As in any other transaction, legal and regulatory issues are only some of the aspects that impact the success or failure of structuring, implementing and executing a buy- or sell-side NPE transaction. Other key driving factors include the economics of the deal, accounting, tax, reputational and general risk management considerations. But in our experience, legal considerations (including in relation to servicing and enforcement) are among the key drivers when it comes to selling or buying a portfolio or single tickets of distressed exposures. This is not only due to the nature of the parties involved, in particular regulated sell-side and partly regulated buy-side businesses, but mainly due to the nature of the assets involved in the transaction, whether a single-name loan claim or a portfolio of (consumer) credit claims.
Below we have set out our thoughts on how to strategically approach a sell or buy-side NPE transaction. Many of the issues addressed will be equally relevant to portfolio as well as single-name (corporate exposures) transactions.
This guide is structured according to transaction stages, from pre-transaction decision-making, through structuring aspects and transaction execution, to post-execution servicing.
2.1 Pre-transaction aspects (decision-making)
A potential sell-side credit institution has many options for managing its clients in distress, ranging from restructuring the debt to forcing borrowers into liquidation.
When considering whether the disposal of certain assets or asset classes may be an optimal strategy for actively managing distressed credits, the management of the potential sell-side institution will have to carefully consider whether the perceived negative effects are outweighed by the advantages.
On the down side, there may be negative effects on an institution's financials, because of losses realised on a sale of assets that are not marked-to-market in an institution's books or because of an unfavourable tax treatment. This might be combined with the threat of foregoing the upside that may potentially come from a successful recovery or even from enforcement. In addition, institutions may be concerned about managing reputational aspects – and the potentially resulting increased scrutiny by consumer protection authorities and/or legal challenges/claims proceedings. That said, we have observed that since the previous (2014) edition of this publication NPE transactions have become a regular feature and are attracting significantly less controversy with the stakeholders.
On the other hand, the most obvious benefit of a successfully completed sale of NPEs is the effect on NPE ratios and risk-weighted assets (RWAs) and the resultant freeing up of equity and, depending on provisioning levels, even immediate P&L effects. Selling institutions, who courtesy of EBA's 2018 Guidelines on disclosure of non-performing and forborne exposures are compelled to make enhanced disclosures in relation to NPEs, have also received positive market and shareholder feedback. This includes rising stock prices once a transaction or series of transactions has been announced and completed, as well as a positive ratings response to the improvement/enhancement of remaining on-balance sheet assets in connection with a perceived increase in focus on that institution's core activities (originating new business) while "outsourcing" certain aspects of problem loan management. Finally, the removal of NPEs from a bank's balance sheet will result in a notable reduction of the administrative burden associated with carrying NPEs, not least in the form of the various reporting and disclosure requirements, as set forth, for example, in the aforementioned EBA Guidelines.
2.1.1 Challenge yourself (sell-side)
- Do I have the organisational and managerial capacities to manage and service distressed exposures in a value-preserving manner and at least in the same quality as experienced third-party special servicers?
- What will be the likely effect on my financials of selling non-performing exposures (substantially) below par?
- Is the jurisdiction of my target portfolio accustomed to NPE transactions or should I be wary of negative stakeholder reception risks (such as increased scrutiny by regulators and/or a "wave" of legal challenges / claim proceedings by debtors)? What mitigants can I put in place to address such risks?
- Am I able to define a portfolio that suits expectations on data quality, credit quality, maturity and pricing?
2.2 Structuring aspects
Once an institution concludes that disposals of single names or portfolios of non-performing exposures form an important pillar of its overall strategy of actively managing its problematic exposures, it is time to decide on the overall transaction structure (auction process, directly negotiated sales, etc.) and to start the vendor due diligence process that precedes most successful sale transactions.
Accurate, reliable and complete data about the non-performing exposures are the key to maximising sales proceeds. It is often at this stage of preparing information for potential investors when institutions learn more than they expected about their own customers/borrowers and the quality and consistency of documentation and data available in relation to the distressed credits.
In addition to practical aspects in relation to the completeness of documentation and data quality, one has to consider that any sell-side (credit) institution will normally be bound by data protection (GDPR), banking secrecy and – depending on the identity of the envisaged investors – competition laws. These rules limit or even prevent the full disclosure of data (including commercially sensitive data) to potential buy-side institutions and their advisors. However, that dilemma can usually be overcome in a manner that satisfies compliance considerations as well as investor due diligence requests. The available options range from disclosure of anonymised/pseudonymised and aggregated data only, to full disclosure of the credit documentation to due diligence advisors formally appointed/endorsed by the selling institution. Those advisors would in turn produce a report to the potential investor on an aggregated and no-name basis only (i.e. without referencing specific loans and customers).
In certain jurisdictions, the aforementioned measures are, as a matter of practice, often coupled with a (seller's) requirement that the purchasing entity meets certain criteria in order to be eligible to acquire an NPE portfolio. For example, the use of buy-side securitisation special-purpose entity may reduce the risk of falling foul of certain secrecy requirements.
By the same token, during this pre-sale vendor due diligence process, sell-side institutions are well advised to scrutinise the credit files relating to the portfolio to be sold to determine whether they contain only the information and data necessary/required by a potential buyer for enforcement purposes. This is because disclosure would typically have to meet an interest balancing test and, likewise, be limited to a strictly "need-to-know basis" (interpretations of this latter requirement vary across jurisdictions).
A fully fledged buy-side due diligence of each credit file has proven to be disproportionally costly (despite support from AI). In certain jurisdictions it could even potentially run afoul of limitations on information disclosure and data transfer. Therefore, selling institutions have in recent years often considered (usually with the assistance of financial and legal advisors) only disclosing samples of, say, 5 % to 10 % of all loan contracts relative to transactions included in the portfolio. This was done on the basis that this constitutes a representative sample of documentation used, including that there are no significant deviations in documentation standard. Consequently, buy-side due diligence was, in certain transactions, limited to the loan contracts included in this sample. Nevertheless, we have observed in practice that selling institutions, especially in non-retail NPE portfolios, have rather tended to lean towards "fuller" disclosure. This is driven, on the one hand, by the fact that material corporate exposures by their nature require more in-depth disclosure, both to support the sell-side pricing estimations and to meet the due diligence requirements of investors. More generally, this was in response to investors' demand for increased contractual protection (in terms of amplified representations/warranties and remedies) in regard to assets where the underlying documentation was not made part of the disclosure package.
Finally, structuring considerations will come into play during this phase of a transaction. In addition to tax (particularly VAT and withholding tax considerations as well as limitations on deductibility of losses resulting from the transfer), the structure will largely be driven by the legal aspects of the transferability of loans and related security interests. Outright assignment is by and large the most preferred and common transfer mechanism, used in instances where title to target assets can be passed to the purchaser without debtor consent, cumbersome/costly re-registration procedures or similar hurdles. In terms of alternatives for tackling transferability hurdles, synthetic structures (trusts or sub-participations, typically on the basis that "elevation" into an outright assignment will occur upon overcoming a particular hurdle) and corporate transactions (spin-off/hive-down) have, in the past, often been successfully deployed in CEE/SEE NPE practice.
2.2.1 Challenge yourself (sell-side)
- Have I used consistent documentation when originating the loans subject to the transaction?
- Are all required customer consents or alternative legal grounds (e.g. based on balancing of interests as recognised by the GDPR and some banking laws) for data processing and information disclosure available?
- What are my alternative options (in the relevant jurisdiction) for transferring and disclosing data and information in a compliant way during due diligence stages and afterwards?
- Am I legally required / practically in a position to strip-off non-core information from the credit files so that disclosure can be limited to data and information on a need-to-know (least intrusive) basis?
- Are the loan receivables and related security interests transferable (under the terms of the contracts and applicable law(s)) or do I need to explore a synthetic (trust or sub-participation) or corporate transaction (such as a spin-off/de-merger of the portfolio)?
Buy-side institutions, on the other hand, when gearing up to participate in a sales/auction process, will be keen to validate their pricing and valuation models against the local legal environment (e.g. their assumptions in terms of collection and enforcement as well as insolvency proceedings). Moreover, they will be looking into setting up a legally compliant and tax-efficient acquisition structure, where their focus will be on compliance with local banking (licensing), consumer protection and servicing regulation. Not least, they will be looking into how the acquisition will be financed.
2.2.2 Challenge yourself (buy-side)
- Do I have the requisite local experience to adequately price the NPE portfolio or is additional due diligence on the local legal and tax regimes required?
- Will the structure I usually use be feasible in the local environment? In particular, will the acquisition vehicle or the servicing vehicle (if different) have to be licensed?
- Is professional servicing expertise available locally or do I have to build this and at what cost?
2.3 Transaction execution
Sell-side institutions will usually be looking at a two-stage sales process, which would commence by asking interested bidders for indicative bids based on a standard information package or fact book made available by the seller.
After this pre-selection process, shortlisted bidders would normally be granted access to additional information to allow them to complete their due diligence and to submit binding bids. The contents and level of detail of the data room / data tape and related access rights will be driven by competition law considerations as well as banking secrecy and data protection laws (see above) and, at times, also by operational and timing constraints.
In a well-structured process, at this stage the proposed transfer and (transitional) servicing documentation would be made available by the sell-side institution to shortlisted bidders. Documentation will largely be driven by issues relating to the transferability of loan receivables and related security, where parties aim at achieving a transfer without debtor involvement. Also, implementing an appropriate allocation of risks (representations/warranties and remedies) and a suitable transfer of servicing of the target portfolio post-closing are key (also see below). As mentioned above, transferability aspects will be decisive in establishing whether an outright assignment of the assets can be implemented or whether the portfolio will have to be transferred synthetically or even hived off from the selling institution's balance sheet into an SPV by means of a corporate transaction with a subsequent sale of that SPV's shares to the investor. This may have a material impact on the overall transaction calendar.
Irrespective of whether the parties pursue an asset or share deal transaction, any buyer will be well advised to not only focus on the desired receivables and security interests transfer, but to also verify whether the structure chosen may have undesirable effects. Such effects could for example arise from creditor liability and/or employee transfers (such as being treated under local laws as a transfer of a business unit). Legal diligence will be required to explore how these risks can best be mitigated. We may observe that, as a matter of practice, the market standard seems to be moving towards a solution whereby such risks are removed from the transaction perimeter by means of indemnities or equivalent buyer protections stipulated in the sale and purchase documentation.
Similarly, the seller will also have to consider continued implications in terms of legal/contractual obligations and liability also after the implementation of the envisaged transfer. For example, assignments of loan receivables are typically not designed to impact/transfer "historic" creditor liability for the time period between origination and up to and including the agreed cut-off date for economic transfer. Therefore, the seller may continue to be bound by information obligations as well as "historic" creditor liabilities/obligations toward the assigned debtors/consumers.
In addition to the receivables transfer documentation, agreements governing the (transitional) servicing and enforcement of the exposures sold and purchased will normally have to be put in place. Whether the servicing will be performed by third-party servicers or by the selling institution on behalf of and for the account of the purchaser will, in addition to banking secrecy and data protection considerations, be determined on the one hand by the servicing capabilities of local special servicers and the selling institution. On the other hand, regulatory and reputational risk considerations of the selling institution in relation to servicing on behalf of, and at the instruction of, the investor will be relevant.
Other ancillary documents may include a data trust agreement if the involvement of a data trustee is required from a banking secrecy or data protection perspective, also in regard to non-performing exposures, and financing documentation at the buyer's end.
2.3.1 Challenge yourself (buy-side)
- Does the transfer documentation result in legally robust transfer/establishment of rights (in respect of the loan receivables, related security and other ancillary rights) required to effectively manage the target portfolio?
- Will the proposed transfer mechanism require the involvement of debtors or trigger costly and/or cumbersome notifications, re-registrations of collaterals or recommencement of enforcement action (potentially coupled with the risk of time-barring)?
- Is there a risk that the transfer will also trigger the assumption of ("historic" / consumer protection or other) liabilities and/or employees attached to the loan portfolio by the buyer? How can this be avoided / mitigated (also in terms of risk allocation provisions in the transfer documentation)?
- Does local law allow a timely transfer of enough data to the purchaser and the servicer to allow a seamless continuance of servicing/enforcement?
2.4 Post-execution servicing
Once the data needed by the servicer to perform its duties is legitimately available to it, the transaction will enter the key value driving stage. The buyer's return will depend primarily on the results yielded by the servicer when servicing the portfolio and when enforcing the loan receivables and related security as well as on the time needed to recover the non-performing receivables.
At this stage debtors will often attempt to raise various types of defences, both in relation to the underlying credit and security documentation as well as in relation to the validity of the transfer to the buyer. The buyer will therefore have to concern itself to provide evidence of transfer to local courts and enforcement authorities in compliance with local laws.
2.4.1 Challenge yourself (buy-side)
- Does the servicer hold all licences required under local laws to perform its duties?
- Has the buyer (or a data trustee) / servicer obtained the documentation required to service the loan portfolio (credit files) in a legally compliant manner?
- Has the buyer obtained all means of evidence required under local laws to prove the validity of the transfer of receivables, related security and other ancillary rights to local courts?