Co-lenders can avoid wasting time and money by discussing these six areas with their co-lenders and their counsel.

When a loan will be made by more than one lender, an additional level of analysis is necessary. Multi-lender deals have more than just financial considerations. You must consider allocation of amounts to fund, securities compliance, and the roles and responsibilities of each co-lender.

In a majority of instances, the opportunity for a multi-lender loan arises in transactions involving attractive properties or borrowers, with loan amounts too high for one lender to fund alone. Given the scale of the loan, there is a need to allocate risk over several lenders. Prospective lenders may want to be part of a highly desirable loan but do not have the financial resources to fund the entire loan amount themselves.

Another scenario giving rise to a multi-lender loan involves a lender that has the resources to fund the loan but prefers to share the burden in order to facilitate funding multiple loans in a short period, thereby diversifying their portfolio through strategic deployment of resources. Regardless of the circumstances leading to the decision, when it is determined that a loan will require multiple lenders, the following pieces need to be examined.

1 Securities Compliance

Loan transactions with multiple lenders should be presumed to be securities unless an experienced securities attorney determines otherwise. If the multi-lender loan is deemed a security, it is necessary to ascertain whether the security is subject to state or federal law. As a general rule, federal law controls any transaction where the lenders reside in multiple states. For example, a transaction with lenders residing in both California and Colorado would be subject to federal law. When all lenders reside in a single state, the law of that particular state controls.

Each state follows a general set of model rules that include some type of exemption associated with limited offerings designed for accredited investors, and they generally also include a whole loan exemption. Every state varies on whether a filing is due, or if these exemptions are self-executing in nature. Co-lenders, or a broker arranging a multi-lender loan, should discuss the requirements with counsel to ensure they are in compliance with any applicable exemptions. In addition, states restrict general solicitation and advertising aimed at investors, adding an additional layer of analysis for transactions governed by state law.

A transaction controlled by federal law is subject to registration with the Securities and Exchange Commission unless it meets one of two Regulation D exemptions. The first exemption, 506(b), allows for securities with up to 35 non-accredited lenders, an unlimited number of accredited lenders, and an unlimited amount of money. However, 506(b) does not permit general solicitation or advertising to market a transaction to lenders. The second exemption, 506(c), allows broad solicitation and advertising, but all lenders making a loan must be accredited investors and reasonable steps must be taken to verify the accredited status of each one. As mentioned previously, transactions controlled by state law will vary by state. Some states are more restrictive of securities, but other states, like California, are less restrictive. An experienced securities attorney should advise concerning whether the transaction is a security and, if so, which law controls.

2 Allocation of Risk

Before committing to making a loan with other lenders, each co-lender must consider the level of risk it is willing to assume. Initially, co-lenders should agree how the risk of a loan will be allocated. Co-lenders can simply choose to share the risk equally or on a pro rata basis. This provides a clear way to determine profits and losses but may not always suit each co-lender’s preferences. Co-lenders have the option to create an agreement that shifts the risk levels among themselves to accommodate their varying risk tolerances. Some co-lenders are willing to assume more risk in exchange for a higher return on investment, while others may be more risk averse.

A common practice is to create multiple classes of co-lenders with the allocated risk varying by class. Often, one or more co-lenders agree to be the first to take a loss and the last to receive distributions, effectively deferring receipt of their share of any loan proceeds until the other co-lenders are made whole. In exchange for the higher risk, these co-lenders receive a higher return or greater profit upon foreclosure of a property. Conversely, the other co-lenders receive a lower return on investment in exchange for receiving distributions first and taking losses last.

3 Handling Future Advances

Co-lenders should consider not only how risk of loss is allocated but also how any advances will be funded. The simple solution is for co-lenders to split an advance pro rata; however, issues may arise if one co-lender refuses or is unable to fund the advance. Like any other aspect of the co-lender relationship, this can be determined at the outset of the transaction. The advances that may be made can be divided into two categories: (1) advances contemplated as part of the loan transaction, including construction holdbacks and debt service reserves (loan advances) and (2) advances to protect co-lenders’ security interest, including those to pay property taxes and insurance (protective advances). Protective advances will be discussed in the Servicing section.

Co-lenders have a few options for handling loan advances. The best option is to require all co-lenders to fully fund their respective funding obligations under the loan and then hold back the amount of the expected loan advances from the loan proceeds. These funds are held by the loan administrator or servicer for distribution to the borrower according to the terms of the loan documents.

If all co-lenders do not agree to fund the loan advances at the time the loan closes, two issues arise. The first is defining the obligation of each co-lender with respect to a loan advance, including how much each co-lender is required to pay, how notice is provided to each co-lender of the obligation to pay their share of the loan advance, and when that payment is due. The second and more problematic issue occurs when one or more co-lenders cannot or will not pay their share of the loan advance.

The best solution to these issues is for the co-lenders to agree in advance about what each one is required to do with respect to a loan advance and the consequences for failing to do so. Although the issue of the amount each co-lender must advance is typically determined pro rata, and the questions of notice and deadlines to perform are relatively simple, what to do if one or more co-lenders does not provide their respective share(s) of the loan advance can be much more controversial.

There are two main approaches to the treatment of nonperforming co-lenders and how to pay the other co-lenders who make the loan advance on behalf of the non-performing co-lender. The less punitive option is to treat the additional loan advances made by the performing co-lenders as loans that accrue interest on the amount advanced and such loans must be repaid under certain circumstances before any amounts being distributed to all co-lenders. The second, and more drastic approach, is to decrease the pro rata interest of the nonperforming co-lender and increase that of the co-lender(s) that perform in their absence.

4 Servicing

The co-lenders next need to determine who will service the loan. They need to agree whether one of them or a third-party servicer will, among other things, receive payments from the borrower and distribute each co-lender’s share, monitor the loan (including status of payment of property taxes and insurance), collect in the event the borrower fails to pay, and handle tax reporting. A third-party loan servicer is generally recommended, but co-lenders should be aware of any loan servicer licensing issues whether they have a third-party service the loan or not. In a third-party servicer scenario, co-lenders will appoint one of their ranks to direct the actions of the loan servicer.

Regardless of whether a third-party or one of the co-lenders services the loan, the parties need to determine how decisions will be made and acted upon and, in the case of a third-party servicer, how instruction will be conveyed to the servicer. The most common method of decision making is requiring a majority vote for certain loan decisions, including collection steps, whether to modify or forbear, or whether to initiate a foreclosure action.

An additional area that should be addressed is who is responsible to pay collection costs and protective advances—and what happens when a responsible co-lender fails to do so. The options in this instance are similar to those discussed previously for loan advances. The most common approach is to require these amounts to be repaid before distribution to the co-lenders of their respective shares of payments interest and/or principal. In rare instances, the more punitive option of recalculating co-lender interests is employed.

5 Foreclosure

The foreclosure process can be complex when multiple lenders are involved. There are numerous decisions required, ranging from whether to commence a foreclosure, timing of the sale (including postponements), whether to forbear or modify, bidding strategy, and what to do if the property is taken back by the co-lenders. To facilitate the process, co-lenders should agree in advance concerning the following. (Note that all decisions are not required to be made in the same manner):

Who makes a given foreclosure decision? Do all co-lenders have a say, or something less?

Who is responsible for paying upfront foreclosure costs? What happens if they fail to pay their share?

Is the unanimous consent of all co-lenders required, or is a majority sufficient?

Who is the point of contact that will convey those decisions and receive information from the foreclosure trustee or counsel?

In addition, if allocation of foreclosure proceeds (or ownership of a reverted property) will be based on something other than the pro rata loan interest of each co-lender as discussed, the allocation should be memorialized in a written agreement to provide certainty. A written agreement between the co-lenders entered before making the loan will help to ensure the foreclosure process runs smoothly .

6 Co-Lender Agreements

The manner in which co-lenders intend to address each of the considerations discussed should be memorialized in a written agreement separate from the underlying loan documents. It is essential to have a clear understanding of each co-lender’s role and decision-making power to avoid issues that can negatively impact the value of the loan and return on investment. The co-lender agreement will detail the rights and obligations of each co-lender and how conflicts between them will be handled. Co-lenders and their counsel should carefully consider how best to document each individual transaction, keeping in mind each co-lender’s goals, risk tolerance, and the considerations discussed previously.

Multi-lender loans are multi-faceted, requiring consideration of several options before a loan can close. Many of these decisions are ultimately determined by each co-lender’s preferences as they relate to their counterparts. Although this may increase the time it takes to make a deal, it is important that all co-lenders have agreed on and memorialized their decisions. Doing so not only makes for a better co-lender relationship and leads to the ability to make larger deals with higher profits but also helps avoid costs down the line. Co-lenders can avoid wasting time and money by taking the time to discuss these considerations with their co-lenders and consult with counsel to ensure a smooth transaction occurs.