Canada: Key Issues In Mortgage Loan Purchases

Copyright 2009, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Real Estate, November 2009

With the rapidly changing environment in the mortgage loan industry since the advent of the credit crunch, the sale of mortgage loans in the secondary market is increasingly becoming a source of liquidity. This is particularly the case due to the demise of the CMBS market.

Several key issues for buyers of single mortgages and portfolios in Canada are outlined below.

Regulatory Matters

If the value of the portfolio being acquired exceeds thresholds applicable to the value of the mortgages and the size of the parties, Competition Act approval may be required. Exceptions may apply if, for example, the transaction is structured as individual mortgages being purchased at the option of the buyer from time to time, or if the transaction is structured to involve only a partial interest in a pool of mortgages, thereby perhaps qualifying for a securitization exemption.

As a threshold consideration, the restrictions on foreign banks carrying on business in Canada should be reviewed. Often foreign banks that simply hold such mortgages may be exempt from registration requirements.

Due Diligence

As in most transactions, the extent of the required due diligence depends on the particular circumstances of the deal.

For example, the due diligence to be performed may be more extensive if an entire loan or a distressed loan is being purchased as opposed to the due diligence to be performed if a participation or partial interest is being purchased, especially if the seller retains an interest and provides representations and warranties as to the assets being acquired.

The scope of due diligence will usually include a review of the loan documents with a focus on the commercial terms and the more important provisions such as prepayment rights, due-on-sale, due-on-encumbrance, prohibition on subordinate security, limited recourse clauses, cross-defaults, and assignability by lender. Typically, a review of title insurance or title opinions is undertaken. If a lender's policy of title insurance was originally obtained, a new assignment endorsement in favour of the buyer as well as a "date down" of the existing policy should be considered. Often, initial due diligence will also involve a subsearch of title to confirm ownership, priority, subsequent mortgages or construction liens, assignments of mortgage, partial discharges and registered renewals or amendments. Personal property searches to confirm the continued effectiveness of prior registrations and any required amendments and renewals as well as bankruptcy, execution and realty tax searches are normally undertaken.

The buyer will also confirm the financial strength of the borrower and other usual underwriting such as a review of leases, operating and management agreements, insurance coverage, repair and other reserves, and rights to future advances.

If a single large loan in default is being acquired, the due diligence involved will likely be extensive and require a complete underwriting of the property secured by the loan. It is likely that the loan will not be repaid in full if the reason for the default is that the underlying cash flow does not support the debt payments. The value of such a loan in default is not a function of the outstanding balance, but rather depends on the likely proceeds from enforcement after deducting all costs and factoring in the risks of delay and frustration inherent in the enforcement process.

As well as performing due diligence on the loan documents and re-underwriting the property subject to a loan, the purchase of a non-performing loan would usually require a review of the actions taken by the lender and the borrower prior to and during the period the loan has been in default. Any actions that will provide a valid defence to enforcement are, of course, extremely important. Any waivers, amendments or correspondence would need to be carefully reviewed.

Another important factor in determining the extent of due diligence is the time afforded for the task. If the seller has a need to sell without delay, due diligence may be shortened and to an extent may result in a lower purchase price to account for the additional risk taken by the buyer. In addition, a more complete set of representations and warranties may be required from the seller.

Representations and Warranties

Often the most heavily negotiated provisions of the mortgage purchase agreement are the representations and warranties of the seller. A more complete "set" may be expected when a seller is selling a participation or partial interest in which it remains as co-owner as opposed to an outright sale of the entire interest of the loan. Typically, on the sale of a distressed portfolio, the representations and warranties will be minimal as these sales are often conducted on an "as-is, where-is" basis given the deep discounts associated with distress sales.

Besides the usual corporate authority representations and warranties, a buyer will typically seek representations and warranties from the seller that:

  1. the purchased assets are owned beneficially and of record by the seller, free of any liens or encumbrances;
  2. seller is not aware of any litigation that might adversely affect the assets;
  3. there are no restrictions on sale or assignability;
  4. complete copies of the loan and security documents have been delivered;
  5. the security has been validly perfected and has not been amended, waived or released;
  6. there are no cross-defaults or cross-collateralization;
  7. the loans are full recourse, the outstanding balance at time of closing; and
  8. the seller is not a non-resident of Canada for purposes of the Income Tax Act.

As additional representations (particularly for performing loans), a buyer may seek comfort that:

  1. there have been no defaults during a certain period of time prior to the sale;
  2. the seller performed customary due diligence on origination;
  3. all the conditions precedent on origination were fulfilled;
  4. there are no rights of set-off; and
  5. all applicable laws relating to usury, anti-terrorism, anti-money laundering or similar "know your customer" legislation have been complied with.

Only representations and warranties that are provided by an entity with a strong covenant and that survive closing for a reasonable period are of value. Typically, survival periods run anywhere from one year to the life of the loans purchased, subject to any limits on survival periods imposed by law. Buyers will often require that the seller agree to repurchase the mortgage if there was a material breach by the seller of representation and warranty with respect to that mortgage or if the mortgage security becomes unperfected.

If a co-ownership interest is sold, the agreement will usually contemplate the administration of the loans by the seller or existing servicer and restrictions on each co-owner's ability to sell without the other coowner's consent (often including rights of first refusal and tag-along rights) and arrangements to deal with the resignation of the seller as servicer. A default under a distressed loan may trigger the requirement that the loan be serviced by the special servicer instead of the master servicer which may result in higher servicing fees, which should be taken into account when pricing the transaction.

Closing and post-closing adjustments are also of importance and often tie into the representations and warranties. For example, consideration of the status of accounts with tenants on properties where the loan is in default can be important as the sums at risk can be substantial and tenants will require recognition of these accounts from the ultimate owner of the property.

Purchase of Subordinate Debt

If mezzanine or other junior debt is being purchased, a review of intercreditor rights is required. For example, the purchaser of a mezzanine loan would want to ensure that default under the mezzanine loan would not trigger a default under the senior loan to allow the subordinate lender an appropriate period in which to deal with defaults or exercise remedies. The subordinate debt buyer would also want to confirm that a cash sweep is not triggered under the senior loan which would deprive the subordinate lender of any available cash flow to service the mezzanine debt. A separate acknowledgment from the senior lender should be obtained to ensure that the senior loan is not already in default. Standstill provisions should also be carefully considered as they may negatively impact the distressed loan buyer's ability to recover losses in a timely fashion.

Conclusion

This article sets out a general overview of some of the issues arising on a mortgage loan purchase. Numerous permutations and combinations may well arise in the upcoming months as the market continues to adjust to the new economic situation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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