American Realty Advisors: Personal Liability In Commercial Loan Transactions

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Personal Liability In Commercial Loan Transactions

A Lender's Practical Approach To Evaluating Judicial Foreclosure, Deficiency Judgments And Personal Liability In California Real Property Commercial Loan Transactions

by Stanley L. Iezman and Russell B. Arnold

During the robust growth years in the real estate market, from 1975 to 1989, many commercial real estate lenders, when structuring commercial loan transactions, often found themselves in the position where they believed that making the loan recourse or obtaining a personal guarantee from a borrower was advantageous to the loan transaction because the guarantee added an additional degree of security to the loan that may not have otherwise existed. The significant decline in the California real estate market over the last four years has resulted in many lenders pursuing borrowers personally following the foreclosure of the defaulted loan in those circumstances where the value of the property was worth less than the outstanding debt. Unfortunately, many of the decisions to judicially pursue the borrowers individually were made with more emphasis on emotions rather than on sound economic analysis.

The purpose of this article is to outline and evaluate from the lender's perspective, the financial implications of pursuing borrowers personally where the loan transaction is recourse in nature. This is accomplished by overlaying a financial model on the legal framework, which exists in California, with respect to enforcement of guarantees and obtaining personal judgments against borrowers. In addition, this article will examine the timing and financial implications of pursuing borrowers personally or pursuing the personal guarantees rather than seeking to "work out" the loan transaction.

The authors of this article do not intend to evaluate the regulatory environment which may impact the decisions of the lenders, the legal steps necessary to judicially foreclose on a deed of trust, or to discuss the myriad of litigation strategies of suing borrowers personally or bringing suit on the personal guarantees of borrowers in real property loan transactions. This article will also not deal with the implications of suing third-party guarantors, which under certain circumstances may be pursued independently of the foreclosure action.

Judicial Foreclosure

Prior to discussing the financial implications of the decision to pursue the borrower personally, we must evaluate the legal framework currently existing in California which impacts the timing and, thus, the "value" of these legal decisions.

As all lenders in California have become painfully aware, where personal liability exists, the lender is required to pursue a judicial foreclosure mechanism to enforce its collection rights. In contrast, one of the undesirable consequences of a non-judicial foreclosure under California law is that the lender is barred by statute from obtaining a judgment for any deficiency after completion of the trustee's foreclosure sale (i.e., the amount by which the debt exceeds the foreclosure proceeds). The Anti-deficiency Rules of California Code of Civil Procedure §726 are very clear in providing:

Only one action is permitted to recover or enforce an obligation secured by real estate;
A lender who obtains a personal judgment on the obligation (or omits to include any of its collateral in the personal action) waives its right to the (omitted) collateral (the "Sanction" Rule);
No deficiency judgment will be permitted following a non-judicial foreclosure or any foreclosure of a "purchase money" deed of trust, as defined below.

However, a deficiency judgment will (subject to "purchase money" limitations) be permitted following a judicial foreclosure, limited by the extent to which the debt exceeds the fair value of the real property security; and
The anti-deficiency protection may not be waived in connection with the making or renewing of a loan.

Thus the lender, in order to enforce a guaranty and/or seek a deficiency judgment, must pursue a judicial foreclosure action.

Much has been written about the legislative framework of California and how it is designed to inhibit unsubstantiated or malicious lawsuits by lenders against borrowers. The impact of this legal framework, while protective of the consumer, is a potential constraint on economic growth in California because lenders are, ultimately, profit oriented and the direct and indirect costs associated with the foreclosure or other collection alternatives in California impact the yield to lenders. Therefore, the astute lender either prices its loans to reflect these facts or does business in regions where there are stronger profit incentives as manifested by a more generous legal framework. The important aspect of this issue is that lenders must not only price their loans to reflect the risk associated with the credit of the borrower, but also the impact of a legal system, which is more protective of borrowers than lenders.

Feasibility Of Judicial Foreclosure

Under California law, there are two limitations on deficiency judgments that can apply to a judicial foreclosure. The first such limitation is there can be no deficiency judgment if the subject of the foreclosure sale is a purchase money deed of trust or mortgage, which is defined as (i) a deed of trust or mortgage in favor of the seller of the property given to secure payment of the purchase price or (ii) a deed of trust or mortgage in favor of a third party lender, whose loan financed the purchase, if the property is a residential property containing not more than four dwelling units. This limitation is inapplicable to most commercial loans made by pension plans, banks, life insurance companies or other commercial lenders. The second limitation, known as the "fair value" limitation [see CCP §726(b)], restricts the amount of any deficiency judgment to the lesser of (i) the difference between the net proceeds from the sale and the secured indebtedness or (ii) the net proceeds from the sale and the fair market value of the property. The fair value limitation may limit the amount of the deficiency to the lender, but it will not prevent a judicial foreclosure.

Most loans which are with recourse to the guarantor, allow the lender to judicially foreclose and, unless the loan documents prohibit a lawsuit on the note, there does not appear to be any other impediment to obtaining a deficiency judgment either in the loan documents or by imposition of law.

Procedure For Conducting A Judicial Foreclosure

A judicial foreclosure is commenced by filing a complaint against the borrower and anyone else liable for a deficiency judgment under the loan, the owner of the property (if different than the borrower), and the holders of other junior interests in the property. A lis pendens or Notice of Action is recorded against the property which will restrict all persons attempting to acquire any interest in the property during the pendency of the action. A complaint is served on the parties, then a trial is held. The foreclosure proceeding is conducted like any other lawsuit until a judgment is entered. Once the lender has obtained a judgment of foreclosure, the court enters an order setting forth the amount owing and requiring foreclosure of the deed of trust to satisfy the indebtedness. The foreclosure sale is thereafter conducted by the sheriff or a court appointed receiver or commissioner after first recording and serving a notice of levy and a consecutive twenty day notice of sale (the notice period is much longer if a deficiency judgment has been waived or is prohibited.) The lender is entitled to bid at the foreclosure sale like any other interested party. Upon completion of the sale, if the sale proceeds are insufficient to satisfy the indebtedness, the lender has the right to apply for a deficiency judgment. The court considers evidence as to the value of the foreclosed property and then enters a deficiency judgment against the guarantors, subject to the fair value limitation discussed above.

Presuming that the properties securing the loans are located in California then the foreclosure action must be brought in the Superior Court in the county in which the property is located. The time required to complete the foreclosure will depend primarily on whether and to what extent the action is contested by the borrower. The borrower will have thirty days after being served to respond to the lender's complaint. If a response is not made within that time period, the lender is entitled to have a default judgment entered against the borrower. The total time to complete an uncontested foreclosure (from the filing of a complaint until the entry of a deficiency judgment) is approximately five months.

If the borrower answers the complaint, it is possible the case can be summarily adjudicated by bringing a motion for summary judgment (the "Motion") based solely upon issues of the law. The likelihood of exercising this option is somewhat dependent on the affirmative defenses or issues of fact, if any, that borrower may assert with its answer. The Motion can be brought as early as seventy-five days after the complaint is filed. However, some discovery is usually recommended to fully document and justify the issues raised by the Motion. Moreover, clogged court calendars can delay the hearing of the Motion for several months. Nevertheless, it is possible, even in a contested proceeding, to summarily adjudicate the issues, complete the foreclosure, and obtain a deficiency judgment within six to eight months after filing suit.

If the borrower contests the foreclosure by citing affirmative defenses which raise issues of fact requiring a trial for determination, it may take much longer to complete the foreclosure. Under the existing expedited trial program in Los Angeles County Superior Court, matters can, hypothetically, be brought to trial within twelve months after the complaint is filed (with another thirty to forty-five days to complete the foreclosure sale and have a deficiency judgment entered). We are not commenting upon the application of the law in other counties, but many also have expedited programs. Unfortunately, many things can delay bringing a case to trial, including a protracted discovery process and delays in obtaining a trial date and courtroom for trial. If the borrower concludes there is a significant economic incentive for delaying the foreclosure as long a possible (for instance, to take advantage of an expected improvement in market conditions), the lender should be prepared for the possibility of a proceeding lasting several years.

Possible Drawbacks Of A Judicial Foreclosure

As noted above, the principal benefit of bringing a judicial foreclosure is that it allows the lender to obtain a deficiency judgment if the foreclosure proceeds are less than the amount owing on the indebtedness. If such a judgment is entered against the borrower, the lender will be entitled to levy and execute the judgment against other borrower assets and, if the borrower assets are insufficient, then against the assets of the partners of borrower, if borrower is a general partnership. One may well conclude that the benefit of being able to obtain a deficiency judgment outweighs all other considerations. There are, however, significant drawbacks associated with the use of judicial foreclosures that should be evaluated by a lender before going forward. They include the following:

In the case of a non-judicial foreclosure, once the foreclosure sale takes place all of the rights of the borrower to the property are terminated. On the other hand, in the case of a judicial foreclosure, unless the right to a deficiency judgment is waived prior to the sale, the borrower has a statutory right of redemption (that is, a right to buy back or "redeem" the property) and a right to retain possession of the property during the redemption period, although he is required to pay rent to the buyer at the foreclosure sale. The likelihood of that occurring, however, is remote (see CCP §729.020, 729.030 and 729.060). The redemption period is one year, commencing on the date the foreclosure sale takes place (unless the sale proceeds are sufficient to satisfy the indebtedness, in which case the redemption period is three months). The redemption price is the amount that was owing to the lender and secured by the deed of trust at the time of foreclosure. The existence of the right of redemption generally makes the property unmarketable during the redemption period. For this reason, the amount bid by third parties at a judicial foreclosure will usually be less than at a non-judicial foreclosure.
If the judicial foreclosure is contested, it will likely take far longer to complete than a non-judicial foreclosure. As noted above, a vigorously contested judicial foreclosure could take well in excess of a year and perhaps several years. A non-judicial foreclosure, on the other hand, can ordinarily be completed within approximately four months from the date the notice of default is recorded. There are alternatives a debtor could pursue to delay or contest a non-judicial foreclosure, but there is less incentive for doing so than in a judicial foreclosure, particularly when the value of the property is less than the outstanding debt, because the borrower in a non-judicial foreclosure does not face any liability for a deficiency.
Because a judicial foreclosure quite often takes more time to complete than a non-judicial foreclosure, it involves a far greater risk that the encumbered property will deteriorate and thus lose its value during the course of the foreclosure proceedings. This problem can be avoided by asking for and having the court appoint a receiver to operate the property, collect rentals, and otherwise see that it is properly managed and maintained until the foreclosure sale takes place.
A judicial foreclosure involves expenses not ordinarily incurred in doing a non-judicial foreclosure. Typically, a non-judicial foreclosure is conducted by a foreclosure trustee service or title company, acting as trustee, for a fee based on the dollar amount of the loan. A judicial foreclosure will require the active involvement of counsel in handling the lawsuit. While there is a wide range of fees charged by trustees for non-judicial foreclosures, as a rule the cost is significantly less than the attorneys' fees and other costs associated with litigation. The loan documents typically allow the recovery of a judgment for attorneys' fees in the event of a judicial foreclosure, but there is no assurance that the judgment will be for the full amount of the attorneys' fees incurred or that the fees will actually be collected.
Finally, because a judicial foreclosure results in a deficiency judgment, it is far more likely to be contested than a non-judicial foreclosure. The lender can therefore expect that borrowers will not only raise affirmative defenses that may be available to avoid payment, but will also assert by way of cross-complaint any and all claims against the lender that it believes exist. Accordingly, if there are any lender liability claims that are capable of assertion, it can be expected that they will be raised in the litigation.

It is important that the lender understand this legal structure when evaluating collection alternatives on a loan in default, because the course that the lender ultimately pursues will significantly impact its overall financial return. Thus, the remaining portions of this article will focus upon the financial impact to the lender of pursuing the borrower personally following a judicial foreclosure sale versus restructuring the loan transaction in a manner which may be more financially compatible with the goals of both parties presuming that the lender can see past its fundamental apprehension to compromising its loan by writing down the principal, extending the loan term, modifying the loan interest rate or a myriad of other changes which are only limited by the financial capabilities, or lack thereof, of both borrowers and lenders. Needless to say, the discussion assumes a declining or stagnant real estate market comparable to what is happening in California today.

We would like to point out, however, that this discussion seeks to evaluate the more immediate economic impact of this decision matrix on the lender, as many lenders have taken fundamentally more aggressive positions with defaulted loans and waived the right to pursue the borrower personally by foreclosing on the security for the loan through a non-judicial format.

These lenders assume that in time the real estate market will return to stability and thus they will recoup any anticipated loss, but without having to either: (i) work with the borrower who will, in most cases, be recalcitrant; or (ii) share in the upside with the borrower as market recovery becomes a realty.

The following facts are being assumed in connection with our hypothetical discussion and evaluation of a loan transaction for purposes of this article:

Factual Background Of The Loan

The lender funded a permanent loan to the developer upon completion of construction of an office building in the mid-1980's, which was valued at origination on a fair market basis at $15,000,000. The debt coverage ratio was 1.2 to 1. The loan was performing for five years in accordance with the pro forma, but beginning in 1990 the borrower began to experience financial problems as lease rates began to drop. By 1992 the lease rates had receded by 25% and the value of the property was worth less than the loan balance. The loan matured in 1993 and the borrower sought to restructure the loan as it could not be refinanced. The following are the pertinent facts that the lender was presented with:

Property:
Seven-story 100,000 square foot multi-tenant Class A office building in Southern California which is currently 80% leased but had been fully occupied at the time of funding of the permanent loan in question.

Loan Amount:
$12,500,000

Original Interest Rate:
13.5%

Late Charges:
7.5% of Late Payment

Default Interest Rate:
9.5% Above the Note Rate

Current Valuation:
The value of the property on a 10-year discounted cash flow analysis is now $9,600,000.

Borrower:
The borrower is a California limited partnership, in which the managing general partner is a local real estate developer. The developer is financially secure with other real estate holdings and has potential exposure beyond the existing personal asset base.

Status Of Default:
The loan is currently 6 months in arrears with its scheduled payments and has also matured. The borrower has been making partial payments equal to the net operating cash flow from the property on a monthly basis. The lender has accepted these partial payments without a reservation of its rights. As further consideration of the borrower's ability to professionally manage the property, the lender has forbeared to initiate a notice of default or to file a judicial foreclosure action and seek the appointment of a receiver.

Market:
The market lease rates have dropped 40% and the net operating income is no longer sufficient to service loan's the debt service. Although the market is stable or declining and the excess supply of office space, coupled with a declining economy portends no growth in the value of the asset for the foreseeable period of time.

The borrower has approached the lender to seek a restructuring of the loan on financial lines which are commensurate with the current market which essentially required a lower interest rate and a write off of a portion of the principal balance of the loan. The lender upon initially reviewing the loan, quickly determined that the borrower is personally liable for the debt and concluded that pursuing the borrower personally following a judicial foreclosure is the only prudent approach to take. The lender, upon utilizing the economic analysis detailed herein, reevaluated this decision in light of the present value conclusions when viewed with the "real politick" of the judicial process.

The lender was presented with a series of economic models which sought to compare the present value of a workout scenario as described below with the present value of the net economic return which would be presumed to be obtained from pursuing the borrower personally under four litigation and/or bankruptcy scenarios.

The four scenarios discussed below compare the net present value of the proposed workout for the loan versus pursuing a judicial foreclosure against the borrower and the related guarantors under various judgment and collection probabilities. The lender has acknowledged in its due diligence process of the proposed loan restructuring that there is no assurance that the borrower will not default again or file for bankruptcy protection and unwind any modification transaction which is agreed to by the parties. However, it is the lender's belief, based upon its internal property valuation that the proposed terms can be supported by the projected operations, but the market risk remains for both parties. The following outlines the proposed workout model which was negotiated between the lender and the borrower:

The Proposed Workout

The term of the modification is for a period of seventy-two (72) months (the "Modification Term").
The loan balance is reduced to $9,500,000.
The interest rate is reduced to 8.25%.
The monthly payments will be $65,312.50.
The borrower will pay into an impound account, on a monthly basis, an amount equal to 1/12 of the annual insurance premiums and real estate taxes.
The borrower will pay to the lender on a quarterly basis as contingent interest 50% of all cash flow after debt service and impounds. The borrower will not be able to deduct from excess cash flow any yield on funds it advances for debt service or capital improvements.
The borrower during the Modification Term will be responsible for the payment of expenses for the completion of capital improvements, which may include tenant improvements and third party leasing commissions on leases previously approved by the lender in writing. Operating cash flow after the payment of debt service, impounds and contingent interest to the lender as detailed above, will be segregated into a capital account (the "Capital Account") and will be available for use for capital improvements subject to the prior written consent of the lender, unless already contained in the pre-approved operating budget, detailed below.
The debt coverage ratio for the loan must be equal to or greater than 1.25 to 1 on a quarterly basis during the Modification Term, or the borrower will be required to immediately make a principal pay down on the loan as modified, to correct the debt coverage ratio requirement. If the pay down does not occur within thirty (30) days after written notice, the loan as be considered in default and immediately due and payable.
If the borrower elects to repay all or any portion of the loan, the lender will be entitled to a Yield Maintenance Fee (the "Yield Fee"). The Yield Fee will be calculated based upon the monthly interest rate difference between the loan as modified and a yield plus 400 basis points above the five year U.S. Treasury instrument as determined from the Federal Reserve Statistical Release H.15 (519) of Selected Interest Rates for the remaining period of the Modification Term. Any prepayment will require thirty (30) days prior written notice from the borrower to the lender.
The borrower, along with the developer will guarantee $2,000,000 of the repayment of the loan as modified. The guarantee will be collateralized with assets other than the property and subject to the lender's approval. The guarantee referenced herein on the loan as modified will supersede and amend the previous guarantee obligations. The borrower will continue to indemnify the lender for any and all costs related to environmental contamination and or its remediation for the subject property, whether known or unknown.
If the property is sold to a third party buyer during the Modification Term or paid in full at maturity, the lender will receive as additional consideration 75% of the excess value, including any undisbursed Capital Account funds after the repayment of $9,500,000. After the lender has received an additional $3,000,000 in excess value, the lender and borrower will split any remaining excess value on a 50/50 basis. Any sale or refinancing of the property during the Modification Term will be at a price that reflects the fair market value of the property at the time and shall be subject to the lender's prior written consent.
If during the Modification Term, the borrower defaults under the loan as modified, then the original terms of the loan will be in full force and effect, including the original scheduled principal and interest payments and the entire principal balance before the reduction will be immediately due and payable. The borrower further agrees that in the case of default it will not oppose the lender in seeking the appointment of a receiver or contest the lender's motion for relief from any bankruptcy petition.
The borrower will submit on a monthly basis to the lender by the 15th day of the following month, monthly financial statements detailing all income and expenses for the operation of the property, a narrative variance report based upon the approved operating budget, a full accounting of Capital Account activity, a marketing report on the leasing activity and an updated rent roll. Bank statements will also be provided monthly on all accounts. Failure to provide said information will be a default under the loan as modified.
The borrower agrees to maintain the property in a first class manner and all repairs and maintenance must be kept current. The borrower agrees to quarterly or more frequent inspections by the lender of the property to ensure that property maintenance and repairs are accomplished. If deferred maintenance is found then the borrower will be provided seven days to correct and if not corrected a default will deemed to have occurred which will provide the lender with the ability to proceed with all available remedies.
The borrower will continue to act as the property's on-site manager and leasing agent. The borrower will be limited to 2.5% of the gross property income, excluding any extraordinary or prepaid rental payments, as monthly compensation. The borrower will be allowed to deduct from the property's cash flow amounts for the on-site management and maintenance staff, subject to the pre-approved budget. The borrower will not be allowed to be paid any leasing commissions or construction management fees during the Modification Term.

The borrower will be allowed to pay third party procuring brokers for leases approved by the lender, consistent with market rates.
The borrower will submit to the lender, for its consent within thirty (30) days of closing the loan modification transaction and on a mutually acceptable form, an annual property cash flow budget prepared on a monthly . Thereafter, said operating budget will be due sixty (60) days prior to the end of the calendar year and will cover the following calendar year's monthly property operations. The property cash flow budget shall also reflect and Capital Account activity. The failure to obtain an approved budget within said thirty (30) and sixty (60) day period will be a default under the loan as modified;
The borrower agrees to promptly reimburse the lender for all costs and expenses incurred by the lender, including but not limited to all legal fees incurred in connection with the preparation of loan modification document and any title insurance costs; and
As part of the documentation and condition for the loan modification transaction, the borrower will deliver at closing updated Non-Disturbance, Attornment and Subordination Agreements and Tenant Estoppel Certificates on all property leases.

It is important to note that a "workout" is very subjective in nature and our outline of the proposed loan restructure is only one of many different models which can be accomplished when attempting to resolve a non-performing loan transaction. The net effect of working out the loan as described above, on a present value basis, is that the lender is anticipated to receive $8.4 million over the life of the loan utilizing a discount rate of 14%.

The lender at this juncture must now compare the overall return to the lender if the borrower is pursued personally through the judicial process. The lender was presented with four scenarios, each of which is either a best or reasonable case of the facts, assuming the legal system as it currently operates. Following each scenario is a spreadsheet which specifically details the assumptions and economic conclusions:

Scenario I
Best Case: Judgment Is Maximum Amount Awarded By The Court With The Borrower Filing Bankruptcy Following The Enforcement Of The Guarantees;

Scenario II
The Reasonable Case: Judgment Is Reasonable Amount Awarded By The Court Following The Bankruptcy Of The Borrower;

Scenario III
The Reasonable Case: The Judgment Is Reasonable Amount Awarded By The Court With Borrower Not Filing Bankruptcy Following The Enforcement Of The Guarantee; and

Scenario IV
The Best Case: Judgment Is Maximum Amount By The Court With No Bankruptcy Filed By The Borrower.

Scenario I - Best Case:
Judgment Is Maximum Amount Awarded By The Court With The Borrower Filing Bankruptcy Following The Enforcement Of The Guarantees

A Judicial foreclosure action is commenced, with the actual lawsuit filed by March 31, 1994.
The estimated timeframe to answer the complaint and complete the discovery process is 12 months or by March 31, 1995.
Preparation for the first trial, plus actually getting a trial date is estimated to take an additional 6 months until September 30, 1995. Currently in California, many counties have implemented "fast-track" procedures to attempt to adjudicate matters within 12 months. However, getting an open court on the date the matter is scheduled can be next to impossible. Most trial dates are postponed a minimum of 2 times to have a realistic chance at being heard.
The first trial is necessary to determine the actual amount owed by the borrower and is estimated to take 1 month or until October 31, 1995. At this point, judgment for the entire debt amount is entered against the borrower and the individual guarantors. It is assumed that no appeal is filed by the borrower based upon the court's determination of the debt. The lender must now complete its foreclosure by Trustee's sale of the subject property located in Los Angeles, California (the "Property") and then have a fair value hearing to determine the Property's value. The referenced Trustee's foreclosure sale is not the typical non-judicial action, which would release the borrower of future payment obligations, but rather a judicial action.
It is assumed that the lender is awarded the total amount owed by the borrower of (i) all principal owed, (ii) all of its delinquent interest at 13.5%, (iii) late charges at 7.5% of the payment amount, (iv) default interest at 9.5% above the note interest rate and (v) all attorney fees, estimated at $500,000. Attorneys fees have been estimated at $350,000 for the judicial foreclosure process and $150,000 for the bankruptcy.

This is only an estimate of the anticipated litigation costs and therefore costs could escalate substantially if the matter is highly contested by the borrower. The total amount owed has been reduced by the Property's net cash flow, which has been reduced for the projected capital costs. The projected cash flow numbers are the same for all judicial foreclosure scenarios and the proposed workout.
In this scenario, the borrower would owe, based upon the court's determination, approximately $18.5 million, versus a current loan amount of $12.5 million.
After judgment has been entered for the total amount owed of $18.5 million, it is assumed that the borrower and/or the individual guarantors file for bankruptcy protection. It estimated that it will take 24 months to obtain relief from the automatic stay of bankruptcy. During the bankruptcy and previous judicial foreclosure, it is assumed the borrower will be in possession of the Property subject to certain restrictions on operations, as ordered by the court. At the end of the bankruptcy, estimated at October 31, 1997, the lender is granted relief to complete its foreclosure and begin the fair value portion of the judicial foreclosure. It is assumed that the bankruptcy did not affect the guarantor's obligation for the payment of the entire deficiency judgment, when finally adjudicated.
One month after relief is granted a Trustee's foreclosure sale occurs transferring the ownership and operations of the Property to the lender, about November 30, 1997, subject to determination of the Property's fair value for the purposes of calculating the deficiency and a one-year redemption period given to the borrower.
Three months after the ownership is transferred to the lender, February 29 , 1997, a fair value hearing occurs. For the purpose of this analysis, the value is determined, based upon the direct capitalization method (11%) of projected operating income for 1998 or $13.25 million. It is assumed that the lender's determination of value, as calculated herein is granted by the court and not the value submitted by the borrower, which would be significantly more optimistic in an attempt to minimize the deficiency amount.
The actual deficiency amount is calculated as the difference between the total amount owed, $20.6 million and the fair value of the Property, which is estimated at $13.25 million after sales costs. This creates a deficiency owed by the individual guarantors of approximately $7.3 million.
After the fair value of the Property is determined, it is estimated to take an additional 2 months to enter judgment against the individual guarantors for the amount of the deficiency or until April 30, 1998. During this period, the lender will be in possession of the Property, subject to the one year redemption period. The fair value is based upon expert testimony i.e., MAI appraisals and not the price someone would offer on a distressed sale basis.
It is assumed that the Property will not be marketed for sale until after the end of the redemption period, which is estimated to be November 30, 1998. After that point, it is projected to take an additional 12 months, or until November 30, 1999, to complete a sale of the Property. Leasing activity will continue to occur based upon the Property's cash flow projections.
The sale of the Property is based upon the direct capitalization method, to be (11%) of the net operating income for 1999 for a value of $12.9 million before sales costs. It is assumed that the sale will be financed at 75% of the purchase price. To develop a cash equivalent value of the note, it is assumed that the acquisition financing is sold at 80% of par after 6 months of marketing, or by May 31, 2000. One could hold the note to maturity but to obtain meaningful present value comparison, it has been assumed the note is sold.
Collection of the deficiency is assumed to take 12 months after deficiency judgment has been entered against the guarantors or until April 30, 1999. It is assumed that the total debt amount will accrue interest at 10% less any property cash flow. This collection process would be independent of the Property's operations and disposition efforts. For analysis purposes, the deficiency amount of $7.3 million has then been spread with various probabilities for collections ranging from 100% down to 10%.
Based upon the various collection probabilities, the combined present value of the deficiency amount collection, sale of the property and sale of the note is determined to be between $7.6 million and $4.6 million. For the purpose of all these scenarios a 15% discount rate has been used. The borrower is assumed to be able to pay any deficiency amount calculated in cash.
The proposed workout has also been discounted at 14% to determine its net present value of $8.4 million, which is compared to the net present value of the litigation scenario referenced herein for Scenario I. No additional economic value has been placed upon the guarantees as contemplated by the proposed loan restructure. The net present value of the proposed loan restructure has been based solely upon the projected cash flows for the Property.
No deduction has been made to the Property's projected cash flow for the judicial foreclosure litigation or any subsequent bankruptcy filing.

Scenario II - The Reasonable Case:
Judgment Is Reasonable Amount Awarded By The Court Following The Bankruptcy Of The Borrower

Same assumptions as Scenario I with the following exceptions.
Lender is not granted any default interest or attorneys fees as part of the courts determination of the total amount owed.
Since the attorneys fees will be the actual costs incurred, they have been netted from the present value calculation for the judicial foreclosure. For the purpose of this analysis, no deduction has been made for the present value of the costs to litigate the matter, therefore, the estimated amount of attorneys fees, $500,000, has been simply deducted from the sum total of the present values for the deficiency amount, sale of the Property and sale of the seller financing.

The deficiency amount in this scenario at $3.3 million is approximately half of the amount as determined in Scenario I, which on a present value basis would be approximately $1.5 million, assuming 100% is collected. Based upon the economic results, the proposed loan restructure with a present value of $8.9 million, substantially exceeds the pursuit of a judicial foreclosure on a net present value basis, which values range between $5.0 million to $3.7 million.

Scenario III - The Reasonable Case:
The Judgment Is Reasonable Amount Awarded By The Court With Borrower Not Filing Bankruptcy Following The Enforcement Of The Guarantee

Same assumptions as Scenario II with the exception that no bankruptcy is filed after the trial is completed for the court's determination of the borrower's debt amount. This reduces the overall period to collect upon the guarantees and disposition of the Property by 24 months.
Actual attorneys fees have been reduced to $350,000 because no bankruptcy was assumed to be filed.

It is fairly unlikely that the borrower would absorb a judgment, as determined by this scenario of approximately $3.9 million, without some from of debtor protection, i.e., bankruptcy. The present value of the deficiency judgment for this scenario would be $2.4 million, assuming a 100% collection probability. But again, the net present value of all collection probabilities which range from $8.1 million to $5.9 million results in a lower return than the proposed loan restructure.

Scenario IV - The Best Case:
Judgment Is Maximum Amount By The Court With No Bankruptcy Filed By The Borrower

Same assumptions as Scenario III with the modification that the court grants the lender all its default interest and attorneys fees of $350,000.

This scenario can be categorized as "best-best" case outcome for the lender. Given that statement, the analysis shows that the lender would have to collect approximately 75% of the inflated total deficiency amount of $7.2 million to equal or exceed the present value of the proposed loan restructure. It is the lender's opinion that any reasonable person would not speculate or risk its decision to litigate on the assumptions presented for Scenario IV. But if they did, the present value of collecting 50% of the total deficiency amount would be approximately $2.2 million, which is again approximately the amount of the reduced guarantee amount of the proposed loan restructure.

Conclusion

The unfortunate outcome of the foregoing analysis is that a lender, in seeking to enforce a personal judgment pursuant to California law, will find that personal liability or guarantees rarely add any tangible economic value to the lender when juxtaposed with a broader financial/legal analysis of pursuing the guarantee. The biggest risk with any litigation is actually collecting upon the judgment. Litigation is a series of compromises, whereby the lender's debt will be reduced and the borrower's maximum exposure to a deficiency will be minimized. If the borrower has the funds available to pay the deficiency, the lender can be assured the individual guarantors will not wait for the lender to achieve total victory to their financial detriment. The borrower could employ various attorneys who practice "estate planning" that could further prevent the lender from collecting its judgment. Also, assuming no deterioration to the property's performance during this 5 year litigation period is probably optimistic, but as the results show, the present value of the judicial foreclosure alternative can only get worse.

Based upon the foregoing, it is the opinion of the authors that reducing the borrower's guarantees as a part of the proposed loan restructure, results in little or no economic enhancement to the lender's ability to be repaid. Clearly, there is a psychological benefit to the borrower, if reduced, but if there is nothing to collect upon, the guarantee is worthless. The reduction of the borrower's guarantees to $2.0 million is a reasonable negotiating point, based upon the uncertain ability to collect fully upon any deficiency amount. In summary, the four scenarios have been compared to the 50% collection probability and in all cases the proposed loan restructure significantly exceeds the present value of the various litigation scenarios.

Given the economic consequences of pursuing judicial foreclosure litigation versus modifying the terms of the existing loan, lender's are best served to fully analyze all of its collection alternatives at the commencement of a default situation. The analyses detailed herein, in relationship to the proposed workout, evidence the possibility of deterioration in a lender's ultimate return if litigation is pursued without an effective business strategy clearly in place.

There have been many scholarly articles written which focus on the "significant" potential abuse by lenders when they are allowed to pursue borrowers on their contractual promises. The authors of these articles often cite "fairness" as being the ultimate concern and that borrowers need protection. But, these discussions are not modeled on the "real" world of finance where lenders must consistently evaluate risk in all respects: risks from market deterioration, legitimate borrower financial deterioration, environmental harm, fire, flood, earthquake and other real or imagined natural disasters, as well as legislative bodies who draft consumer protection laws and who have nothing at risk but votes, which do not cause an economy to grow. The analysis previously discussed assumes California consumer protection laws remains in place and that the underlying real estate market conditions remain static. The proposed reform to California's Anti-Deficiency laws as proposed by the Joint Committee on Anti-Deficiency laws of the Real Property Law section and the Business Law section of the State Bar of California will go far to bring about a level playing field. California has been the recipient of significant, even unprecedented economic growth since the end of World War II. That is no longer the case and the laws which deal with the real property loan area must become more "user friendly," otherwise lenders will find other more viable investment opportunities in other states.

Stanley L. Iezman is the President and CEO of American Realty Advisors and is an adjunct professor at the University of Southern California, teaching asset management at the School of Urban and Regional Planning, Lusk Center for Real Estate Development.

Russell B. Arnold is an Asset Manager with American Realty Advisors. American Realty Advisors is a registered investment advisor with the Securities and Exchange Commission and provides real estate investment management services to tax-exempt entities.