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By: Travis Knobbe
All too often, we get recovery files months, sometimes years, after the tipping point when assets begin depleting faster than they can be preserved to maximize lender recovery. To be fair, there are times when credit monitoring would not have revealed the issue any sooner. That said, there are plenty of instances where routine diligence could have led to a larger recovery. Simply put, loan officers have a second critical job (beyond gathering the right information and getting the right loan documents at intake) in the recovery process: adequately monitoring the loan’s life cycle.
To appreciate the problem, we would like to offer two examples. In one instance, we represented a lender who loaned money secured by inventory and accounts receivable from an upstart borrower. For five years, the lender received audited financial statements and inventory and account receivable reports quarterly. Suddenly, however, the borrower stopped providing this audited information. It was a subtle change. The front page of the reports changed a single word from “Audited” to “Unaudited.” The lender did not default the loan for another eighteen months after the borrower’s accountant stopped auditing the information. In fact, during the first eight of those months, the borrower continued to draw on a credit line secured up to a percentage of combined inventory and account receivable value.
You can probably guess what happened in the interim. The inventory reports went unaudited for a reason. Entire piles of inventory (worth millions in total) went “missing.” The borrower inflated inventory quantity at the same time it jettisoned existing inventory to third parties not then revealed to the lender. For inventory sold, however, the borrower claimed it sold the inventory to known contractual counterparts and therefore inflated account receivable totals as well. Then, it borrowed against the inflated totals.
Once the file came in, it took a five-year process weaving through a forbearance period, a receivership proceeding, an involuntary bankruptcy, a contested appointment of a Chapter 11 trustee, and multiple commercial torts and discharge litigation efforts to even come close to recouping the lost money. As you can imagine, the effort required substantial expense, further reducing the net recovery to the lender. Had someone recognized the subtle differences in those reports, the lost inventory and lost money could have been recovered far more quickly, in far greater percentage, and at far less expense.
In another example, we represented a lender secured by commercial real property. The loan officer loaned against property in a city about 300 miles from the originating branch. The lender, however, had a branch within five miles of that collateral. At intake, the lender exercised its diligence, obtaining environmental reports, obtaining and reviewing leases for the property, and obtaining a commercial appraisal. Several years into the loan’s life cycle, however, the borrower started paying out of routine. Loan payments made within five days after the due date crept to payments made twenty days after the due date. Again, this represented a subtle shift. Considering the loan featured a grace period of 15 days, the shift did not trigger a review.
The facts behind the shift, however, proved critical. As it turns out, the primary tenant (one of three) in the building abandoned their lease space. Behind the scenes, the borrower was diverting money from other sources to maintain the payments, thus causing the delay from its normal payment cycle. What were the “other sources,” you might ask? Well, the borrower was diverting from capital accounts intended to fund deferred maintenance items. As a result, not only did the borrower lose its most substantial source of income, but it also could not keep up with necessary repairs. Perhaps an apt metaphor for the situation, the building sprung a leak. What started as a small hole in the roof grew and the resulting water intrusion caused damage to the structure and caused mold growth.
Unfortunately, the lender did not send anyone to conduct quarterly or semi-annual inspections of the property. As a result, by the time the payments stopped, the building lost substantial value and required hundreds of thousands in repairs. The borrower depleted its cash reserve, so anticipated secondary sources of recovery in the event of a deficiency balance were gone. Had the lender established a routine site check (or followed the protocol if it had already established one), the issue would have been caught sooner, and the lender could have either declared default or expended resources (that it could have recouped) to make the repairs itself.
In both instances, careful diligence during the loans’ life cycles would have revealed to the lender that it needed to take swift action. By the time these files came to recovery, the damage had been done. In both files, intervening events (one intentionally fraudulent, the other unintended but concealed) altered the recovery path significantly. “You gotta know . . . when to fold ’em,” after all, only applies when you are actually looking at the cards.
This is Part 3 of Travis Knobbe’s Creditor’s Rights Spotlight series. View the rest of the series here.