What is a Loan Purchase Agreement?
A loan purchase agreement is a binding contract in which a lender agrees to sell a loan to a buyer and a buyer agrees to buy that loan. Specifically, the agreement will convey a loan, which includes the mortgage documents, any guarantees in which a bank or insurance company guarantees the amount of the loan, and any additional loan documents. The lender is typically a bank or other financial institution, while the buyer is usually another bank or investment firm looking to invest in the loan . For banks, this will allow for liquidity to make new loans, while for investment firms, this will allow for ownership or fractional ownership of an U.S. investment with potentially fixed payments. Due to these factors, loan purchase agreements are common in financing, particularly with residential mortgage notes, destroy notes, deed notes, and land contracts.
Essential Elements of a Loan Purchase Agreement
The loan purchase agreement is the backbone of the loan portfolio sale and purchase transaction. A well-drafted loan purchase agreement serves as the foundation for the transaction and preserves the value of the loan portfolio, both for the seller and buyer.
Identifying the key components of a loan purchase agreement is necessary in establishing a solid foundation, and by doing so the parties are protecting their interests. A loan purchase agreement generally includes the following:
The Purchase Price section sets forth the amount the buyer will pay for the loan portfolio and how the purchase price will be paid to the seller. In order to arrive at the purchase price, the seller and buyer will need to determine how many loans they are buying and selling and how much those loans are worth.
In most instances, loans will be sold to the buyer on a non-recourse basis except for (1) specified representations and warranties made by the seller and (2) duties owed by the seller. The seller will warrant to keep the loans free of liens and encumbrances, and indemnify the buyer for any breach of a nonrecourse seller duty or representation and warranty. The seller’s obligations are strictly enforced, and the buyer has the right to seek a recourse claim against the seller for such breaches. The parties will also agree to conditions precedent that must occur before closing. For example, seller conditions may include (1) receipt of the purchase price (or evidence of such receipt), (2) delivery of executed documents transferring the portfolio, and (3) delivery of loan files in the same condition as delivered. Buyer conditions may include (1) completion of borrower due diligence, (2) satisfaction of all conditions precedent, and (3) commitment to fund.
A loan purchase agreement will include representations and warranties made by the seller. These representations and warranties will cover a variety of collateral and risk management factors, including among others (1) all loans are lawful and enforceable, (2) no loan is classified or designated as substandard, doubtful or loss, (3) each loan is duly authorized and valid and enforceable against the seller, (4) the seller has good title to each of the loans, (5) there are no adverse claims, restrictions, encumbrances, security interests or liens on the loans, (6) No material adverse change has occurred, (7) the loan files contain all loan documents required by the loan purchase agreement, and (8) the loan purchase agreement constitutes a legal, valid and binding obligation.
Buyer will typically agree to deliver to the seller a statutory limited guaranty. Such guaranty will include a limited guaranty of the (1) non recourse guaranty of the seller’s purchase price obligations, (2) non recourse guaranty of the seller’s duties and obligations and (3) seller’s obligations under representations and warranties and due diligence.
The Closing and Post Closing Procedure section outlines the procedures the parties will follow in closing and after closing. The parties may agree that the seller will prepare and deliver documentation and establish funds. The parties may also agree to requirements in connection with funding of investments, among others.
The parties will also agree to an Assignment of Loans post-closing. The assignment may serve as a statutory limited guaranty of the buyer’s obligations to the seller.
Types of Loans Covered Under Purchase Agreements
Numerous types of loans can be involved in a purchase agreement, including residential mortgage loans, commercial loans, and government-backed loans. Many of these loans can be residential, commercial, or industrial in nature.
Residential Mortgage Loans
Among the most common loans are residential mortgage loans. These loans are typically made to home buyers for the purchase of single family residences. The borrower executes a promissory note made payable to the noteholder (lender) and the loan agreement is "secured" by the property via a deed of trust on file with the county. Typical terms of residential mortgage loans range from seven to thirty years with interest rates at or below market. Usually, payments are made to the lender in monthly installments. Upon making all principal and interest (and in some cases insurance and/or tax) payments, the property is conveyed free and clear of any liens or encumbrances.
Commercial Loans
Commercial loans are made by banks or private investors to individuals and corporations for the financing of business operations. Personal guarantees of company officers are typical requirements of commercial loans. For example, the owner/operator of a large gas station chain may purchase an additional location with the profits of the existing business. The owner/operator will seek financing to facilitate the purchase. One common form of commercial loan is a line of credit secured by an owner’s business assets.
Government-Backed Loans
Government-backed loans include federally-insured loans such as Federal Housing Administration (FHA) loans for first home buyers and Veterans Administration (VA) loans for veterans. Such loans are guaranteed by the federal government against default. In the case of an FHA loan, the buyer is usually required to make a down payment of at least 3 percent of the home’s purchase price. Those obtaining a VA loan must be an eligible veteran of U.S. military service and are not required to pay a down payment.
The Importance of Due Diligence
The process of due diligence is absolutely essential to guarantee the success of an LP transaction. As with the vast majority of business deals, the purchase and sale of loans is not without its inherent risks. The complex nature of loan transactions, combined with the multiple parties and interests involved, make the process almost innately susceptible to "gremlins." In order to minimize the exposure to such issues, it is important to include a due diligence period in the agreement. An LP can include provisions that permit a thorough review of the borrower, the asset and the overall transaction, prior to closing. For both the seller and the buyer, an extensive due diligence process helps ensure that there are no hidden issues or unknown circumstances that could later complicate or even collapse the transaction.
While the specific nature of the due diligence process will vary from deal to deal, there are numerous common areas where it is important to conduct investigations: Having some form of the due diligence process is key to successfully completing an LP. Even if the most comprehensive due diligence investigations are not completed by the buyer, there are myriad LOI terms that can significantly mitigate the liability of the seller in the event the LP ultimately ends up failing.
Legal Framework and Considerations
Like many agreements, the loan purchase agreement must comply with a number of legal requirements. Any negotiated provisions must be reviewed for enforceability, interpretation, and conflict with state, federal, and internal regulations. Any deviations from regular practices should be approved through established channels, such as briefs to management, boards of directors, regulators, or other appropriate groups. Any areas of risk exposure or potential conflicts with established procedures should be vetted in advance by appropriate internal authorities and external advisors . Examples include violation of privacy laws, preference claims, breach of fiduciary duty, fraud and abuse provisions, anti-money laundering, or Bank Secrecy Act provisions. Considerations of law are especially necessary when discussing the Foreign Corrupt Practices Act, anti-money laundering articles, consolidated regulations, and state and Federal requirements. Competent legal counsel should be involved prior to initiating the transaction, while negotiations are occurring, and when drafting and finalizing the contract.
Common Mistakes and How to Prevent Them
Loan purchase agreements are intricate contracts that often lead to misunderstandings and disputes between parties. Forewarned is forearmed, so an understanding of common pitfalls that can arise in loan purchase agreements, and the means to avoid them, can play a key role in facilitating a seamless transaction.
A frequent issue seen in loan purchase agreements is a lack of agreed-upon definitions for key terms. More often than not, parties use standard forms of loan purchase agreement that rely on definitions established by the standard form itself. However, parties should seek to clarify key definitions within the loan purchase agreement itself in light of their specific business practices. Failure to do so can result in costly, time-consuming arguments about how to interpret undefined terms in the agreement.
Another common issue involves failure to clearly delineate who is responsible for preparing the loan documents. In most cases, a seller of loans will prepare the loan documents, but it is not uncommon for the parties to agree that the purchaser should do so, which may offer advantages for the purchaser. This provision can result in additional cost to, and perhaps delay the sale, however, if there is not a corresponding reduction in the price of the loans.
Another common issue is a general lack of attention to issues related to confidential information about the loans being sold. A seller may not want customers to know that their loans have been sold. The seller and purchaser need to address this concern in the loan purchase agreement, if necessary. An example of an issue related to confidential information is if there is an online portal where relevant information about the loans are uploaded for review by the purchaser. The parties should confirm that access to such information is limited and that certain information should not be made available to other personnel or related entities of the purchaser. In addition, the loan purchase agreement should contain language specifying that the purchaser should not directly communicate with a borrower without the permission of the seller.
A final issue regularly seen in loan purchase agreements is an unwillingness on the part of a seller to provide a subordinate lien position in the event of a breach. This issue arises where buyers and sellers have competing interests in the same borrower who may be experiencing financial trouble. For example, a bank may have a master loan agreement with a borrower that covers multiple extensions of credit. If the borrower is having trouble making payments, another lender (the "loan buyer") may attempt to purchase the borrower’s loans, at a discount, directly from the selling bank. In such cases, the loan buyer may not want to be subordinated to the bank’s master loan agreement.
To facilitate a good working relationship and to provide for a clear and expedient closing, parties to a loan purchase agree should aim to clearly articulate their intentions in the loan purchase agreement.
Successful Loan Purchase Agreement Case Studies
To further illustrate the importance and functionality of loan purchase agreements, the following case studies will be considered. From this, trends will emerge for best practices. Example 1 In a recent transaction, Bank A sold a large volume of commercial loans to Hedge Fund X. The terms were agreed upon, and the loans were put on Deposit in escrow pending completion of due diligence by Hedge Fund X’s fund board (who needed to sign off on the purchase of such assets) and the completion of other conditions to close (mixture of investor-related and borrower-related items). When completing its due diligence, Hedge Fund X discovered a discrepancy between the underlying documentation and the way the loan had been coded in the bank’s systems. Although the bank believed it had a modest indemnification exposure in connection with the discrepancy, Bank A did not want to close the sale of the loans because it felt that the due diligence results would provide Hedge Fund X with an argument to believe it could reduce the agreed purchase price. Conversely, Hedge Fund X believed the discrepancy was of sufficient size and quantity that it should not have to close the acquisition for the price agreed to, and wanted to hold the bank responsible for the discrepancy. This transaction did not close. Taking a step back overnight, both parties realized their positions, and closed the next day with one simple line added to the loan purchase agreement: "The banks disclosures provided under Section 7.02 shall survive the Closing." With that, the deal was able to close. Example 2 Another transaction is one where Bank B sold a mixed portfolio of commercial and residential loans to a credit opportunity fund . While the initial objective was to do a single transaction, it quickly became apparent that the costs to the bank, in terms of adjustments and the reduced purchase price, were going to be significant, and they were not able to allocate the expected risk to the target(s) identified by the fund. After a considerable amount of back and forth, the parties came up with a reasonable solution: one that provided an incentive to the credit opportunity fund to complete its proposed acquisitions quickly. The spirit of this approach was that the bank would take the economic risks of doing a deal early, to achieve a net present value acquired at a favorable yield, rather than doing the deal later and accepting the plain vanilla risks described above where the value of high equity positions had eroded. Many transactions were structured as follows, where if the loan purchase agreement was signed prior to a definitive agreement on the single transaction within 3 business days: and if loan purchase agreement is signed after a definitive agreement on the single transaction: On closing, the bank then funded an investment account with a certain amount of cash (backed by a letter of credit) on which it earned a return. If the bank breach were to occur (other than a breach of a fundamental representation, covenant or obligation), the return on that money was used to pay to the credit opportunity fund (essentially the representative for the other funds) until the investment account balance was exhausted. If not breached, the credit opportunity fund was obliged to make a payment to the bank any remaining balance on the 4 (after a certain period of time). While not every transaction can be done under these terms, structuring the deal so that each party has a financial incentive to close is a good start.