FDIC statistics show that Other Real Estate Owned (“OREO”) for reporting financial institutions in the upper Midwest continues to increase. For 2011, Minnesota, Wisconsin and North Dakota, the dollar value of OREO is up again, over and above the roughly 400-500% growth from the end of 2007 to year end 2010. South Dakota and Iowa show a slight decrease in OREO through mid-year 2011 but still have historical balances that are 400-500% over year end 2007.
The growing amount of OREO with longer holding periods have created the “new” business of financial institutions as property owners. Issues that historically may not have been addressed as properties quickly moved in and out of bank portfolios are now of greater concern. Important considerations that affect the ownership of new properties are the costs and administration associated with the manner in which the property will be held, the nature of the risks presented by the property and how those will be insulated against, and the effect of the property on the bank’s financial statements and continued compliance with regulations. This update provides guidance on transactional administration, controlling risk and exposure and regulatory compliance concerns of OREO.
Proper planning during foreclosure or when taking a property by deed-in-lieu can prepare lenders for unexpected costs and shift the risk involved with property ownership while maintaining compliance with banking regulations. Every foreclosure involves a period of redemption in which the borrower or junior lien holders may pay the amount of the sheriff’s sale, (plus interest and other amounts that might have been expended on the property such as taxes and insurance), to retain the property. Each state has variations on the concepts and procedures for title transfer but in general, if there is no redemption, title vests in the sheriff's sale purchaser. In Minnesota, the sheriff's sale certificate operates as a conveyance of title after the expiration of the redemption period (usually six months) vesting the purchaser with all of the attributes and risks of full property ownership. Similarly, a resolution of a borrower’s loan obligation by deed-in-lieu of foreclosure is a conveyance to the lender of fee title.
Therefore, the appropriate time to consider and plan for the holding of property is during foreclosure and before expiration of the redemption period or before taking title by deed-in-lieu. Property management issues often become manifest before title vests and should be considered early in the process. Depending on the type of property and the bank’s right to collect rents, the use of a receiver should be considered if there are lease relationships that will burden the bank’s resources in a self-management approach more than the cost of a receiver in managing the property and collecting rents. This is also the time to begin planning for ownership, liability risks and compliance with regulations.
Administration and Costs of Ownership
In order to avoid title residing in the operational banking entity, a common ownership shifting mechanism is to convey or assign the property into a separate corporation or limited liability company. This is also a useful mechanism for handling participated loans since Minnesota banks are now authorized to hold minority ownership interest in LLCs formed solely for the purpose of holding real estate. Any transfer of OREO property to an affiliated LLC requires a determination that the action is in the best interest of the bank by improving prospects for recovery or limiting loss and notification of regulatory agencies.
Unless your bank has a policy to take all its real estate owned property into a separate entity, the nature of the property involved and the expenses that might be generated are factors to consider in whether to hold the property in separate entity. Certain types of property pose more significant risks, such as a heavy manufacturing facility or a bar. Properties that involve more substantial human activity or interaction with manufacturing operations that could give rise to property damage or personal injury would be more appropriately held in a separate entity. Although undeveloped land would not normally pose the same risks, investigation into possible environmental concerns or premises liability factors may still suggest separate ownership.
The creation, administration and conveyance of the property into a separate entity will involve added costs. Besides the cost of forming a separate LLC, it is necessary to administer the entity on an ongoing basis and properly govern it as a separate business entity. One main purpose behind creating a separate entity is to separate the liabilities related to that entity from the bank or any other entities or shareholders. If the corporate formalities of the property ownership LLC are not respected, then it is at risk for having its corporate veil pierced. If the corporate veil is pierced, a primary benefit for which the entity was created and the ownership conveyed would be lost.
There are also potential costs that may be required to convey the property into the separate entity. While a lender may choose to pay real estate taxes on property that it holds (or might be forced to do so to avoid tax forfeiture), historically it might have let those unpaid taxes ride until the property was sold and the taxes were paid with closing proceeds. In Minnesota, a voluntary assignment of the property to a separate entity will require that delinquent real estate taxes be paid before the conveyance instrument can be recorded. This can be a substantial amount and could be the deciding factor in whether to convey the property into a separate entity.
Liability Exposure Protection
Regardless of whether property is owned by the bank or a separate subsidiary, it is always prudent to address potential liability exposure. This is usually done through insurance but can also take the form of indemnity agreements if there is a tenant or occupant of the property with whom the bank can contract in that regard.
Review of insurance policies should be a periodic undertaking to ensure that the types, amounts, properties and parties are covered. This is a discussion to have with the bank’s insurance agent to address the business side of these issues. From a legal perspective, a review of the policies in the context of the practical risks associated with the owned properties is also prudent, particularly those related to liability and environmental coverage. It is bad enough to suffer a loss or a claim, but the problem is compounded if the bank has to fight with its insurer about whether there is coverage.
Another way to shift the risk of exposure, is through an indemnity agreement. Under such an agreement, the indemitor promises to defend and indemnify (hold harmless from) any loss with respect to a certain type of claim. The scope of any indemnity can be negotiated and sometimes courts strictly interpret indemnity agreements, for example, in Minnesota, an indemnitor’s promise to hold the indemnitee harmless for damages caused by the indemnitee’s own negligence must be explicit. The ability to obtain an indemnity agreements is limited to circumstances where there is another party involved in the property and the lender has the bargaining power to negotiate for such an agreement. Usually this would involve a tenant who continues to operate a business at the property. In exchange for retention of the tenant or concessions under the lease, the tenant may be willing to provide indemnity.
Maintaining Regulatory Compliance
The growing amount of OREO on bank balance sheets continue to attract the attention of regulators. This has become manifest in Minnesota Administrative Rule 2675.2170 which requires accounting for OREO at the lesser of the principal amount of the indebtedness at the time of acquisition or the estimated fair market value of the property. The fair market value must be determined by an appraisal prepared within 60 days of acquisition – the date a bank acquires title which is usually the expiration of the redemption period. Regulators are also requiring revaluation of properties that have been held for longer periods of time. Given the depressed values of real estate, this is certain to require continuing write down of many property assets.
The continued stagnation of the real estate market also raises to a reality the prospect that assets will have to be written off if not disposed of within five years of acquisition, as required by the administrative rule. Since the devaluation or write-off of these assets must be taken as a charge against reserves or earnings, the detrimental effect to the capital and financial health of a bank can be drastic.
The problem is further compounded by the prolonged property-ownership obligations and carrying costs. While maintaining insurance is only required “where necessary,” the property taxes are required to be kept current on other real estate carried as an asset. This limits a bank’s ability to push that obligation to a purchaser to be paid out of closing proceeds.
Recognizing the benefit of incenting financial institutions to improve OREO properties for resale, the Minnesota legislature has repealed the administrative rule limitation on the amount of expenditures that could be capitalized. Now, the only limitation as to the amount of improvement expenditures that can be capitalized is the appraised value. In order to realize the benefit of capitalization, it may be prudent to re-appraise the property after the improvements are completed.
Improvement in the real estate market would certainly provide opportunity to avoid many of the costs and risks of prolonged ownership. Since the road to recovery may be as long as the three year path to where we are, the issues, risks and requirements discussed above will be important for quite a while. As property owners, financial institutions should plan for and address the issues encountered in this new line of business. Lindquist & Vennum would be pleased to discuss this topic with you.
This Legal Update is a periodic publication of Lindquist & Vennum LLP and is intended to provide basic information about new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.