The Four Seasons of loan documentation

RMA Journal, The, May, 2004 by Bruce Bates

Lending to municipalities or governmental agencies has unique quirks and may involve creating new documents to qualify for special legal or tax treatments. These documents can be voluminous, but it's very important to review them carefully. As a case in point, a multi-city agency established for psychiatric patient care was having severe cash flow problems. The agency's executive management had recently changed, but that did not stem the exodus of doctors and staff. With the doctors' flight, cash inflows continued to erode. It looked like an irreversible tailspin.

The documents transferred had been drafted for the specifics of this situation and entity, and the originating lending unit allowed the bond counsel for the governmental agency to prepare the agreements. We discovered that the bank had not been represented by its own attorney to review the documents. The lending unit, who were specialized in lending to municipalities, believed themselves to be experts and were concerned that bank counsel could slow the process. In other words, thoughts of a never-ending summer lulled the lending unit into a false sense of security, and they cut corners.

After the transfer to workout, the projected cash flow statements indicated, at most, six months of life left to the entity. Monthly payments to the bank were in default, and we retained counsel to prepare the demand and acceleration. When the call from counsel announced that there were no acceleration provisions in the documents, we were genuinely shocked. An acceleration provision is so commonplace in documents, no one anticipated such news. It is almost like building a new house and forgetting to connect to the sewer; while not evident at first, things soon begin to stink.

Clearly a loss existed before the transfer to workouts, but the lack of an acceleration provision hobbled our negotiating options and probably reduced the recovery by an additional $300,000.

Every item contained in documentation is like another bullet in the chamber--the more bullets, the better. Each term or condition, guaranty, or other negotiating point waived up front takes away a precious shot from the resolution arsenal.

Most files are chronologically ordered archives--structured to hold information rather than to recount a story. Most of the time. I feel like a sleuth with magnifying grass in hand, building a case from disparate cities that will be used as the foundation for a recovery strategy. The primary objective in a workout is to concurrently maximize recovery and minimize loss. The unfortunate underlying implication is that not all the principal loaned will be retrieved. Using every fact to its best advantage, however, will help the institution achieve maximum-recovery and minimum-loss objectives.

A great negotiator will boost the benefit of a trade by understanding that an item of little value to one party may have great value to the opposing side. Grasping this concept is akin to exploiting arbitrage in a foreign-currency translation. In another example, we loaned $2 million to a metal container leasing company. The underwriting process identified an existing senior lien. Steps were taken to pay off the senior debt and release that lender's UCC filing. It's not clear what caused the snafu, but when the senior debt was repaid, the associated UCC was not released. Unfortunately, that senior lender re-lent monies to the company and then claimed a continuing superior lien. The documentation no longer reflected the intent of the parties. In an early summer cycle, the foregoing problem would likely have been resolved among the lenders. Because the loan was funded in an autumn cycle, there was not enough time to resolve the dispute before the company stalled and died. By the time we discovered the competing security interest remained unresolved, the company was headed for bankruptcy court. The president's net worth was centered almost exclusively in the value of the company; as a guarantor, he added very little financial strength to the downside liquidation analysis. Nonetheless, that guaranty became a pivotal piece of documentation. It ensured the guarantor's active involvement during the resolution process with the other lender, which had no guaranty. In the resolution negotiations, his affidavit regarding the intended release of the other lender's UCC became the defining fact. It corroborated our undocumented claims of priority security interests in the metal container. Without the president's guaranty, I am convinced his willing involvement would have been greatly reduced--even nonexistent--and our legal position would have been seriously weaker. It could have been easy to negotiate away the soon-to-be-valuable guaranty during the underwriting process, because the president did not add financial strength to the transaction. However, what seemed of no value to the bank became extremely valuable to the guarantor.