Litigation Involving Private Money, Hard Money, Commercial Lenders, and Alternative Lenders
The author explains some of the important issues that arise in litigation involving private lenders and credit companies.
These lenders are variously called credit companies, commercial lenders, private money lenders, private lenders, private capital providers, hard money lenders, alternative lenders, and many other names; but whatever name they go by, it is meant to describe a business that is not a bank or generally a deposit-based lender. For this article, I will use the term “credit company” since that is what the one that I worked at as its top business producer for six years was called: Commercial Credit Company.
Lines of Business for Credit Companies
Credit companies often specialize in one or a few types of financing. For example:
● A lender might target a particular industry for its lending. For one example, some credit companies specialize in financing high-tech companies while others would not even consider financing for a high-tech company since they don’t understand high-tech industries. (They’re actually in pretty good company since Warren Buffett says he doesn’t invest in high-tech since he doesn’t understand it. I’ve got a hunch that he could figure it out if he wanted to.) A credit company can specialize in any industry, but some common industries are small manufacturers, contractors and subcontractors of all types, wholesalers and retailers, trucking companies, and just about any other type of business you can name.
● While some credit companies may choose to specialize in lending to a specific industry, other credit companies may choose to concentrate their lending on a particular type of collateral, such as real estate, home improvements (first or second mortgages), swimming pools (second mortgages), rolling stock (fleets), aircraft, boats of all types, railcars, certain types of goods being manufactured and sold, and you name it.
● Some credit companies are more concerned with the stage of the business than they are with the type of business or collateral. For example, a credit company may choose to finance new start-ups while another credit company might choose to only offer financing to seasoned up-and-running companies.
● Regardless of a credit company’s customer and collateral targets, some credit companies tend to rely more on the financial strength of the borrowers and guarantors while other credit companies rely more on the value cushion created by a transaction’s loan-to-value ratio.
● Larger credit companies, such as Commercial Credit Company where I worked and that had assets of approximately $16 billion in current dollars, naturally cover more lines of lending than do smaller credit companies, and extend their activities into virtually every line of business. The company financed accounts receivable, inventory, working capital loans, real estate, vehicle fleets, aircraft, consumer loans, plant and equipment financing, leasing, and even expanded its tentacles into cross-selling related business areas such as property and casualty insurance, credit insurance, mortgage insurance, and even owned an industrial bank. (As an interesting side note, our credit company had a CFO you probably have heard of: Jamie Dimon. Yes, him.)
As you can see from these widely varying examples, the lack of governmental regulation over their lending activities allows credit companies to specialize to a degree not really possible for more regulated lenders.
How Credit Companies in Real Estate
Generally, credit companies who finance real estate operate very similarly to other real estate lenders in that they rely upon a loan-to-value cushion as at least a portion of their protection against loss. Even if a lender makes a high loan-to-value mortgage loan, the lender assumes that rising property values will provide some value cushion in case something goes wrong with the loan.
A credit company also may have a business model of relying upon the creditworthiness of the borrower, their income and their other assets when evaluating a loan. Given the added comfort of a borrower’s credit worthiness, these traditional lenders will often lend from 80% up to 100% of the value of a property.
Some alternative lenders have a business model that relies almost exclusively on the value cushion provided by the excess of the collateral property’s value over the loan amount. Then if a problem develops with the loan, the collateral can be liquidated, and the lender’s investment recovered. The alternative lender’s lower level of concern about the borrower’s creditworthiness is offset by the value cushion offered by the excess of the property’s value over the loan amount. The thinking is that the borrower’s creditworthiness may turn out to be less valuable than originally thought, but the value of the property should hold up to cover any potential losses that the lender my encounter. Therefore, it is very important that the values that are provided to an alternative lender by a real estate appraiser are accurate.
Advantages of a Credit Company
● Permanent Capital – Credit companies rely upon their permanent capital and sometimes borrowings (such as through bonds) to fund their lending, as opposed to deposits such as banks have available.
● Flexibility – Credit companies have infinitely more flexibility than do banks in how they can structure financings to precisely fit the needs of the borrower. Credit company loan documentation often is less intensive than typical loan documentation at a regulated lender. For example, at Commercial Credit, we had a novel little start-up package delivery company approach us about financing some planes for them. It looked promising to us, so we worked out a deal that minimized their up-front cost to finance their aircraft and gave us some upside return in the form of warrants to buy their stock in the future at a fixed price that hopefully would be lower than the market value of the stock at that point in time in the future. Things worked out pretty well for them, and we made a nice profit too when we later bought and resold our stock in Federal Express.
● Regulatory Restrictions – Whereas a borrower might encounter trouble structuring a lending transaction with a bank due to regulatory restrictions, credit companies are not bound by those regulatory restrictions.
● Speed – Due to less bureaucracy and reduced documentation requirements, credit companies generally can approve and close a loan quicker than can a regulated lender. (There are exceptions: I remember one loan that was approved on October 12th and closed on October 26th, but the October 26th was of the following year!)
● Creditworthiness – A credit company may be willing to consider extending credit to a borrowing entity that does not qualify for credit at a traditional institutional lender such as a bank. In the case of alternative lenders such as a credit company, its business model often is to rely almost exclusively on the value cushion provided by the excess of the collateral property’s value over the loan amount. Then if a problem develops with the loan, the collateral can be liquidated, and the lender’s investment recovered. The alternative lender’s lower level of concern about the borrower’s creditworthiness is offset by the value cushion offered by the excess of the property’s value over the loan amount. The thinking is that the borrower’s creditworthiness may turn out to be less valuable than originally thought, but the value of the property should hold up to cover any potential losses that the lender my encounter. Therefore, it is very important that the values that are provided by an appraiser to an alternative lender are accurate.
Some Similarities of Private Lenders and Traditional Lenders
● Industry Standards - Notwithstanding the above comments about less strict documentation requirements at credit companies, it is a nationwide industry standard policy, practice, principle and procedure that credit companies of all types have written lending guidelines as to what loans they will and will not originate, how they approve them, how they ensure the borrowing entity has approved entering into the financing transaction, how they document their loans, how they monitor their loan closings, and how they service the loans after they are originated.
For example, even though there may be no external requirement that a credit company obtain a standard real estate appraisal before originating a real estate loan, a credit company will obtain an appraisal prepared by a qualified and certified appraiser and should handle it just as a regulated lender would.
● Progress Payments When Necessary - Likewise, if a credit company approves a loan that is for construction or any work that is in process, then the credit company normally would only disburse loan funds to cover the actual work that is in place and verified by a qualified inspector. The operative principle is that by making progress disbursements, the value of the collateral increases along with the loan balance.
These are just a few examples of industry standards that are common among private lenders and credit companies.
Disadvantages of a Credit Company
● Finding an Acceptable Lender – It may be difficult or impossible to find a credit company lender that can meet all of your company, collateral, loan size, loan structure, and timing requirements.
● Pricing – Since a credit company does not have a source of funds that is as cheap as deposit funds at a bank, the credit company’s increased cost of funds has to be priced into the fees and interest rates charged to its borrowers.
● Size – Notwithstanding the exceptional size of the credit company cited earlier, most credit companies are relatively small operations that may not be able to meet the future borrowing needs of a growing company. Credit companies sometimes participate out to other lenders interests in their loans in order to accommodate loan requests that are larger than the company otherwise would be able to originate and service on its own.
The variations found in the operations of credit companies and alternative lenders are so vast that it would be impossible to write an article covering all of them. This article simply summarizes some of the possibilities that may be encountered when dealing with these companies.
If you are an attorney involved in litigation involving any of these alternative lender types, engage an experienced expert witness that can guide you through a credit company’s lending and servicing process compared to nationwide industry standard, policies, practices, principles, and procedures. These lenders are often niche lenders which makes it unlikely that you will be able to find an expert in the particular niche that is important to your case, so seek an expert that has broad experience in the entire spectrum of the private lending and credit company industry.
ABOUT THE AUTHOR: Don Coker
Expert witness and consulting services. 525 cases for plaintiffs & defendants nationwide, 120 testimonies, 12 courthouse settlements, all areas of banking and finance. Listed in the databases of recommended expert witnesses of both DRI and AAJ.
Clients have included numerous individuals, 90 banks, and governmental clients such as the IRS, FDIC.
Employment experience includes Citicorp, Ford Credit, and entities that are now JPMorgan Chase Bank, BofA, Regions Financial, and a two-year term as a high-level governmental banking regulator.
B.A. degree from the University of Alabama. Completed postgraduate and executive education work at Alabama, the University of Houston, SMU, Spring Hill College, and the Harvard Business School.
Called on by clients in 32 countries for work involving 61 countries. Widely published, often called on by the media.
Copyright Don Coker
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.