“Prevention is better than cure,” Desiderius Erasmus. You're
probably asking how a quote from a guy that was born about 550 years ago
is relevant to avoiding and surviving borrower lawsuits and bankruptcy.
Well, it's extremely relevant.
The first step to avoiding or surviving borrower lawsuits and bankruptcy
is to prevent them from occurring in the first place. Even if you prevail
against borrower lawsuits, which represents the cure mentioned in the
quote from Erasmus, you will have expended valuable resources to obtain
that cure. You can mitigate the effect of borrower lawsuits and bankruptcy
by being proactive when you extend a loan.
How can you be proactive when making a loan? The following three tips are
critical to protecting yourself against borrower lawsuits and bankruptcy filing:
- First, require the borrower to provide Letters of Explanation (an “LOE”).
- Second, carefully review borrower entity documents.
- And finally, review borrower and guarantor trusts.
REQUIRE LETTERS OF EXPLANATION
I'm sure most of you are familiar with and require LOEs from borrowers,
but have you ever considered why you do so?
Here are some obvious reasons why you need to properly review LOEs:
- First, the LOE requires the borrower to state his or her intention early
in the process. If you are a private money lender and you have no interest
in extending consumer loans, an LOE from the borrower stating that he
intends to use the proceeds from the loan to pay off personal credit cards,
or that she intends to make improvements to her residence, will let you
know that the loan is not for you. Furthermore, if you're a residential
mortgage lender, it is important to know that the borrower does not intend
to reside at the property securing the loan in order to determine whether
or not the requested loan fits within your loan programs.
- Second, the LOE allows lenders to recognize potential problem loans before
getting too far into the loan process. For example, what if the loan application
states that the applicant does not reside at the property that will be
securing the loan? But when you look at the driver’s license and
credit report, the property is actually identified as the applicant’s
residence. Of course, you ask the applicant to provide an explanation
concerning the discrepancy in an LOE.
- Third, the LOE creates a written document that is prepared and signed by
the borrower that can be used as evidence. Whereas the first two reasons
identified for using an LOE are primarily aimed at underwriting and helping
you make a good decision about whether or not to make a loan, this one
is to protect you in the future. What if you extend a loan to a borrower
relying on his representation in an LOE that the funds will be used to
purchase a fix and flip, then six months into the loan, the borrower files
a lawsuit against you? In the majority of instances, delivering the LOE
to borrower’s attorney will make the lawsuit go away.
The LOE can serve as a great sword and shield for lenders when the proper
amount of attention is given to them.
The way to maximize the impact of an LOE is to follow a few simple do’s
- Do require the borrower to handwrite and sign the LOE. This helps to avoid
claims that the letter was placed in front of the borrower and he just
- Do require the borrower to submit documents supporting the representations
in the LOE. For example, if the borrower claims the property is being
rented, request a copy of the lease executed by the tenant and proof of
- Do keep your request for the letter as general as possible. If your request
is too specific, the borrower can write a letter that is tailored to what
you want to hear and not representative of the actual facts. In addition,
the borrower can claim that you told him what to write.
Don't prepare the letter for the borrower.
- Don't tell the borrower what the letter should say.
- Don't coach the borrower on what should be included in the letter.
I'm sure that you can see the theme here. Each don’t, if avoided,
will help guard against the most common argument asserted by borrowers
to negate the LOE, that you told him to prepare and/or sign the LOE despite
your knowledge that the contents were not true. This can be an effective
argument for the borrower, even if the LOE was accurate and true at the
time it was prepared.
Some common LOE requests are:
1. Describe the intended use of the loan proceeds. When reviewing this
LOE, make sure that it is specific concerning how the funds will be used,
and that includes an itemization, if applicable, and that it is not just
a blanket statement. For instance, “the funds will be used for a
2. Another common use to the LOE is to explain discrepancies. For example,
where the borrower’s statement that the loan funds will be used
to fix up a rental was contradicted by the borrower’s driver’s
license, credit report, or other documents which identify the alleged
rental property as her residence. In this instance, you should request
supporting documentation to explain the discrepancy, including a copy
of the lease and proof of payments received from the tenant.
3. A third example of a common LOE is to explain irregularities in income
such as recent raises, increased rent on a rental, a new job, or a new
REVIEW BORROWER’S ENTITY DOCUMENTS
The next tip is to make sure you request and review an entity borrower’s
formation and governing documents. When I refer to entity borrowers, I
mean corporations, limited liability companies, limited partnerships,
partnerships, and pretty much any borrower that is not an individual or a trust.
One reason to review an entity borrower’s documents is that the state
where the borrower is from can carry substantial implications. If a borrower
that is formed in another state does not file the necessary documents
to be authorized to conduct business in California, but still operates
a business and contracts in California, your ability to foreclose may
not be impacted, but the borrower’s ability to use California courts
to collect and to defend lawsuits could be impaired, thereby potentially
affecting the borrower’s ability to pay you.
In addition, if the borrower is not taking the necessary steps to be authorized
to conduct business in the state, it probably is not paying state taxes
and could end up with substantial tax liability and tax liens, which in
turn will impact the borrower’s ability to pay you.
Furthermore, a borrower that is formed outside of California may be able
to file a bankruptcy in the state where it is formed if its assets are
located in that state or its principal place of business is identified
as being in that state. By way of example, if a Delaware LLC owns property
in California but maintain its principal place of business in Delaware,
that borrower can file a bankruptcy in either Delaware or California.
While your rights may not be impaired by an out-of-state bankruptcy filing,
it is incredibly inconvenient and can be costly if you or somebody from
your company is required to testify as part of a contested motion or adversary
proceeding in the bankruptcy.
You should also review borrower’s entity documents in order to confirm
that the party executing the loan documents has authority to bind the
entity. If you fail to confirm that an individual has authority to bind
an entity borrower, you could jeopardize your ability to foreclose against
the collateral, leaving you with the option of suing the party that signed
the loan documents for fraud. While you may obtain a judgement, chances
are that you are not the only judgment creditor of that fraudster, so
your prospects of recouping your losses are not bright under these circumstances.
Finally, you should confirm that the entity borrower is in good standing
with the state in which is formed, as well as in California. The entity
formation documents that were filed with the regulator and the state where
the entity was formed should be reviewed.
Formation documents could be Articles of Incorporation, Articles of Organization,
or a Certificate of Partnership. In addition, for out of state entities,
you should request a copy of the documents that were filed with the State
of California requesting authorization to conduct business in the state,
or whichever state where you are located and are extending the loan. It
is important that you request filed copies. You will know that they are
filed copies if they include the filing date and entity number that were
placed thereon by the regulating agency.
You should also review the operating documents of the entity borrower.
The operating documents can be bylaws, an operating agreement, or a partnership
agreement depending on the type of entity. With the exception of corporate
bylaws, this is typically where you'll discover the name and title
of the individuals authorized to bind the entity and the extent of that power.
For corporations, you should request corporate minutes appointing officers
and identifying the parties authorized to contract on behalf of the corporation.
It is also advisable to obtain a copy of the most recently filed Statement
of Information that identifies the officers, managers, or partners of
the entity borrower. And if it happens to just be a no change statement
that is filed with the state, we also recommend that you obtain the most
recently filed one that does contain changes or the original one that
first identifies all the officers, in the event that there have not been
any changes over the years.
Finally, you should request a copy of Certificate of Good Standing issued
by the government regulator in which the entity was formed. If it is a
foreign entity, a certificate from the state of California or the state
in which you're located or extending the loan should be obtained as
well. The certificate should be recent. We recommend that you do not accept
certificates that are issued more than 30 days in the past.
REVIEW TRUST DOCUMENTS
Another way to be proactive when making a loan is to review the trust documents
for borrowers that are a trust, meaning either the Trust Agreement itself
or Certificate of Trust. The Certificate of Trust should identify the
trustee, the successor trustee, the trustee’s authority, and the
manner in which the trust should take title to assets.
It is crucial that you review the trust documents for the borrower to confirm
that the party executing the documents actually has the authority to sign
them on behalf of the trust. You will want to determine who is identified
as a trustee.
Finally, another reason to review the trust documents is to confirm that
the required vesting identified in the trust matches how the borrower
has or will be taking title to the property. I found that in about a third
of all loans to trusts in which our firm has been involved, the trust
is not properly vested on title.
Please take the words of Erasmus as words to live by, "Prevention
is better than cure." These are just a few ways that you can be proactive
to mitigate the possibility of or impact from borrower lawsuits and bankruptcy.
In addition, if you'd like to discuss other ways to be proactive,
feel free to contact me.
If you would like more information on this topic, please contact Dennis
Baranowski, Esq. or call our main office at (949) 298-8050.