While the FDIC is well known for providing deposit insurance, another of its principal roles is that of receiver for failed depository institutions (i.e., banks and thrifts). In connection with this activity, the FDIC engages in the post-failure sale of the assets of these institutions in order to recover the maximum amount possible to settle the claims of the institution’s creditors, including the FDIC.
The FDIC’s Division of Resolutions and Receiverships, located in the FDIC’s Washington, D.C. and Dallas offices, coordinates the sale of these assets, which, while numerous and varied (including furniture, art and other miscellaneous items), are comprised primarily of performing and non-performing loans held by failed institutions. Although the FDIC has great latitude in how it structures its loan sales programs, it must comply with its statutory obligation to dispose of a failed institution’s assets in a way that is least costly to the FDIC’s Deposit Insurance Fund. While these efforts have typically involved the direct sales of loan pools comprised of similar loans to various qualified purchasers, the FDIC has also begun to utilize a relatively new structure that permits the FDIC to participate in the future revenue stream from pooled loans alongside investors, thereby potentially increasing the total amount recovered by the FDIC.
Direct Loan Sales
The FDIC has engaged in the direct sale of whole loans to investors since 1976, and while the methods have varied slightly over time, the process has generally remained the same, with the FDIC:
- Packaging performing and non-performing loans for sale in pools based primarily upon size, asset quality, asset type and geographic location,
- assigning values based on projected cash flows and establishing minimum reserve prices for each package,
- developing a bidder’s information package containing the procedures, terms and conditions of the sale, including such things as the availability of loan information for review by the bidders and the requirements that each bidder must meet to bid on and purchase the loans,
- requiring potential bidders to complete and return certification statements and forms through which each bidder detailed its qualifications and acknowledged that it has no ethical conflicts in purchasing the assets,
- requiring each person having access to or reviewing loan data to execute a confidentiality agreement, and
- selling the loans through auctions or a sealed bid process.
As the volume of loans processed through the loan sales program has increased over time, the FDIC has been forced to delegate significant portions of the sales process to third parties, with the FDIC retaining responsibility for overseeing the process. Today, the FDIC continues to sell loan pools directly to investors in this manner through two primary outside financial advisors, First Financial Network and DebtX.
Structured Loan Sales
In addition to the long-standing direct sales programs, the FDIC has also begun to sell loan pools under a private placement structure (“LLC Structure“) whereby instead of selling the loans directly to investors, it:
- Contributes a pool of performing and non-performing loans to a newly established limited liability company (“LLC“),
- retains a participation interest in the future cash flows pursuant to a participation agreement with the LLC, and
- sells the entire membership interest in the LLC (which represents the remaining interest in the loan revenue stream) to a single investor.
As with the direct sales program, the FDIC has engaged two other primary outside financial advisors, GlassRatner and Keefe, Bruyette & Woods, to manage the process. This structure, which offers the potential of providing the FDIC with a higher level of recovery (comprised of the initial sales price received from the bidder and a significant portion of the ongoing revenue stream from the contributed loan pool) in exchange for taking a stepped approach to receiving all amounts associated with disposition of the assets, seems particularly attractive in today’s financial climate where the FDIC might otherwise be forced to accept a lower sales price due to the uncertainty in the market, resulting inability to accurately value assets and reluctance of investors to pay anything more than a fire-sale price.
To date, there have been five transactions of this type, and while the description below is specific to these transactions, we understand that the LLC Structure may reflect the preferred structure for all future sales of this type.
How are loans sold through the LLC structure?
The FDIC initially establishes a LLC, following which it contributes a pool of loans to such LLC pursuant to a Loan Contribution and Assignment Agreement. The LLC simultaneously enters into a Participation and Servicing Agreement (“Participation Agreement“) with the FDIC, pursuant to which the FDIC is issued a “Participation Certificate” representing a certain participation interest in the future loan payments. Bidders are then permitted to bid on a 100% membership interest in the LLC, which provides the winning bidder with the remaining interest in the loan payment stream. However, once the FDIC has recovered a pre-determined amount, its participation interest is reduced, thereby increasing the future amount received by the LLC (and the bidder). For example, in four of the five recent transactions, the FDIC’s initial participation interest was set at 80% and will be dropped to 60% upon reaching the pre-determined recovery threshold, while under the fifth transaction the FDIC’s initial interest was set at 60% and will be dropped to 40% upon reaching the recovery threshold.
The winning bidder is required to form a special purpose entity (“Purchaser“) to purchase the 100% membership interest in the LLC, which will serve as the LLC’s sole managing member and will be required to ensure that the loans are properly serviced by a contract servicer (“Servicer“) retained by the LLC but approved by the FDIC as part of the bid process. Note that the Purchaser will also be required to provide the FDIC with a guaranty from a financially responsible source in order to guaranty the obligations of the LLC and the Purchaser as the sole managing member of the LLC.
In addition, in instances where the contributed loans involve future advance commitments on performing loans (such as construction loans), the FDIC and the Purchaser will contribute the necessary amounts to funds such obligations in proportion with their initial participation interests, with the funds to be maintained in an interest-bearing account (“Advance Account“) and accessed by the LLC to funds the commitments in accordance with their terms. The Advance Account will typically terminate 12 months following the date upon which the Purchaser acquires its interest in the LLC, with any remaining funds to be distributed pro-rata to the FDIC and Purchaser in accordance with their respective cash contributions to the Advance Account.
All costs payable by the LLC pursuant to the servicing agreement between the LLC and the Servicer are the sole responsibility of the Purchaser, as these may not be passed on the FDIC. However, the Purchaser is entitled to a monthly management fee, and all cash advances made by the LLC or the Servicer for items such as foreclosure expenses, property preservation and maintenance costs, property taxes and sale expenses will be reimbursed in accordance with the terms of the Participation Agreement.
The LLC is required to remit to the FDIC its proportionate share of all cash received from the loans on a monthly basis (net of any expenses authorized to be paid or reimbursed under the terms of the Participation Agreement), and may distribute any or all of the remaining cash to the Purchaser as it deems appropriate. The Purchaser is required to provide monthly reports to the FDIC (or its designee) concerning portfolio-level and loan-level activities.
What is required in order to bid on the LLC membership interest?
Potential bidders must first be qualified by the FDIC in order to receive information regarding sales and participate in the bid process, which requires the completion and submission of the following documents to the FDIC:
- Confidentiality Agreement
- Purchaser Eligibility Certification – this document establishes that potential bidder is eligible to purchase assets from the FDIC or any entity controlled by the FDIC
- Bidder Qualification Request – this document establishes that the potential bidder is an “accredited investor” under the federal securities laws and has (i) the knowledge and experience in financial and business matters so as to be capable of evaluating the merits and risks of purchasing the LLC interest and (ii) the resources to purchase such interest.
Once these documents have been received and approved by the FDIC, the bidder will receive a password and access instructions for the website that provides sale information, and will be eligible to submit bids in any future sales. Each bid submitted must be final, non-contingent, and submitted on an “all or nothing basis,” meaning that no bid will be accepted for fewer than all of the loans to be contributed to the LLC or in any sale structure other than that proposed by the FDIC.
It is our understanding from prior transactions that each bidder may submit multiple bids.
How can a potential bidder conduct due diligence on the loan pool to be contributed to the LLC?
While the information available for each pool of loans may vary, the FDIC has previously provided electronically scanned copies of all available loan documents, including credit files and servicing records, for review by bidders and their representatives on the sale website. In certain instances, the FDIC has also made physical copies available for review in a designated location (such as an FDIC regional office). However, as the availability of these items may vary between transactions, bidders may not always be given the option to physically examine documents.
Note that the FDIC does retain the right to require the liquidation and sale of any loans or other assets remaining in the LLC, and liquidate the FDIC’s participation interest, upon the earlier of (i) the seventh anniversary of the date upon which the Purchaser acquires its interest in the LLC, or (ii) the date upon which the aggregate unpaid principal balance of the loans is reduced to 10% of the loan balance as of a set date (which has previously fallen at some prior point during the due diligence period but before bids are due).
While, given the time and expense involved, this new LLC Structure is likely to be used only to dispose of relatively large loan portfolios, it does provide an interesting and seemingly effective way for investors to take advantage of significant profit opportunities at a reasonable price, while at the same time furthering the FDIC’s ability to recover more in its disposition of assets, thereby potentially providing greater liquidity for the FDIC’s Deposit Insurance Fund.
Chris Daniel is a partner in the Banking and Financial Institutions practice at Paul Hastings. Associates Todd Beauchamp and Azba Habib co-authored the article.