Potential New FDIC Loan Sale Approach

By: Richard O. Kopf
Real Estate in the Changing World: Confronting the Crisis
March 4, 2009

Sales of bad loans will be increasing in frequency over the coming months as the effects of the credit crisis are felt by the banking industry around the country. Due to issues that arose out of the RTC sales process back in the early 90's, governmental and political leaders have pressured the FDIC to increase the efficiency of their sales while retaining some of the "upside." This is consistent with the government's general approach to the current bailout (e.g., AIG). Accordingly, as sales increase, we can expect changes in structuring from the FDIC. A recent sale offering provided a glimpse into one such revision.

Recent FDIC Sale
The KBW-CML 269 sale offered by the FDIC as receiver for First National Bank of Nevada, covered two packages of loans, one residential and one commercial. That transaction was particularly unique in that the sale was structured as a sale of the entity that held the assets, as opposed to a sale of the assets themselves. While this change may seem like a mere technicality, if it reflects a new approach, it fundamentally changes the risk profile for the purchaser and is likely to have a wide ranging impact on the loan sale business.

Risks in Entity Sale Approach
To understand how this structure impacts the risk profile for a loan purchaser, it is important to understand the difference between an entity sale and an asset sale and why the FDIC took the entity sale approach. In a traditional corporate transaction, the seller conveys its interest in the entity that owns the assets rather than conveying the assets. The transfer document is a stock sale or transfer agreement. The focus in a stock sale is on the entity (rather than its assets) and the purchaser, since it is not directly receiving the assets, typically obtains representations and warranties, purchase price holdbacks and/or indemnifications from the seller. In an asset transaction, each of the assets is transferred by the means necessary to vest ownership of that asset in the purchaser – for example, in the sale of a real estate loan, by an endorsement of the note, a transfer of the deed of trust and other loan documents and an endorsement of the title insurance policy to the purchaser. When assets are being transferred directly, with appropriate due diligence, extensive representations and warranties from a seller are less necessary.

Reasons for the FDIC Entity Sale Approach
Why would the FDIC take the entity sale approach? I offer three possible reasons.

• First, perhaps the FDIC seeks an easy way to retain an ownership interest and preserve some upside from the sale. Not true in this case. The offering materials reflect that while a participation interest is being retained by the FDIC through a Participation and Servicing Agreement, 100% of the membership interests in the LLC are being conveyed.
• Second, the sale of an entity can simplify closing of the transaction from the FDIC's perspective by reducing the number of conveyance documents, thereby accelerating the timing of closing. (Note, while the number of conveyancing documents required to be signed at closing is significantly reduced, title to the assets must still be placed into the selling entity. I suppose the FDIC still retains the advantage of being able to transfer assets at its leisure, rather than all at once at closing.) In an asset sale, the purchaser will want to obtain endorsements to the existing title insurance policies, which are sometimes difficult to obtain on a timely basis, especially for a large portfolio with multiple issuing title companies. No such endorsements are required in an entity sale. The advantages discussed in this paragraph will also apply if the FDIC adopts the entity sale approach in connection with the sale of foreclosed properties.
• Third, and most significantly, an entity sale can substantially reduce the FDIC's potential liability with respect to ownership issues.

It is for this third reason that purchasers need to sit up and take notice. Since all the purchaser is receiving in an entity sale is sole ownership of the LLC entity, it will be hard for that purchaser to object in the event of problems related to the transfer or ownership of the assets themselves. The standard FDIC contract contemplates an "AS IS, WHERE IS" sale. An "AS IS, WHERE IS" approach is absolutely not appropriate in a corporate transaction of this type. Without representations and warranties by the FDIC, the purchaser will not have any redress against the FDIC for the most basic component of any sale transaction – failure of title. It remains to be seen if the FDIC is willing to provide those types of representations and warranties.

Borrower Defenses
Another issue purchasers will have to consider is the viability of any defenses that the borrowers may have against enforcement of the loan documents. For example, did any of the prior holders of the loan take any actions that may give rise to defenses by the borrower and/or guarantor? While this issue already exists with respect to the initial lender, depending on how long the loan has been held by the FDIC there may exist a new round of claims for lender liability, estoppel, laches or similar defenses. By law, certain defenses against enforcement, which are ordinarily available to borrowers may not be asserted against the FDIC, but purchasers must confirm the applicability of those defenses to purchasers from the FDIC.

Like all governmental entities, the FDIC has its "forms," which it is reluctant to change since they are supposedly tried and true. If the FDIC is "changing" its standard approach to sales, however, it must realize that sale of ownership interests in an entity is markedly different from sale of assets. Unless the FDIC provides representations, warranties and other protections typically provided in corporate transactions, purchasers must realize that they are getting something far different, and potentially far less secure, than what they would receive in a traditional loan sale transaction, and they must factor those additional risks into their pricing model.