Lender A is a commercial lending officer at a large financial institution and has landed a $100,000,000 commercial loan in favor of a large company. Lender B is a commercial lending officer at a small community bank and has landed a $1,000,000 commercial loan in favor of a small, local company. In both cases, there will be parent, subsidiary or affiliate guarantees of the loans, and each bank will be taking a lien on all of the assets of the borrower, including significant real estate.
In the case of Lender A’s deal, the legal fees are expected to be in the $50,000 range. In the case of Lender B’s deal, the legal fees are expected to be in the $1,000-$2,500 range. For the lawyer documenting and closing the smaller deal, however, the issues involved are quite often just as complex and time-consuming as those involved in the larger deal.
Beyond drafting the relevant loan documents to conform to the lender’s approval, what type of diligence is typically involved in commercial lending deals, regardless of the number of zeros at the end of the loan amount? Here’s a brief summary of some of the customary diligence items:
(1) Real Estate: Any lender that deals with real estate is accustomed to ordering an appraisal and an environmental report and pulling title. But why is it so important to also obtain a survey and zoning opinion and to read the underlying instruments noted in the title?
As my colleague, Kenneth MacKenzie, best puts it: “Real Estate is like a beating heart; you need to be able to get utilities, waste, drainage, people and products into and out of the property”. In industry parlance: “What you see is what you get”. In reviewing the title, there are two important items for the lawyer to discern: (a) does the borrower have good and marketable title to the property and (b) is there anything disclosed on the title report or survey that would affect the value of the property as determined by the appraisal or the operations of the borrower, and therefore, the bank’s underwriting?
In order to make this determination, the lawyer must review the title and survey together. The title report “discloses”, while the survey “locates”. How does the company get its utilities, waste, drainage, people and products in and out of the property? What’s the property’s access to the public way? Is there a perfected easement to and from the public way? Are there any easements that run through the property? What would the impact be if these easements were removed (e.g., is there an easement that runs directly under the building)? Are there restrictions or covenants that impact the operations at the property (e.g., a restriction that prohibits overnight parking of trucks where the borrower’s business requires such parking)? Is there improper drainage from a portion of the property onto another’s property without an easement? Is the property in compliance with current zoning laws-i.e., is its current and proposed use permitted? What about expansion plans; do they comply with current zoning laws?
In granting a mortgage loan, the bank relies heavily on the appraisal. The foregoing is only a sampling of the types of issues that could impact the valuation in the appraisal, and thus, the bank’s loan. As an example, let’s presume that the bank is lending money to a manufacturing business (again, the amount of the loan doesn’t matter, as the issues are the same). The property is legal-nonconforming, meaning that the property originally conformed to local zoning ordinances and is grandfathered but doesn’t comply with current zoning requirements. That’s okay, isn’t it? Maybe; maybe not. If all or a substantial portion of the property is destroyed by casualty, municipalities impose different rules. Many municipalities will require a special permit to be issued to rebuild the property to its former state and/or that it be brought “up to code”, all within a certain period of time from the date of loss. If the property becomes “REO” following the casualty, the lender will need to be continually aware of the ticking clock and the potential loss of grandfather rights arising from the failure to rebuild or commence the use, neither of which the lender will want to do. The appraisal assumes these issues away and leaves it to the lawyer to ensure that the diligence supports the appraisal the bank has received.
Obtaining a survey, plot plan, zoning opinion or independent zoning report can take several weeks and can be costly. Because Lender A’s deal is so large, obtaining these diligence items is the norm, regardless of the time and expense involved. On the other hand, even though these same issues can apply equally to Lender B’s loan, we often find that surveys, plot plans and zoning opinions or reports are resisted by borrowers in the loans with fewer zeros at the end. Ultimately, it is up to the lawyer to assist the lender in determining whether to require these items and understand the risks involved in not obtaining them.
(2) Lien Searches: Regardless of whether the collateral for the bank’s loan is solely personal property or real property or a mix of both, lien searches on the borrower (and any other obligor granting collateral to support the loan) should be conducted. There are four (4) basic types of liens for which searches are generally conducted: (a) UCC liens, (b) federal tax liens, (c) state tax liens and (d) judgment liens. The searches are best performed by third-party service providers. Unlike real estate where liens are tied to the real estate, liens on personal property are tied to the debtor and searches must be made under the debtor’s name. A lender making a senior loan secured by real estate and/or personal property expects that it will be first in priority with respect to its collateral. While a title examination generally ferrets out any liens on the real estate, it’s still possible that there may be a federal or state tax lien or judgment lien filed against the borrower or other obligor that is not separately filed in the real estate records. When it comes to personal property, the only way to ensure priority of the lender’s lien is to search the UCC records where the debtor is “located” for Article 9 purposes, as well as searching for tax and judgment liens that may trump the lender’s priority.
As is the case with obtaining a survey, plot plan, zoning opinion or independent zoning report, lien searches take time and can be costly. Where to search and what name to search can also be an issue. For example, if a debtor changed its name from ABC Corp. to XYZ Corp. within the last 5 years, then searches must be conducted under both names, which will lead to additional expense. Again, as is the case with obtaining a survey, plot plan, zoning opinion or independent zoning report, because Lender A’s deal is so large, conducting such lien searches is the norm, regardless of the time and expense involved.
On the other hand, even though these same issues can apply equally to Lender B’s loan and may impact the bank’s underwriting, borrowers tend to resist comprehensive lien searches in the deals with fewer zeros at the end, or, if they are conducted, they may be conducted by the lender or the closing attorney via an informal on-line search of the state secretary’s records under only the debtor’s current name to minimize expense. The problem with not conducting searches is obvious-the lender cannot be assured that it will have a first priority lien on the assets of the debtor and there may be other creditors on record that will take ahead of the bank in a bankruptcy of the debtor or there may be a tax or judgment lien filed against the borrower which could be a red flag that potentially signals more significant issues with the borrower and its business. The problem with merely conducting informal on-line searches is two-fold: (a) these searches only search for UCC liens and do NOT search for judgment or tax liens that can also impact a lender’s priority and (b) on-line filing and searching standards vary from state to state.
For example, if the debtor’s name is ABC Marketing, Inc., the secretary of state’s office may abbreviate the name to “ABC Mkting Inc.”, and a search under the correct name may not disclose any filings under the abbreviated name. Third-party service providers conducting formal searches are familiar with the nuances of the various states’ search logic and can tailor their searches to include multiple variations of a debtor’s name, thereby providing more accurate search results in which a lender may take comfort.
(3) Guaranties: Many times, banks rely heavily on a guarantee of a parent, a subsidiary or affiliate in underwriting the loan. But what if that parent, subsidiary or affiliate does not receive adequate consideration for its guarantee? For example, a strong sister entity of the debtor provides a guaranty. Without that guaranty, the bank would not make the loan. The question is-what benefit does that sister entity receive in return for its guaranty? Is it sharing in the proceeds of the loan? If no direct or indirect benefit can be established, that significant guaranty may be held to be unenforceable for lack of consideration.
To identify these types of issues, the lender and lawyer must understand the organizational structure of the borrower and, ideally, obtain an organizational chart. Most sophisticated borrowers will have organizational charts, but that’s not always the case with smaller companies. Again, the issues are the same regardless of the zeros.
So, what does this all mean? It is the lawyer’s job to ensure that the diligence supports the bank’s underwriting and that the bank gets the deal for which it bargained. A defect in the diligence for the $1,000,000 loan may have the same impact as a defect in the diligence for the $100,000,000 loan. The $1,000,000 loan for the small, community bank may represent the same percentage of capital or portfolio of the community bank, as the $100,000,000 loan does for the larger bank, and failure of the loan may be immense for both banks regardless of the difference in the zeros.
The lender in both cases can be helpful by preparing its borrower appropriately for the type of diligence (including surveys, zoning opinions and lien searches) it expects to be performed and the expense involved early on in the deal and by building in enough lead-time to obtain these items. The lender can also be helpful in explaining to the borrower the need to cooperate with the lawyers in conducting this diligence, including completing a “Perfection Certificate” or “Collateral Questionnaire” to be drafted by the bank’s lawyer in order to ascertain where to conduct lien searches and under what names to search. Lastly, the lender can also be helpful by explaining up-front to the borrower how issues discovered during the diligence can lead to increased legal fees in trying to resolve these issues.
ABOUT THE AUTHOR: Christine Sullivan Higgins
Christine Sullivan Higgins is a partner and leader of the C&I/asset-based lending commercial
group at Dalton & Finegold, LLP in Andover, Massachusetts. She specializes in UCC, Article 9. Prior to joining Dalton & Finegold, Christine was senior counsel in the leveraged finance department at a large Boston law firm. Dalton & Finegold is a boutique firm comprised mainly of former partners at large Boston firms engaged in sophisticated legal practice in commercial real estate, hospitality, commercial and industrial/asset-based lending, bankruptcy and creditors’ rights, civil litigation, housing and estate planning.
Copyright Dalton & Finegold, LLP