Due to the wide range of economic difficulties which have confronted financial institutions in the 1980's--the "deindustrialization of America," the farm crisis, the energy crisis, and the overbuilding of many cities--there has been an explosion of troubled real estate loans. Even the best managed institutions are feeling the effects.
The result of all this turmoil is that while many lenders "bury their heads in the sand" in the hopes that their problems will go away, just as many go to the opposite extreme by rushing to initiate litigation proceedings. All too often attorneys who do not specialize in problem real estate loans do not creatively explore alternatives to filing suit. Instead, their training leads them to file suit first and ask questions later. Unfortunately, litigation is a very time-consuming and expensive process.
This article will focus on three broad areas:
The Economic Realities of Litigation
In the past, litigation was often viewed as the preferred means of resolving non-performing loans. For the most part, litigation was not complicated, technical, or time-consuming. Typical issues in loan disputes centered around the amount of principal, the rate of interest, and the event of default. Many foreclosure actions were simple summary proceedings.
However, times have changed, and so too must the attitudes of those managing financial institutions. Litigation is no longer the most effective course of action for resolving non-performing loans. The emergence of lender liability law and numerous borrower defenses have substantially reduced the odds of a timely and inexpensive trial. Additionally, financial institutions are now offering a much wider range of products and financial services. The possibilities for misunderstandings and disputes have never been greater.
While some disputes may best be left to traditional litigation, it is important for a financial institution to carefully weigh the high costs of protracted litigation against alternative settlement techniques.
Litigation results are unpredictable and can often be quite different than originally anticipated. A "typical" foreclosure action, or suit to enforce a security agreement may lead to a bankruptcy. This, in turn, results in additional expenses, delays, and the very real possibility that the collateral will deteriorate and diminish in value. In such a situation, the costs of the trustee, receiver, court appointed appraisers, managers, or other professionals, as well as substantial attorneys' fees, must be factored into the decision whether to litigate.
Due to the litigious nature of today's business world, more and more court proceedings are being delayed by backlogged court dockets. Additionally, the discovery process can be very time-consuming and the availability of appellate proceedings can add months, if not years, to a final decision. In contrast, the negotiation process is less formal and may provide a forum for more creative dispute resolution than litigation.
Litigation also consumes an enormous amount of a financial institution's executive and staff time and energy which could be used in more innovative and entrepreneurial activities.
Additionally, though "hardball" can and is being played in settlement negotiations, the atmosphere is not as adversarial as in an actual litigation proceeding. Instead, there is more cooperation in achieving a mutually beneficial end.
Furthermore, the adverse publicity which is generally associated with a trial cannot only damage a financial institution's reputation among its customers, but also any prospective clientele. If the publicity indicates that a financial institution is unwilling to work with its borrowers in difficult times, the result proves to have a chilling effect on the institution's business.
Finally, not all judges and juries can grasp the complicated or technical facts needed to reach a decision. Therefore, the triers of fact allow their emotions to intervene in their decision-making process and often times rule in favor of the borrower.
In summary, the high cost of litigation not only consists of a monetary figure, but also personnel time, strained business relationships and the possibility of an adverse public image.
Analysis to Eliminate Uncontrollable Litigation
In order to curtail the high cost of litigation, a financial institution's general counsel or experienced workout specialist should conduct a litigation risk analysis which should address the following issues:
Once a litigation risk analysis is completed, but before a final determination on how to proceed, an evaluation of the collateral must be made.
Among the analyses that can be performed on the collateral are:
Once a comprehensive analysis is complete with regard to a problem real estate loan, the borrower, and the collateral, an informed business judgment may be made by the financial institution as to the most efficient and cost effective manner in which to resolve the problem loan.
Such a litigation risk analysis should also be undertaken for all pending litigation. The focus of this analysis is to determine, from a business standpoint, whether it is sensible to continue to vigorously pursue a particular borrower. This litigation analysis also should focus on the performance of the institution's general counsel. Are they proceeding as swiftly and efficiently as possible? It has been my experience, that at times an institution's general counsel lacks the experience and knowledge to effectively represent the financial institution in complex commercial transactions. Additionally, the litigation volume could overwhelm and tax the resources of general counsel to the point that the results may be unsatisfactory, untimely, and hence not cost-effective.
The monthly fee statements of an institution's litigation counsel should be reviewed with an eye toward results obtained. Each case should be assessed as to whether or not said case involves significant legal issues or whether the case is "routine." The main concern is the aggressiveness of counsel in obtaining the best result possible with the least amount of time and expense. Litigating solely for the sake of litigating should be discouraged.
To summarize, both before initiating litigation and during the course of the action, a financial institution should synergize the areas of business and law to make an informed business judgment as to whether or not an alternative to litigation is the most cost-effective manner in which to resolve a problem loan.
Alternative Settlement Technique
Alternative settlement techniques--alternatives to litigation--include, but are not limited to:
Negotiations should begin when a borrower and a lender realize that the loan will not perform according to its original terms. Rather than immediately initiating litigation, the lender and borrower should attempt to voluntarily negotiate a restructure, modification, or extension of the terms of the loan. This can be mutually advantageous to both parties.
The lender's goal in negotiations should be to convert a non-performing loan into an asset of greater value. It's an attempt to make the best out of a bad situation. Ultimately the lender desires to recover principal plus accrued interest and expenses, even if they are recovered at a later time period. However, one should realize that this is not always possible, and that delusions of so may actually lead to diminishing returns.
The lender may also have other goals in negotiations. Specifically, there may be defects in the loan documentation which need to be addressed; there may be an opportunity to gain a share of the development profits or to establish greater control over the project or borrower; there may be a chance to obtain additional collateral or guaranties.
On the other hand, the borrower will also have certain goals in workout negotiations. Ideally, he will want to maintain his property and business. This can be done through an extension of the maturity date; a reduction of the principal; a reduction, waiver, or accrual of the interest; additional advances to strengthen or complete a project; and other similar lender concessions. At a minimum, the borrower will want to preserve his credit and reputation.
In many instances, it will be in the lender's best interests to arrive at an agreement wherein the borrower maintains possession of the property. Too many financial institutions fool themselves into believing that they are real estate developers or management firms. Only after they obtain the property do they realize that they are in over their heads.
During the course of workout negotiations, both the lender and the borrower need to realize that compromises will be necessary. Personal animosities must be set aside, and a quick solution to the problems will be in everybody's best interest.
When negotiations encounter difficulty, alternative settlement techniques which do not involve litigation can be used. One such alternative is mediation. Mediation is a process in which a neutral advisor, who lacks the power to force parties to accept a binding decision, assists the parties in reaching a settlement.1
At this point in time, however, arbitration is the most widely established alternative to litigation. Ample avenues of appeal available in litigation guarantee both parties the opportunity to have each issue reviewed more than once. In arbitration, these rights can be limited and therefore reduce the amount of time and money spent in appealing an arbitrator's final decision.
Arbitration reduces the need for attorney hours to be spent in preparing a streamlined presentation of complicated facts to a court. Parties, as a general rule, submit a large volume of complex business contracts, correspondence, financial statements, and stipulated expert testimony to an arbitrator selected by the parties. Presumably the arbitrator is someone with commercial experience, who can digest the information at his or her own pace without the burden of the whole panoply of a court proceeding.
Not only do specially selected arbitrators often speed the process along; they frequently develop a more accurate understanding of the complicated and technical cases. Such expertise proves particularly useful in disputes involving custom in the particular field and trade usage.
Parties with valued, longstanding relationships may prefer arbitration since it is less adversarial in nature than litigation. Relationships are less likely to be destroyed by private arbitration than by the intense battles which often erupt in the course of lengthy and public litigation.
Many financial institutions do not suspect problems with a loan until there is an actual monetary default. This is a mistake. The earlier you can detect a problem and act upon it, the easier it is to correct.
Lenders and borrowers alike should be aware of the troubled loan warning signals. For construction loans, the signals may be quite overt--failure to meet project deadlines, failure to pay subcontractors, cost overruns, etc. However, other loans' signals are much more subtle--failure to meet earnings, occupancy, or sales projections; operating at a loss during a normally peak income period, etc. And, of course, late payments are always a strong signal of trouble especially when they occur frequently.
Another method of detecting potential trouble is to visit the property. Even a simple "drive past" may prove to be enlightening. What condition is the property in? Does it appear rundown and deteriorating, or is it well-maintained?
It is also advisable to keep abreast of general economic trends. Neighborhood and metropolitan economics are just as important as national and world economics. A rise in interest rates will hurt construction-related businesses. Similarly, a new shopping mall in town may affect neighboring retailers.
In any event, once a troubled loan is detected, financial institutions must conduct a litigation risk analysis. Then, they must weigh the costs of litigation against the costs of the litigation alternatives.
Typically, with the aid of an experienced real estate workout specialist, negotiations and other alternative settlement techniques can be the most effective method of working out a non-performing loan. Upon completion of an in-depth litigation risk analysis, if a financial institution determines litigation is the manner in which to resolve a non-performing loan, the philosophy with respect to such litigation should be to pursue an approach that is aggressive and forthright, avoiding coercive, delaying or obstructive tactics, and consistent with an overall objective of resolving litigation in the most expeditious and cost-effective manner.
1. McLaughlin, Resolving Disputes in the Financial Community: Alternatives to Litigation, The Arbitration Journal, Vol. 41, NO. 3, P. 16, 20 S '86.
This publication is intended to serve you. If you would like certain topics covered, or have any questions or comments, you are invited to contact Mr. Dunham at: 941.951.1800, Ext. 250, Facsimile: 941.366.1603, E-Mail: firstname.lastname@example.org, Web site: www.jrdlaw.com or write him at LUTZ, BOBO, TELFAIR, DUNHAM & GABEL, Two North Tamiami Trail, SARASOTA, FLORIDA 34236.
This publication is designed to provide accurate and authoritative information in regard to the subject matter covered and report on issues and developments in the law. It is not intended as legal advice, and should not be relied upon without consulting an attorney.