been abolished

by California Civil Code Section 787. California Civil Code Section 2787 states that “[a] surety or guarantor is one who promises to answer for the debt, default, or miscarriage of another, or hypothecates property as security therefor.” Cal. Civ. Code § 2787 (West Supp. 1999); see also Everts v. Matteson, 21 Cal. 2d 437, 447, 132 P.2d 476, 482 (1942) (“The suretyship relation . . . arises where two persons are under obligation to the same obligee, who is entitled to but one performance, as between the two who are bound, and one of them should ultimately bear the burden of the obligation.”). See, “California Commentary On The Restatement Of The Law Third, Suretyship And Guaranty,” The UCC Committee of the Business Law Section of the State Bar of California, Loyola of Los Angeles Law Review, Vol. 34:231.

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l. Condominium Projects

In projects in which the seller is the initial developer of a condominium project, it is important to check for the existence of provisions granting the lender in the deed of trust all of the trustor’s right, title and interest in and to any unsold units, common areas, development rights and any declarant and/or special declarant’s rights under the declaration of covenants, conditions and restrictions of record and the bylaws, both in the borrower’s capacity as a unit owner and as declarant. There should also be provisions dealing with partial releases and approval of sales prices.

m. Defaults

First, check to make sure the default provisions cross-default the loan documents amongst themselves. Then see if the default provisions cross-default to other lending relationships between the seller and the borrower (or affiliated entities), or between the borrower (or affiliated entities) and third party lenders. The focus is on the financial commitments of the principals of the borrower (or guarantor) on other transactions.

n. Remedies

Do the remedies cover the full range of options for lenders under applicable law? Does it contemplate mixed collateral in the case of projects with significant real estate and personal property collateral, such as a hotel or resort? Is the attorneys’ fees clause sufficient broad to cover attorneys’ expenses, court costs, consultants, expert witnesses, auditor fees, environmental studies, soils studies, brokerage fees, storage, fees in any appellate proceeding (and remand), bankruptcy proceeding and appeals (and remand) and the like? Does it cover optional remedies under applicable state law which must be in the agreement or otherwise not available?

o. Receivership Provisions

Check the completeness of the receivership provisions. In many states, if the document does not contain a specific list of the receiver’s powers (or make appropriate reference to a

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statute enumerating the powers), it will prevent a court from allowing the receiver to exercise the omitted powers.

p. Indemnification Provisions

With single purpose entities, the indemnification provisions may be functionally meaningless unless guaranteed by a solvent guarantor or otherwise secured.

q. Definition of Transfer

Does the definition of prohibited transfers by the borrower include transfers of the property outright, installment sale, master leases or leases or a significant portion of the project, changes in a significant percentage of the ownership interests in borrower or guarantor, and the like.28

r. Documentary Stamps

Does the deed of trust have the appropriate documentary revenue stamps affixed to it as required by some states such as Florida?

28. The following is a typical provision defining prohibited transfers: “A sale,

conveyance, alienation, mortgage, encumbrance, pledge or transfer within the meaning of this paragraph shall be deemed to include (i) an installment sales agreement wherein Trustor agrees to sell the Trust Estate or any part thereof for a price to be paid in installments; (ii) an agreement by Trustor leasing all or a substantial part of the Trust Estate for other than actual occupancy by a space tenant thereunder or a sale, assignment or other transfer of, or the grant of a security interest in, Trustor’s right, title and interest in and to any Leases or any Rents; (iii) if Trustor, any guarantor of all or any part of the Debt, if any, or any managing member or general partner of Trustor or Guarantor is a corporation, the voluntary or involuntary sale, conveyance or transfer of such corporation’s stock (or the stock of any corporation directly or indirectly controlling such corporation by operation of law or otherwise) or the creation or issuance of new stock by which an aggregate of more than 10% of such corporation ‘s stock shall be vested in a party or parties who are not now stockholders; (iv) if Trustor, any Guarantor, and managing member or any general partner of Trustor or any Guarantor is a limited liability company or a limited or general partnership or joint venture, the change, removal or resignation of a managing member, general partner or managing partner or the transfer of the membership or partnership interest of any managing member, general partner or managing partner; and (v) the removal or resignation of the managing agent for the Trust Estate or the transfer of ownership, management or control of such managing agent to a person or entity other than the general partner or managing partner of Trustor.

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4. Guaranty

In non-construction loans, it is common for lenders to require a payment guaranty, which is a guaranty of payment and not of collection.29 A guaranty of payment means that the lender may proceed against the guarantor without having to first attempt to collect against the borrower. What does the guaranty actually cover? Does it cover all payment obligations under the underlying loan agreement and note (and other loan documents) or is a limited guaranty (to principal and interest) or is it a percentage of debt guaranty or is it a last dollar guaranty or is the liability of the guarantor capped? Does it cover costs of enforcement for the lender, including attorneys’ fees and expenses, etc.? [See, Section 4.m. above].

In analyzing guaranties, it is important to consider the following additional provisions and concepts: a. Is the guaranty language unqualified and absolute or are there

any conditions to its enforcement? b. Are there multiple guarantors and are all of their obligations

the same, i.e., full payment guaranty, or are some limited in amount? Did each guarantor waive the order in which the lender enforces the guaranty?

c. Is there consideration for the guarantor’s promise? Is the guarantor a principal of the borrower? What is the benefit being conferred on the guarantor for providing the guarantor? The consideration must be able to withstand an attack on fraudulent conveyance and fraudulent transfer law under applicable state law and Section 548 of the Bankruptcy Code. Is there sufficient consideration for a subsidiary to guaranty the payment of a parent corporation or sister corporation’s debts?

d. What are the notice requirements, notice procedural requirements and time limits for giving notice, and when is notice required?

29. In construction loans, it is typical to have both a guaranty of payment and a

guaranty of completion by the guarantor (usually a principal of the borrowing entity). A guaranty of completion, on its face, may require the guarantor to pay for the cost of completing the construction of a project even if the cost of completion exceeds the actual amount of the construction loan.

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e. Has the guarantor waived all of the usual defenses available to a guarantor (surety), e.g., California Civil Code Section 2856?30 In the absence of a full set of waivers, the guarantor can assert the technical defenses available under common law and under statute, i.e., the guarantor did not consent to increased risk in writing involved in a loan modification, or the lender did not exhaust all security before proceeding against the guarantor, or the guarantor is entitled to the benefit of the security provided by the borrower to the lender before the lender proceeds against the guarantor. Does the guaranty provide a waiver or delay of subrogation until the lender has been paid in full so that at the time of payment by the guarantor, the guarantor does not have immediate rights to step into the shoes of the lender?

f. Does the guaranty allow the lender to apply (and if necessary reapply) the guarantor’s payments in the order and to the obligations selected by the lender in its discretion to avoid preferential transfer arguments?

g. Does the guaranty reinstate the guarantor’s obligations to the lender in the event that any payments received by the lender have to disgorged in a bankruptcy proceeding?

h. Has the seller released any one or more of multiple guarantors and if so, under what circumstances and documentation? A release of one guarantor or compromise of the liability of one guarantor may act to release the other guarantor(s).

i. Has the seller modified any of the terms of the loan documents without the written consent of each guarantor, e.g., a release or substitution of collateral, change in payment terms, etc.? Despite the language of the guaranty that the lender has the right to modify the terms of the loan documents without the consent of the guarantor and without waiving any liability of the guarantor, best practices dictate that the guarantor’s consent be obtained in each such case.

30. See, the following cases interpreting the scope of the waivers effectuated by

California Civil Code Section 2856: River Bank America v. Diller, 38 Cal.App.4th 1400 (1995); WRI Opportunity Loans II LLC v. Cooper, 154 Cal.App.4th 525 (2007); Commercial Money Center, Inc. v. Illinois Union Insurance Company, 508 F.3d 327 (6th Cir. 2007).

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j. Does the guaranty allow the lender to pursue multiple guarantors in such turn or order as the lender determines in its sole discretion so that it can pursue a deep pocket guarantor first?

k. Does the non-individual guarantor’s organizational documents authorize or prohibit guaranties by that entity? Does applicable law?

l. Has the non-individual guarantor authorized the execution and delivery of the guaranty (and the granting of a lien on any collateral for the guaranty obligation) by all necessary entity action, and has the person signing on behalf of the guarantor been duly authorized to do so by such action? Best practices is to check for a resolution that states that the execution, delivery and performance of the guaranty is in the best interests of the entity.

5. Environmental Indemnity

Environmental indemnity agreements are separate undertakings by the borrower and typically by the guarantor or principal in the transaction to protect a lender from exposure to hazardous waste contamination affecting the project, both during and after the deed of trust (mortgage) is released. During the term of the deed of trust, there are specific covenants addressing contamination and hazardous waste, both pre-existing and current. However, when the loan is foreclosed and the deed of trust is no longer of any effect. A well-drafted environmental indemnity covers both the term of the loan and thereafter. It is unsecured so that the foreclosure of the deed of trust will not extinguish any obligation secured by the lien granted in the deed of trust, and will therefore survive. The intention is that even if the applicable law is in a state with anti-deficiency and one-action rules such as California, such environmental indemnity will not be subject to such restrictions.31

If the lender either buys the property at foreclosure or accepts a deed-in-lieu of foreclosure and then discovers contamination, it will seek a deep pocket to reimburse it for the remediation. In measuring the effectiveness of the indemnity a buyer might acquire as part of the loan purchase, a buyer should consider the following:

31. See, California Code of Civil Procedure, Section 726.5.

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a. Types of Contamination and Hazardous Substances

What is the scope of the indemnity in terms of types of contamination and hazardous substances covered? Clearly, the scope should be as comprehensive as possible and include both generic descriptions and specific identification of types of prohibited chemicals. Typically, there will be exceptions and carveouts for types of chemicals typically used in the operation of the particular kind of project. In reviewing the seller’s file, check for a Phase I and Phase II environmental study which should be studied for evidence of actual or potential problems. Also, it is essential for the seller to have completed certain basic environmental due diligence to avoid liability in the event the seller becomes the owner of the project in the future and wishes to establish a defense under federal and state law.

b. Time Periods

The second aspect is the time scope of the indemnity. The indemnity should ideally cover the time period prior to the time the lien of the seller is placed against the project. If the seller financed the acquisition of the project, the borrower may have no better idea of the environmental risks and condition of the project than the financing seller, i.e., they both rely on Phase I (and if necessary, Phase II) environmental studies, a site inspection (including adjacent lands and uses of adjacent lands) and a review of title to determine if there is any indication of a prior hazardous use at the project. However, as between the seller and the borrower, the risk allocation militates in favor of imposing that risk on the borrower and borrower principal (or guarantor) signing the indemnity.

c. Damages

The third inquiry is the scope of the types and kinds of damages covered by the indemnity. Remediation of contamination can affect not just the project but adjacent and nearby land depending on the spread of the contamination. Accordingly, the scope should cover (i) investigation and remediation of any such contamination and violations of

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environmental laws, including the preparation of any feasibility studies or reports and the performance of any cleanup, remediation, removal, response, abatement, containment, closure, restoration, monitoring or similar work required by any applicable law, (ii) injury or damage to any person, property or natural resource occurring on or off the project, including the cost of demolition and rebuilding of any improvements on real property; (iii) all liability to pay or indemnify any person or governmental authority for costs expended in connection with any of the matters included within the document’s definition of damages; (iv) the investigation and defense of any claim, whether or not such claim is ultimately defeated; and (v) the settlement of any claim or judgment.

d. Environmental Insurance

An immediate inquiry should be made to see if there is environmental insurance and whether it is assignable to the buyer.

e. Environmental Assessments

The indemnity should also permit the seller to require periodic environmental assessments, again depending on the nature of the project and the use of the property.

f. Waivers

As with a guaranty, an environmental indemnity signed by a principal or other guarantor should contain comprehensive suretyship/guarantor defense waiver provisions.

6. Financing Statements

Although the personal property collateral in many real estate financings is secondary in importance to the real estate and improvements, a number of projects, such as hotels, include a lot of equipment, inventory, accounts and other types of UCC categories of collateral and must be closely scrutinized to make sure the security interests in such collateral have been properly and timely perfected. There may also be important intellectual property collateral, such as trade names, trademarks, and domain names. Among the most common problems in perfection status are

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(a) lapsed filings which were not timely continued during the last six months of the five year term of such filings, (b) improper description of the debtor’s name, (c) changes to the debtor’s name which are not corrected and which are seriously misleading to someone checking the records for possible security interests, (d) the debtor’s address changes without a timely correction, (e) the collateral is not sufficiently described or fails to include after-acquired property or property arising in the future, e.g., future accounts, equipment, etc., or (f) the UCC-1 financing statement was filed in the wrong governmental office instead in the appropriate state office in the state where the debtor is “located” according to UCC definitions.

7. Estoppel Certificates from Tenants

Sometimes the loan agreement (and sometimes the deed of trust or separate assignment of leases and rents) requires tenants of the underlying real estate project securing the loan to provide tenant estoppel certificates so that the buyer can determine if there are any claims against the borrower which remain to be addressed and the cost factor associated with any such remediation. If the purchase of a loan is to proceed, new estoppel certificates should always be obtained to ascertain whether any of the tenants has an unresolved claim against the borrower or is alleging a breach of the lease by the borrower, as landlord.

8. Review of Leases

In a commercial project with tenants, in addition to the typical lease review due diligence (not covered in this article), it is important to determine whether the original tenant is in possession, or whether there has been an assignment or sublease and whether the original tenant has been released from liability under the particular lease. There should be a sufficient paper trail to identify assignments and subleases, consents to lease assignments and subleases and lease assumptions.

9. Inspection

Most loan documents provide for inspection of the real estate project. The seller should arrange for such inspection by the buyer (structural, architectural, soils, engineer consultants) and other

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consultants to determine the condition of the project and any costs of remediation.

10. Contracts

The buyer should review all major contracts affecting the underlying real estate and the terms of such contracts. For example, a management contract should be terminable upon not more than 30 days notice. Many times poor management is the cause of a borrower’s default and the need to rapidly terminate and replace management may be critical to the buyer. Other key contracts include brokerage and sales contracts. The buyer should consider requiring the seller to terminate all undesirable contracts as a condition precedent to the sale of the loan.

11. Assignment of Contracts

Depending on the nature and pricing of a contract and the identity and reputation of the vendor, the buyer may wish to keep the vendor in place following the sale of the loan. Many loan agreements require the borrower to execute an assignment of contracts as part of the original closing. The buyer should review the collateral assignment of contracts which is typically one of the loan documents to determine if the buyer must first cure any existing defaults by the borrower before an assignment can occur, the timing of the cure, if required, any relevant notice provisions, and the like. The buyer may wish to obtain an estoppel certificate from the vendor to assure itself of the financial and default status of the particular contract.

C. Other Considerations

Multi-State Collateral. If a loan is secured by deeds of trust or mortgages encumbering real estate in different states, the process and order of enforcement by a lender must be carefully evaluated to avoid violations of applicable one action rules and anti-deficiency laws applicable to transactions governed by the substantive law of states such as California and other western states. For example, if a non-judicial foreclosure (trustee’s sale) is first brought in California, such type of enforcement precludes pursuing a deficiency judgment action against the borrower (and possibly the guarantor) if California substantive law is deemed to apply to the transaction.

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IV. EFFECT OF CHAPTER 11 BANKRUPTCY

Investors buying (or selling) defaulted commercial real estate secured loans should be mindful of the impact of a borrower’s bankruptcy on their secured loans. In the event of a chapter 11 bankruptcy by the borrower, secured lenders will need to take certain steps to protect their rights in the real estate collateral and their claims against the borrower.32 Given the precipitous decline in real estate values around the country, many secured lenders are “undersecured,” which means their claims exceed the value of the real estate collateral. In particular, an undersecured creditor should carefully consider whether or not to utilize the bankruptcy election under 11 U.S.C. § 1111(b)(2) (hereinafter, the “1111(b)(2) election”) to become fully secured for the full amount of its claim. Holders of secured loans should also be wary of potential challenges which may be brought by a borrower in bankruptcy (or a bankruptcy trustee), including possible claims for fraudulent conveyance, equitable subordination, and/or preferential transfer.

A. Conversion of Claims From Non-Recourse to Recourse

Many secured real estate loans are non-recourse, which means that, under non-bankruptcy law, the secured creditor must look only to the collateral for satisfaction of the debt and not the borrower’s other assets. However, in the event a borrower files a chapter 11 bankruptcy petition, an undersecured creditor’s non-recourse claim is converted to a recourse obligation under 11 U.S.C. § 1111(b)(1)(A).33

32. While secured lenders can take steps to protect their rights in bankruptcy cases, a

secured lender should proceed with caution in dealing with a bankrupt borrower to make sure no actions are taken which violate the automatic stay. A borrower’s bankruptcy filing gives rise to the automatic stay, which operates as a nationwide injunction preventing actions against the borrower or the borrower’s property. 11 U.S.C. § 362. The automatic stay becomes effective without prior notice and voids actions taken in violation of the stay. Bankruptcy counsel can assist real estate lenders in determining which actions may violate or implicate the stay. Depending on the circumstances, a lender may want to move for relief from stay to foreclose on the borrower’s property under 11 U.S.C. § 362(d). There are generally two separate grounds under which a lender may move for relief from stay: (1) for “cause” (including lack of adequate protection in the property), and/or (2) where the borrower does not have equity in the property and the property is not necessary to an effective reorganization. In addition, 11 U.S.C. § 362(d)(3) provides some unique provisions governing relief from stay with respect to single asset real estate.

33. This conversion applies while in chapter 11 bankruptcy and not in a chapter 7 liquidation.

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The conversion from non-recourse to recourse claims is an exception to the general concept that a bankruptcy law respects non-bankruptcy entitlements.34

The legislative intent of 11 U.S.C. § 1111(b)(1)(A) was to create an equitable balance between the secured lender’s right to receive fair treatment (by, among other things, protecting against unfavorable judicial valuations of the collateral) and the debtor’s ability to reorganize and retain encumbered real estate or other property. Thus, in a chapter 11 case, even a non-recourse creditor will retain an unsecured deficiency claim against the borrower’s bankruptcy estate. However, depending on the borrower’s financial condition, an unsecured claim may have little to no value in a borrower’s chapter 11 bankruptcy case. In instances where the borrower seeks to retain the real estate or other collateral and recovery on an unsecured deficiency claim is unlikely, a secured creditor should carefully consider whether to make the 1111(b)(2) election.

B. Effect of 1111(b)(2) Election

The 1111(b)(2) election permits an undersecured creditor to choose to become fully secured for the full amount of its claim regardless of the bankruptcy court’s valuation of the real estate collateral. While the intent of the election is fairly straightforward, courts and commentators have struggled to interpret the precise language of 11 U.S.C. § 1111(b)(2), which is, at best, vague and unhelpful.35 The application of the 1111(b)(2) election is perhaps best illustrated via a practical example.

For instance, presume that a creditor holds a $20 million note secured by real estate with a current value of approximately $15 million. In the event of a chapter 11 bankruptcy by the borrower, the creditor would maintain a $15 million secured lien in the property, and a general unsecured claim for the $5 million deficiency (to the extent there is recovery to unsecured creditors in the bankruptcy case, the $5 million claim would receive a distribution parri passu with other unsecured creditors). However, in the event the creditor utilizes the 1111(b)(2) election, it relinquishes its unsecured deficiency claim and obtains an allowed secured claim for

34. In some instances, this conversion means that a bankruptcy filing by the borrower

may actually be favorable to a non-recourse secured lender. 35. 11 U.S.C. § 1111(b)(2) provides that “if such an election is made, then

notwithstanding section 506(a) of this title, such claim is allowed.”

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the total amount of its $20 million claim pursuant to the borrower’s plan of reorganization.36

An undersecured creditor may jump at the opportunity to have the full amount of its claim treated as secured under a plan of reorganization, but the practical effect of the 1111(b)(2) election may not be as attractive as it first appears. While it is certainly true that the plan of reorganization must provide a payment stream or interest payments for the full amount of the $20 million claim, this may be discounted to the present value of the collateral (in this hypothetical, $15 million). Essentially, the creditor retains a note for the full $20 million, but the note is given a below market interest rate which is more akin to the market rate interest payment on a $15 million note. While the interest payment may not be substantially different from what the creditor would have received on the $15 million note, the creditor retains the upside if the real estate collateral increases in value. For example, if the borrower later sells the real estate collateral for $18 million, the creditor would recover all the sale proceeds since the face value of its note is $20 million.37

C. Limitations on 1111(b)(2) Election

There are several significant limitations to the 1111(b)(2) election, most notably:

• Collateral of Inconsequential Value: Where the secured lender’s interest is “inconsequential,” the lender may not make the 1111(b)(2) election. 11 U.S.C. § 1111(b)(1)(B)(i). The determination of whether the real estate collateral is of inconsequential value is largely a question of fact to be decided by the bankruptcy court. The Ninth Circuit Court of Appeals held that a controlling equity interest in the successfully reorganized debtor is not inconsequential. In re Tuma, 916 F.2d 488 (9th Cir. 1990).

36. Secured creditors should make sure to file a proof of claim in the borrower’s

bankruptcy case (setting forth the nature, amount and priority of their claims) before the claims bar date and follow any applicable claims procedures adopted by the bankruptcy court.

37. Without the election, the creditor would only recover the $15 million and the borrower would benefit from the $3 million increase in value. The non-electing creditor would retain its $5 million unsecured claim, but distributions to unsecured creditors would only take place if allowed secured, priority and administrative claims are paid or provided for in full.

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• Sales of Real Estate: The secured creditor (or class of secured creditors) may not exercise the 1111(b)(2) election where the creditor has recourse against the borrower on account of its claim and the real estate (or other collateral) is to be sold under the plan or under 11 U.S.C. § 363. 11 U.S.C. § 1111(b)(1) (B)(ii). As such, the election is often available only where the borrower seeks to retain the property.38

• Oversecured Creditors: Simple logic dictates that an oversecured creditor would not obtain any benefit from utilizing the election.

• Cases Other Than Chapter 11: The election is only available in chapter 11 cases. For example, a secured creditor would not obtain the benefit of the election if the borrower was liquidated under chapter 7 of the Bankruptcy Code.

D. Procedures for 1111(b)(2) Election

An electing creditor should consider the timing, class requirement (if applicable), and form of the election.

1. Timing

The election must be made before the conclusion of the hearing for approval of the Disclosure Statement.39 While the election is generally required to be made in writing, there is no prohibition against making the election orally at the Disclosure Statement hearing.

2. Numbers/Amount of Class Claims

Pursuant to 11 U.S.C. § 1111(b)(1)(A)(i), the election must be made by at least two-thirds in amount and more than one-half in number of the allowed claims in a class. If the secured real estate creditor is classified separately (i.e., in its own class under a debtor’s proposed plan), this requirement is irrelevant.

38. The primary reason for this exception is that in the event of a sale, a secured

creditor generally has the right to credit bid its debt and seek to recover the real estate collateral.

39. Or within such later time as the Court may fix. See F.R.B.P. 3014.

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3. Form of Election

Unless provided by local rule, there is no mandated form for the 1111(b)(2) election. The electing creditor should generally file a written election with the Bankruptcy Court.40 The form of such election should contain language which references the applicable Bankruptcy Code section and rule, such as:

[ABC Corp.] hereby elects to have its secured claim against the Debtors in the above-titled chapter 11 cases treated under 11 U.S.C. § 1111(b)(2) and Federal Rule of Bankruptcy Procedure 3014. In conjunction with this election, [ABC Corp.] respectfully submits that the real estate collateral subject to its lien is not of inconsequential value and, upon information and belief, will not be sold by the Debtors under a plan of reorganization or under 11 U.S.C. § 363.

E. Strategic Considerations—To Elect or Not to Elect

The secured creditor should carefully deliberate whether or not to utilize the 1111(b)(2) election in a borrower’s chapter 11 case and consultation with bankruptcy counsel is strongly advised. A secured creditor should be particularly mindful that there are significant variables which may influence a decision to elect under 1111(b)(2), including but not limited to (1) projected recovery to unsecured creditors, (2) the prospect for increase in value of the real estate collateral, (3) leverage over the borrower in chapter 11 case (such as ability to block plan confirmation) and (4) consequences of exercising and/or failing to exercise the election.

1. Recovery to Unsecured Creditors

In evaluating the 1111(b)(2) election, one of the key factors to consider is the prospect for recovery to unsecured creditors in the borrower’s bankruptcy case. If there is no reasonable chance of recovery to unsecureds, the secured creditor may not be giving up anything of value by foregoing its deficiency claim.41

The difficulty with this calculation is that precise projections of unsecured creditor recovery may be impossible. Frequently, a borrower’s Disclosure Statement provides an estimate of recovery to unsecureds, but such estimates are not always available or

40. The election could also be made via a proof of claim filed in the borrower’s

bankruptcy case. 41. However, as discussed further below, the secured creditor may be giving up

leverage to block confirmation of the borrower’s plan of reorganization.

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provided. Furthermore, ultimate recovery to unsecured creditors is often contingent on litigation (such as preference and/or fraudulent transfer litigation, claims objections, director and officer litigation, and insurance coverage litigation), which may significantly affect the amount of funds available for distribution to unsecured creditors. Consultation with bankruptcy counsel may assist a secured creditor in estimating the value of its deficiency claim and better evaluating the prospect of recovery to unsecured creditors.

2. Prospect for Increase of Collateral

A secured creditor should weigh the estimated value of its unsecured claim against the prospect for increase in value to the real estate securing its claim. As discussed, the creditor foregoes its unsecured deficiency claim when it makes the 1111(b)(2) election. On the other hand, the electing creditor retains the upside of an increase in value of its real estate collateral and benefits if the real estate is later sold at a higher price (since the creditor elects to be secured for the full amount of its claim). The 1111(b)(2) election may be the preferred option if the creditor believes that the real estate is undervalued by the court, or that the downturn in the market is only temporary.42

Given the declines in real estate values, secured creditors optimistic for a market rebound may be particularly willing to utilize the election. At the very least, the election prevents the borrower from obtaining a judicially depressed valuation in bankruptcy court and then retaining the benefit if it quickly sells the property for a higher price.43

3. Leverage

Retaining a large unsecured deficiency may provide an undersecured creditor with significant leverage over the borrower in the chapter 11 case. Without the 1111(b)(2) election, an

42. Timing issues in the borrower’s bankruptcy case may make the election more

difficult. For example, in some cases, the election is made prior to a court valuation of the collateral. In such cases, a secured creditor may consider moving to compel the judicial valuation or requesting additional time to make the election.

43. In fact, the 1111(b)(2) election was designed to protect secured creditors from precisely this situation and one of the principal purposes of the election is to permit undersecured creditors to obtain the benefit of any post-confirmation appreciation of value to the real estate.

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undersecured creditor may vote in two classes (one class for its secured claim and one class for its unsecured claim). Under the plan confirmation requirements of 11 U.S.C. § 1129, the borrower needs at least one impaired class to vote for the plan of reorganization. An impaired class must vote more than one-half in number and two-thirds in amount for the borrower to confirm its plan of reorganization.

With a large unsecured deficiency claim, a creditor may, in some instances, successfully block plan confirmation. For example, if there is just one class of unsecured claims of which the creditor’s unsecured deficiency claim forms the largest voting part, and the creditor decides not to make the 1111(b)(2) election, then the creditor can block acceptance of the plan notwithstanding the cram down provisions of 11 U.S.C. § 1129. See In re Boston Post Rd. Ltd. Partnership, 154 B.R. 617 (D. Conn. 1993), aff’d. 21 F.3d 477 (2nd Cir.), cert. denied 513 U.S. 109, 115 S.Ct. 897. The ability to block plan confirmation provides an important bargaining chip for a creditor, which can be utilized to obtain more favorable treatment in the borrower’s bankruptcy plan or serve as the “nail in the coffin” leading to foreclosure of the real estate collateral.44

44. In order to avoid a situation where a lender can effectively block plan

confirmation with a large deficiency claim, a borrower may attempt to separately classify the lender’s deficiency claim from other unsecured creditors. There is some disagreement among the courts as to whether the plan may separately classify similar claims, or whether it must classify similar claims together. Claim classification may be an important strategic factor for a creditor in deciding whether to utilize the 1111(b)(2) election. Many courts, including those in the Ninth Circuit, have found the separate classification of an unsecured deficiency claim impermissible. For instance, in the case In re Tucson Self-Storage, Inc., 166 B.R. 892 (9th Cir. B.A.P. 1994), the court ruled that the separate classification of a secured creditor’s unsecured deficiency claim from other unsecured creditors was improper, where it was for the sole purpose of gerrymandering an accepting impaired class and where there was no business or economic justification for separate classification. See also In re Barakat, 99 F.3d 1520 (9th Cir. 1996) (ruling that separate classification of deficiency claim of the holder of a deed of trust was not permitted); In re Greystone III, 995 F.2d 1274, 1278 (5th Cir. 1991), cert. denied, 506 U.S. 821 (1992); but see In re ZRM-Oklahoma Partnership, 156 B.R. 67, 70 (Bankr. W.D. Okla. 1993) (noting that the plain language of the statute does not alone support any other restriction than prohibiting the single classification of dissimilar claims).

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4. Consequences of Failure to Elect

The main consequence of failing to make the 1111(b)(2) election is that the creditor’s secured claim will be valued under 11 U.S.C. § 506(a). Under 11 U.S.C. § 506(a), the creditor’s lien is limited to the value of the property. See In re Weinstein, 227 B.R. 284, 292 (9th Cir. B.A.P. 1998).45 In addition, certain courts have held that a non-recourse creditor which fails to make the 1111(b)(2) election does not have a corresponding right to credit bid its unsecured deficiency claim. In re Broad Association Limited Partnership, 125 B.R. 707 (Bankr. D. Conn. 1991).46

F. Fraudulent Transfer Claims

Secured lenders should be cognizant that a borrower in bankruptcy (or a trustee) may challenge pre-bankruptcy transfers as fraudulent conveyances under 11 U.S.C. § 548. These fraudulent transfer provisions allow the borrower to essentially undo certain pre-

45. Of course, as discussed previously, this consequence must be weighed against the

consequences to an electing creditor of foregoing its unsecured claim and ability to vote in two classes.

46. The rights of a secured creditor in the event a borrower seeks to sell the property in bankruptcy, while outside the focus of this article, is nonetheless an important and timely topic. In light of depressed real estate values, borrowers (especially those with no equity in the property) are utilizing the bankruptcy process to sell real estate assets either through a bankruptcy plan or via the provisions of 11 U.S.C. § 363 (a ”363 sale”). Certain courts have held that secured creditors have an absolute right to credit bid at a 363 sale, which vitiates the need to value the collateral under 11 U.S.C. § 506(a). In re Kent Terminal Corp., 166 B.R. 555, 567 (Bankr. S.D.N.Y. 1994). While 11 U.S.C. § 363(k) explicitly provides that a creditor with an allowed secured claim may credit bid at the 363 sale, this provision does provide a limited exception to the right to credit bid, stating “unless the court for cause orders otherwise.” At least a few courts have found that the right to credit bid was not absolute where “cause” existed to deny the credit bid. In re Theroux, 169 B.R. 498 (Bankr. D.R.I. 1994) (finding cause under § 363(k) where there was gross inadequacy in price); In re Diebart Bancroft, 1993 WL 21423 (E.D. La. 1993) (finding cause under § 363(k) where there was a failure to adequately provide for a potentially prior lien). In recent years, borrowers are utilizing the 363 sale process to sell real estate free and clear of all liens, claims and interest pursuant to 11 U.S.C. § 363(f). Bankruptcy courts, particularly those in New York and Delaware, have been generally willing to approve 363 sales “free and clear” of claims, but a recent case in the Ninth Circuit may limit the circumstances in which 363 sales are utilized (at least in the Ninth Circuit) to sell assets free and clear. Clear Channel Outdoor, Inc. v. Knupfer (In re PW, LLC), 391 B.R. 25 (9th Cir. B.A.P. 2008). The Clear Channel decision has ignited significant debate among commentators, practitioners and courts.

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bankruptcy transactions, if a transfer of the borrower’s property was made, or an obligation was incurred by the borrower, which either (1) had at its purpose an intent to hinder, delay or defraud the borrower’s creditors, or (2) was made while the borrower was insolvent47 and the transaction did not provide the borrower with “reasonably equivalent value” in exchange for the property transferred or obligation incurred.

Under 11 U.S.C. § 548, the borrower (or trustee) may seek to avoid transactions made with two years of the bankruptcy filing.48 The statutory language of 11 U.S.C. § 548 is drafted broadly enough to cover almost any type of transaction. While a lender which engaged in actual fraud is clearly at risk to have the transaction deemed a fraudulent transfer, the more heavily litigated situations involve “constructive fraud” (i.e., where the borrower is insolvent and transfers property for less than reasonably equivalent value). This “constructive fraud” issue may be particularly relevant in the current real estate market where opportunistic investors are looking to acquire property at depressed prices.

1. Reasonably Equivalent Value

The key determination in constructive fraud cases, particularly for real estate transfers, is whether the debtor received reasonably equivalent value. Whether a pre-bankruptcy transfer of real estate or other property is made for “reasonably equivalent value” is a factual determination made by the court on a case-by-case basis.49 This determination turns on an analysis of the type and amount of benefit obtained by a debtor in return for the transfers. In re Image Worldwide, Ltd., 139 F.3d 574 (7th Cir. 1998). Courts will consider the “totality of the circumstances” in determining reasonably equivalent value. Peltz v. Hatten, 279 B.R. 710, 715 (Bankr. D. Del. 2002).

47. 11 U.S.C. § 548(a)(1)(B)(ii) includes, in relevant part, transfers where the

borrower was insolvent on the date the transfer was made or became insolvent as a result of the transfer, transfers leaving the borrower with unreasonably small capital, and transfers where the borrower intended to incur debts beyond its ability to pay.

48. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 extended the reachback period from one year to two years. Secured lenders should be cognizant that a bankrupt borrower or trustee may also utilize applicable state law fraudulent transfer provisions, many of which have longer reachback periods.

49. The term “reasonably equivalent value” is not defined in the Bankruptcy Code.

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2. Foreclosures

Investors who have purchased or otherwise acquired defaulted real estate loans sometimes elect to foreclose on the real estate securing their loans. Under applicable law, in the absence of actual fraud or collusion, a secured lender will have good defenses to allegations by a borrower that a pre-bankruptcy foreclosure constitutes a fraudulent transfer under 11 U.S.C. § 548.

The fraudulent transfer provisions of the Bankruptcy Code were applied to real estate foreclosure sales in the Fifth Circuit case of Durret v. Washington National Insurance Co., 621 F.2d 201 (5th Cir. 1980). The Durret case created a bright-line rule that a foreclosure sale which failed to realize seventy percent of the real estate’s fair market value constituted a transfer for less than reasonably equivalent value. The adoption of the “seventy percent test” was far from universal and many courts developed alternative theories to determine whether or not a foreclosure sale was a fraudulent transfer.50 The Supreme Court clarified this issue (at least partially) in the landmark case of BFP v. Resolution Trust Corp., 511 U.S. 531, 114 S.Ct. 1757 (1994), where it ruled that the price received at a regularly conducted, noncollusive foreclosure sale is, by definition, reasonably equivalent value.51 As such, under BFP, a mortgage foreclosure sale conclusively establishes reasonably equivalent value for the price obtained, as long as requirements of the applicable state’s foreclosure laws are met.52

While the BFP case clearly establishes that the price obtained at a judicial foreclosure sale is for reasonably equivalent value, the application of the BFP ruling to non-judicial foreclosures has been the subject of much debate. For example, the BFP decision did not specifically address whether the same rationale would apply to a non-judicial strict foreclosure, foreclosure by power of sale, tax foreclosure, or deed in lieu of foreclosure. Courts have reached different conclusions as to whether such non-judicial foreclosures conclusively establish reasonably equivalent value or whether

50. For example, the Ninth Circuit avoided applying the Durret rule and held that the

transfer took place when the mortgage was perfected and not when the involuntary foreclosure sale occurred, thus placing the transfer beyond the challenge period. In re Madrid, 725 F.2d 1197 (9th Cir. 1984).

51. The BFP ruling was a five to four decision authored by Justice Scalia. 52. California, as well as certain other states, similarly enacted state law provisions

which invalidate fraudulent transfers for regularly conducted foreclosure sales. See Cal. Civ. Code § 3439.08(e).

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non-judicial foreclosures can be challenged as constructively fraudulent.

For example, the bankruptcy court in the case In re Chase, 328 B.R. 675 (Bankr. D. Vt.), held that the BFP analysis did not apply to a strict foreclosure. In Chase, the court found if that foreclosure for less than seventy percent of fair market value carried a presumption against reasonably equivalent value, greater than ninety percent carried a presumption for reasonably equivalent value, and in between seventy percent and ninety percent should be evaluated under a totality of circumstances. See also Federal National Mortgage Association v. Fitzgerald, 255 B.R. 807, 810 (Bank. D. Conn. 2000) (ruling that state law did not accord a conclusive presumption of reasonably equivalent value to strict foreclosures). On the other hand, certain courts have expressly rejected the argument that BFP does not apply to strict foreclosures, particularly where there is no showing that the borrower has been denied procedural rights or that the foreclosure process contained irregularities. In re St. Pierre, 295 B.R. 692, 697 (Bankr. D. Conn. 2003).

Some cases have held that the reasoning of BFP applies to tax foreclosure sales, such that the amount obtained at the sale constitutes reasonably equivalent value (assuming compliance with state foreclosure laws). In re McGrath, 170 B.R. 78 (Bank. D. N.J. 1994); In re Russell-Polk, 200 B.R. 218, 220 (Bankr. E.D. Mo. 1996); In re Comis, 181 B.R. 145, 150 (Bankr. N.D.N.Y. 1994); In re T.F. Stone Co., Inc., 72 F.3d 466, 471 (5th Cir. 1995). Bankruptcy courts have applied the BFP holding to tax sales where the borrower’s rights are protected the procedures are sufficiently similar to those of a mortgage foreclosure sale under state law. However, not all courts have reached the conclusion that the BFP rationale applies to tax sales. In re Butler, 171 B.R. 321, 326 (Bankr. N.D. Ill. 1994) (finding that bids at tax sales were not related to valuation such that the rationale of BFP may not apply); In re Sherman, 223 B.R. 555 (10th Cir. B.A.P. 1998); In re Wentworth, 221 B.R. 316, 319 (Bankr. D. Conn. 1998).

There are still many unanswered questions in the wake of the BFP decision regarding a borrower’s ability to challenge non-judicial foreclosures as constructively fraudulent transfers. For example, it is possible that deeds in lieu of foreclosure may result in fraudulent transfers if the borrower is insolvent and does not receive reasonably equivalent value for the deed. As such, when

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taking a deed in lieu of foreclosure, a secured creditor incurs at least some risk of a future fraudulent transfer challenge if the value of the real estate is greater than the outstanding debt.53 Courts have also reached different conclusions as to whether a foreclosure under a land sale contract may result in a fraudulent transfer. See In re Vermillion, 176 B.R. 563 (Bankr. D. Or. 1994) (holding that a seller’s state law right to forfeiture under a land sales contract fell within rationale of the BFP decision and that the forfeiture was for reasonably equivalent value); but see In re Grady, 202 B.R. 120, 125 (Bankr. N.D. Iowa 1996) (ruling that BFP decision was inapplicable to foreclosure of a land sale contract because market forces did not apply and the amount paid was dependent solely on the outstanding balance).

Leveraged buyouts, inter-company guarantees and/or cross-collateralization in secured lending transactions may, under some circumstances, give rise to fraudulent transfers under 11 U.S.C. § 548. Likewise, the redemption of equity interest by a corporation of limited partnership may constitute a fraudulent transfer, where it represents an attempt to transform a failing investment into a secured creditor relationship. Buncher Co. v. Official Committee of Unsecured Creditors of GenFarm Ltd. Partnership IV, 229 F.3d 245 (3rd Cir. 2000).

G. Equitable Subordination

In bankruptcy, like outside of bankruptcy, secured lenders generally enjoy priority over other creditors. A borrower in bankruptcy (or a trustee) may seek to destroy that priority by alleging that a lender’s claims should be equitably subordinated to the claims of other creditors. While the circumstances under which a borrower can successfully make such claims are limited, lenders should nonetheless be aware that unfair, inequitable or egregious conduct pre-bankruptcy may spawn equitable subordination claims in a borrower’s bankruptcy case.

The Bankruptcy Code provides, in relevant part, that a court may “under principles of equitable subordination, subordinate for purposes of distribution all or part of another claim.” 11 U.S.C. § 510(c). Most courts considering equitable subordination have utilized the three-prong test originally set forth in the seminal case

53. For its protection, a secured creditor may consider obtaining an independent

appraisal of the property before accepting a deed in lieu of foreclosure.

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of In re Mobile Steel Co., 560 F.2d 692, 700 (5th Cir. 1977). A borrower seeking subordination of a lender’s claim must establish:

(1) the claimant engaged in some type of inequitable conduct, (2) the misconduct resulted in injury to the creditors of the bankruptcy or conferred an unfair advantage on the claimant, and (3) the subordination of the claim is not inconsistent with bankruptcy law.

Id.; see also In re Big Wheel Holding Co., Inc., 214 B.R. 945, 951-953 (D. Del. 1997) (noting that the purpose of equitable subordination is to see that injustice and unfairness is not done in the administration of the bankruptcy estate); see also, In re Universal Farming Industries, 873 F.2d 1334 (9th Cir. 1989) (ruling that equitable subordination was not available against purchaser of first trust deed where legally cognizable harm to creditors or unfair advantage was not demonstrated, and further concluding appeal was frivolous and awarding attorney’s fees and double costs).

1. Inequitable Conduct

The key element that must be demonstrated by a borrower to subordinate a lender’s claim is inequitable conduct. Generally, courts have found three categories that satisfy the inequitable conduct requirement: (i) fraud, illegality, breach of fiduciary duties; (ii) undercapitalization; and (iii) the claimant’s use of the debtor as a mere instrumentality or alter ego. In re Herby’s Foods, Inc., 2 F.3d 128, 131 (5th Cir. 1993).

The severity of inequitable conduct necessary for equitable subordination depends on whether “insiders” are involved.54 An equitable subordination claim arising from the dealings between a debtor and an insider is to be rigorously scrutinized by the courts, whereas if the claimant is not an insider then evidence of more egregious conduct such as fraud, spoilation or overreaching is necessary. In re Fabricators, Inc., 926 F.2d 1458, 1465 (5th Cir. 1991).

Certain courts have held that claims of lenders will not be equitably subordinated in the absence of egregious misconduct.

54. If the debtor is a corporation, the Bankruptcy Code defines insider to include the

following: (i) director of the debtor; (ii) officer of the debtor; (iii) person in control of the debtor; (iv) partnership in which the debtor is a general partner; (v) general partner of the debtor; (vi) relative of a general partner, director, officer, or person in control of the debtor. 11 U.S.C. § 101(31)(B).

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For example, the Delaware bankruptcy court held that equitable subordination was not warranted, even though a subsequent secured lender took its lien in violation of a prior creditor’s negative pledge clause. In re Epic Capital Corp., 2003 WL 683165 (Bankr. D. Del. 2003). Similarly in the case In re Clark Pipe and Supply Co., Inc., 893 F.2d 693 (5th Cir. 1990), the court found that the conduct of a lender who reduced its loans to the borrower and carefully monitored the borrower’s operations was not so inequitable as to justify subordination of the lender’s secured claim. Rather, the lender merely exercised those rights reserved to it under a typical arm’s-length financing arrangement. The court in Clark noted that while lenders always exercise some control over borrowers because of the lender’s ability to foreclose or reduce funds in the event of default, this alone does not warrant taking away the secured lender’s priority unless the lender exercises such total control to have essentially replaced the borrower’s decision-making capacity with that of its lender. Id.; see also In re Kham & Nate’s Shoes No. 2, Inc., 908 F.2d 1351 (7th Cir. 1990) (in overturning a bankruptcy court ruling of equitable subordination, the appellate court ruled that while a bank’s refusal to advance funds left the borrower scrambling for credit, the bank did not create the borrower’s need for funds and was not contractually obligated to satisfy the borrower’s desires).

2. Loans to Undercapitalized Corporate Debtors

Claims based on loans to undercapitalized debtors have also been subordinated on equitable grounds. However, subordination on this basis is generally only available for loans from insiders.55 Equitable subordination of loans to corporations which are not adequately capitalized may be particularly appropriate where no other disinterested investor would have extended credit to the corporation, where payments are linked to the borrower’s financial difficulties, or where an insider took equity in exchange for the loan. While lenders should be especially cautious when extending credit to an undercapitalized debtor, a borrower may have difficulty establishing equitable subordination without showing gross misconduct. In re Dry Wall Supply, Inc., 111 B.R. 933

55. An arm’s-length lender is clearly not an insider, but a lender which exerts

substantial control over the borrower may risk being deemed an insider for equitable subordination purposes.

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(D. Colo. 1990) (absent evidence of gross misconduct in the financing agreement, the court found equitable subordination inappropriate with respect to the claim of a successor to a lender that financed a LBO of a corporate debtor, despite the trustee’s contention that the lender knew, or should have known, that the loan transaction would render the debtor insolvent, and that it was made without adequate consideration).

H. Preferential Transfer

In the event of a bankruptcy filing of the borrower, pre-bankruptcy payments to lenders (and other parties) are sometimes challenged as preferential transfers under 11 U.S.C. § 547. To establish an avoidable preference, a borrower must demonstrate the following:

• a transfer of the borrower’s interest in property;

• made on or within ninety days before the date of the bankruptcy filing;56

• to or for the benefit of a creditor;

• for or on account of antecedent debt owed by the borrower before such transfer was made;

• made while the borrower was insolvent; and

• that enables the creditor to receive more than it would receive in a chapter 7 liquidation.

11 U.S.C. § 547(b). The purpose of the preference provisions are to facilitate the bankruptcy policy of equality of distribution among creditors and to deter creditors from racing to the courthouse to dismantle a debtor during its tumble into bankruptcy. See H.R. Rep. No. 595, 95th Cong., 1st Sess. 177 (1977).

If a creditor is required to disgorge pre-bankruptcy payments as an avoidable preference, the creditor is entitled to an unsecured claim for such amounts under 11 U.S.C. § 502(h). With pre-petition transfers from borrowers to lenders, preference allegations may arise in many different contexts, but may be particularly applicable to lien perfection issues and payments of interest.

56. The reachback period is extended to one year if the creditor was an “insider” at

the time of the transfer.

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1. Perfection of Security Interest

When buying a real estate loan in default, this article emphasizes the importance of thorough and proper due diligence by the investor or purchaser. Proper documentation of the security interest and perfection of the loans becomes even more critical in the bankruptcy process, where a borrower, trustee or other creditor may seek to challenge the priority of the liens.

In particular, if a lien is not properly perfected prior to the bankruptcy, the lienholder will be treated as a general unsecured creditor. Furthermore, the act of perfecting a lien during the ninety day period prior to the bankruptcy may be deemed avoidable as a preference under 11 U.S.C. § 547(b), since the final act of perfection will be deemed a transfer of the borrower’s interest in property for preference avoidance purposes. See In re Taylor, 390 B.R. 654, (9th Cir 2008) (under the Bankruptcy Code, a transfer of a security interest does not occur, for preference avoidance purposes, until after all of the steps related to perfection are completed, and the interest is perfected under state law); see also In re QMECT, Inc., 373 B.R. 100 (Bankr. N.D. Cal. 2007) (transfer of security interest occurs, for preference purposes, when security agreement is signed or when security interest is perfected by recordation, as long as debtor owned the asset which serves as creditor’s collateral when security documents were executed).

If an investor or secured creditor discovers defects in the perfection of the loans, such defects should be remedied immediately.57 When a borrower files bankruptcy within ninety days of perfection of a lien, the holder of such lien faces the unpleasant prospect of having the lien avoided as preferential and receiving the same treatment as other unsecured creditors.

2. Payments of Interest or Principal by Borrower

While borrowers may, in certain cases, attempt to recover pre-bankruptcy payments made to real estate lenders within ninety days of the bankruptcy as preferential, real estate lenders possess strong arguments to counter such challenges. If a lender is fully secured, certain courts have ruled that there cannot be a preferential payment. In re Telesphere Communications, Inc. 229 B.R. 173 (Bankr. N.D. Ill. 1999). This is because if there is

57. Assuming, of course, the borrower has not already filed for bankruptcy.

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sufficient collateral to fully secure the creditor’s claim, then the claim would have been paid in full in a chapter 7 case, so that the creditor would have been in the same situation as the one produced by the pre-bankruptcy payment. Id. Even if a creditor is not fully secured, a payment made within the ninety day preference period will not be preferential if it comes from the collateral securing the loan thereby reducing the secured portion of the indebtedness.58

In the context of real estate lending, pre-bankruptcy payments of interest within ninety days of a borrower’s bankruptcy may meet the required elements for a preferential transfer. However, the Bankruptcy Code provides an important exception to preference avoidance protecting transfers for payments of debts “incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer is (A) made in the ordinary course of business of financial affairs of the debtor and the transferee; or (B) made according to ordinary business terms.” 11 U.S.C. § 547(c)(2), (hereinafter, the “ordinary course of business exception”).

Under well established Supreme Court precedent, both short term and long term interest payments may qualify for the ordinary course of business exception. Union Bank v. Wolas, 502 U.S. 151 (1991).59 In Union Bank, the Supreme Court reversed a Ninth Circuit Court of Appeals decision which held that the ordinary course of business exception was not available to long-term debt. In so doing, the Supreme Court clearly ruled that “payments on long term debt, as well as payments on short term debt, may

58. In essence, a payment is not preferential if it only reduces the secured portion of

the debt, but may be preferential to the extent it reduces the unsecured portion of the debt.

59. Additional exceptions to preference avoidance may apply in the event a borrower challenges pre-petition payments made to a lender. For example, if the lender gave new value in exchange for a payment, the preference exception for substantially contemporaneous exchanges of new value may apply under 11 U.S.C. § 547(c)(1). Certain “enabling loans” are also excepted from preference avoidance, such that the transfer of a security interest in property of the borrower to a creditor whose earlier loan enabled the borrower to acquire the subject property is not a preference, provided the security interest is perfected as of the date the borrower obtains possession of the collateral, or within thirty days thereafter. 11 U.S.C. § 547(c)(3).

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qualify for the ordinary course of business exception.” Id. at 162.60 Under appropriate circumstances, even payments made pursuant to debt restructuring agreements may be insulated under the ordinary course of business exception. In re Kaypro, 218 F.3d 1070 (9th Cir. 2000); see also In re Jeffrey Bigelow Design Group, Inc., 127 B.R. 580 (D. Md. 1991), aff’d 956 F.2d 479 (4th Cir. 1992) (interest payments made by debtor during preference period to bank on note held by debtor’s shareholder fell within the ordinary course of business exception to the trustee’s power to avoid preferential transfers).

60. The Union Bank case resolved the circuit split on this issue. It is important to note

that the Supreme Court expressed no opinion on whether the payments actually qualified for the ordinary course of business exception, remanding this for determination in accordance with statutory requirements.

436

NOTES

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NOTES

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