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ow many of your charged-off loans in the last three years were the result of an unforeseen risk resulting from events seemingly unrelated to the business or the investment you were financing? How many of your well underwritten credit decisions were sabotaged by a seemingly unrelated business or investment of your borrower or guarantor who got into trouble? How many of your borrowers simply understated their presumably passive liability in another business or investment because it wasn’t believed to be part of their relationship with you? How many of your borrowers were facing seemingly unrelated contract risk from an unrelated business venture and didn’t disclose it to you? How many of your borrowers or guarantors were involved in seemingly unrelated litigation at or subsequent to closing? How many of your borrowers or related parties are subject to judgments or other enforcement actions of which you are not aware?

The list goes on. Everyone has examples, some dramatic, most resulting in significant losses and expensive litigation. Some losses are the result of actual fraud, others the result of the more subtle, but nonetheless unfortunate, lack of adequate underwriting, monitoring or control. Many losses resulting from this contingent liability risk are unrecoverable because the discovery of the risk was made too late.

Contingent liability risk, a lender’s plague, can now be better anticipated, assessed, underwritten, monitored and controlled.

If you finance only one segment of your client’s business, you cannot assume that all is well with the remainder of the borrower’s balance sheet or other investments, especially if the borrower is: 

• A sole proprietorship or business owned or controlled by one or a few individuals with significant other investments in which they are principally involved.
  
  
• An individual investor who finances only one of his investments or businesses with your bank.
  
  
• A corporation, private or public, with additional subsidiary businesses.
  
  
• Heavily invested in off balance sheet assets such as real estate, minerals, commodities or closely held partnerships or other companies presumably unrelated to its primary business.
  
  
• Generating significant income or tax losses from seemingly unrelated business activities.
  
  

An example

Our borrower’s primary business (the one we finance) is doing fine. Cash flow is tight, but that has always been the case. Loan payments have always been made on time. Mike, the principal owner, is also heavily invested in real estate, but it has never had a negative impact on his retail business. He has always done a great job of separating and effectively managing the two businesses. His real estate business has never been a concern to us. His sons are now managing the real estate business so he can devote more time to his primary business. They seem to know the real estate business well, as this investment portfolio has grown over the last three years since they became partners. Mike’s sons are not involved in the retail business. Mike guarantees all loans in the real estate company, but no longer actively manages this business segment. It’s nice that we don’t have to closely monitor this business as part of our loan administration efforts.
Granted, this may be an oversimplification, to make a point. The problem is that Mike is involved in the real estate business, in a big way, and it’s about to affect his primary business, the one we finance. How? By signing as a guarantor or co-maker on the seemingly unrelated real estate loans, Mike’s financial risks could be:

• Unexpected capital calls.
  
  
• Worker injury or other catastrophic construction event.
  
  
• A judgment as a result of a defaulted partnership commitment.
  
  
• A potential contractor or subcontractor suit for nonpayment.
  
  
• Personal liability for recourse debt in the event of a foreclosure action which may result in a deficiency.
  
  
• Legal fees resulting from defending and/or not satisfying any of above.

How many times must we be surprised by contingent liability risk? It can and does happen. A previously healthy borrower withholds information which would have changed our credit decision or changed the way we would have structured a loan.

The solution – investigate

If you are a lender negotiating a new loan or a loan modification, you must know now the borrower’s real financial character and capacity. You cannot know this without assessing possible contingent liability risk. You may be saying to yourself, "nothing new here, right?" WRONG! Well, you may be partially right. The need to assess this risk is not really new, although it is often treated casually, especially with long-time borrowers. However, history can reduce our objectivity and our need to exercise proper and prudent care in evaluating this financial risk.

Our recent past has taught us that there is a greater need to formally assess this contingent liability risk. The old ways simply don’t work anymore. Even those whose traditional business has been to assess financial risk find the business of loan due diligence and risk assessment a different ballgame today. New rules are being made and must be followed to avoid unnecessary contract losses.

The business of determining a borrower’s ability to perform has never been easy. However, the information available today to empower decision makers provides a tremendous resource which, if used properly, can enhance their ability to write collectible loans or recover on loans believed to have been a financial loss.

Total reliance on traditional consumer credit reports, reference checks and Dun & Bradstreet reports is grossly deficient as a method of assessment of financial capacity. These methods do not thoroughly assess judgment or other lien exposure or the contingent liability risk inherent from failed, but presumably unrelated, business or partnership interests.

Earlier this year in a failed special district municipal bonds case, an out-of-state lending institution granted a land acquisition and development loan to a real estate development partnership. Its general partner had over 50 judgments of record at the time of loan closing, which were presumably unknown to the lender. Sound extreme, unconscionable? It was both, but we have investigated hundreds of cases, post contract failure, only to find that if additional investigation had taken place before execution of contract, a loss could have been avoided. Naturally, not every loss can be avoided. Changing economic and business conditions and general market risks can play hob with even the most thorough financial investigation. However, if traditional risk assessment practices continue to be used (or if none are used), the contract collection risk is significantly increased. The result: unnecessary losses.

Tough questions must be asked and answered. Nothing can be assumed. The balance sheet of a borrower or guarantor must be broken down, questioned and fully understood. The risk inherent with the non-collateralized assets to our loan must be analyzed.

Finally, and most importantly, INVESTIGATE. Hire a reputable independent third party to perform an independent financial investigation of all the businesses and investments in which your borrower is involved. Do this routinely as a part of your underwriting, due diligence and monitoring process. A financial investigation provides information not available through a routine credit report. Examples of information provided through an independent financial investigation and not provided by a credit report include:

• Corporations or partnerships formed and trade names filed involving your borrower or guarantor.
  
  
• Pending litigation, civil and criminal, against your borrower or guarantor.
  
  
• Judgments or tax liens, unrecorded or recorded, in your state and in a jurisdiction or state other than the state or jurisdiction in which your borrower or guarantor resides.
  
  
• Undisclosed assets owned by your borrower or guarantor and corresponding liabilities, if any.
  
  
• Previous litigation, including foreclosure actions, involving your borrower or guarantor or litigation involving other partnerships or corporations with which they have been involved.
  
  

Legal considerations – Fair Credit Reporting Act

Businesses that provide financial investigation services are considered consumer reporting agencies, and, therefore, are subject to all of the requirements of the Fair Credit Reporting Act of 1970 (FCRA).

The FCRA establishes minimum federal standards for credit reporting bureaus and other companies that collect and disseminate financial information about individuals for a fee. FCRA is designed to protect consumers from the assemblage, maintenance, and dissemination of inaccurate or unfair credit information and the misuse of credit information. Financial investigation reports on individuals provided by independent third-party investigation firms are usually considered to be consumer reports as defined by the FCRA and, as such, must be used for a "permissible purpose" under the FCRA. The enumerated permissible purposes are:

• In response to a court order;
  
  
• In accordance with instructions of the consumer; or
  
  
• If the reporting agency expects the report to be used in connection with a credit transaction involving the consumer, for evaluating the extension of credit to a consumer, collection of an account, employment, the underwriting of personal insurance, a consumer’s eligibility for a license, or any other legitimate business needed.
  

Permissible purposes under this definition clearly include the evaluation of a loan application as well as debt collection activities, including the collection of a consumer debt or judgment, or a deficiency. Consequently, financial institutions that use, and investigation firms that provide, consumer reports for the enumerated permissible purposes are in compliance with the use requirements of such reports. However, there could be situations where a commercial report could be treated as a consumer report, notwithstanding its present purpose, if it included information from consumer report files.

Financial investigations – a matter of policy

For loans of a certain size or borrowing relationships of a certain complexity, a policy should be adopted to perform a thorough financial investigation as part of the routine and ongoing underwriting practice within your credit underwriting policies and procedures. Only then will you be assured to detect the unforeseen risk associated with other assets and contingent liabilities on a timely basis. You need to know all that you can, and today’s information technology provides the information necessary to empower you to make the best informed credit decisions.

Make it policy to inform your borrower that you are going to perform an independent financial investigation for purposes of assisting you with your underwriting and due diligence, although you are not required to do so. The fee charged for the investigation can be justifiably charged to the borrower as an additional application fee, loan processing fee or closing fee. It can be reflected within the loan fee and pricing charged on the loan transaction. Even if absorbed by the financial institution, the fee for such an investigation is justified by the offsetting risk/reward or cost/benefit relationship.

A need for change

In the area of risk assessment and management, the old methods are not adequate to underwrite the risk associated with a borrower’s related assets or contingent liabilities. The use of traditional credit investigation and inquiry techniques will not identify in many instances the appropriate risk, resulting in unnecessary financial risk and losses. However, with advancements in information technology, more thorough financial investigations can unveil contingent problems that may plague the lender, as they plague the borrower. In today’s lending environment, assume nothing. The necessary intelligent information is available. And, intelligent information is power, if acted upon.