Shifting from CRE to C&I and Legal Documentation Observations

Share this post:

In the course of visiting client banks we make observations on particular items which sometimes are indicative of more universal issues. One of these universal issues has bubbled its way to the forefront.

In the changing climate of the largest banks acquiring regional banks and turning their branches into solely deposit gathering and consumer lending units, a vacuum has developed in the capital formation process for larger C & I companies to obtain business loans. Into this vacuum the community banks, savings banks and credit unions have entered and to a greater or lesser extent begun to build C&I portfolios in addition to continuing their historical involvement in real estate lending. Some of the momentum for this change has come from regulators desirous of seeing those institutions diversifying their portfolios. From our observations, these institutions have generally recognized that there is a need to bolster their credit departments and staff with training to develop expertise in the analysis of this different model of business lending. Hiring experienced personnel, developing credit models, preparing business analysis have generally proceeded in many of these institutions with varying degrees of success.

On the other hand, an aspect of successful lending in this new arena is given little or no attention, that being the legal documentation and structure appropriate to non real estate loans. We consider this factor to be an element which needs attention based upon our review of these newly developing portfolios. We have observed weaknesses which over time could result in portfolio losses and or regulatory concerns. The import of some of the weaknesses is immediately obvious and others are more subtle. By citing some examples we hope to make the case for attention to the issue and that adjustments will be made sooner rather than later.

Next, let’s take a look at some issues that we have uncovered at institutions which were in the transition from real estate to C&I lending and then make some suggestions for action which will hopefully improve this process for other institutions looking to make these changes.

We have noted banks where loans secured by marketable equity issues have not included the Regulation U Purpose Statement completed by the borrower and signed by an account officer, which is a regulatory violation. In those instances, it was not just an oversight but rather a complete lack of awareness of the requirement as part of the approval and documentation process.

Separately, we noted an instance where a bank was relying upon its borrower’s accounts receivable from US Government entities on a formula basis to support its credit accommodation but had only filed a UCC 1. The Bank did not have any oversight in its process, which if in place would have noticed that while a lien may be perfected under the UCC filing, only by complying with the Assignment of Claims Act (“Notice of Assignment”) can the lender ensure that it receives payment directly from the applicable governmental agency.

In another instance we have noted a Bank relying upon “legend” stock as collateral for its lending with no awareness on the lending line or in the loan processing department that, because the shares were not registered, they could not be sold on the market without the significant expense of registering them.

Then, we have uncovered an instance where a bank was lending against cash surrender value of life insurance but had not obtained acknowledgement of the assignment from the insurance company issuer.

Lastly, we came across and instance where an institution was using forms from a software vendor to document its C&I loans, but had no apparent legal oversight as to what forms were necessary and appropriate to the transaction.

In all the cited examples, the error was not one made in contravention of bank policy and procedures, but rather one where the bank had not been aware enough of the issue to have an appropriate policy and procedure in place.

On the structuring side, in the universe of these changing institutions, there is an almost total lack of appropriate affirmative and negative covenant protection written into C&I loan agreements. In fact, loan agreements are frequently non existent in credit accommodation where they are very much needed. As a result the lending institution does not require or receive appropriate current financial information or protect itself against declining financial performance with covenant defaults which would be triggered by such. We see numerous instances where significant credit accommodation to growing middle market companies is disjointed and does not tie the overall accommodation and collateral into one rational arrangement related to the intrinsics of the borrower. Rather it is often written as a series of individual notes and specific collateral which is the model for real estate lending but does not address the essence of lending to a cash flow generating company which does not have static credit needs.

OK. We have cited some of the issues. Now what can or should be done to address them.

Many, if not all of the institutions emerging from a real estate lending milieu into one encompassing commercial and industrial loans, have a long relationship with one or more law firms which document and close their loans. And many or most of those law firms specialize in real estate and have no practice on the C&I side. Those law firms themselves are unfamiliar with SEC issues and bank regulation issues outside of real estate lending. They are not familiar with the Uniform Commercial Code and many tax and legal issues which pertain to non real estate loans. We believe that it is incumbent upon an institution making a foray into C&I to associate itself with law firms which have a significant practice in documenting such loans. We also believe that the institutions, just as they have educated their personnel in C&I credit analysis, should provide training to all involved personnel, including senior management, in documentation of C&I loans and the perfection of collateral attendant thereto. As the institution begins to do business with larger and more sophisticated borrowers, training in structuring credit accommodation to such borrowers is necessary. Again, this training is necessary for senior management also. Successful institutions recognize that entering a new line of business requires an investment into their personnel, and/or the hiring of skilled and experienced personnel, to compete in the new arena.

To gain further insights on the topic and/or see how CEIS Review may be of assistance please contact us.

James Brown

Executive Consultant, CEIS Review