You can ignore banking law, but it is a life force that is always around us, everywhere, all the time – just like Ryan Seacrest. Similar to that hard working celeb, banking law, particularly as it pertains to commercial lending, really came into its own during the downturn. It seemed like every loan had an issue. You could have the most air tight loan documents in the industry, but it was still like trying to nail Jell-O to a tree as borrowers argued that they did not understand the loan terms, other verbal contracts were entered into or that the lender misrepresented the transaction.
During our most recent financial crisis a cloud of liability arose from commercial real estate lending. These problems largely fell into two categories: a) problems with a loan that prevented repayment and/or collections; and, b) lender liability issues. Given that many of these problems stem from the time commercial real estate loans are negotiated and the fact that competition is forcing banks to reduce covenants and documentation, we figured now is the time to review some helpful tips. We recently attended a lecture by Mark Cameron of the law firm of Miller Starr Regalia and Ken Russak of Frandzel Robins Bloom and Csato to gain a deeper understanding of both topics.
The Riverisland Issue
Leave it to CA and its Supreme Court to hand down its unanimous decision at the start of this year which overruled the 78-year old, lender-favorable Pendergrass case. Before, it was the written loan contract that mattered. With the Riverisland Cold Storage v. Freson-Madera Production Credit Association ruling, now the borrower can allege that prior oral promises were made that were at odds with the loan documentation. Not only did this provide a wide berth for borrowers to legally navigate, but it has made it almost impossible to reach a settlement in pre-trial as the borrower now has hope of winning in front of a judge or jury. The very certainty that the loan documentation used to afford is now uncertain. Matters were subsequently made worse as there is now case precedence that applies The RiverIsland ruling even to sophisticated borrowers. As Messrs. Cameron and Russak point out, “Desperate borrowers, lessees and guarantors will swear to the most remarkable inconsistencies when their financial futures are at risk.”
It’s the Little Things That Matter
Like Seacrest’s strategically tousled hair, lenders need to pay attention to the details. While we are not lawyers, and you should of course check with yours, here are 10 things that we learned from the school of hard knocks combined with lessons from Cameron and Russak that banks can do to help reduce the legal risk associated with commercial lending:
Arbitration - Banks should include arbitration and judicial reference clauses in all agreements to increase the probability of not going to trial by jury.
Acknowledgement – When lenders extend any credit to their customers, the agreements should include recitals acknowledging the debt, the outstanding loan amount and the fact that there is no defense to the obligation. While this will not help with false inducement to enter into the agreement, it will help block evidence that tries to assert there were alleged promises about the loan terms prior or contemporaneous with the original loans and amendments.
Releases – Lenders should obtain releases from their customers at the time of extension or renewal of the credit to reduce the probability of a legal issue associated with time. The less time that has passed since the release, the lower the probability of a problem.
Training – Lenders should be trained to recognize problem clients that often confuse terms or misrepresent the facts. These are red flags that raise the legal risk of a transaction. Loan officers also must be taught to refrain from making any representations outside of the loan documents.
Reject In Writing – Often times loan terms are negotiated over the phone. If done, loan officers should insist that the offered or counter-offered terms be in writing followed by a clear acceptance or rejection in writing. In addition, each correspondence in the negotiation should contain an additional disclaimer that states something to the affect of: “Terms and conditions herein are not final or agreed upon until the final agreement is reviewed, approved and executed.”
English As A Second Language – Banks should insist on or provide for an interpreter for any borrower that has limited English skills.
Covenants Matter – Covenants allow for an early “trip wire” and should be negotiated away with great care. Consider the increased legal risk when removing or reducing covenants plus the economic risk of waiving covenants.
Title Insurance – Title insurance is not like auto insurance that pays even if the insured owner was at fault. Almost all title policies exclude losses that were “created, suffered, assumed or agreed to by the insured claimant.” In other words, to be able to rely on title policies, make sure your lending, disbursements, notices and procedures are in order because the title insurance companies could be looking for a reason not to pay.
Construction Progress Inspection – One big lesson that we learned during the downturn was progress inspection reports were often light on substance and may have been done via phone, email or in quick “drive by” fashion. Since documentation is so important, when it comes to construction, having an understanding of the project is key. There were many cases where the project was over budget but the inspection failed to catch the issue and the borrower submitted the additional invoices closer to completion to force the lender to absorb them or to carry for repayment out of future sales. Unfortunately, banks often found more mechanics liens than they wanted. For that matter, each progress draw should include signed, dated lien releases in the amount for the invoices and unconditional progress payment lien releases for all invoices paid prior to the draw. The “paid through” date should be managed with care.
Diversification – Develop a diversification rating system for the LLC for related borrowers. Lending to several LLCs with related parties may be the same as lending to a single borrower. Understand the relation of each borrower or guarantor can help underwriters be clear on the potential for credit, legal and reputational risk associated with a group of borrowers. Everyone is always a “pillar of the community” until there is a loan problem.
For more information on understanding how banks got sued and how to avoid being sued, go to our Resource Center to download a report by Mark Cameron and Ken Russak that covers some of the above and much more. Ryan Seacrest is known for not only working hard, but doing is homework and always being prepared. Now is the time to get an education to ensure your lending processes, underwriting procedures and legal documentation are as strong as it can be.
Submitted by Chris Nichols on May 13, 2014