by Kevin S. Kim, Esq.
Geraci LLP

COVID-19 has turned the mortgage world upside down. The private lending market is no different. With Wall Street falling over itself, the private lending market has become an industry fraught with uncertainty. This has led to contraction in the private lending market and put additional stresses on mortgage funds. The exit of Wall Street has created opportunity for these mortgage funds, but the economic crisis has waged havoc on their investor base. This article will address five key pitfalls funds and fund managers face in navigating an economic crisis like this one and suggest solutions to avoid them.

1. Succumbing to Panic

With every economic downturn comes opportunity. With the secondary market drying up, direct lenders with discretionary capital can seize on the residual loan origination that normally went to correspondents and conduit programs. It takes proactivity, vision, and strategic execution to succeed in times like this. It also takes a strong will to avoid succumbing to the media-induced panic. While you may have to make some unpopular or painful decisions on behalf of your investors, presenting a confident plan to succeed and executing on that plan is going to instill investor and employee confidence. We strongly advise fund managers consult with counsel, CPAs, servicers and their executive teams to create a plan of action during crises like this.

 

2. Insufficient Data & Reporting

Fund managers need to see where they are currently and where they are headed to make informed, defensible positions. If you do not have the means to easily extract accurate data on the fund’s portfolio, it’s like driving in a snowstorm with a blindfold on.

These performance indicators will allow the fund manager to provide accurate reporting to investors, forecast and project future performance, and make key decisions to protect investors and the fund manager. Accurate reporting also instills investor confidence through transparency. It also provides additional evidence that the fund manager is executing its fiduciary duty.

Performance data will also allow the fund manager to take certain assumptions and apply them to the data in order to prepare for worst case scenarios and understand the true financial impact on the fund. This will allow the fund manager to make informed decisions based on data as opposed to decisions based on investor sentiment or circumstantial data. For example, many fund managers are contemplating or already have suspended redemptions from the fund. This is oftentimes within their rights. But it isn’t a decision that should be made simply because investors requests for redemption are increasing. Without sufficient data to support the decision and counter investors’ emotional responses, it is a recipe for disaster.

Some examples of key performance data are: weighted average LTV, interest rate, default rate, foreclosures, geographical concentration of loans, property type concentration, total loan volume, total assets under management, and average loan term.

Most fund administration and loan servicing software and third-party providers provide these data points. It’s a question of whether they are easily accessible, accurate, and consistently available to the fund manager.

 

3. Failure to Communicate with Investors

One of the biggest reasons investors in funds get angry, seek counsel, and contact securities regulators is because the fund manager is not communicating clearly or frequently. The fund manager may have all the data, resources, and legal discretion at its disposal, but without a clear, transparent and consistent communications policy, investors will lose confidence and seek to enforce their rights. Not only should a fund manager be reporting, but ensuring you are communicating regularly in writing, via telephone calls, and even webinars.

We have seen too many fund managers operate in full compliance with the law, but made the unfortunate decision to make blanket announcements via cold e-mails or investor letters. They did not include a personal touch to their approach. They didn’t answer investor calls, give them an opportunity to ask questions, or present a clear strategy and plan to protect their capital. These failures led to litigation and SEC investigations.

 

4. Deviating from the Offering Documents

Many fund managers are not fully aware of the terms, scope of authority, restrictions or even business restrictions in their fund’s offering documents. This creates significant risk because continued deviation from the offering documents could amount to an argument the fund manager violated Rule 10b-5 or committed securities fraud.

This becomes extra problematic when the terms are so broad that the fund manager operates inconsistently. For example, if a fund has a “best efforts basis” redemption provision with no additional guidelines, it is important the fund manager utilize and stick to a firm policy on redemptions for investors. Deviation from this policy is too easy because the documents have no strict guidelines. Further, continued and inconsistent deviation from an unwritten redemption policy will create arguments that one investor was treated preferentially over another, thereby supporting an argument for breach of fiduciary duty.

Another problematic example is the fund manager deviating from the stated business plan in the offering documents. If your fund documents don’t permit you to make certain types of loans, or exceed certain loan to values, it would be improper to do so without revising and disclosing these changes to the investors and giving them an opportunity to exit the fund. It is so common for funds to suddenly add new asset classes to their business model without verifying their capability to do this.

It is imperative that fund managers consult with securities counsel consistently to ensure they are fully aware of their authorities as the fund manager but also to make decisions that will not create additional liability in the long term. Further, it is important to ensure you evaluate your offering documents to determine whether any revisions, additional disclosures, or updates may be required.

 

5. Insufficient Legal Protections in your Offering Documents

The last pitfall is very specific. Many fund’s limited partnership agreements or operating agreements fail to grant sufficient authority and protection to the fund manager. Certain key powers include discretionary authority to suspend withdrawals and distributions, halt operations, raise additional capital, secure their tenure as manager or general partner, and expand or contract the business model. Further, many offering documents fail to include sufficient indemnification and arbitration provisions to ensure the fund manager is not buried in legal bills for doing nothing wrong. Finally, fund documents oftentimes fail to have up to date risk factors and disclosures.

We strongly recommend fund managers have their offering documents evaluated to ensure they have the right components to whether the COVID19 storm. The true challenges in fund management come during economic crises such as this. It is imperative that fund managers consult with their experts and their advisors and execute using best practices and sound business judgment. Utilizing best practices, avoiding dangers such as those mentioned above, and operating with integrity will reduce risk, unnecessary legal bills, and protect the investors capital long term.

Kevin Kim is an experienced corporate and securities attorney with Geraci Law Firm, dedicated to providing reliable and innovative legal solutions. Kevin focuses his practice on private placements and other alternative investments for private lenders, real estate developers, and other real estate entrepreneurs. Kevin has advised and prepared hundreds of securities offerings including mortgage funds, structured debt offerings, real estate syndications, crowdfunding offerings, EB-5 projects, and Qualified Opportunity Funds.