Due Diligence in Acquiring Distressed Debt — Part Two
This is the second of two articles about counseling clients in acquiring distressed commercial mortgage loans. In the first blog post we discussed due diligence regarding the loan documents and loan collateral. This post addresses due diligence on the borrower and any guarantors, and due diligence regarding the status of the loan being acquired. As noted in Part One, due diligence for acquiring distressed mortgage debt takes place under tight time constraints, without the cooperation or participation of the property owner, with no opportunity to interview tenants or, in many cases, to inspect the property itself. You will basically be reviewing files that are sometimes incomplete and often contain outdated information. Nevertheless, there will be information of value in the files to be reviewed with a discriminating eye.
A. The Borrower and Guarantors
Questions regarding the borrower and any guarantors really go to the likelihood of the loan being repaid, with or without entering into a workout agreement.
The pricing of the loan sale undoubtedly will take into account the risk and hassle likely to be associated with collecting the loan, which will be significantly impacted by the availability of a deep pocket to pay the loan.
- What is the reputation of the borrower and any guarantors? Is there a competent management team in place? You will want to run judgment and lien searches, bankruptcy and litigation searches, credit and other investigations to determine the ability of a borrower to repay the obligations.
- Determine the nature and extent of personal liability for the loan. The borrower may have personal liability if the loan is recourse or even if it is non-recourse, to the extent of the carve outs, discussed below. However, most borrowers are single asset entities owning only the mortgaged premises, so the borrower’s personal liability is not giving the lender much of anything beyond what the lender already has by virtue of its mortgage collateral.
- You may also have recourse under personal guaranties. Personal guaranties run the gamut from full recourse for the entire amount of the loan, partial recourse for a portion of the loan amount, recourse for completing construction in the case of a construction loan, recourse for environmental liabilities of the borrower and recourse for carve outs. You will scrutinize any personal guaranties to make sure they contain all the usual waivers of defenses and the like, and be particularly careful of partial guaranties to make sure the scope of liability is clear and unambiguous, which sometimes becomes an issue if not well drafted. For example, is a guaranty of fifty percent of the “loan” extinguished when half the loan is repaid, or does it remain outstanding for half of the unpaid principal balance until the loan is paid in full? As noted above, you will want to run judgment and lien searches, bankruptcy and litigation searches, credit and other investigations to determine the ability of a guarantor to repay the guaranteed obligations.
- Few loans are completely non-recourse. Most so-called non-recourse loans have carve outs, i.e., exceptions to the non-recourse terms listing events that will result in personal liability of the borrower which, in turn, may be guaranteed by one or more guarantors. The carve outs can be very important if the borrower’s liability for breaching them is personally guaranteed, or in the unlikely event that the borrower has assets over and above the real estate collateral. Bankruptcy of the borrower is one of the most valuable carve outs if there is a deep pocket guarantor who most likely controls the borrower to a significant degree, because it reduces the likelihood of the borrower filing bankruptcy. Other carve outs similarly may be important, especially if and to the extent they impose liability for the full unpaid amount of the loan and not just for the actual losses resulting from breach of the carve outs.
B. Loan Status
The status of the loan, i.e., whether it is in default or not, and the stage to which it has progressed and the route taken to get there, is a consideration as critical as any others.
- Is the loan in default? If so, how? Is the default material? What default notices are required by the loan documents? Have they been sent as required by the loan documents and do they conform with the requirements of the loan documents? Have notices been sent to guarantors? Has the lender elected to accelerate?
- Are there other mortgage loans on the property? Are there intercreditor agreements? Mezzanine loans? Participants with the lender? What is the status of the foregoing?
- Is the loan cross collateralized or cross defaulted with other loans? What is their status?
- Have the lender and borrower entered into a pre-workout agreement? Have there been workout discussions?
- Has the lender started exercising rights against the collateral? Does the lender collect or control rents?
- Review the lender’s credit file, including internal memoranda. Review the loan administration history. Will loan officers be available as witnesses?
- Is there any evidence that the borrower might be able to assert defenses to repayment? Has the lender exercised undue control over the borrower’s business or management? Has the lender agreed to forebear or conveyed a false sense of security to the borrower? The list of possible foreclosure defenses and lender liability claims is too long to enumerate here. It will be difficult at best to determine if any valid defenses or claims might exist based on a review of lender’s files, but you will want to be on the lookout for any evidence in the way of letters or notes that might suggest a problem.
In summary, due diligence on a distressed mortgage asset is akin to a doctor doing a physical on a patient. You may not have time to examine everything, you will not be able to get all the information that would be available when a loan is originated, you need focus on what is important first and report on issues. This is a diagnostic exercise; you cannot cure defects at this stage but you can evaluate them.
To the greatest extent you need to understand the status of the loan, the collateral, the borrower and any guarantors. You will then be able to assist your client effectively in strategizing how the asset can be dealt with if and when it is acquired and, bottom line, determining if the asset is worth buying at the price the lender is demanding or can obtain.