Note Terms & Clauses

[Aaron Mazzrillo]

On another post which we kind of derailed, we got into discussing creative financing techniques and clauses some of us use in notes secured by real estate. You can read more about it here:

Original "Motivation" Thread

I'd like to continue that discussion on clauses we sprinkle into notes such as 'substitution of collateral' and 'personal guarantees.'

[Bill Gulley]

Okay, but please understand 1. I'm not writing a book here and 2. What I'm about to say is my opinion based on several factors; a. experience in reviewing thousands of RE transaction with respect to lending issues. b. legal aspects from personal experience and formal training and c. subjective judgment in applying learned experiences. I'm not an attorney, I'm a finance guy, one who has given expert testimony in courts with such given without much, if any, objection or challenge to it. That translated, means I'll give you my opinion, I'm not about to argue with anyone, so let's move on politely and with due mutual respect.

As to the issues of non-recourse financing or not taking personal financial responsibility for debts created.

Let's start by giving some reasons why non-recourse debt is used and where and when it's appropriate.

Non-recourse debt (NRD) is customary in certain business loans where either a personal guarantee is illegal or it fails to comply with regulations or where the entity lending has 1. A borrower with a greater degree of having the ability to repay which poses a significantly lower risk of paying as agreed and 2. Where the amount of collateral is highly marketable, is clearly sufficient to cover the unpaid balance together with all expected costs involved in securing and disposing of the collateral and 3. falls within prudent lending practices in extending credit in similar financing transactions. All three of these aspects should be present in any NRD arrangement.

NRD is common when the underlying loan is guaranteed by another underwriter, endorser or guarantor or where any bond or surety is provided. An example is in Section 42 low-moderate income housing projects where the borrower developer is bonded and prevented from providing a personal guarantee by statute.

A lender may provide a commercial loan where the circumstances meet the two points mentioned above, where the borrower is an entity having sufficient capital and income fro operations where the ability to pay as agreed carries little lending risk. The other issue as to collateral, another example could be where "qualified bonds" (being government issued bonds "A" rated or better) can be pledged to reduce or even eliminate collateral risks. Such are considered to fall within the arena of prudent lending practices.

Now, let's shift gears to an individual level.

By statute and IRS code, a borrower may not receive a loan from a qualified tax deferred plan on a recourse basis, this is partly due to funds can becoming tainted and lose the deferred status. So, such is governed by government rules and regulations.

Now, consider any small investor. Do they meet the three aspects mentioned above, does the NRD carry little risk of paying as agreed, is it over collateralized and is such a financing arrangement usual and customary in similar transactions.

Firs of all, individual borrowers die, they can become incapacitated, they can be injured or become ill to the point they can no longer perform. If they are the key person in a business entity, that entity is no more able to continue than the individual running it. The individual small investor probably does not have life insurance and disability coverage to continue operations not are they bonded to ensure business continuation. So, in reality, a small investor will never be able to overcome the aspects of a lender acting prudently accepting that the ability to cover the debt will be ensured.

Next, is the collateral issue, is the individual borrower or small entity providing readily marketable assets as collateral sufficient to cover the debt together with all related costs to secure and dispose of same and pay the outstanding balance over the term. You might pass this test at 50% LTV, but by the nature of RE, it is not considered "marketable" from a liquidation stand point without slashing the price for an immediate sale. Why so extreme? Because the NRD nature requires the collateral to be more than sufficient for liquidation. RE foreclosures and collateral sales are not readily liquid and the fact that a recourse loans are made, address this issue of accepting a less liquid asset.

Now, if the individual borrower were to pledge the property as well as cash assets, say a bond or even stock or bank CDs, then the collateral aspect could swing the risk assessment toward a NRD.

Off to other areas.

Usual and customary carries legal weight in any transaction, from buying a car to having pizza delivered to residential and commercial real estate deals.

What would a reasonable person do in the same situation if they had equal or nearly equal knowledge as other parties?

In a transaction, at some point one party or the other is expected to have some slight advantage, transactions are rarely exactly equal. The question then becomes did one party have any distinct advantage, does one party have any clear advantage over another party.

The guru followers really need to understand these issues in contract law and what is looked to in assessing any dispute.

Is the transaction usual and customary for the type of transaction accomplished? Is the conduct of the parties prudent and rational under the circumstances? Does one party have a greater knowledge or expertise that constitutes an unfair advantage?

Lastly, to this post, as I shall return with more, any third party who is ever in a position to review or examine or judge any transaction doesn't give two hoots about the intentions of any party beyond what an agreement states and affords. To make any agreement that dictates any degree of performance or the ability to avoid any obligation, the contract dictates the intent before the claims or verbal recitals of that party as to their intent to take advantage o f such benefit. That falls on deaf ears. If some benefit to one party was not the intention, as an option to exercise then why is that benefit included?

As to reputation, most investors are still building their reputation in many ways, your personal reputation does matter as well as your business reputation. While we can preach about our business ethics, the proof is in the pudding over a long period of time. I'm not questioning anyone's reputation, but I can tell you from experience that your reputation stops at the courthouse doors in many respects as it can quickly become unraveled by the evidence provided in court. Saying I'm a great person and then entering an unfair, unusual, non-customary transaction that provides unusual benefits for the type of transaction at hand will likely be seen as predatory and there goes the claims as to any reputation.

Consider what I've said here in detail, in depth and with thought as to doing odd ball transactions in financing or in real estate. Just because some angle can be constructed and agreed to does not mean it will fly. It's not that we can't get creative, but the creativity needs to still comply with social and legal aspects, within the bounds of prudence and fairness.

I'll be back. :)