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

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

The FDIC has given banks a temporary reprieve from the impact on their securitizations of the recent changes in GAAP, until March 31, 2010. By then, the FDIC has promised new securitization rules.

The FDIC has stated (pdf) that it will issue new rules for bank securitizations in December 2009, which rules will likely impose mandatory structural changes to bank securitizations including credit risk retention, increased disclosures to investors, and more flexibility for servicers of securitized debt. There will be a comment period before the revised rules go into effect, during which time interested parties will be invited to provide comments and feedback to the FDIC on the proposals.

The FDIC's action under the Interim Rule (Fed. Reg. Vol. 74. No. 220, Nov. 17, 2209) extends the current safe harbor for bank securitizations contained in the "Securitization Rule" (12 CFR 360.0) until March 31, 2010, thereby giving banks the ability to securitize without considering whether the recent GAAP accounting changes in FAS 166 and 167 (the "New GAAP Rules") affect their securitizations during the interim period. We've prepared a separate report on the content of these recent changes to GAAP.

Under the "Securitization Rule", the FDIC clarified its authority as receiver or conservator to reclaim as property of a bank any financial assets transferred by the bank in connection with a securitization did not apply to a sale which met all conditions for sale accounting treatment under GAAP. The New GAAP Rules may affect whether an issuing entity has to be consolidated on the bank's balance sheet for financial reporting purposes. Given the changes in the accounting treatment, securitizations would not likely meet all conditions for sale accounting treatment. As a result, the safe harbor provision of the Securitization Rule may not apply to the transfer.

The Interim Rule provides that for securitizations and participations for which transfers were made or interests were issued before March 31, 2010, the FDIC will not exercise its statutory authority and reclaim as property of the institution any transferred financial assets notwithstanding that such transfer does not satisfy all conditions for sale accounting treatment under the New GAAP Rules for reporting periods after November 15, 2009, if such transfer satisfied the conditions for sale accounting treatment set forth by GAAP in effect for reporting periods before November 15, 2009. The FDIC has requested comments on all aspects of the Interim Rule, which must be received by January 4, 2010.

Of course, not all issuers are banks. Non-depository institutions will continue to have to deal with the impact of the GAAP changes on their securitization structures.

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In our prior posts on this topic, we focused on what your loan agreements might say about how to deal with a defaulting lender.  In this post,  we'll talk about what happens when a member of your bank group goes into default because it is taken over by the FDIC.  Special rules apply in that case.

Automatic Stay.  The Federal Deposit Insurance Act  provides for an "automatic stay" whenever a lender is taken over by the FDIC.  In part, the statute says that no one may "exercise any right or power to terminate, accelerate, or declare a default under any contract" that the failed institution is a party to, for a period of 90 days after appointment of the FDIC as receiver (45 days, if it is a conservatorship).  

My colleagues Colleen McDonald and Nikki Kolhoff have explained (pdf) that this means you can't do anything that would affect the contractual rights of the defaulting lender, if such action is based solely on the insolvency or FDIC takeover.  So, for example, you can still amend your loan documents, but you have to invite the defaulting lender to vote, and the amendment can't affect the rights of the defaulting lender without that lender's consent.  According to McDonald, the bottom line here is "if you are going to amend your loan agreement, make sure you do it correctly."  She points out that both the "D'Oench Dhume doctrine" (D'Oench, Duhme & Co. v. FDIC, 315 U.S. 447 (1942)) and 12 U.S.C. Section 1823(e) impose specific requirements on modifications of loans involving financial institutions taken over by the FDIC.  Contracts that don't meet the requirements can be avoided altogether by the FDIC - so it's worth taking the time to make sure those requirements are met.

In addition, even if the loan agreement would otherwise permit you to stop sharing payments with a defaulting lender, if the lender is taken over by the FDIC, you'll still have to share all principal and interest payments with it -- at least, to the extent of the obligations it has previously funded.  (As discussed in our prior post, the loan documents should ordinarily prohibit the defaulting lender from sharing in principal and interest payments relating to advances it did not fund.) 

As a practical matter, the automatic stay can create significant problems for a bank group, particularly if the defaulting lender is the administrative agent for the credit facility.  Since the agent manages the funding and payment processes, and often holds the borrower's bank accounts and controls other collateral for the loan, an FDIC takeover could bring everything to a halt - at least temporarily.  

McDonald recommends that to help protect against these problems, the loan agreement should include the right to declare the lender in default early -- before FDIC takeover.  This would allow the bank group to take action before the automatic stay kicks in.  For example, if the agent in a syndicated loan goes into default (pre-FDIC takeover), its rights as agent could be terminated and assigned to a successor, and all the collateral could be transferred to the new agent -- thus permitting the credit facility to function pretty much as usual through the FDIC takeover.  McDonald suggests including a definition of  "Impaired Agent" in the loan agreement that would include an agent that fails to make payments or fund loans required under the loan documents, or that rescinds or repudiates a loan document.

Exceptions.  There are other sections of the Federal Deposit Insurance Act that provide exceptions to the automatic stay, including an exception for when the FDIC as conservator/receiver fails to comply with otherwise enforceable provisions in the loan agreement.  Sometimes these exceptions can provide relief for the bank group, though their full effect is as yet untested.   I have a feeling we'll get the chance to test some of these provisions over the next few months.

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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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