[COVID-19] Risk Factors Related to Mortgage and Non-Performing Loan Funds

April 16, 2020 by Tae Kim, Esq.

Risk, risk, risk…

A reader often encounters that long list of “boilerplate” or “template” provisions in a private placement memorandum under a section called “Risk Factors.” “Do you need that?” is something a securities attorney often hears. The risk factors can be cumbersome and often hinder the sales pitch of a fund sponsor when promoting his, her, or its fund to offer for sale of securities.

Under Item 503 of Regulation S-K (17 CFR Section 229.105), the SEC mandates that “when appropriate, provide under the caption ‘Risk Factors’ a discussion of the most significant factors that make an investment in the registrant or offering speculative or risky….Do not present risks that could apply generically to any registrant or any offering.”

Risk factors should be individualized and customized to each offering. However, there are risk factors that are consistently and commonly applied throughout in a mortgage fund. Some of these risk factors include, without limitation:

  • Risks related to Investment Company Act
  • Competition with other lenders
  • Risks related to loan defaults and foreclosures
  • Potential government actions and new regulations
  • Risks associated with leveraging the fund
  • Risk of real estate ownership

On the other hand, certain risks are particularized to the fund sponsor’s business operations and investment decisions. To be sure, the benchmark of disclosure is “materiality.” The SEC considers information or a fact material if there is a substantial likelihood that a reasonable investor would consider it important in deciding how to vote or make an investment decision. The fund sponsor should discuss and parse through with the sponsor’s securities counsel when providing such disclosures in the offering documents.

However, when in doubt, it is better to over-disclose rather than under-disclose.

Risks Related to a Non-Performing Loan (“NPL”) Fund

During these unprecedented times, more and more loans are in the process of defaulting or non-performing. A fund sponsor may form a fund and raise capital for the purpose of purchasing the NPLs in the market, with the intent to modify or undergo foreclosure process.

However, there are inherent risks that are associated in administering the NPL Fund. The assets, after all, are non-performing. The loans are not generating any income, and there is a high probability that it won’t do so for the foreseeable future. The sponsor must have the experience, knowledge, network, and skill level in navigating the NPL market to successfully generate returns to the investors.

Disclosing Risk Factors to Investors

In addition to the inherently riskier profile the fund will engage, the sponsor should disclose to the investors these commonly associated risk factors that pertain to the NPL funds:

Phantom Income

In an NPL fund, there will be many instances where the NPLs will be modified and re-performed. In such event, the fund may recognize gain based on the difference between the purchase price of the NPL and the value of a re-performing loan. However, no income is generated. In effect, there may be a taxable event, but no distribution event and the investors may incur tax without any income.

Valuation Risks

Valuation of a typical mortgage fund is based upon the total outstanding book value of the performing loans. However, in an NPL fund, the valuation methodology is different. The NPL typically is valued, initially, at purchase price. After purchase, if the NPL continues to remain non-performing for a period of time, the fund sponsor may be required to write-off interests and/or fees, thus, devaluing the share value of the investors. On the other hand, if the NPL re-performs, the valuation of the investor’s shares may increase due to the higher probability of realized principal and/or interest payments. In other words, the valuation of the investor’s shares fluctuates. If there is a shareholder redemption, and the fund sponsor’s calculation of the shares is incorrect, the sponsor may have returned more money to the investor or vice versa, thereby, increasing litigation and creating uncertainty.

Licensing Requirements

Many of the NPLs are consumer-purpose loans. Consumer-purpose loans require licensing during servicing of such loans and/or modification. Consequences of the non-licensed activities should be disclosed in the offering documents.

“Clients often fail to realize that the purchase of consumer mortgage loans, and any subsequent modification, are often considered activities that require a Mortgage Loan Originator license. Each state determines what activity constitutes licensable activity, and an NPL fund must be careful to understand the licensing needs of the fund and its operators. By way of example, the state of Georgia requires a license to simply purchase a consumer mortgage loan. The state of California requires a real estate broker’s license if a party purchases eight or more loans (business purpose or consumer) if they resell those loans to the public.”

Nema Daghbandan, Partner, Geraci LLP

Regulations Related to Consumer-Purpose Loans

In addition to the licensing requirements, consumer-purpose loans have specific regulatory requirements:

  • Dodd-Frank Wall Street Reform and Consumer Protection Act
  • Truth in Lending Act
  • Equal Opportunity Act
  • Fair Credit Reporting Act
  • Fair Debt Collection Practices Act
  • Home Ownership and Equity Protection Act
  • Home Mortgage Disclosure Act

The offering documents should explain these regulatory regimes, and the risks and ramifications associated in the event that the fund sponsor fails to comply with the above regulations.

Bankruptcy

Many of the owners of the homes secured by NPLs may undergo bankruptcy, whether through Chapter 7 or 13. The offering documents should disclose the effect and the adverse consequences of the bankruptcy of a borrower.

The above risk factors are not exhaustive. However, it should lead the fund sponsor to recognize that these risk factors are important to the parties involved when successfully forming and administering the NPL fund.

Conclusion

Disclosure is vital in securities laws. Justice Louis Brandeis from the United States Supreme Court famously stated, “sunlight is said to be the best of disinfectants.” The fund sponsor should adhere to that message when offering for sale of securities, and consult together with the securities counsel to achieve that goal.

ABOUT THE AUTHOR

Tae Kim is a Corporate and Securities Attorney at Geraci LLP, whose practice involves advising clients on securities compliance in private and public offerings, fund designing, and preparing offering documents. Mr. Kim works closely with clients to establish mortgage funds, real estate acquisition funds, syndications, real estate investment trusts (REITs), and Qualified Opportunity Funds.

If you have any questions about how COVID-19 is affecting your business, reach out to Geraci Law Firm here.

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