In these days of declining property values, lenders and investors have to do more than just cover the basics. Failure to keep up with rapidly changing laws will result in accelerated losses.
Lenders secured by income-producing properties or collateral (such as commercial properties, multi-unit residential properties, businesses and so forth) often ignore the biggest “weapons” at their disposal when facing a default by their borrower: The income generated from the collateral and the rights to manage or control the collateral. Reacting late can be as bad as doing nothing at all. Income and collateral preservation are both critical.
A smart borrower can take a lender/investor on a multiyear-long journey through foreclosure, bankruptcy and eviction proceedings, improperly using cash collateral for the borrowers’ benefit while destroying or diminishing the value of the collateral. Savvy lenders can reverse the process. But it’s up to the lender/investor to act promptly, proactively and to force compliance with a borrower’s obligations under applicable loan documents. This can often be the difference between staggering losses on loans and investments and reduced losses or profit.
Assuming the loan documents and security interest granted give the lender/investor such rights, the following are essentials to consider when facing a default on income-producing collateral.
Obtaining updated financial statements. Doing so regularly, and not just at loan inception, will give you insight into a borrower’s ongoing assets and financial condition and will allow you to recognize fraud, which will give you leverage in any negotiation with your borrower, even if a bankruptcy is filed.
“Poor man’s” receiver. Many lenders worry about the cost of vindicating their rights to restrict the borrower’s use of cash collateral (rents, profits and so on) after default. While “penny wise can be pound foolish,” consider using a Notice to Require a Tenant to Pay Rent to you after default, pursuant to California Civil Code 2938. While not a “cure all,” it’s a less expensive way than a receiver to force recognition of the lender’s rights and to stop payment of rents to a borrower who isn’t paying the lender. There are drawbacks, including but not limited to, tenant claims that you should take on landlord responsibilities.
Receivers. Under a proper security agreement, a lender always has the right to have a receiver appointed. The appointment of a receiver benefits the lender not only by restricting diversion of cash collateral by the borrower, but also by helping preserve the collateral from waste, which allows for greater resale if the collateral is foreclosed or sold (including the value of the borrower’s business, if applicable).
Many lenders find, to their chagrin, conditions that they could have prevented if they’d acted promptly to interpose a receiver. Examples include: Waste to the collateral; dissipation of tenant security deposits (that the lender is jointly responsible for); loss of key tenants; obligations to repair under local, state and federal laws; and environmental claims. The appointment of a competent receiver can change this.
Bankruptcy. This often paralyzes lender/investors into indecision and inaction. If a receiver is in place prior to the filing of a bankruptcy and improper borrower conduct is shown, a lender can request that the receiver stay on the property (11 USC 543). If this isn’t an option, then the Bankruptcy Code requires a borrower obtain the agreement of the creditor or an order of the court if use of income is to continue. A lender/investor should act promptly to ensure cash collateral (rents and profits) is used to maintain and preserve the real estate or personal property collateral, that there are rights to inspect the books and records of the debtor, that tenant deposits are maintained and segregated and that excess cash is paid to the lender, when appropriate.
Note: Every lender secured by income property that’s subject to a bankruptcy must vigilantly monitor any proposed plan of reorganization. Today’s deflated values may give way to tomorrow’s increased or inflated values. Borrowers regularly use the “cram down” provisions allowed under the Bankruptcy Code to restructure loans and reduce indebtedness, akin to a “call option” in the stock market (a bet that the property will go up in value, while cash flow is under a court ordered restructuring). Lenders should monitor and respond appropriately to protect rights and seek to apportion risk and future appreciation.
Post-foreclosure and eviction. New laws that impact certain multi-family properties allow tenants’ increased rights to stay on a property after foreclosure (see Protecting Tenants at Foreclosure Act, Pub. Law 111-22, 123 Stat. 1632, 1660, which will end in December 2014).
California law provides that lenders are jointly responsible with the former owner for security deposits.
Finally, newly enacted SB 1137 (Civ. Code 2924.4) holds foreclosing lenders responsible for maintaining the exterior of foreclosed properties for certain residential properties. Fines and penalties can be imposed for failure to comply.
These laws can operate to force foreclosing lenders and investors to accept below market rate tenants or to have residual obligations due to unlawful or unscrupulous actions taken by the former borrowers. These laws mandate that lenders do their homework before foreclosing on certain properties, if for nothing more than to determine if they’re foreclosing themselves into more problems, and whether they should consider other alternatives such as “cash for keys” agreements and so forth.
These are some primary and essential considerations that every lender and investor with income-producing security should consider. Things aren’t going back to the way they were in 2007 anytime soon. Savvy lenders and investors will continue to do well in this environment and will forge mutually beneficial relationships with their borrowers when appropriate and will take effective action to cut through inappropriate legal challenges by borrowers seeking to drain equity and/or cash from the security. Developing a coherent and effective strategy to protect your income-producing collateral and implementing a team of professionals that will help you do so efficiently will benefit you now and in years to come.
Note: This article is a general discussion of issues of law that change regularly. If you decide to pursue any of the actions discussed, you should first review with counsel experienced in the areas of law covered.
Spencer Scheer is managing partner of the Scheer Law Group, LLP (“SLG”), a five-attorney firm in San Rafael. SLG represents secured creditors, including banks, credit unions and individual investors. You can reach him at (415) 491-8900 or sscheer@scheerlawgroup.com.
