Tuesday, January 18, 2011

Texas Two-Step Trap for Secured Lenders

When is a secured lender not a secured lender?  When a loan guarantor steps into the secured lenders shoes through subrogation following foreclosure of the borrower's equity.  Suddenly, the lender owns the equity of the borrower, but the guarantor has a lien on the borrower's assets!  It's what I call the Texas Two-Step Trap. 

Allow me to back up and explain.  Let's say a Bank lends $20,000,000 to Borrower, which loan is secured by (1) all of Borrower assets, (2) a guaranty of the loan by Guarantor, the 100% owner of Borrower, and (3) a pledge of all of the stock of Borrower by Guarantor.  Now let's say Borrower defaults on the loan and Bank acquires all of Borrower's stock pledged by Guarantor at a foreclosure sale with a credit bid equal to all amounts owed to Bank by Borrower under the loan.  So now Bank owns all of the stock of Borrower and the debt has been extinguished.

But wait.  Bank has exercised its right to enforce the guaranty against Guarantor, thereby giving Guarantor the right to seek reimbursement from Borrower.  Guarantor probably also has a right of subrogation to step into Bank's shoes as a secured creditor of Borrower.  Hence, now the Guarantor is structurally ahead of Bank with regard to claims against the assets of Borrower! 

One possible way for Bank to avoid this Texas Two-Step Trap is to make sure its credit bid is for an amount less than 100% of the oustanding balance of Borrower's loan.  Guarantees typically provide that the Guarantor waives its right of subrogation until the lender has been paid in full. 

Thanks to Lynn Soukup and Steven Weise who explored this hypothetical in their CLE presentation earlier today.