Lending Law Report : Corporate Finance Lawyer & Attorney : Reed Smith Law Firm : Lending Transactions, Secured Investments

This post was written by Joel Schaider, a partner in the Financial Industry Group here at Reed Smith.

With failed financial institutions approaching record numbers, the Federal Deposit Insurance Corporation (“FDIC”) has been required to step in and seize the assets of these institutions.  The single largest categories of assets held by a failed financial institution are its performing and non-performing loans.  These loans are in the process of being sold to the public in bulk through a sealed bid process.

How to Find Information on Loan Sales  

The FDIC’s website contains information on current loans which are available for bid.  The loans of each failed institution are grouped into pools by loan type (e.g. commercial and industrial, consumer, residential, agriculture).  The website contains a list of offering announcements which are currently available for bid including the name of the financial institution which originally held the loans, the number of loans in each pool, a general description of the loan type, a description of the nature of the collateral securing the loans, the location of the collateral and the percentages of seasoned performing and non-performing loans in each group.  There are also key dates listed for the commencement of due diligence and the due date for the submission of a bid.

Additional information on loan sales may be obtained from two loan sales advisors (First Financial Network and DebtX) who the FDIC has retained to manage the sales process. The offering announcement for each loan sale will identify the sales advisor who has been assigned to manage the particular sale. 

How the Sale Process Works

• Purchaser Qualification.   The first step in the sale process to for the purchaser to become qualified.  First Financial and DebtX have established similar qualification requirements, however, it is advisable for the purchaser to qualify with both advisors.  Once the qualification requirements have been met, purchasers will be given passwords and access instructions to the loan due diligence and other information pertaining to a particular loan sale.
   
• Timing.  Generally, the period of time involved in bidding and purchasing a group of loans from the FDIC is approximately 6 to 8 weeks from the time the offering is first announced. The initial period of due diligence is typically 4 to 5 weeks in length with the bids to be submitted on a specified date after the expiration of the due diligence period. Generally, it takes two weeks for the bid to be awarded. The closing would then occur within a short period after the bid is awarded.
   
• Due Diligence.   The FDIC makes no representations or warranties in connection with the purchase of any loans and all of the risk of loss associated with the loans are passed to the purchaser upon closing.  The rights and remedies available to the purchaser are solely contained in the underlying loan documents and the associated collateral.  Therefore, a review of the loan files including the collateral is a critical element which must be completed prior to the submission of a bid. 
  
  The due diligence process may vary depending on the size and characteristic of the loans contained in each portfolio. Larger-sized commercial loans may require greater scrutiny than smaller consumer loans. However, a large number of consumer loans, for example, may contain defective terms which could affect the enforceability of all the loans in the portfolio. The loan files may be missing signed documents or important pieces of collateral. Experienced counsel needs to be involved in order to conduct due diligence in an efficient and effective manner.
  
  The due diligence files are obtained through the financial advisor assigned to the particular sale. The files are typically available on a secured website, on a separate hard drive (which may be purchased) or in a physical location.
   
• Bid Submission.  Upon completion of due diligence, an interested purchaser needs to submit a bid.  An initial deposit of $100,000 is required from each bidder to be sent by wire transfer at the time of bid submission.  The deposit is fully refundable, without interest, if the purchaser’s bid is not accepted.  If the purchaser’s bid is accepted, a final deposit equal to 10% of the purchase price of the loan portfolio, less the amount of the initial deposit, is required to be deposited within one business day following the bid award.
   
• Closing.  Closing occurs on a specified date within a short period of time after the bid is accepted by mail or in person at a place designated by the sales advisor.  The balance of the purchase price is due at the time of closing. All loan documentation such as notes, collateral documents and loan files will be delivered to the purchaser within a reasonable time after closing.

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Lenders often express concern about potential defaults under their loan agreements – but it’s usually default by the borrower that they’re concerned about, not default by the lenders.  It's a sign of the times that this has now become a significant issue.  With an increase in the number of bank failures and FDIC receiverships over the past year, we’ve begun to see an increase in the number of lender defaults in syndicated loan deals.  If you're a lender (or a borrower) in a syndicated credit facility, you might well find yourself facing this situation.

If a lender in your bank group defaults, what can you do – and what can’t you do?

As an initial matter, it’s important to keep in mind that default by a lender does not excuse anyone else from performance.  The remaining lenders still have to fund loans when requested, and the borrower still has to make payments and comply with all the covenants.  However, depending on what your loan agreement says, you may be able to mitigate the effects of the default.  Here are some typical provisions that many loan agreements already contain:

1. Limitation on Voting Rights.  Many loan agreements provide that a defaulting lender’s commitment is not counted when determining whether a required/majority lender vote has been achieved.  Some loan agreements also provide that the defaulting lender simply does not have the right to vote on any issue – even issues otherwise requiring a 100% vote (perhaps with some very limited exceptions such as for increases of that lender’s commitment).  This is extremely helpful, because if the lender has gone into bankruptcy or has been taken over by the FDIC, it will be very difficult, if not impossible, to get that lender to vote on even the simplest of amendments.
    
2. Replacement of Lenders.  Most syndicated credit agreements permit the borrower to remove a defaulting lender from the credit facility, under so-called “yank-a-bank” provisions. Removal of the lender would be accomplished through a forced assignment of its commitments and outstanding loans to another lender.  Taking the defaulting lender out of the deal would certainly solve a lot of problems.  However, the practical reality is that it can be difficult to find another lender willing to purchase the commitment at par as required – and this is particularly true when the loan is trading at a large discount in the secondary market (whether due to market conditions, as has been true recently, or due to a decline in the borrower’s performance).
    
3. Commitment Fees.   Though some agreements are silent on this point, several credit agreements include provisions permitting the borrower to stop paying a commitment fee to the defaulting lender. This seems appropriate, as borrowers otherwise find it rather unfair to have to pay a fee for a commitment that the lender has demonstrated it will not honor.  A few loan agreements provide instead for the fee to be paid in the same amount as always, but for it to be shared only among the non-defaulting lenders.  This provides something of a windfall for the non-defaulting lenders - which may be why this formula is less popular.  
    
4. Letters of Credit and Swingline Loans.  It is relatively common to require the borrower to cash collateralize the portion of an outstanding letter of credit or swingline loan that would otherwise have been backed by the defaulting lender’s commitment.  This protects the issuing bank or swingline lender from having to bear additional risk for that portion of the loan/commitment, beyond its pro rata share.  Some agreements provide that letters of credit cannot be issued at all (and swingline loans cannot be made) if there are any lender defaults, but this approach is used less frequently these days, as losing access to letters of credit can make things very difficult for certain types of borrowers.

At a minimum, you’ll want to make sure your loan agreements cover these important topics.  If these provisions aren't already in an existing agreement, you might consider taking the opportunity to add them the next time there is an amendment. 

In our next post, we’ll offer some suggestions for how to further improve protections for the bank group and the borrower in the event of a lender default, beyond these basic provisions.
 

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