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Interagency CRE Guidance Update

February 4, 2016

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Interagency CRE Guidance Update

February 4, 2016

Authored by: Jerry Blanchard

In the ancient world kings and emperors regularly sought advice from the Oracle at Delphi when making important decisions. The Oracle would respond to questions, sometimes in poetry, other times in prose, in a manner that sometimes required some interpreting. For example, King Croesus of Lydia asked about the wisdom of his taking on the Persian empire. The Oracle replied that “If you attack you will destroy a great kingdom.” Proving that one should always ask for details, Croesus lost the battle and the Persians, under Cyrus the Great, conquered his kingdom.

Some say that the closest thing we have to the Oracle at Delphi today is the triumvirate of the federal banking regulators, the Federal Reserve, the FDIC and the OCC. The “Oracle” prognosticates and bankers guide their business activities accordingly. Well, perhaps. There was that prediction back in 2006 called “Concentrations in Commercial Real Estate Lending, Sound Risk Management Policies” when the regulators pointed out that CRE concentration levels at community banks had increased from 156% of total risk based capital in 1993 to 318% in the third quarter of 2006. They noted that some banks had begun to relax underwriting standards as a result of strong completion for such loans. Overall, the guidance was a “soft” sort of warning that bankers needed to make sure they understood how to manage the risk they were undertaking. A year or so later the economy was collapsing and banks beginning to fail.

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Loan Sale and Loan Participation Lessons Learned From the Recession, Part 2

January 14, 2016

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(Note: Part 1 is available here.)

One of the problem areas that came up during the recession was the accounting treatment for loan participations and loan sales. The difficulty arose from the fact that FASB changed the guidance for how to recognize a “true sale” several times over the last decade and not all banks realized that their form documents needed to be changed to reflect those changes. The current guidance is now found in Accounting Standards Codification Topic 860 “Transfer and Servicing” (formerly FAS 166 “Accounting for Transfers of Financial Assets”) which itself was an update of FAS 140 “Accounting Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.

If we go back ten years ago, there were several different variations on how loan participations divided distributions from loan payments among the parties. Pro rata is perhaps the most common but it was also typical to see both LIFO (last in first out) and FIFO (first in first out) arrangements. The older accounting treatment allowed an institution using any these different distribution models to be treat the transaction as a true sale, thus removing the asset from its books. The accounting treatment today is dramatically different. Under ASC 860, neither LIFO nor FIFO participations transferred on or after the beginning of a bank’s first annual reporting period that began after November 15, 2009 qualify for sale accounting and must instead be reported as secured borrowings.

Many banks actually used preprinted loan participation forms where one simply checks the block showing whether distributions were shared pro rata, LIFO, or FIFO and continued to use such forms after the FAS change. This resulted in interesting situations where pieces of the same loans can receive differing accounting treatments. For example, assume that Bank A originated a $1 million loan on June 1, 2009 and sold 50% of it on a LIFO basis to Bank B on the same date. Assuming that it meets all of the tests necessary to move an asset off of its books then Bank A can treat that as a true sale. If Bank A later sells another 10% of the loan to Bank C on March 1, 2010, also on a LIFO basis, that transfer will not be treated as a true sale and must be accounted as a secured loan by Bank C to Bank A.

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Loan Sale and Loan Participation Lessons Learned From the Recession, Part 1

January 7, 2016

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Watching loan participation activity over the last decade has been like watching the progression of a car on a roller coaster. The early to mid-2000’s showed the car heading ever upward and then in 2008-09 it hurtled downwards at breakneck speed. The last several years have shown a resurgence as the car begins climbing slowly back up the track. Not surprisingly, the FDIC has taken notice of that trend and issued a Financial Institution Letter on Effective Risk Management Practices for Purchased Loans and Purchased Loan Participations in November of 2015.

The reasons why lenders want to sell either loan participations or whole loans and others want to purchase them remain the same today as they were a decade ago. Sellers may have loan to one borrower issues that a loan participation may cure, they may be seeking to reduce overall exposure to a particular borrower or industry or they may find that providing loan product for other institutions is a profitable venture as it may generate gains on sale as well as servicing income depending on how the sale is structured. Buyers are looking to broaden their geographic and industry diversity in order to better manage the overall credit risk inherent in their portfolio and it may be more cost-effective to source loans from another lender than trying to originate them yourself. Another, more recent development, has been the purchase of loans from peer-to-peer non-bank lenders who operate on a national basis.

When the US economy hit the skids in the 2007-2010 time frame with its corresponding bank failures, it became clear that in many situations loan participations had not generated the expected benefits. There were several reasons for this, the most significant being that simply obtaining geographic diversity of ADC loans still left a lender susceptible to outsized losses when that segment of the economy ground to a halt. Too many community banks failed to realize that true diversity in a loan portfolio means that ADC can only be a portion of the entire portfolio, not the entire portfolio, even if you have geographic diversity. The perceived reduction in risk was therefore illusory.

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Georgia Secretary of State’s Office Has An “Oops Moment” Over Personal Identifying Information

The Georgia Secretary of State posted a letter on its website on November 18, 2015 admitting that, on October 13, the office inadvertently released personal identifying information on registered voters in Georgia. While the letter does not actually spell out what information was released, a lawsuit filed in Fulton County Superior Court this week alleges that the information on the 6,184,281 Georgia voters includes:

  • voters full name
  • residential address or mailing address if that is different
  • race
  • gender
  • voter registration date
  • last date the person voted
  • their social security number
  • driver’s license number
  • date of birth.

The information had been provided on CDs to 12 groups, including political parties and journalists, in a release that normally would only include basic information, such as names, addresses, registration and the last time the person voted. Under normal circumstances, the Secretary of State makes such information available for $500 to interested individuals and entities.

The Secretary of State letter indicates that the office has retrieved all of the CDs that contained the information and has confirmed that none of the data was retained by or disseminated to any third parties. In a day and time when state and federal governments have aggressively pursued private companies for similar inadvertent disclosures, the Secretary of State may still face liability.

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Cleaning Out the Attic: Making Sense of Cash and Treasury Management Agreements

October 27, 2015

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Everyone has that pile of objects in the basement or the attic that over the years just keeps growing in size. It could be old toys no longer used but saved for use by the grandchildren, old clothes you think you might wear again someday, or the furniture from your parents’ house that you hated to give up but really had no room for in your own house. In the banking context, the pile of objects closely resembles the cash management agreements many banks use. Many of these agreements were first put in use years ago when the bank decided to offer ACH services in addition to the normal commercial deposit account. Eventually the bank added wire transfer and a money market sweep account to the suite of options. Oftentimes banks use a separate form for each of the available services, some of which may or may not conflict with the other forms that were developed over a 10- or 20-year period.

Technology, cyber-risks and the ways people initiate transfers of funds have changed over time and will continue to change in the near future. If you haven’t updated your cash management agreements in several years, now may be a good time to review that pile of documents and agreements and consider what items needs to be addressed. A good way to handle such a review is to combine the separate agreements into one master agreement. Consolidating the documents in such a manner ensures that all of the definitions are consistent and any security processes are addressed across the entire platform.

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Loan Documentation Lessons Learned From the Recession

September 17, 2015

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One of the first things we do as lawyers when handling a problem loan is to review the loan documents.  We do this because we will sometimes find defects in the loan documents that may alter the strategy the bank was going to take in its collection process.  Instead of moving to foreclose, for example, a lender might be more inclined to enter into a forbearance agreement with an opportunity to clean up documentation defects.  The following are some of the issues we typically ran across while handling problem loans originated during the Recession.

1. Term Sheets and Commitment Letters.  The use of Term Sheets and Loan Commitments varied dramatically between banks and even within the banks themselves.  For example, we found that if a bank did tend to use Term Sheets, the forms oftentimes were ones simply adopted by a particular loan officer, and not used uniformly across the bank.

Why care one way or the other?  The problem arises in the use of internal loan approval forms that are inconsistent with the Term Sheet sent to the customer.  In many cases, outside counsel attempted to document a loan based on the Term Sheet only to later discover discrepancies between the Term Sheet and the loan approval form.  Such discrepancies often resulted in the lender believing that it had certain collateral or certain rights only to find out later on when the loan went into default that it had neither.

The inconsistencies were also fertile ground for borrowers and guarantors to generate defenses and counterclaims based on the documentation not accurately setting forth the deal.  The original loan officer may or may not be available (or interested) to answer questions about exactly what occurred when the loan was being negotiated and later documented.

2. SignaturesGetting loan documents signed correctly is such an important foundation for enforcing a loan that it was always surprising when we reviewed a package and realized that documents had been signed incorrectly.  Signature deficiencies are particularly troublesome when dealing with real estate collateral.  For example, a Deed to Secure Debt might state on the front page that the Grantor is ABC, Inc. but when you get to the signature page it is signed by XYZ, Inc.  Trying to foreclose on the real property in that situation is, shall we say, somewhat problematic, and can involve, among other things, a suit to “reform” the documents.  Not exactly what a special assets officer wants to hear when he or she is expecting a simple, straightforward foreclosure action.

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Georgia Garnishment Statute Held Unconstitutional

September 15, 2015

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The recent opinion of Judge Marvin Shoob in the Strickland v. Alexander case has created a great deal of confusion among banks about their duties in responding to a summons of garnishment in Georgia.  In that opinion, Judge Shoob declared the Georgia garnishment statute to be unconstitutional on multiple grounds. Primary among the  grounds cited by Judge Shoob was the absence of any notice to the debtor of the existence of statutory exemptions which shield certain funds from garnishment or the procedures available to assert those exemptions.  It is unclear whether the decision will be appealed, modified, or cured by subsequent legislation.  Numerous esoteric questions have been raised by the legal community about the validity of the opinion, but those questions are beyond the scope of this post.

Whether Judge Shoob’s opinion is appealed, modified or cured by the Georgia General Assembly, banks currently face significant questions in its wake.  The most important of these questions is “should a bank continue to answer summons of garnishment or not.”  Many Georgia banks understandably have questions about their potential liability to both creditors and debtors by continuing to participate in the garnishment process.  While banks could choose to litigate the validity of every single summons that they have received or subsequently receive, that is hardly a practical or economical strategy for most of our banking clients.

An initial option available to any bank during this time is to contact the creditor which served the summons and ask that the summons be withdrawn. This may be effective since questions of liability are also being faced by the very creditors who are seeking to use the garnishment process.

If the creditor will not withdraw the summons, and pending a resolution of the constitutional issues by the courts or the General Assembly, the next best option is (1) to continue answering summons of garnishment after performing an appropriate review for the existence of funds covered by statutory exemptions and (2) to pay the non-exempt funds into the registry of the court.  Doing so will eliminate any risk the bank may run to the creditor which served the summons of garnishment through default or otherwise.  Moreover, since a summons is essentially a court order, the bank will have a strong argument that its actions are both justified and in good faith.  We note that even Judge Shoob found that the bank involved in the Strickland v. Alexander case could not be found liable for responding to the summons.  See Strickland Order at p. 9.

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Cyber Criminals Don’t Dig Mile Long Tunnels

September 1, 2015

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Digging a tunnel for a mile so that El Chapo could slip into the shaft through his shower and disappear from a high security Mexican prison is something you might expect a Hollywood screenwriter to come up with. Is it any more remarkable though than a cyber-criminal reaching all of the way around the world to try and slip into a bank’s or a customer of the bank’s computer system in order to initiate a wire transfer?

We live at a time when individuals and criminal gangs can reach across oceans and national boundaries to try and initiate unauthorized transfers of funds. Bankers understand that this is a hot topic and that the risk of cyber-fraud is what is currently keeping  regulators awake at night. While a great deal of attention is now being focused on how to keep cyber criminals out of the bank, recent attacks on various public and private institutions illustrates the complexity of denying malefactors access.

In such an environment, bankers look to various risk management strategies including insurance coverage in the event a breach occurs. The first question many banks raise is about their existing insurance coverage Are we already covered under any of the myriad of existing policies we are required to maintain? For example, what about our general liability coverage? While there may be some exceptions, the typical general liability insurance policy that banks have traditionally purchased oftentimes contains an exclusion for losses incurred by data breaches or intrusions to bank networks. If your existing policy does not currently contain such an exclusion it is highly likely that on your next renewal the exclusion will be included. Thus, it is important for bankers to not only understand what their existing policy does or does not cover but also where industry trends are headed.

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Mafia Guaranties Loan to Murder Inc.

July 28, 2015

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Every now and then the name of the parties in a case just sort of jumps out and grabs you. A recent decision out of Nevada involved a guaranty given by The Mafia Collection (“Mafia”) for certain loans made to Murder, Inc., LLC (“Murder”).  Murder defaulted on the loans and the secured creditors sought to foreclose on the collateral pledged by Mafia comprising some 1500 mob related artifacts.

While the foreclosure case was pending, Mafia acquired some of the secured notes that it had guaranteed. Mafia then filed a counterclaim/third-party claim against the collateral agent for the lenders, Andrew DeMaio, alleging unjust enrichment and breach of fiduciary duty. The lower court ruled in favor of the collateral agent and the secured creditors and awarded attorney fees and costs as allegedly provided for in the parties’ secured notes and security agreement.

On appeal to the Nevada Supreme Court, Mafia raised several issues, one of which dealt with whether the district court erred by dismissing as nonassignable Mafia’s claim for breach of fiduciary duty. A claim for breach of fiduciary duty is similar in nature to a claim arising under fraud as opposed to a breach of contract type of claim. In many states, including Nevada, a claim for fraud is not assignable to third parties, it is deemed to be “personal” to the defrauded party.

The court found that the district court erred by dismissing Mafia’s claim because there was a disputed issue of material fact as to the basis of Mafia’s claim, namely, whether the collateral agent allegedly breached his fiduciary duty to Mafia in its personal capacity, as a guarantor and/or a creditor (after it acquired the secured loans), or whether he allegedly breached his fiduciary duty to the selling noteholders, who in turn attempted to assign their claim to Mafia by virtue of the loan assignments. The former claim would be permissible; the latter would not.

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US Supreme Court to Review ECOA Spousal Guaranty Rules

June 29, 2015

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The US Supreme Court has agreed to review a decision by the Eight Circuit Court of Appeals in Hawkins v. Community Bank of Raymore, 761 F3d 937 (CA8 2014) where the court found that the Federal Reserve  had overstepped its bounds in adopting rules under the Equal Credit Opportunity Act to protect spousal guarantors. The case arose out of a series of loans in 2005 and 2008 made by the Bank—totaling more than $2,000,000—to PHC Development, LLC to fund the development of a residential subdivision. In connection with each loan and each modification, the principals of the LLC and their spouses (who had no interest in the LLC) executed personal guaranties in favor of Community to secure the loans.

In April 2012, Community declared the loans to be in default, accelerated the loans, and demanded payment both from PHC and from the guarantors. The guarantors defended on the basis that Community had required them to execute the guaranties solely because they were married to their respective husbands. They claimed that this requirement constituted discrimination against them on the basis of their marital status, in violation of the ECOA. The Federal Reserve has adopted Regulation B which prohibits a lender from requiring a person’s spouse to join in on any credit documents unless the parties are applying for joint credit. 12 CFR 202(d)(1).

The ECOA makes it “unlawful for any creditor to discriminate against any applicant, with respect to any aspect of a credit transaction … on the basis of … marital status.” 15 U.S.C. § 1691(a).

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