By Michael A. Hackard
January 17, 2013
Hackard Law attorneys regularly represent borrowers and guarantors in negotiating with and litigating against lenders. By the time that our law firm is engaged, it’s not unusual that “the wolf is at our client’s front door”, and there can be precious little time to be deliberative. A recent case illustrates that an entire wolf pack might also be at the lender’s door.
Lenders are worthy adversaries. They generally have financial strength, a strong body of favorable federal and state law supporting lender-initiated actions, and professional, skilled and experienced lawyers. They are also highly regulated. Understanding how state and federal regulatory oversight and processes impact lenders is an important part of representing borrowers and guarantors against lenders.
Lenders have been cautioned by regulators to “Know Your Customer: It’s Not Just a Good Idea, It’s the Law.” We counsel our clients to “Know Your Lender: It’s Not Just a Good Idea, It’s Essential.”
EDF Resource Capital, Inc. (“EDF”) v. United States Small Business Administration (“SBA”) et al. brings the need for lender knowledge to life. EDF was an SBA-authorized Certified Development Company (CDC). As such it was allowed to arrange, close, service and when necessary collect on SBA 504 Loans. EDF, on behalf of the SBA, received processing and closing fees for both originating as well as servicing 504 Loans. Since 2006, EDF has received over $49 million in fees from its participation in the 504 Loan Program.
The SBA 504 Loan Program provides long-term financing not otherwise available to small business concerns for the acquisition, construction, conversion or expansion of fixed assets, including real estate and heavy machinery and equipment. The SBA does not make loans directly to small businesses under the 504 Loan Program. CDCs deliver SBA 504 Loans on behalf of the SBA. CDCs do not use their own funds to make any 504 Loans. All 504 Loans are guaranteed by the SBA. 504 Loans from CDCs on behalf of the SBA are funded through the CDC’s issuance of a 100% SBA-guaranteed debenture secured by a junior or subordinate lien covering up to 40% of the project cost. Such projects require equity contributions from the small business borrower at a minimum of 10% of the project cost. If a 504 Loan defaults and the borrower does not resume regular payments within a certain time period, the SBA is obligated under the terms of its guarantee to purchase the full amount (principal and accrued interest) of the SBA-guaranteed CDC debenture from the investor holding the debenture.
EDF also had additional authority under SBA’s Premier Certified Lender Program (“PCLP”) to make SBA determinations of credit worthiness for the 504 Loans they arrange on the SBA’s behalf. PCLP CDCs, like EDF, are statutorily required to bear a share of losses suffered by the SBA on PCLP loans. EDF has had PCLP CDC status since 1997.
All CDCs are required to calculate, fund as needed, and maintain a Loan Loss Reserve Fund. The purpose of the reserve fund is to ensure that there are sufficient funds available, in reserve, for the PCLP CDC to pay its PCLP CDC share of 504 Loan losses. A PCLP CDC’s Loan Loss Reserve Fund must be a deposit on account with a federally insured depository institution.
The Standard Loan Loss Reserve is 1% of the original PCLP Loan balance. EDF opted to use an Alternative Loan Loss Reserve that allowed it to use a risk-based approach instead of the 1% approach. The risk-based approach turned into a time bomb when economic conditions spawned by the “Great Recession” devastated real estate values in California. EDF became responsible for funding loan loss reserves equal to 15% of the SBA’s losses on defaulted PCLP loans. By the time that EDF shut down, the SBA had already invoiced EDF over $11 million for SBA’s charge off of over $99 million. SBA was in the process of invoicing EDF another $3.6 million for additional SBA losses. EDF’s loan loss reserve accounts totaled a little less than $2 million. In addition the SBA estimated that “EDF’s potential PCLP loss reimbursement exposure on the 334 other non-performing PCLP loans totals approximately $29 million.”
The EDF v SBA court case was argued in late December, and the opinion was reported on December 21, 2012. The case was filed in Washington D.C. by EDF and sought to secure a temporary restraining order (“TRO”) and preliminary injunction against the SBA. The action sought to enjoin the SBA from enforcing their December 17, 2012 Final Agency Decision Revoking (EDF’s) Authority To Participate in SBA’s 504 Loan Program and Permanently Transferring (EDF’s) 504 Loan Portfolio (“Final Agency Decision”) to an agent for the SBA. The U.S. District Court Judge denied the TRO. EDF closed its doors the same day as the denial of the TRO.
EDF, at the time of its December closing, had 2,381 loans in its portfolio with a total outstanding balance of about $1.3 billion. It had the “second largest SBA 504 Loan portfolio of the CDCs currently participating in the 504 Loan Program. Its obligations to the SBA were enormous and dwarfed its available resources to meet its SBA obligations. Defaulted borrowers negotiating with EDF had little knowledge that their lender was facing a cataclysmic melt down – one that ultimately resulted in its closure.
The SBA’s 82-page Final Agency Decision indicates that EDF refused to pay its payment and loss share obligations. The decision recites that “the nature, extent and severity of EDF’s breaches and violations, including the dollar magnitude of the risk, EDF’s insolvency, the unwillingness of EDF’s management and board to correct identified problems, and program integrity considerations, all warrant the permanent revocation of EDF’s 504 program authority and require the permanent transfer of EDF’s SBA 504 Loan portfolio.”
We have negotiated with a large number of lenders, EDF among them. Knowledge that the SBA had identified “significant problems in EDF’s systems or controls, deceptive action, substantial law violation, serious compliance problems, and serious reporting failures” would surely have been helpful in explaining EDF’s unusual negotiating techniques. The public record and governmental order detailing some of this wrongdoing was followed days later by EDF’s closure. That said, it is still better late than never to “Know Your Lender.”
EDF as a lender in its final months or years of operation was in a precarious position. The SBA record reveals that it was insolvent and was not paying the millions that it owed on its SBA reimbursement obligations. The record also indicates that EDF was maintaining two sets of accounting books and records, one disclosed to the SBA and one not. When these facts are considered it is evident that EDF had a financial disincentive to fully resolve or compromise claims against borrowers and guarantors whose loans were in default. A real compromise between borrowers, guarantors and lenders brings both certainty of settlement and certainty of loss. Such loss certainty would trigger loss share provisions that EDF was contractually and statutorily bound to pay. It is little wonder that the SBA acted to protect the integrity of the SBA 504 Loan Program from EDF’s concealment from the “SBA the status of hundreds of defaulted loans, thus knowingly painting a materially incomplete, misleading and falsely positive picture of its Loan Loss Reserve Fund and of the Fund’s ability to protect SBA from the risk of loss.”
© Copyright Michael A. Hackard, 2013. All rights reserved.