Representing the Asset-Based Financial Services & Factoring Industries Worldwide April 09

        Demand for Factoring...
Practical Strategy for Improved Risk Management
Article 9 Collateral Insurance Shifts Risk for
Secured Lenders

segments are causing lenders to seek         Document on Operational Risk stated:          standards (and loan covenants),...
the legal risks associated with equity        ance was developed specifically to             fice buildings, manufacturing...
prior liens in Puget Sound Financial, LLC      quality utilizing UCC insurance, which
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Secured Lender Practical Strategies April09 Sprink


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Secured Lender Practical Strategies April09 Sprink

  1. 1. Representing the Asset-Based Financial Services & Factoring Industries Worldwide April 09 Demand for Factoring High, But Challenges Still Exist Participations: Traditional Factors Discuss Current Credit Environment Interview with Peter Rosenthal: Factoring is in His Blood the face of factoring
  2. 2. Practical Strategy for Improved Risk Management Article 9 Collateral Insurance Shifts Risk for Secured Lenders By theodore h. sprink The nation’s most respect- Frozen credit markets, residential foreclosures, government bailouts of the private sector, Fed Funds rates not seen since the 1930s, the questioning of the SEC and the rating agencies, stock market setbacks, unstable ener- e d f i n an c ia l re porte rs , gy prices, interest rates, cap rates, the fear of inflation, deflation, stagflation, recession, depression, increases in business bankruptcy filings, higher unemployment rates, reduced orders for manufactured goods and slipping economists and market ana- consumer confidence: these are just some of the issues that suggest commercial-loan default rates may play a lysts have m a d e more significant role in bank strategies than they have in the past. In recent years the stable economy has “masked” commercial-loan defects, today’s reces- not linking them directly to defaults, loss-given-default and loan recoveries. Documentation defects that will directly sion and federal affect value and recoverability of col- lateral have been kept somewhat below bailouts seem very the surface because many of the affect- ed loans are not yet in monetary default. complicated. However, to And, in the past, a good loan work-out effort, coupled with alternative sources many, devastating econom- of capital, could move a defaulted bor- rower out of the bank. No more. The existence of technical defaults, ic developments particularly repeatedly renewed “PIK” loans, and a swelling emergence of monetary as experienced in the third defaults suggest a strong likelihood that many borrowers are headed toward and fourth insolvency proceedings. This potential is increasing dramatically each month and quarters is likely to result in frequent challenges to commercial lenders’ security interests as competing parties focus on collateral of 2008 are in order to maximize their recoveries. a rather Today’s Business of Banking: Little Room for Error simple Perceived equity cushions, a stable economic environment and plentiful story of alternative sources of capital have for years artificially hidden problems as- sociated with collateral value, borrower risk man- cash flow and management difficulties. Loan concentration, relaxed underwrit- agement ing standards, declining asset values and increasing defaults in core lending and cred- it quality. 46 Visit the CFA CAreer Center At www.CFA.Com. the seCured lender April 2009 47
  3. 3. segments are causing lenders to seek Document on Operational Risk stated: standards (and loan covenants), regula- basis. Additionally, UCC insurance was risk-management tools that protect “One growing risk of mitigation tech- tors can be expected to call for improved developed to protect commercial lend- credit quality and liquidity. nique is the use of insurance to cover identification and management of risk. ers against fraud, forgery, documenta- ThroughouT The laTe 1990s and 2000s The Throughout the late 1990s and 2000s certain operational risk exposures.” Risk Both lenders and investors benefit from tion defects, search-office errors and markeT was awash in liquidiTy wiTh far the market was awash in liquidity with managers have used title insurance to strengthened collateral positions and omissions and indexing problems in the “Too much money chasing Too few deals.” far “too much money chasing too few shift risk in past real estate transac- the shifting of risk as it relates to lien financing statement search and filing PerhaPs, iT could be said, Too few well- deals.” Perhaps, it could be said, too few tions, in what has become an essential perfection and priority. process. sTrucTured deals exisTed well-structured deals existed: hedge component of the real estate-secured The title industry has essentially Further, UCC insurance was designed funds and private equity partnerships in loan-origination business. adapted the standard ALTA real estate to insure the “lending gap” and provide competition with, or financed by banks, title-insurance policy form to provide cost-of-defense coverage in the event of were deploying vast sums of money Traditional Shifting of Risk the benefits of title insurance to com- a third-party challenge to the lender’s from pension plans, endowment funds Traditionally, real estate lenders for both mercial lenders securing loans with security interest and lien priority. From and foreign investors. In the wake of this commercial and residential transac- non–real estate collateral. In a few short a secondary-market perspective and competition, relaxed covenant packages tions, as well as investors, have used years the nation’s leading title insurers portfolio-management standpoint, the and historically low-risk pricing, there title insurance to minimize documenta- have produced new UCC insurance poli- policies are “life-of-loan” and assignable. has been very little room for error. tion errors and to perform processes cies covering an estimated $450 billion Such relaxed standards have had a associated with perfecting lien priority. in secured lending. Avoiding the Most Obvious and significant impact on credit quality, loan Lenders and investors have utilized title Most Common Risk loss reserves, regulatory capital require- insurance to benefit from improved The Evolution of Title Insurance As a significant benefit to the lender, ments, loan pricing, reliance collateral, credit quality, secondary market value Historically, real estate title insurance UCC insurance overcomes limited “UCC default rates, potential legal fees and, and liquidity. played an important role in loan origina- search vendor” indemnification in con- ultimately, recoveries. As late as the mid-1950s, real estate tions by insuring proper perfection and nection with search office errors and title insurance had not yet become uni- priority of collateral and by protecting omissions, indexing inconsistencies and Connecting the Dots versally accepted or utilized by lenders. lenders from fraud, forgery and docu- financing-statement inaccuracies. Most The broadening of the recession is re- Lawyers’ legal opinions and abstracts mentation defects. UCC insurance for commercial-loan documentation defects flected by connecting the dots from sub- were widely used in the nation’s real es- non–real estate collateral is the natural that jeopardize a lender’s security prime and Alt-A loans, generally viewed tate markets. Standardized real-property evolution of this concept in light of the interest are clerical in nature: incorrect as entirely toxic, to traditional residen- title-policy forms of coverage, endorsed growing need to protect and enhance name of borrower, search of the wrong tial real estate loans, now suffering from by the American Land Title Associa- the strength and quality of commercial- jurisdiction, wrong state of filing, the plummeting values and skyrocketing tion (ALTA), were still a decade away. loan assets. lack of filing the appropriate documents, default rates; to commercial real estate Although title insurance developed into The original concept of applying the an error in the collateral description and loans, due to suffer significantly from a cornerstone of traditional real estate benefits of real estate title insurance to the like. Moreover, it is often junior staff cap-rate and occupancy issues; to the lending, a new concept of title insurance the commercial finance market segment at either the bank or the law firm that is commercial finance asset-based lending has evolved over the last few years into was simple: if every bank in the United responsible for perhaps the greatest risk market, anticipated to be a final resting an accepted risk-management tool for States originating real estate–secured to the lender: the loss of reliance collat- ground for the defaults, collateral con- secured lenders primarily within the loans requires real estate title insurance, eral. Without UCC insurance, a lender’s ucc insurance, available from The tests, bankruptcies and other economic private equity space. would those lenders originating non– recourse to an inaccurate search or filing naTion’s leading real esTaTe TiTle- ills generally associated with recession. However, there is one significant dif- real estate secured loans not also gain function from leading search and filing insurance comPanies, is a relaTively new These ills will likely result in increased ference: title insurance is now available from the risk-shifting and protection vendors is limited to the cost of the develoPmenT in The financial markeTs. loan defaults, which will cause greater to lenders in which “reliance collateral” benefits of title insurance? service rendered by the vendor—$100, reliance on collateral, credit quality and is personal property as defined by Article UCC insurance, available from the na- for example. risk-management tools. 9 of the Uniform Commercial Code. Such tion’s leading real estate title-insurance Exposure to operational risk for title insurance for non–real estate loans companies, is a relatively new develop- Benefits of UCC Insurance as a commercial lenders has also escalated has been recently been positioned by ment in the financial markets. Similar Risk-Management Tool substantially and has made many insti- one major title insurance underwriter as in many respects to traditional real Risk management is, of course, every- tutions more vulnerable to losses from a risk-management tool. estate title insurance, UCC insurance one’s business within a bank. However, failed or inadequate internal processes, was introduced specifically to insure the risk managers are specifically charged people and systems. From the perspec- New Risk-Management Tools for a commercial lender’s security interest in with the responsibility to anticipate, tive of risk managers, shareholders and New Regulatory Environment non–real estate collateral for validity, identify, quantify and manage risk regulatory authorities, the consequenc- With regulatory authorities subject to enforceability, attachment, perfection across each of their increasingly compli- es of such failures are severe. criticism for allowing an excess con- and priority. cated portfolios of businesses. That’s why title insurance has become centration of subprime and Alt-A loans Policies include UCC search and Positive economic conditions in more important. The Basel Committee within certain financial institutions, filing services, are life-of-loan, and are recent years appear to have led lenders on Banking Supervision’s Consultative coupled with relaxed underwriting frequently issued on a postclosing to fail to “price-to-risk,” particularly 48 Visit the CFA CAreer Center At www.CFA.Com. the seCured lender April 2009 49
  4. 4. the legal risks associated with equity ance was developed specifically to fice buildings, manufacturing concerns, be defective in documentation were not and other personal-property collateral. insure the lender’s security interest in retail operations, power plants, casinos, an issue until they were in (monetary) However, in a complex and threatening non–real estate collateral, rather than hospitals and the like. default. Naturally, by then, it is often too environment, evidenced by the recent the ownership or chain of title of real Now lenders could outsource UCC late — for our homes as well as the for eruption of subprime-related credit- property. Significantly, the program was searches, document preparation and the lender’s collateral position. The $100 quality and liquidity issues, hazards in development during a time of change filing functions while wrapping the indemnity furnished by the bank’s UCC to the bank’s capital are substantially and uncertainty for the commercial entire transaction in an insurance policy search vendor, or the right to sue out- elevated. UCC insurance imposes a finance industry. Revisions to Article 9 offered by Fortune 500 insurance com- side counsel, do not represent attractive discipline and provides an insurance of the Uniform Commercial Code were panies, effectively shifting risk for the alternatives to insured perfection and product that can significantly reduce looming, scheduled to become effective proper attachment, perfection and prior- priority to the lender’s risk-management these legal risks. in most states in July 2001. The substan- ity of their security interests in non–real team. Considering the high level of both tial revisions represented uncertainty estate collateral. loan-origination and merger and and risk to lenders and their outside The Case for UCC Insurance acquisition activity in recent years, the counsel in the granting, perfecting and UCC Insurance Broadens Because most banks have grown opportunities for both human error and enforcing of their security interests. Protection for Secured Lenders through mergers and acquisitions, there statistical risk modeling that is ineffec- There was also significant concern on UCC insurance would complement, if not is little consistency in commercial-loan tive in abnormal economic circumstanc- the part of lenders and law firms with replace, the costly, traditional, lender-re- underwriting standards. Market re- es pose significant undiagnosed danger respect to compliance with the five- quired legal opinion crafted by borrow- search in the early days of the develop- to loan portfolios and the integrity of year transition rules of Revised Article ers’ counsel with respect to perfection ment of the concept of UCC insurance the documentation of their underlying 9. Non–real estate assets are defined and priority and provide cost-of-defense found that up to 40% of loans reviewed collateral. by Article 9 of the Uniform Commercial in the event something went wrong. were subject to some type of documen- Risk managers are now able to shift Code and often referred to as “per- With regard to high-risk, low-billable tation defect that could result in the risk managers are now able To shifT commercial-loan risk associated with sonal property” or “Article 9 collateral.” documentation matters, outside counsel lender’s security interest being set aside. commercial-loan risk associaTed wiTh The the broadening of the current consumer Personal property includes inventory, would be able to focus more appro- But, all so frequently in recent years, broadening of The currenT consumer and and residential-loan quality “meltdown” furniture, fixtures, equipment, accounts priately on negotiating and drafting the loans were either not in default residenTial-loan qualiTy “melTdown” by by utilizing a basic, traditional solution: receivable, deposit accounts, general primary loan documents, letting the UCC (yet) or were in some manner adjusted uTilizing a basic, TradiTional soluTion: “Time Tested Title Insurance: No Longer intangibles, securities and pledges insurers worry about UCC matters. The to reflect a satisfactory internal rating, “Time TesTed TiTle insurance: no longer Just for Real Estate.” (often crucial to the mezzanine loan insurance coverage would also relieve notwithstanding the potential for the JusT for real esTaTe.” transaction). A general angst in the liability to outside counsel in connection borrower to head toward insolvency. It Underwriting, Insuring and marketplace over the possible loss of to priority and perfection issues. is in an insolvency proceeding that often Protecting Lien Perfection and priority in collateral virtually called out There were those who believed results in a challenge to the lender’s se- Clear Title for a shift in risk — the core function of that replacing the (multijurisdictional) curity interest, either by the Bankruptcy Many believe it is the secondary market, an insurance company and the basis for opinion with actual (national) insurance Trustee, the Creditor’s Committee or evidenced by the advent of Fannie Mae which UCC insurance protection would coverage would serve to reduce risk to even the borrower. and Freddie Mac and their crucial roles be positioned. the law firms and, by extension, perhaps Recent cases recognized by the title in the American economy, that led to not one day to reduce malpractice-coverage industry as publicly adjudicated illus- like all insurance ProducTs, PerhaPs ucc only the importance of title insurance The Development of UCC Insurance premiums. trate lenders’ exposure from relying on insurance could be viewed as similar To for residential (retail) transactions, but Being introduced by the title industry search vendors and/or outside counsel The fire insurance we all Purchase for the investment community’s need for and served by a number of major, na- Value of Shifting Risk to ensure proper attachment, perfec- our Personal homes: you don’T really need enhanced, high-quality, real estate–relat- tional underwriters providing insurance Like all insurance products, perhaps UCC tion and priority of security interests The fire insurance unTil The house caTches ed (wholesale) asset- backed securities. coverage to an industry requiring title insurance could be viewed as similar to in personal property. For example, the on fire. in oTher words, There is unlikely This quality enhancement was pro- insurance for essentially every real the fire insurance we all purchase for failure to file a UCC-1 Financing state- To be a challenge To The lender’s securiTy vided by the nation’s title industry and estate secured transaction, provided a our personal homes: you don’t really ment by outside counsel led to a legal inTeresT, unless There is a defaulT. based on the industry’s ability to deliver, unique opportunity to take advantage of need the fire insurance until the house malpractice judgment against a law firm insure and defend “clear title.” Although existing sales, marketing and distribu- catches on fire. In other words, there is in an action brought by the client, in UCC insurance is a relative newcomer to tion channels. For the first time, the title unlikely to be a challenge to the lender’s Kory vs. Parsoff, 745 NY S. 2d 218 (2002). the financial markets, lenders and inves- industry would be able to insure “both security interest, unless there is a An incorrect/ambiguous financing tors are poised to gain many of the same sides” of a mixed-collateral transac- default. However, unlike the fire at your statement limited the collateral subject benefits currently and prominently tion: those deals secured by both real home (that may not result in a total loss to a bank’s filing in Shelby County State enjoyed in the real estate markets. property and personal property. Thus, a of contents), when a perfection or prior- Bank vs. Van Diest Supply 303 F. 3d 7th broadening of coverages was available ity defect occurs, it is often catastrophic Cir (2002). In another example, a UCC Change, Uncertainty and Risk to lenders already familiar with title to the lender in that it consumes all search vendor’s liability for damages Similar in many respects to traditional insurance in transactions involving the collateral. was limited to $25 for the failure/inaccu- real estate title insurance, UCC insur- financing of hotels, shopping centers, of- So, even loans known by the lender to racy of the vendor’s search in identifying 50 Visit the CFA CAreer Center At www.CFA.Com. the seCured lender April 2009 51
  5. 5. prior liens in Puget Sound Financial, LLC quality utilizing UCC insurance, which vs. Unisearch, Inc. 146 Wn. 2d 428 (2002). is positioned to provide for reduced Further, a defective description in col- loan loss reserves and, in turn, lead to lateral and incorrect filing jurisdiction lower regulatory capital requirements. led to a lender failing to properly perfect This provides for increased liquidity and its security interest in Fleet National bank operating margins. TSL Bank vs. Whippany Venture I 370 B.R. 762 (d. Del 2004). Ted Sprink is senior vice president and The exposure for lenders and outside national marketing director for the UCC counsel often takes form in the catego- Risk Management Program of the Fidelity ries mentioned, with litigation and loss National Financial Family of Companies. of collateral supporting the case for UCC UCCPlus insurance policies are centrally insurance. Other cases generally fitting underwritten and produced by Chicago into these categories include: Title, Fidelity National Title and Ticor Title In re Knudson, 929 F.2d 1280 (8th insurance companies, collectively a leading circuit 1991), District of Columbia vs. Fortune 500 provider of loan-origination and Thomas Funding, 15 UCC Rep Serv 2d closing services. Fidelity National Financial 242 (D.C.), First National Bank of Lacon purchased in December 2008 the Lawyers vs. Strong (663 N.E. 2d 432 Ill. App 3d Title and Commonwealth Title insurance 1996), ITT Commercial Finance Corp vs. brands from LandAmerica Financial Group. Bank of the West (166 F.3d 195 5th Cir 1999), LaSelle’s Bicycle World (120 B.R. ucc insurance has, in many TransacTions, 579 Bankr. N.D. Okla 1990), In re Matter reduced loan-originaTion cosTs, increased of Ellingson Motors (139 B.R. 919 Bankr . lender and invesTor-TransacTion ProTecTion D. Neb 1991), Franklin National Bank as well as TransParency), eliminaTed ucc- vs. Boser (972 S.W. 2d 98 Tex App. 1998), relaTed documenTaTion defecTs and filing Avalon Software, Inc. (209 B.R. 517 D. Ariz. errors, and shifTed risk from ouTside counsel 1997); In re: Isringhausen (20 UCC Rep wiTh regard To The legal oPinion. Serv. 2d 366 Bankr S.D. Ill. 1993), Banque Worms vs. Davis construction Co, Inc. 831 S.W. 2d 921 (Ky. Ct. App 1992), In re Nenko, Inc. 209 B.R. 588 (Bankr E.D. NY 1997), Schaheen vs. Allstate Financial Corp., 17 UCC Rep. Serv. 2d 1309 (4th Cir. 1992), and Mellon Bank, N.A. vs. Metro Communica- tions, Inc. 945 F.2d 635 (3rd Cir 1991). UCC Insurance Today for Credit Quality and Liquidity UCC insurance has, in many transac- tions, reduced loan-origination costs, increased lender and investor-transac- tion protection (as well as transparency), eliminated UCC-related documentation defects and filing errors, and shifted risk from outside counsel with regard to the legal opinion. UCC insurance has further served to enhance the strength and value of loans and loan portfolios securitized or otherwise sold into the secondary market. Perhaps most crucial in today’s unstable economic environment is that lenders can now improve internal credit 52 Visit the CFA CAreer Center At www.CFA.Com.