September 22, 2009 Authors: Clifton M. Dugas, II clifton.dugas@klgates.com +1.214.939.4953 Eugene F. Segrest gene.segrest@klgates.com +1.214.939.4991 Matthew Lopez matthew.lopez@klgates.com +1.214.939.5683 K&L Gates is a global law firm with lawyers in 33 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com. Purchasing Notes Secured by Real Estate Introduction Many investors are once again looking to purchase real estate-secured notes at a discount from face value in order to capitalize on the steadily declining real estate values prevalent in today s market. If history is any indication of what we can expect as a result of the current downturn (e.g., investors profits from the RTC days of the 1990s), investors may indeed be able to profit from the downturn in today s market and the resulting pressure on banks to get certain assets off their books. Prior to closing on a typical real estate note purchase, an investor must determine, through financial due diligence, (i) whether the borrower and/or guarantors of the note being purchased have the financial capability to honor the note, or (ii) whether the value of the collateral exceeds the amount paid for the note together with incidental costs. Either or both of these questions must be answered in the affirmative in a loan purchaser s determination of whether the transaction will be profitable and thus worth the risk of a borrower default. The investor must also analyze the underlying collateral for title issues, lien priority, materialmen s liens, environmental and architectural concerns, etc., in preparation of ultimately owning and operating the property, should the borrower default on the note and the investor elect foreclosure as its remedy. While an investor seeking to purchase a single note or a pool of notes may think of itself as simply an investor in the traditional, financial sense of the word, it is essentially a mortgage lender, real estate purchaser, financial analyst, real estate operator and due diligence expert all wrapped into one. A successful purchaser of real estate notes must possess expertise in all of the foregoing areas or be prepared to engage third parties who are experienced in such transactions. It is important to remember the parties goals as a backdrop to the note purchase transaction. The ultimate goal of the party selling the note is either to remove a bad asset (i.e., a defaulted, underperforming, or soon to be defaulted loan secured by real estate) from its balance sheet or to sell the distressed loan (or even a fully performing loan) at a profit. The purchaser in a note purchase transaction will seek to make a profit by (i) receiving a payoff from the borrower in an amount exceeding the purchase price of the note, or (ii) foreclosing on and liquidating or operating the underlying real estate in an amount exceeding the purchase price of the note. The keys to limiting the investor s liability during the note purchase process and enhancing the likelihood of an eventual profit to the investor are careful documentation of the transaction and thorough due diligence. An investor purchasing a pool of real estate notes must analyze the transaction as though it were purchasing the underlying collateral securing the notes. Considerations and issues differ depending on the type of note and the type of collateral securing the note. Moreover, engaging counsel experienced in these types of transactions may help investors avoid potential liability. This alert includes a discussion of the various types of transactions an investor may expect to see in this environment, as well as a general description of the issues relating to real estate note purchases.
The Note Purchase and Sale Agreement The first step in a purchase of notes secured by real estate is the negotiation of a note purchase and sale agreement. The parties to a purchase and sale of real estate notes should strive to use a contract tested in previous transactions. The contract should be fair to each party and should include all specifically negotiated deal points. Any investor should, through its counsel or otherwise, make every effort to obtain as much information as possible on the notes and the documents governing the underlying loan before executing the contract. The more information an investor can gather at the outset of the process and prior to entering into the contract, the better able it is to evaluate any resulting implications and incorporate them into its purchase price offer for the notes, as well as mitigate the risk of reaching an impasse (due to the necessity of a major purchase price adjustment mid-contract) after incurring significant due diligence expenses. A well-drafted loan purchase and sale agreement is the parties greatest tool in ensuring a successful transaction. The contract should provide for the seller s agreement to unconditionally sell the note and transfer all governing loan documents relating to the note, including without limitation the deed of trust or mortgage encumbering the real property, any assignments of leases and rents, any guaranties, and any other documents securing the underlying loan. Such a transfer obviously includes with it all of the Seller s rights to enforce the terms of the loan documents and exercise all remedies against the borrower, including without limitation the right to foreclose on the real property collateral, commence deficiency actions, and assert claims against guarantors. Moreover, the contract should contain provisions requiring the seller to fulfill various obligations as a condition to the purchase, such as: 1. Clearly and specifically identify and deliver the note, the deed of trust, the assignment of leases and rents, the UCC financing statements, the guaranty, the SNDA agreements and any other documents and files relating to the note including the loan file and the correspondence file; 2. Provide for an assignment of the original lender s title policy coupled with an endorsement bringing the policy up to date, as well as copies of all exception documents referenced in the title policy; 3. Provide for delivery of seller s existing survey of the real estate collateral and state a mechanism by which the investor can obtain an updated survey, if necessary; 4. Clearly state the time for a feasibility study period whereby the investor can adequately conduct all due diligence and, if necessary, terminate the contract without any liability other than the independent consideration bargained for under the contract; 5. Require the seller to deliver a certified payment history related to the note through the closing date; and 6. Contain a provision whereby the seller represents and warrants, at a minimum, (i) that seller is the current owner of the note and that it has not been previously assigned, (ii) that there are no unaccounted for escrow payments held by seller, and (iii) that the note is free and clear of all claims and liabilities. Due Diligence Process (a) Generally The due diligence process is perhaps the investor s most crucial undertaking in connection with the real estate note purchase transaction. It is during this stage that the investor can truly determine whether the price to be paid under the contract justifies the risks associated with the real estate note purchase. The only way the investor can do this is by meticulously analyzing each aspect of the purchase, including review of the loan documents, the real property collateral for the note, the financial condition and solvency of the borrower and any guarantors, and the financial condition and solvency of the seller. If during this process the investor discovers an unacceptable risk (assuming its attorney has appropriately drafted the contract), it can terminate the contract without continued liability prior to the expiration of its free look feasibility period. Haphazard due diligence, however, may place the investor in a less September 22, 2009 2
desirable position with severely undervalued assets if, for instance, an unresolved title defect, development restrictions, or pre-existing environmental conditions exist on the real estate securing the notes. It is an understatement to say that the due diligence process is crucial to a successful real estate note purchase. In fact, the process for a real estate note purchase is often more intensive and cumbersome than it would be for a purchase of the underlying real estate alone. (b) Review of Loan Documents (i) Loan Agreement The loan agreement governing the loan, along with the deed of trust or mortgage, serves as a general guide of the lender s remedies in the event of borrower s default. The terms of these documents determine the various rights and remedies of the investor, as lender and holder of the note, and those of the borrower. Other matters to be considered include the loan-to-value ratio, covenants imposed in the loan agreement, income and expense projections relating to the cash flow of the real estate, and any covenants relating to debt service. In the event of any existing borrower defaults, the investor will want to consider whether the default is material, whether the lender (or loan seller) has formally placed the borrower in default, and the likelihood that the borrower can cure the default. Also during its analysis, the investor should determine the existence of any inter-creditor or other co-lender agreements and determine if they affect the priority of the investor s lien. (ii) Note With respect to the note itself, the note purchaser should first determine whether the note evidencing borrower s payment obligations is a negotiable instrument. In order for the note to be negotiable, the Uniform Commercial Code requires that the note (i) be signed by the borrower, (ii) contain an unconditional promise to pay a certain amount, (iii) be payable on demand within a stated time, and (iv) be payable to order or bearer. Ideally for the note purchaser, all the foregoing elements would be met, the note would be negotiable and the note purchaser would become a holder in due course upon consummation of the transaction. If this is the case, the note purchaser is in the best position to enforce the borrower s payment obligations under the note and has minimized the risk of various common law defenses to its enforceability. Particular attention should be given to the payment terms under the note, including the interest rate and maturity date, which are especially important because of the various statute of limitations applicable to the right to foreclose under a real estate loan agreement and/or deed of trust. The note purchaser may often find itself, however, in a situation where the note is non-negotiable. These circumstances increase the necessity for heightened scrutiny of the seller s and the borrower s past performance under the note, because the note purchaser will be taking the note subject to all claims and defenses affecting its enforceability. In these instances, the note purchaser should secure an estoppel certificate from the seller whereby the seller clearly states all known or unknown defenses which would affect the enforceability of the note. While securing the estoppel certificate from seller does not preclude the assertion of such defenses by the borrower, it will, however, provide the note purchaser a remedy against the note seller (who hopefully is financially solvent) in the event the note is deemed unenforceable due to any such defenses arising during the time period in which the seller held the note. As noted above, the note purchaser should take physical possession of the note upon consummation of the transaction. A detailed analysis of all the issues surrounding the note is beyond the scope of this article; however, the main issues a note purchaser should pay particular attention to include: September 22, 2009 3
1. Security for the note (with the note referencing the deed of trust, as discussed below); 2. Maturity date and interest rate; 3. Order of application of any prepayments; 4. Right of holder to accelerate upon default (allowing the note purchaser to seek the full amount due in the event borrower fails to meet its payment obligations); and 5. Recourse or non-recourse status of note. (iii) Deed of Trust or Mortgage The deed of trust or mortgage constitutes the security for the note and is the legal mechanism by which the note purchaser can obtain title to the real estate encumbered by such deed of trust or mortgage. This document plays a crucial role because it allows the note purchaser, directly or through its trustee under the deed of trust, depending on the state, to obtain ownership of the property, whether through judicial (court-enforced sheriff s sale) or nonjudicial (public sale) procedures. The mortgage or deed of trust should specifically give the lender the right to foreclose on the underlying real estate in the event of the borrower s failure to make its payment obligations under the note or for any other material default under the note, loan agreement, or any other loan documents. A determination by the note purchaser of the priority of the lien granted in the deed of trust or mortgage is of paramount importance since a first lien on the property allows the note purchaser to institute foreclosure proceedings upon the borrower s default (without regard to the application of sales proceeds) and subsequently receive title to the property through foreclosure generally free and clear of any inferior liens. Any senior liens, however, should be reviewed to determine order of priority and to assess any risk that the sales proceeds from foreclosure proceedings would be insufficient to pay the borrower s debt to the note purchaser after satisfying the senior lien. In addition, the note purchaser should, at a minimum, review the deed of trust or mortgage to ensure it contains: 1. The identity of the borrower, beneficiary and trustee (including addresses); 2. A specific description of the indebtedness under the note (the amount of debt secured); 3. A due-on-sale clause (triggering the full amount of the indebtedness becoming due upon a sale or other disposition of the real property collateral); 4. The right to foreclose through judicial or non-judicial foreclosure proceedings, depending on the state; and 5. A satisfactory legal description of the real estate. The note seller s title insurance policy should also be reviewed in order to confirm that the lien is insured at the priority level that the note buyer believes it is acquiring. (iv) Real Estate Collateral With respect to any real property collateral, the note purchase transaction should be treated as a traditional real estate purchase. The note purchaser should perform an onsite inspection of the property secured by the deed of trust or mortgage and determine whether an updated survey is required. To limit the note purchaser s liability, an environmental site assessment of the property should be obtained, and the note purchaser should ensure that the current use of the property is in compliance with zoning and other governmental restrictions on the property. Additionally, it is essential that the note purchaser obtain a new appraisal of the real property collateral, so that it may get an accurate understanding of the current value of the land and improvements relative to comparable properties in the local market. The September 22, 2009 4
appraisal will show the approximate market value of the property, but not necessarily what the note purchaser could expect to receive at a foreclosure sale. The note purchaser should also obtain architectural reports, and any other third party reports during this stage. Finally, the note purchaser should analyze any income stream from the property, and ensure that the purchase price justifies the risk relating to such income stream in the event the note purchaser ultimately owns the property via the foreclosure remedy under the deed of trust. Analyzing the foregoing issues will mitigate any chance of the note purchaser being exposed to unknown, and potentially costly liabilities relating to the property. In addition to undertaking typical title and survey due diligence that one would see in a standard real estate acquisition, the note purchaser must also secure an endorsement to the original mortgagee policy of title insurance. In most circumstances, the note purchaser will not secure a new mortgagee policy because it will be insured as a successor or assign under the original policy. The note purchaser can realize a cost savings by bringing the seller s existing policy up to date through an endorsement from the seller s original title company. This allows the note purchaser to enjoy all the protections of the original title policy without incurring the full cost of a premium on a new policy. When issuing the endorsement, the title company will reveal all new liens against the real property, if any, arising after the date of the original policy. The endorsement from the title company coupled with an estoppel certificate from the seller should adequately protect the note purchaser from any unknown claims to title that would affect the note purchaser s lien under the deed of trust or mortgage. (v) Financial Analysis of Borrower and Seller The financial solvency of the borrower and any guarantors of the note is important to the note purchaser for several reasons. Determining the solvency of the borrower allows the note purchaser to assess the likelihood that the borrower can remedy any current or future default under the note or other loan documents. The note purchaser should analyze the borrower s financial statements to determine if it is in compliance with any financial performance covenants and/or reporting requirements pursuant to the loan agreement (e.g., net worth requirements, debt-to-income ratios, etc.). Implicit in this analysis is a determination of the likelihood of whether the note purchaser will ultimately be forced to foreclose on the property. By determining the amount of equity the borrower has in the property (by comparing a recently appraised value of the property against the current loan balance), the note purchaser can determine the likelihood of default and foreclosure, with the more equity held decreasing the possibility of borrower s default, and vice versa. The financial solvency of the seller should also be analyzed in case any issues relating to the loan arise subsequent to the sale. Although today s market typically calls for loan sales to be held on an AS IS WHERE IS basis, the seller may, in some instances, have ongoing lender liability due to errors in calculating escrow payments made under the loan agreement related to the note. This liability can be transferred to the note purchaser upon the purchase of the note and, although the purchase and sale agreement will provide for seller to indemnify the note purchaser for such claims, the note purchaser will want to be certain that the seller has the financial ability to do so. Analysis of the seller s financial solvency should include researching any litigation related to the seller and the property, Uniform Commercial Code and tax lien searches, mortgagor complaints and regulatory inquiries associated with the loans. Real estate note purchases have once again become the opportunity of choice for clients to profit from the uncertainties in the real estate market, defaulting September 22, 2009 5
borrowers, and declining real estate values. Understanding the process as a whole and appreciating the risks associated with owning the underlying real estate is key to success in these endeavors. We have several years of experience in this area and would be happy to provide assistance in these transactions. For more information contact Eugene Segrest, Clifton Dugas, or Matthew Lopez. Anchorage Austin Beijing Berlin Boston Charlotte Chicago Dallas Dubai Fort Worth Frankfurt Harrisburg Hong Kong London Los Angeles Miami Newark New York Orange County Palo Alto Paris Pittsburgh Portland Raleigh Research Triangle Park San Diego San Francisco Seattle Shanghai Singapore Spokane/Coeur d Alene Taipei Washington, D.C. K&L Gates is a global law firm with lawyers in 33 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com. K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the United States, in Berlin and Frankfurt, Germany, in Beijing (K&L Gates LLP Beijing Representative Office), in Dubai, U.A.E., in Shanghai (K&L Gates LLP Shanghai Representative Office), and in Singapore; a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining offices in London and Paris; a Taiwan general partnership (K&L Gates) maintaining an office in Taipei; and a Hong Kong general partnership (K&L Gates, Solicitors) maintaining an office in Hong Kong. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office. This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. 2009 K&L Gates LLP. All Rights Reserved. September 22, 2009 6