REQUIRED READING: Appointing A Receiver Can Offer Protection During Foreclosure

Written by William J. Hoffman
on September 17, 2008 No Comments
Categories : Required Reading

Industry statistics show that defaults on commercial loans are increasing. In fact, delinquencies on U.S. commercial mortgage backed securities could as much as triple by the end of 2008, according to New York-based Fitch Ratings.

Despite the alarming data, there are many ways lenders can mitigate losses and maximize recovery on commercial loans for traditional income properties, operating businesses and construction loans.

In the past, when other workout solutions failed, the simple alternative of foreclosing and then selling the asset was often the action of choice. In this current weak cycle, however, not only may the property lose significant value during the foreclosure, but a borrower with little remaining interest may allow the property to deteriorate – further diminishing its worth.

When you have a cooperative borrower, another option is to accept a deed in lieu of foreclosure, thereby gaining immediate control of the property to protect its value. While that process can be speedy and possibly more cost-effective in the short term, it is fraught with danger.

Unknown problems and conditions, unpaid debts and other surprises like environmental exposure can turn this seemingly simple action into a nightmarish surprise.

An alternative to the deed in lieu is to have the borrower stipulate to the appointment of a receiver. Doing so isolates the lender from the above dangers and protects the property's value.

While there are some additional costs involved, this expense is usually more than compensated by limiting the lender's exposure, preserving and protecting the asset during the foreclosure process and avoiding delays in marketing and selling the property.

Confusion between bankruptcy and receivership still exists – not only with asset managers, but sometimes even with attorneys and judges – particularly those who do not work with both options on a regular basis.

The defaulting borrower, of course, has the option to file bankruptcy. That right cannot be forfeited, even if the borrower agreed in writing not to file.

A Chapter 11 bankruptcy is filed when a debtor wants time to solve its financial problems while maintaining business operations, while a Chapter 7 liquidates the business. There are other forms of bankruptcies, but these two are most commonly encountered by commercial mortgage lenders.

Bankruptcy v. receivership
The most basic and fundamental difference between bankruptcy and receivership is fairly simple. Bankruptcy is a legal process to protect a borrower/debtor from collection actions by creditors, and its rules are aimed at protecting the borrower – not the lender. Receivership, in contrast, is an action in which the lender seeks to protect its security by having an independent third party take possession of the asset.

It is important to remember that a receivership is not a legal action in itself, but an ancillary remedy that is sought while another action (e.g., foreclosure) is pending.

A receiver is not an agent for the lender, but an independent third party that acts as an agent of the court. In general, a receiver protects the business from being damaged and keeps its value from being diminished.

This legal detachment from both parties – and the receiver's status as an agent of the court – can be beneficial. The receivership can be as critical to the lender as the foreclosure itself, because the property's cash now goes into the receivership estate and, ultimately, to the lender.

The estate generally has no legal obligation for debts incurred prior to the receiver's appointment, which protects the lender's interest and acts as a barrier against some creditor actions such as garnishment, attachment or repossession of assets.

In fact, the receiver generally has no authority to pay such debts – even voluntarily. While this rule seems perfectly logical, it often comes as a surprise to the debtor.

Immediately after appointment, the receiver will send written notice to every known creditor advising them that pre-receivership debts are still the responsibility of the borrower and that only debts incurred by the receivership estate will be paid by the receiver.

A creditor can still exercise its right to collect from the borrower, but it generally may not take possession of any property, cash, accounts receivable or other assets in possession of the receiver pursuant to the court order. Creditors that have security interest in specific assets may still be able to enforce those rights against that property, usually by repossession.

Leased equipment that can be repossessed may be critical to the value of the asset. For example, a restaurant whose kitchen equipment is removed will need to be shut down.

Aside from any legal arguments or actions, a receiver is often able to negotiate an interim arrangement for continued use without having to assume a long-term obligation. In fact, any contract for a period of over one year almost always requires prior court approval.

In the courthouse
When working with the courts, lenders should understand the differences between state and federal jurisdictions. State court jurisdiction is confined to the state in which the court and property are located, while federal receivership actions are conducted in the federal district court.

Because of this distinction, federal receiverships allow a receiver to exercise nationwide jurisdiction, which can provide more flexibility and be less costly. However, a secured creditor is afforded a choice between federal and state court only if jurisdiction exists in both courts.

Federal receivership rules have a specific provision for allowing the receiver to sell any or all of the assets in the receivership estate, subject to court approval. But most state courts' receivership rules are less specific and do not automatically provide the receiver with the power to sell.

There are circumstances in which a state court is likely to allow a sale. The most common is a stipulation from both sides that such a transaction is beneficial to all. When borrowers have personal liability or a guaranty, they are more likely to cooperate, which reduces potential loss.

In some cases, the court will allow the sale – even over the objection of the borrower – when the recovery from an early sale will be higher and there is no harm to the borrower.

It is important to note that every case and every state is different, and the lender should speak with its counsel and the receiver to determine the possibility – and consequences – of an early sale.

The receivership estate generally has no legal obligation for debts incurred prior to the receiver's appointment, which not only protects the lender's interest, but also acts as a barrier against some creditor actions, such as garnishment, attachment or repossession of assets without court consent.

While dramatic changes or improvements to the property or its business operation are considered capital improvements rather than maintenance and repairs, they are not usually a part of the receiver's duties or authority. The receiver does, however, have the authority to spend money to correct all health and safety hazards, avoid deterioration and maintain the asset and its value.

If the property will not generate sufficient income to properly maintain itself, a prudent receiver will ask the court to allow the issuance of receiver's certificates, allowing loans to the receivership estate by the lender.

In the case of imminent danger to the property (e.g., damage to the value of the underlying security, potential loss of franchise or failure to pay taxes or wages), a receiver may be appointed ex parte – with shorter notice to the debtor or opposing counsel. Jurisdictions vary in their requirements for ex parte actions.

In addition to simply objecting to the appointment of a receiver, the debtor may also file bankruptcy prior to the hearing to appoint a receiver to avoid losing control of the property and its income. If a bankruptcy has been filed prior to the appointment of the receiver, some lenders and servicers respond as though all of their options are lost – or at least suspended – while the bankruptcy action is pending. This view is a common misconception, as the lender need not be a passive observer.

A proposed cash collateral order opens the door for the lender to negotiate a number of conditions and stipulations, which will not only help to control the uses of cash, but also establish conditions under which another opportunity for gaining control may arise. A relief from stay may be sought to remove the lender's secured asset from the bankruptcy action.

If a receiver has already been appointed prior to a bankruptcy filing, legal counsel and the receiver will determine if the receiver will argue to remain in possession as a trustee or other officer of the bankruptcy court.

Operating businesses
When considering the workout options, lenders also need to remember the vast difference between operating businesses, such as hotels, restaurants and gas stations, and traditional income properties, such as office buildings and shopping centers.

Receiverships can help deal with the complexities of an operating business, such as payroll and employment, tax liabilities, vendor and supplier relationships, utility services, and inventories that may require immediate attention. In addition, an operating business will frequently have other technical issues that mandate attention, such as liquor licenses, franchise agreements, equipment leases and retail-space tenants.

In addition to protecting the property that represents the security for the loan – its improvements, furniture, fixtures, equipment and income – the receiver is in charge of accounting for all receipts and disbursements and repairs and maintenance – particularly important in the case of an operating business.

The receiver will usually hire a management company for day-to-day operations. If this company is connected with the receiver, overlapping fees and expenses will be minimized. For this reason, the receiver will often seek permission of the court to hire a related company.

As many lenders know, a rapidly growing number of condo projects are going into default. With nonrecourse financing and/or a developer with no other assets to cover loan guaranties, many projects are being abandoned or offered to the lender without further legal action required, spawning a menu of unique issues for lenders.

If the lender has a receiver appointed for a condominium project, an important issue is the Condo Owners Association (COA) and obligations the developer has to that COA. The developer may have agreed to fund all COA operating shortfalls (in lieu of having to pay full dues on every unsold unit).

A receiver does not automatically assume this responsibility. Remember that the receiver is responsible for specific assets, but not the development company. The developer may have also promised to rent units for investor/owners, or even guaranteed a monthly income to that owner.

Again, that is an obligation of the developer which does not attach to the receiver, whose only responsibility is to protect the specific assets that are the lender's security.

Taking control of the COA board has both good and bad implications, which can be argued by lawyers for months and years to come. We normally find it a good idea for the receiver to replace the developer's directors with directors of the receiver's choosing. We do, however, usually find it best for the COA to retain its own management company for daily affairs – rather than one already working for the receiver – so as to avoid conflicts.

William J. Hoffman, an attorney and licensed real estate broker, is president, CEO and founder of Trigild, a San Diego-based company specializing in maximizing recovery on nonperforming commercial loans. He can be contacted at (858) 720-6700.

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