When putting together a mortgage fund, it is an understatement to say there are many things to consider: regulations, exemptions, accounting, supervision, and more.
Mortgage funds introduce those involved to a plethora of risks, challenges, and rewards, requiring a keen attention to detail. To avoid risk most effectively with your fund, it is essential to additionally consider how you will be defended in case of lawsuits.
In this article, we are going to look at mortgage funds from a litigator’s lens. We will discuss common clauses in both operating agreements and fund documents, why they exist, as well as some real-world stories in which these helped our mortgage fund clients defend themselves with no losses.
What if I’m sued by one of my mortgage fund investors?
Do your fund documents include verbiage in case of an investor lawsuit? If they don’t, they need to. Your mortgage fund should indemnify you for any acts that are not fraudulent. For example, if you commit simple negligence, the fund will indemnify you for any mistakes you make.
This is usually standard in most operating agreements. Why is this standard? You need look no further than the 2005 to 2007 market crash, in which many mortgage funds ceased to exist or, worse, dealt with a myriad of lawsuits from their investors.
Real World Mortgage Fund Story – October 2009
In 2009, Geraci Law Firm represented a fund facing the challenges of the 2005 to 2007 crash. They turned to Geraci to advise them. A large investor comprising over 1/3 of the fund’s investments decided to sue the fund manager, instead of work with them, for negligence on top of all kinds of other accusations.
When drafting their fund documents, we made sure to include the above language. The investor had a large national law firm represent them. Eventually, it was found that there was simple negligence by the fund manager, which did not cause the investors’ losses. The cause was due to the market. At the end of the day, our client paid none of our legal fees, and the investor paid over $400,000 to his highly paid lawyers. Our client won, which means that, unfortunately, the investors lost. We told the investor that if we wound down peacefully, we could return $0.70 on the dollar to all the investors. Instead, our client was only able to return $0.22 on the dollar because of this lawsuit. Moral of the story: always make sure that you are indemnified by the fund.
Sometimes, the best thing is to do nothing.
In some cases, the best course of action is to do absolutely nothing. What that means is if the world is losing its mind and valuations are decreasing significantly and rapidly, the best course of action you can do to protect your investors’ capital is to freeze the mortgage fund. By giving you the power to freeze distributions, you are preserving capital to pay for any and all contingencies that may occur. Do your fund documents have the ability for you to freeze all distributions and not pay them in order to weather a future storm?
Real World Mortgage Fund Story – December 2016
We were the first law firm to include a freezing option in managers’ fund documents, born from the lessons we learned from the mortgage crises. One of the first funds we formed after the crash needed to use it in 2015. At the time, this fund was heavily focused in the subprime market. After sustaining temporary losses, they exercised a nine-month freeze as they repositioned assets, and, nine months after the freeze, sold the fund to an institution. Instead of losing money, the investors made 7% annualized interest. This only happened due to their ability to freeze the distributions, giving the fund manager enough time to reposition the assets for an exit.
Plan for a rainy day.
Lastly, you are in the business of running a business. As such, are you setting aside reserves to pay for needed activities like your accountants, lawyers, and other professional advisors who will help you make more money than you spend on them? A prudent fund manager will have a rainy-day fund of 1 to 2% of the fund’s assets sitting in reserve to pay for these activities.
Real World Mortgage Fund Story – Numerous Times
Thankfully, Geraci has been blessed with smart clients. These clients set aside money and, when lawsuits arrive, they do not hesitate to call on us to make things happen. As a result of setting away this rainy-day fund, our clients have had no issues both defending lawsuits and maintaining a steady investor return.
With hundreds of pages of writing, you may gloss over your fund documents, thinking they are nothing more than boilerplate. However, having done this my entire career, I can assure you that there is a reason for each and every clause in your fund documents. I could fill a book with all the clauses that you should have in your fund documents and why they are there.