When Banks Foreclose
By Chris Groobey
As more borrowers slip from full performance to covenant default, and then from covenant default to payment default, lenders are reviewing security packages and planning whether and how to exercise their remedies. Some borrowers will contest a bank’s foreclosure on a project; others will willingly hand over the keys. However, in all cases the lender needs to ensure it complies with applicable law and contracts so as to avoid becoming liable to the borrower, subordinated lenders and others as a result of its actions.
Previous articles in the NewsWire have addressed the bankruptcy, tax and other implications of purchasing a distressed project. Many of the same issues apply as well when a lender forecloses on the equity in its borrower. However, the focus of this article is the legal requirements under the Uniform Commercial Code, or “UCC,” for a lender to foreclose successfully on a borrower. The article is based on a senior secured lender’s recent foreclosure on a portfolio of power generation facilities located in the United States.
The first step in preparing for a foreclosure is cataloguing the available collateral and determining which parts of the collateral are desirable to own or control. A properly-documented loan relating to a power plant generally includes the following collateral:
1. A series of waterfall accounts controlled by a trustee for the benefit of the lender.
2. Pledges of the equity in the borrower and its subsidiaries.
3. Pledges of the assets of the borrower and its subsidiaries (including the physical assets and contracts relating to the power plant).
4. Mortgages on the real property interests relating to the power plant.
5. Consents from contract counterparties detailing the lender’s rights to assume contractual obligations of the borrower and its subsidiaries.
Once the lender has catalogued the available collateral, the next analysis is whether to proceed generally against the equity or the assets.
Foreclosure on equity is usually preferable as, in one relatively simple and quick transaction, the lender can obtain control over an entire project. However, with equity also comes exposure to all of the liabilities of the foreclosed-upon entity, including possible tax, environmental, pension and litigation exposures and all existing contractual obligations. The prudent lender contemplating foreclosing on equity learns as much as possible about the current operations of its borrower before becoming the owner of a troubled entity.
Lenders usually benefit from equity pledges at more than one level of a project’s ownership structure. Careful consideration needs to be given to which entity or entities the lender will foreclose upon so as to insulate the project as much as possible from, for example, parent company tax or pension liabilities, bankruptcy proceedings, pending or threatened litigation and undesirable contractual commitments. Care must be taken to preserve tax benefits and regulatory exemptions, as well.
The alternative to foreclosing on equity is to foreclose selectively on individual assets.
Under this approach, the lender identifies all physical, contractual and intangible assets necessary to ensure the continued operation of the facility (or, alternatively, to sell a complete facility to a third-party investor). This is a daunting task and should only be considered by a lender when the borrower faces significant troubles that would not be able to be cured with a reasonable expenditure of time and money following a foreclosure on equity.
The remainder of this article assumes that the lender has performed the analyses described and determined to foreclose on the equity in the borrower.
Laying the Groundwork
Before a lender can begin to foreclose on equity, it must first determine who else might also have an interest in the equity. This is usually accomplished by reviewing the equity and debt documents relating to the borrower and the project, including subordinated debt documents and guarantees, and also performing UCC and real property searches for liens that have been filed by others against the assets of the borrower. The results of this research dictate who must be notified of the lender’s plan to foreclose and what rights the recipients of the notice have to object to the lender’s plans. If a lender fails to notify another lienholder of its proposal to foreclose on collateral, then the lender will be liable to the lienholder for any damages suffered in connection with the foreclosure.
Next, the lender must decide whether the foreclosure will satisfy all or only part of the borrower’s obligations to the lender. Again, the result of this analysis will guide the lender’s rights and actions going forward.
In addition, it is also important for the lender both to have notified the borrower of the event of default and, assuming it is permitted under the loan documents, to accelerate the full amount of the secured obligations. Notice to the borrower usually enables the lender to begin to exercise its rights under the security documents, including the right to trap cash in the waterfall accounts and to exercise the various pledgors’ rights to vote the equity in the borrower. Acceleration of the loan makes it more difficult for a borrower or third party to cure the outstanding event of default by paying only the unpaid amount, delaying the lender’s ability to foreclose on, and maximize its recovery from, the collateral.
Full or Partial Satisfaction?
Under the UCC, secured lenders have a choice when foreclosing on collateral: they may take collateral in full satisfaction of the obligations it secures, or they may take collateral in partial satisfaction of the obligations and continue to pursue the borrower for the remaining unpaid obligations. The UCC is drafted to encourage the former option, largely to protect borrowers less sophisticated than those usually involved in power project financings. (The UCC applies equally to $300 loans for sofas and $300 million loans for power plants.) Lenders who offer to take collateral in full satisfaction need not obtain the borrower’s consent to the foreclosure. Rather, the foreclosure automatically occurs 20 days after notice is given to the borrower and if the lender does not receive a written objection from the borrower to the proposed foreclosure. The borrower may also give its consent to the foreclosure, in which case the foreclosure occurs immediately, but borrowers are more likely to let the clock run out to protect themselves against claims from other secured parties and also to preserve any claims they may have against the foreclosing lender for failure to comply with its obligations under applicable laws and contracts.
In contrast, if the lender offers to forgive only a portion of the borrower’s obligations in return for the collateral, then the lender must obtain the borrower’s written consent to the foreclosure. If the lender does not receive the borrower’s consent, then the lender must either make a revised offer to foreclose on the collateral, but this time in full satisfaction of the obligations, or proceed with a sale of the collateral.
No matter whether the foreclosure is proposed to extinguish all or part of the borrower’s obligations, the lender must also notify subordinated lenders and other creditors who have liens on the interests on which the lender desires to foreclose. Each of these lienholders also has the right to object to the proposed foreclosure, in which case the lender must conduct a public (as opposed to private) sale of the collateral under the UCC. The lender is permitted to purchase the collateral at such a sale, but the “public” sale requirement increases the time and costs involved in the sale process and the presence of other bidders may increase the price that the lender must pay to retain the collateral if it so desires.
The UCC imposes no requirements on the relationship of the value of the collateral to be foreclosed upon and the amount of the obligations that will be extinguished upon foreclosure. This means that a lender is just as entitled to the full collateral package at the beginning of a loan’s term (when the owed amount is greatest) as at the end of the term (when the value of the collateral may be much greater than the remaining unpaid amount of the loan). This also means that a lender may offer to foreclose on collateral in return for extinguishing only a very small portion of the borrower’s obligations. Although unlikely, if the borrower accepts these terms, then the lender could receive both valuable collateral and, subsequently, significant cash to pay the remaining amount of the borrower’s obligations.
Effect of Foreclosure
Assuming a successful foreclosure on equity in accordance with the UCC, the borrower’s obligations to the lender are extinguished to the extent agreed between the borrower and lender — namely whether the obligations are extinguished in whole or in part. In addition, foreclosure extinguishes subordinate security interests in the collateral (which is why other lienholders must be notified of, and given an opportunity to object to, the proposed foreclosure) and vests with the lender all of the borrower’s rights in the collateral, free and clear of subordinate liens.
The foreclosing lender need take no further action to complete the foreclosure and accept the collateral after all applicable parties agree, are deemed to agree, or fail to object to the collateral. For example, in the case of a foreclosure in full satisfaction of the debt, if the lender receives no objections to the foreclosure within 20 days after the date of the foreclosure notice, then the equity automatically transfers to the lender on the 20th day.
Unenforceable Contract Provisions
The traditional documentation governing project loans contains a litany of remedies that are supposedly available to the lender. However, many of these remedies are unenforceable.
The UCC contains numerous protections for borrowers and dictates that many of those protections cannot be modified or negated, even by contract between two sophisticated parties. If a lender attempts to avail itself of such remedies, it opens itself to lender liability claims from the borrower and others with interests in the collateral. Examples of unenforceable provisions include those that purport to permit the lender to purchase collateral at a private sale (which the UCC does not permit if the borrower objects), to excuse the lender from giving various notices to the borrower, or to limit the lender’s liability for failure to follow the provisions of the UCC when dealing with collateral.
In order to protect against lender liability claims and ensure a successful foreclosure, the lender should first catalog the rights it believes it has under the loan documents and then confirm the validity of those rights under the UCC and other applicable laws before attempting to exercise them.
The UCC imposes the overarching requirement on lenders that all of their actions in connection with collateral must be “commercially reasonable.” The UCC itself does not define what actions are or are not commercially reasonable, but it does permit lenders and borrowers to agree as to the standards for commercially reasonable behavior in the contracts between them. For example, lenders and borrowers may agree to various notice and time periods, methods of sale or other disposition matters. The only restriction on such agreements is that they not be “manifestly unreasonable.”
Lenders must also act in “good faith.” For purposes of the UCC, good faith is defined as “honesty in fact.”
The UCC imposes many obligations on lenders when dealing with collateral. If a lender fails to act in compliance with the UCC, then the borrower may pursue remedies against the lender. For example, a borrower may petition a court to order or restrain collection, enforcement or disposition of collateral on appropriate terms and conditions. A borrower may also seek damages from the lender in the amount of the borrower’s loss due to the lender’s failure to comply with the UCC, including losses caused by the borrower’s inability to obtain, or increased costs of, alternative financing. The UCC instructs the court to award damages for violation of the UCC in the amount reasonably calculated to return the borrower to the position it would have occupied had the lender not violated the UCC.
Interestingly, however, a lender’s failure to comply with the UCC will not unwind a foreclosure on collateral. Even after failing to act in a commercially reasonable manner, for example, the lender will still have title to the collateral, but it will face possibly substantial monetary liability to the borrower.
In sum, foreclosure on equity in a borrower is often the most attractive option to a lender following a default — but the proper procedures must be followed and the proper resources consulted to ensure immunity from lender liability claims.