Hollis Carter, a 23-year veteran with the SBA and a Hilco strategic alliance partner, joins the Hilco Global Smarter Perspectives Podcast Series to discuss the best practices in problem loan management during challenging times.
Steve Katz 0:12
Hello again, and welcome to the Hilco Global Smarter Perspective Podcast Series. I'm your host, Steve Katz. Today, we're pleased to have Hollis Carter with us again. Hollis, as you may remember, is a 23-year veteran with the SBA and a Hilco strategic alliance partner. And our discussion today will focus on best practices in problem loan management during challenging times. We're going to discuss several things. First, we're going to talk about what CDCs can do to better prepare for the likely increase in the volume of defaulting loans. Then we're going to talk about what tools are available to effectively monitor and manage portfolio risk and identify problem loans. Talk about best practices for responding to third-party lenders, GPL defaults and foreclosure notices, responding to a TPL sale of note, and finally, SBA purchase of the TPL note. So quite a bit to cover again today, but we'll keep it moving as promised, and we'll keep it informative. Some brief quick background as we always provide - Hilco Real Estate is a unit of Hilco Global and provides strategic advisory and transactional services to minimize cost and maximize the value of real estate assets for both healthy companies and companies in transition. Hilco has been involved in repositioning more than 35,000 leases, and in the disposition of over 200 million square feet in retail, industrial, and office properties since it was founded over 25 years ago. With that said, Hollis, welcome back to the podcast.
Hollis Carter 1:36
Thanks Steve. It's great to be here again.
Steve Katz 1:39
Well, we're really glad to have you back. Hollis, can you start us off today by discussing how CDCs can better prepare for the likely increase in the volume of problem or defaulting loans?
Hollis Carter 1:50
Sure, Steve. The short answer is that CDCs need to make sure that they have an effective lone servicing program in place because that's going to put them in the best possible position to manage their risk and to identify their problem loans early. Really early identification is critically important because this is when the lender is going to have its best chance to effectively address or remedy the borrower's problem. And examples of ways they might do this would be through a deferment of the principal and or interest or debenture purchase (which we talked about in the prior podcast) but in conjunction with a debenture purchase of possible restructure of the loan, such as a rate reduction, extension of maturity, things like that. Or a debenture purchase combined with a self liquidation. And this would be a case where the borrower recognizes that their situation is untenable and that their best alternative is to liquidate assets. Or it could be a combination of those two; a combination restructure and maybe a partial liquidation of assets. And of course, the last resort would be a forced liquidation by the CDC or the third-party lender. I'd end this, though, by saying, to summarize that the earlier a problem can be identified, the better the outcome we're likely to have for both the borrower and SBA.
Steve Katz 3:16
Okay, great overview. Can you break that down a bit further for us, though, provide maybe another layer of detail that goes beyond that?
Hollis Carter 3:24
Sure, you bet. Really the keystone of a loan servicing program is a CDCs' monitoring system. And first of all, let me give a definition of what monitoring is. And I think it's pretty obvious, but I think this definition does bring it more into focus. And this is from dictionary.com, and it says that "monitoring is to watch closely for the purposes of control, surveillance, to keep track of, and to check continually." So I think that goes hand in glove with what pretty much what is an effective CDC monitoring system should address or look like. But one thing CDCs need to always keep in mind is that they are the eyes and ears of the SBA. The SBA doesn't have the staff to service these loans themselves and they do rely very heavily on CDCs for servicing and monitoring the portfolio. This being the case, it is very critical that they have effective monitoring systems in place that will quickly identify any problems that might pop up in the loan portfolio. I want to go through just a few key indicators that must be monitored and also just a couple of monitoring tools. But the first thing and I guess probably the most obvious thing that the CDC must monitor is loan performance. Not only the 504s loan performance but they also need to stay in contact with that third-party lender (TPL) to monitor how their loan is performing. Creditworthiness is also extremely important to monitor. And by that what I mean is the CDC should be requiring annual federal tax returns or financial statements from the borrower. These statements should be spread-that is, put into a spreadsheet where you can look at year-to-year comparisons of performance. And the CDC should also complete an annual review of the loan which primarily is a credit analysis, that would feed eventually into a risk rating. Now, I'll get to that a little bit more here in a minute. It's very important that the insurance be monitored, in particular, hazard insurance, flood insurance, even liability, workers comp, life insurance, etc. So CDCs are required to get evidence of insurance on an annual basis. This can be challenging because it's going to kind of be all over the board, that CDCs are dealing with different insurance companies, and they don't all put the same priority on that as SBA does. But the most important thing of all the insurance is hazard insurance since that is what's protecting the SBAs collateral. CDC is also expected to monitor property tax, primarily real estate, that's to be done annually. We'll talk about some red flags in a little while and how that can come into play there. And one of the most important things they must monitor is the UCC financing statements, which are required to be renewed or continued every five years. They've got to have an effective tickler for that because if that is not renewed timely, the SBA can lose their lien position on a personal property. This is like machinery, equipment, furniture, and fixtures. So they could lose their lien priority and it could have a major effect on the outcome of the loan, particularly if it goes into a liquidation status. As far as monitoring tools, I mentioned annual risk ratings; that's one of them. And very importantly, these must be done at least annually and they must be updated anytime there's maybe some kind of an adverse event like default, bankruptcy, foreclosure by the third party lender. And these risk ratings basically rate the quality of each loan using a rating scale. And then you pull it all together where you can get a good handle on what the quality of the entire loan portfolio is. And then finally, site visits are required at minimum within 15 days of a non-payment default and within 30 days of a payment default. So that's a requirement and will give the CDC a very good sense of what's going on with the borrower. I mentioned some early warning signs that the CDC should also be on the lookout for. These are all pretty straightforward; slow pay of the 504 third party loan. If you have a borrower that is slow or just won't provide financials or tax returns, or their financials are starting to show negative trends, that situation may mean that you need to increase the surveillance on that loan. Insurance cancellation notices; obviously, the borrower's running into some financial difficulties if they allow their insurance to lapse, or late payment of premiums, loan covenant violations, delinquent property taxes, a change in marital status that can have a huge impact on a small business. (If there are some difficulties in marriage, there are so many issues with marriage or marriage situation) Change in behavior or personal habits of the principal. Changes in attitude. And that's particularly with regard to cooperation if they were previously very cooperative, and suddenly they won't return your phone calls, answer your emails, that's usually indicative of some type of problem with the business that needs to be addressed. Changes in management, ownership, key personnel (particularly a change in ownership if they do that without notifying the SBA, that's a major red flag) changing the nature of the company's business if they were to completely change directions or products or industries that's also something you got to really be aware of, declining sales, or conversely, even rapidly expanding sales those both can be signs that there could be trouble, deterioration of liquidity, working capital, or receivables from affiliated companies. In other words, if there's a lot of money being switched back and forth between affiliated companies, you could have one propping up another that's experiencing problems. So to summarize, the main thing I want to stress is that a successful problem on management really does depend on early identification of these credit weaknesses and any adverse credit trends. And one key takeaway as well is that really the CDC credit culture and risk rating system should encourage their loan officers to identify problem loans in a very timely manner. In by credit culture, what I mean is that the sum of the CDC's credit values, beliefs, and behaviors, and you can bet it because I have seen it, these values and behaviors that are rewarded eventually become the standards, whether it's good or bad. And these standards will take precedence over written policies or procedures. So if management is not encouraging the right kind of credit culture, basically, it doesn't make much difference what your policies say if you're not carrying out these monitoring activities and identifying problems early, it really doesn't matter what your policies are.
Steve Katz 10:41
Yeah, it makes sense. I would imagine, you know, staying true to the policies is critical. So, okay, let's shift gears. What can you tell us about best practices for responding to TPL defaults and foreclosure notices?
Hollis Carter 10:54
Sure, we touched on this a little bit in the last podcast, so I'll try to keep it fairly brief. But the third-party lender agreement (or the TPL agreement) is basically an intercreditor agreement between the TPL and SBA. And among other things, it contains two really important requirements to make sure the TPL gives the CDC and SBA sufficient time to formulate a response to any kind of adverse action. Usually, it's going to be a foreclosure action or some kind of default. But these two requirements in the TPL agreement: number one, is that within 30 days of any default, on the TPL loan or lien, they must provide written notice of that default to the CDC and SBA. So they've got to keep CDC and SBA informed of the status of that loan if it begins to have trouble. Secondly, (and this is the most important of the two) the third party lender is required to give at least 60 days notice prior to any legal proceedings or liquidation of common collateral. And this usually relates to a foreclosure sale. So, if they move to foreclosure and set a sale date, they must give SBA notice at least 60 days prior to that foreclosure sale date. The TPL agreement also includes some restrictions on default charges, swap or hedging contract costs. #1. Any default charges, prepayment penalties, late fees, default interest or other default charges are always going to be subordinate to the 504 loan and the 504 liens. #2. If the TPL loan documents contain a swap component or a hedging contract, all of those associated costs including swap fees, termination fees, default fees, or any other related fees are also subordinate to the SBA 504 loan. To kind of wind it up it's very important to CDCs react to default notices from the TPL immediately they should contact the borrower, the TPL and SBA also in most cases and appraisal or BPO - brokers opinion of value would need to be promptly ordered. And I take a minute here to point out that Hilco can usually provide a BPO with within a week; they can turn those around very quickly. Immediate action is especially critical if the property is located in a non-judicial foreclosure state, also known as a deed of trust state. If this is the case, the foreclosure sale doesn't require any kind of court approval, and it can occur in as little as three to four weeks. So it's pretty clear there that the CDC and SBA are gonna have to make decisions regarding bid strategy at a third-party lender foreclosure sale very quickly in those cases. The contact with the TPL that I mentioned a moment ago, if you do get a default notice, it should focus on borrower cooperation. You should also request a detail TPL payoff statement. And the reason for that is so you can address those default charges and swap costs, things like that any of those kind of loan charges default charges you'd need to identify to make sure the TPL understands that those are subordinate to SBA. And finally, need to discuss the possibility of a private sale because I think the guys I've worked with at Hilco have shown time and again that the best outcome is likely to be achieved if the property can be handled for a private sale versus for sale. If the third party lender is open to a private sale, Hilco is very cooperative, very proactive, very skilled at working directly with borrowers and maximizing benefit for both them and recovery for SBA.
Steve Katz 15:03
Okay, then let me ask you this, do TPLs ever sell their note as an exit strategy?
Hollis Carter 15:08
Yeah, they do. This doesn't occur very often, but it's not a totally uncommon practice. The TPL agreement does offer a couple of protections to CDCs and SBAs in the event that the third-party lenders sells their note. Number one: within 15 days of any note sale, and that is whether the loan is distressed or performing, TPLs are required to provide SBA, the CDC with written notice, including the purchaser's name, address, contact information, and that there to confirm that the purchaser has received a copy of the executed third-party lender agreement. So that's the basic requirement for any note sale by a third-party lender. If the TPL loan is in default, and they propose to sell the note as part of their liquidation strategy, in those cases they must give SBA the right of first refusal to purchase that note at the same price offered by the other potential purchaser. Once SBA receives that notification first refusal rights, they have 45 days to exercise the option to purchase the third-party lenders note. If SBA doesn't exercise it's options then of course, the 15 day requirements that I just mentioned previously kicks in and they have to provide all that information to SBA once the note sale closes.
Steve Katz 16:35
Got it. Okay, well, time flies when we're having fun. Right. But I've got one more question. And then we'll have to wrap it up, unfortunately. But I know we'll have you back on again soon. Having just covered circumstances that might lead to the note's sale, how often does SBA actually purchase the TPL note and how is that decision typically made?
Hollis Carter 16:55
Steve, SBA rarely purchases a third-party lender note, but it does happen on occasion. And I've actually done it a few times when I worked for SBA ran their liquidation division in Little Rock. When it's likely to happen (about the only time it's going to happen) is if the TPL is unwilling to work with a borrower that's having difficulties and it's moving to foreclosure. And it's pretty clear that the borrower could remain viable that with some significant restructuring of both the third-party lender and 504 loan. So basically, if SBA can step in, purchase the third-party lender note and keep the business in operation, save the jobs, etc., the SBA servicing centers could and would consider purchasing that note. But the reason it's so rare is that it's very difficult to justify. And because the purchase has to make sense from a cash flow standpoint (a repayment ability standpoint-of course, those go hand in hand) and also a collateral standpoint. So the decision process is therefore based on a number of factors. First, the purchase of that note should maximize recovery and gain control of the liquidation process to enable, as I said, an otherwise viable borrower to retain possession of the assets and continue operating and ultimately pay off the 504 private debt. That's kind of the bottom line. So the purchase of that note has to make sense as pretty much a long-term liquidation strategy that's maybe the best option to get the debt repaid and save the jobs, as I said and, save the business. Number two: the borrower has to have sufficient cash flow to make the payments on the adjusted SBA loan balance, which of course, now includes the TPL debt. And that's offset that by the you know, there's no longer TPL debt. Purchasing or paying off the loan, you have to show that that will improve the borrower's repayment ability and their ability to retire both debts. Risk has to be justified by post-default appraisal and recoverable value analysis, which is very similar to the protective bid analysis that SBA completes in a foreclosure sale situation (what I think we discussed that in some detail in the last or the first podcast). So as I said, it's got to be justified from both a cash flow standpoint and also a collateral standpoint, and the collateral analysis is key and may require or likely would require a current appraisal or BPO. And finally, the purchase amount should be consistent with the TPL agreement regarding the subordination of those default charges that I mentioned a few minutes ago. Okay, so if the note purchase request meets all those requirements and SBA decides to proceed with that note purchase, there's a lot of other details the CDC also has to address. Number one. They've got to submit the proposal to SBA. They can use their liquidation plan or they can send an amendment in on a liquidation plan they've already submitted. In order to request the note purchase and the issuance of a treasury check by SBA to pay off the TPL. The CDC is also going to need to draft a loan purchase and sale agreement or, have their attorney do so and also an assignment of documents that comply with SBA's standard operating procedures or SOP guidelines. The CDC has to give the obligor-all obligors written notice that they are purchasing the note and the resulting increase financial liability on the SBA loan. Of course, again, this is offset by the decrease in liability to the third-party lender. And finally, when the CDC receives the Treasury check from SBA, they need to go ahead and prepare the assignment of note, mortgage, or deed of trust. Prepare the TPL purchase agreement (which includes instructions for completing the transaction), and again the TPL transcript must be consistent with the payoff amount. So, in addition to a payoff, it's very critical that they get a complete transcript of the TPL's loan just so they have a complete record or complete history of the repayment over the entire history of the loan. And at that point, when that's all done, the purchase amount is basically added to the SBA loan balance, or in many cases, it may be set up as a a separate companion loan just since you've got separate loan documents, separate note separate security instruments, we normally would set it up as a separate companion loan. But again, it would ultimately be added to the SBA loan balance. And the TPL must forward that executed assignment to the CDC. And then, the CDC is responsible for making sure all of these documents that need to be recorded get recorded, and then forward all of those documents to the collateral cashier at the Fresno or Little Rock Servicing Center. So that's a fairly detailed discussion of what's involved. But as I say, for something that doesn't happen very often, but again, in many cases, that can be the best alternative, particularly if you've got a TPL that is unreasonably not working with a borrower.
Steve Katz 22:41
Yeah, it makes sense. And, you know, sometimes the longer explanations are the ones that actually simplify things. So it was actually great to hear you get into the details on that. So thanks so much, Hollis, for visiting with us again and sharing your knowledge on problem loan management. Obviously, you know, making it easy to understand isn't easy because it's so complicated. But we definitely need to get you back on and visit with us again in the near future. Does that sound good to you?
Hollis Carter 23:12
That sounds great. Steve, I'd be happy to, and thanks for having me on.
Steve Katz 23:16
Yeah, absolutely. It was great having you here again. So for certified development professionals; those from the SBA and others who joined us today, if you'd like to learn more about best practices for problem loan management during these challenging times, Hollis has asked that you reach out first to James Keith here at Hilco Real Estate as he and the team work closely with Hollis on these matters. So here you go, James' email is JKeith@hilcoglobal.com, that's JKeith@hilcoglobal.com. And with that said, we hope that today's Hilco Global Smarter Perspective Podcast provided you with at least one key takeaway that you can put to good use in your business or share with a colleague or client to help make them that much more successful moving forward. Until next time for Hilco Global, I'm Steve Katz.