The following article was printed in North Western Financial Review on September 15, 2008.
Delinquent borrowers often look for flaws in loan documentation. If flaws exist, they can be costly to the bank. Further, inadequate due diligence may increase the potential for losses even with a well-documented loan transaction.
It is fairly common, for example, for lenders to use internal form documents when renewing or otherwise extending a promissory note. References in the form documents to the security documents and guaranties supporting the loan should be reviewed to insure that such references are complete and accurate. The lender should take care to insure there is no confusion regarding whether the lender has inadvertently released collateral or a guarantor by failing to identify the collateral and supporting security documents for the loan, or failing to identify the guarantors of the loan. A borrower or guarantor may raise this type of omission in the documentation as a defense to payment, slowing the ability of the lender to exercise its rights and remedies. The use by legal counsel of a formal amendment which contains recitals accurately reflecting the loan transaction, a comprehensive reaffirmation of the loan documents and a full release by each credit party is a cost-effective tool to mitigate risk associated with improper loan documentation.
Documentation containing inconsistent events of default may also lead to losses for a bank. Discrepancies in defined default terms contained in multiple documents and inconsistent notice, grace and cure periods can hinder the lender's ability to timely exercise its rights and remedies, providing the borrower with ammunition to attack the loan documentation, raise defenses to payment and cause delays. Inconsistent notice and timing provisions can have extreme consequences.
For example, a borrower may argue that it did not receive proper notice or enough time to cure as required under the loan documentation because of different notice provisions contained in the note, the loan agreement and the security documents. The lender's ability to provide proper notice “after the fact,” and thus enforce its available rights and remedies, can be delayed by an intervening bankruptcy filing. Definitions of defaults should be “internally” consistent within the documents evidencing the loan. Preferably, defaults should be identified and defined in a master loan agreement. The ancillary supporting documentation (i.e., security agreements, mortgages, pledge agreements, guaranties and the like) should then refer to the defined defaults in the master loan agreement rather than attempt to restate and/or add to such defaults.
In addition to drafting adequate loan documentation, legal counsel can assist in the due diligence process. For example, evidence of property insurance in connection with a real estate loan is of the utmost importance. A lender can utilize legal counsel to review the form of insurance coverage and assist in obtaining a certificate that conforms to the lender's internal requirements and provides proper coverage for the lender. Evidence of such insurance should, among other things, show the borrower as the named insured, set forth the amount of coverage available and identify the lender as both “mortgagee” and “loss payee.” If the lender is only named as “loss payee,” the protections afforded the lender are limited to the protections afforded a borrower. In other words, if the carrier has a defense to payment as against the borrower, the same would apply to the lender. The “mortgagee” designation protects the lender against the possibility that the insurance carrier denies coverage due to “bad acts” of the borrower, such as arson. The “lender's loss payable” designation is the personal property equivalent of the “mortgagee” designation for real property, providing separate coverage to the lender.
In troubled times, lenders may lose sleep because of economic woes plaguing their customers, but they should not be kept up at night as a result of inadequate or ineffective loan documentation or due diligence. Effective legal counsel can mitigate such risks by providing reliable loan documentation, advice concerning loan structure and effective due diligence supervision and support.