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Loan Doc Due Diligence Is Critical with NPL Purchases

April 6, 2010

For small-balance investors jumping into the distressed-debt arena, correspondence between lenders and distressed borrowers can provide critical information supporting bidding strategies - particularly when defaulting property owners refuse to cooperate.

That's one of many tips seasoned non-performing loan disposition and acquisition experts offer for investors aiming to perform cost-effective legal due-diligence on distressed small-balance assets.

As SmallBalance.com reported in our last installment, CMBS special servicers in particular are becoming more active in disposal of non-performing and otherwise distressed small-balance commercial mortgages. And the expanding offering volume is, in turn, attracting more and more wannabe buyers - and closed deals.

Thorough due diligence is obviously critical in an increasingly competitive NPL marketplace. But with small-balance assets, budgets are necessarily limited.

However as our experts point out, enlightened due diligence can help investors understand risks - and bid accordingly - without costing an arm and a leg.

Indeed, the most fundamental purpose of due diligence in a distress situation is to provide information required to understand risks related to enforcing performance under the note and other loan documents, says real estate attorney Maura O'Connor, a partner with Seyfarth Shaw LLP in Los Angeles.

And O'Connor's firm, which is active in reviewing note-sale transactions, can often assist in due diligence with an initial review of the legal documentation for a single commercial real estate loan at a cost under $5,000.

While effective due diligence covers the borrower and collateral assets as well, those loan docs along with lender motivations should be the first priorities for a would-be buyer, adds Tampa-based broker and mortgage banker Andrew Wright, founder of multiple-services firm Franklin Street Financial Partners.

It may well be more pertinent to understand the paper and the note-holder's reasons for disposing of it, than the borrower's likelihood of contesting enforcement actions, continues Wright, who has focused on note sales and workouts in recent years.

A balance-sheet lender's motivations for selling distressed assets - and its negotiating position - may differ sharply from decisions by conduit-loan special servicers or government agencies, he continues.

For instance, regulators may be participating in disposition decisions of solvency-challenged balance-sheet lenders - leaving them little negotiating flexibility in structuring a note sale. In contrast, if special servicers are close to hitting the three-year limit for holding conduit loans, they may become extremely accommodating in disposition negotiations, Wright elaborates.

Logically a thorough review of loan docs as well as lender-borrower communication will help identify risks that could affect performance enforcement - not to mention collateral value.

For instance, the debtor's counsel will likely pore over documents seeking legal defects potentially helping its client's cause, O'Connor relates. These might include oversights such as omissions of required waivers or UCC filings, or even simple errors such as an incorrect legal description or party name - errors the note buyer’s counsel should look for as well.

When borrowers aren't cooperative with would-be note purchasers - as is often the case - the periodic financial statements lenders require can provide fresh risk-related information. In addition to estimating any remaining income stream, this will help investors identify tenant rent delinquencies, and in some cases even provide updated rent-rolls, advises Bill Ballard, a managing director with Pathfinder Partners, a San Diego distressed debt investor.

And it's not unheard of for the borrower side to throw a wrench into note sale negotiations by claiming that, during initial workout discussions, the lender promised some relief under certain circumstances. Attorney O'Connor cautions that she's seen borrower's counsel cite emails in making such claims, even when the communications were informal and hypothetical.

To help minimize these legal confilicts, effective due diligence entails gathering as much current information as possible about the relationship between the borrower group and the lender. This should include details of any actions taken to date, and also review of any correspondence between and among lender, borrower and related parties, O'Connor suggests.

If the lender refuses to provide this documentation once a loan purchase agreement has been negotiated (with the exception of appraisals and other privileged information), the prospective buyer should see this position as a glaring red flag, O'Connor concludes.

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