BASIC SECURED LOAN DOCUMENTATION By Robin Russell CHAPTER 3

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1 BASIC SECURED LOAN DOCUMENTATION By Robin Russell CHAPTER 3 I. INTRODUCTION... 1 Overview... 1 Purpose... 1 Use of Forms... 1 Checklist... 2 II. LOAN APPLICATIONS... 2 Overview... 2 Consumer Issues... 2 Reg B... 2 Non Dischargeable Debts... 2 III. FINANCIAL STATEMENTS... 3 Overview... 3 Monitoring... 3 Covenant Testing... 3 IV. LOAN COMMITTEE MEMOS AND PRESENTATIONS... 4 Overview... 4 Description of Borrower s Business... 4 Financial Information... 4 Purpose of Loan... 5 Management... 5 Loan Proposal... 5 Location & Market Dynamics... 6 Risks... 6 V. PROMISSORY NOTE... 6 Overview... 6 Content... 6 VI. LIEN DOCUMENTS... 6 Overview... 6 Content... 7 VII. PERFECTION... 7 Overview... 7 Methods... 7 VIII. TITLE VERIFICATION DOCUMENTATIONS... 8 Overview... 8 Real Estate... 8 Titled Assets... 8 Other... 8 IX. LIEN SEARCHES... 8 Overview... 8 i RUSSR

2 Subordination... 8 X. AUTHORIZATION DOCUMENTATION... 8 Overview... 8 Individuals... 9 Business Entities Churches Estates Trusts/ Custodian Municipalities XI. POWERS OF ATTORNEY Overview Content XII. EVIDENCE OF INSURANCE Overview Collateral Protection Insurance Credit Life Disability and Involuntary Unemployment Insurance: Optional Insurance: Insurance Sold by Bank or Affiliate: Comprehensive Liability Coverage: General Liability Exclusions: Flood Crop XIII. KEY PERSON LIFE INSURANCE Life Insurance Overview Cash Surrender Value Life Insurance Face Value Life Insurance Considerations Applicable to Assignment Beneficiaries Consent to Assignment Assignment in Special Cases Existing Assignments Policy Provisions Death of Insured Perfection XIV. OTHER BASIC DOCUMENTS Business Purpose Statement Reg Z and Other Consumer Disclosures Guaranty Arbitration Agreements Legal Opinions XV. FORMS ii RUSSR

3 I. INTRODUCTION OVERVIEW: What is Secured Lending? Secured lending is the term used to describe loans which are supported by a lien on some type of property owned by the borrower or a third party. The owner of the property agrees that if the money borrowed from the Bank is not repayed by the borrower, the Bank (which is the Secured Party ) can sell the property securing the loan and use the proceeds to repay the loan. [UCC 9.102(a)(73)] Secured lending is typically safer than unsecured lending. In the event the borrower files bankruptcy, a secured lender generally gets paid before an unsecured lender. This Guide deals with secured or collateralized lending including types of collateral covered by Article 9 of the Uniform Commercial Code (the UCC ). Bracketed references in this Guide to the UCC such as [UCC 9.101] refer to the UCC. A working knowledge of the UCC is essential for Bankers. See The UCC for Bankers, Chapter 2. PURPOSE: This Guide s purpose is to assist loan officers in understanding various secured lending arrangements and documents so that loan agreements are clearly spelled out and all parties know their respective rights and responsibilities. The goal of this Guide is to acquaint the lending officer with the relevant terminology, legal principles and practices, and standard security arrangements. The loan officer should become generally familiar with the format and the content of this Guide and then study in detail the subjects which apply to particular loan transactions. With such a broad spectrum of topics and issues, it is impossible to give an exhaustive treatment of the many questions and problems that may arise in complex lending situations. USE OF FORMS: Forms are included at the end of various chapters. These forms are either issued by governmental agencies which oversee lien perfection on specified types of collateral or are produced, marked and copyrighted by Bankers Systems/Wolters Kluwer Financial Services. The Bankers Systems/Wolters Kluwer Financial Services forms serve as guides only, are reproduced in this Guide with the 3-1 RUSSR

4 permission of the form vendor and neither the author of this Guide nor your state Bankers Association has undertaken an independent review of the forms. CHECKLIST: Certain chapters of this Guide contains checklists of the documentation required to secure routine loans. Each checklist has been formulated to assure that appropriate documents are prepared and/or received by the Bank. The sections below outline certain basic documents which should be considered in any lending arrangement. For every loan, the Bank should consider whether the documents below should be in the loan file. II. LOAN APPLICATIONS OVERVIEW: CONSUMER ISSUES: REG B: A sample Universal Credit Application form and Commercial Credit Application form are located at the end of this Chapter. A loan application signed by the borrower is required for loans secured by the borrower s principal residence and is strongly recommended for all other loans. The Equal Credit Opportunity Act Reg. B [12 CFR 202] requires that certain notices be given to persons who apply for consumer and business credit. Specifically, a creditor must notify an applicant of action taken within 30 days after receiving a completed application concerning the creditor s approval of, counteroffer to, or adverse action on the application; 30 days after taking adverse action on an incomplete application; 30 days after taking adverse action on an existing account; or 90 days after notifying the applicant of a counteroffer if the applicant does not expressly accept or use the credit offered. A written loan/credit application provides a date from which a Bank may calculate these deadlines. NON DISCHARGEABLE DEBTS: Alimony and child support Certain taxes. (Most taxes cannot be discharged) 3-2 RUSSR

5 Debts for certain education benefit (Student Loans) Loans made or guaranteed by a governmental unit Debts for willful and malicious injury by the debtor to another entity Or to the property of another entity Debts for death or personal injury caused by the debtor s operation of a motor vehicle while the debtor was intoxicated from alcohol or other substances Debts for certain criminal restitution orders Debts for money or property obtained by false pretenses -- this includes any debt that the court finds was obtained fraudulently or illegally Debts for fraud or defalcation while acting in a fiduciary capacity III. FINANCIAL STATEMENTS OVERVIEW: The borrower s financial statements are often part of a loan application form, particularly in consumer loans. The loan file should contain a current Financial Statement of the borrower and all contingent obligors such as cosigners and guarantors. A Financial Statement form and Statement of Financial Information form are located at the end of this Chapter. MONITORING: COVENANT TESTING: As part of the loan monitoring process the Bank should obtain a current financial statement from the borrower at regular intervals (monthly, quarterly, annually). Financial Statements are of key importance when the borrower is required to maintain certain financial ratios and amounts throughout the life of the loan in order to avoid being in default. These include: Debt Equity Ratio Debt Service or Debt Coverage Ratio Interest Coverage Ratio Minimum Net Worth 3-3 RUSSR

6 Minimum Working Capital Current Ratio Fixed Charge Coverage Ratio These are covered in more detail in Advanced Commercial Loan Documentation Chapter 9. IV. LOAN COMMITTEE MEMOS AND PRESENTATIONS OVERVIEW: The information for the Loan Committee Memo comes from the borrower and the Bank s due diligence on the borrower. The memo should cover the Seven C s of Loan Review : Credit Capacity Capital Collateral Character Conditions Commitment If a loan ultimately goes into default and is fully or partially uncollectible, the loan committee memo will be heavily scrutinized by Bank regulators in order to determine if there were flaws in the underwriting process. The key components of the Loan Committee Memo and Presentation are outlined below. DESCRIPTION OF BORROWER S BUSINESS: FINANCIAL INFORMATION: This section should include: the type of business entity to which the loan will be made a description of the borrower s capital structure (i.e. subsidiaries/owners) a history of the business the current status of the business such as its business location(s), major purchasers/suppliers, etc. future plans including marketing strategy The following financial information should be provided by the borrower to the Bank: tax returns 3-4 RUSSR

7 balance sheet income statement/profit loss statement cash flow projections with clearly articulated assumptions on which the projections are based operating cycle For project financing a detailed operating budget and sources and uses of funds should be included. Key financial information should be summarized in the Loan Committee Memo and the financial data should be attached to the memo. PURPOSE OF LOAN: The purpose(s) for which the funds will be used should be set forth. Purposes can include: working capital equipment & machinery furniture & fixtures leasehold improvements acquisition of real estate debt consolidation/refinancing/restructuring acquisition of a business or business line MANAGEMENT: The Loan Committee Memo should identify board members of a corporation, managers of a limited liability company, general partners of a partnership, etc. The memo should identify key employees of the business including their roles, responsibilities and experience. Profiles of Top Management may be attached to the memo and key person life insurance (discussed below) should be considered. Outside business professionals, including attorneys and auditors may be included. LOAN PROPOSAL: The Loan Committee Memo should include a description of the loan for which approval is requested including: type amount collateral and its value guarantors repayment plan 3-5 RUSSR

8 other key terms LOCATION & MARKET DYNAMICS: RISKS: The Loan Committee Memo should reflect an assessment by the Bank of the strength of the market for the borrower s goods or services. For projects involving real estate development or new businesses a Market Study is often warranted. The Loan Committee Memo should identify all known risks. V. PROMISSORY NOTE OVERVIEW: A promissory note evidences the borrower s obligation/promise to pay the loan back to the Bank. The original Promissory Note should be maintained in the collateral file, using the appropriate form according to type of credit, rate and payment terms. A sample form is located at the end of this Chapter. CONTENT: A Promissory Note typically contains provisions addressing the following: Identification of Bank and Borrower Principal Amount Single/Multiple Advance Conditions of Credit Interest Rate Accrual Method Default Rate/Late Charges Payment Schedule Maturity Date Applicable Law Defaults Remedies Security/Collateral (recitation of recording information) Signature of Borrower VI. LIEN DOCUMENTS OVERVIEW: A lien document can be a security agreement, pledge agreement, collateral assignment, mortgage, deed of trust or any other written document signed by the owner of the collateral in which the owner 3-6 RUSSR

9 grants the Bank a lien on specifically described collateral [UCC (collateral description)] to secure a debt owed to the Bank by the owner or some other person. [UCC 9.102(a)(74) (definition of security agreement)] A sample Commercial Security Agreement is located at the end of this Chapter. A sample Deed of Trust is located at the end of Chapter 7. CONTENT: The security agreement may cover after-acquired property other than consumer goods and commercial tort claims [UCC (after acquired property)] A loan agreement, if properly drafted, can be a lien document. The lien document commonly contains representations and warranties, covenants and events of default. Chapters on specific types of collateral discuss the appropriate lien document for that collateral. [UCC (general effectiveness of security agreement)] In a consumer transaction, the promissory note and security agreement are often combined. VII. PERFECTION OVERVIEW: METHODS: Perfection places third parties on notice of the Bank s lien. There are six basic methods of perfecting consensual liens on a debtors assets. The method used by the Bank for any given loan will depend upon the type of collateral. Common methods of perfection include: File UCC-1 File in the county or parish real property records a *Mortgage, *Deed of Trust, or *Leasehold Mortgage or Deed of Trust Take possession of collateral Take control of collateral *Investment Property *Letter of Credit Rights *Electronic Chattel Paper Notation of a Lien on a Certificate of Title 3-7 RUSSR

10 *Car *Boat Special filings with state or governmental agencies. *Vessel with U.S. Coast Guard *Airplane with Federal Aviation Administration VIII. TITLE VERIFICATION DOCUMENTATIONS OVERVIEW: REAL ESTATE: TITLED ASSETS: OTHER: Title verification documentation confirms that the debtor has title to the collateral it proposes to pledge to the Bank as collateral. For real estate, a deed establishes title and typically, a title company insures the title. For non real estate assets the ease of verifying ownership varies. For titled assets such as directly held stock certificates, instruments, motor vehicles, vessels, airplanes (and boats in title states), the record title holder is the presumed owner (i.e., the name on the stock certificate, car title, etc.). For assets such as equipment, fixtures, inventory and farm products, invoices and bills of sale may establish ownership. When these are not available, the debtor s business records such as the general ledger may suffice. IX. LIEN SEARCHES OVERVIEW: SUBORDINATION: A lien search on the collateral should be conducted in the same location where the Bank would perfect a lien. If the lien search reveals the existence of prior liens, the Bank should obtain a Personal Property Lien Subordination Agreement from the prior lienholder(s). A sample agreement is located at the end of this Chapter. A lien subordination is different from debt subordination. X. AUTHORIZATION DOCUMENTATION OVERVIEW: Authorization Documentation establishes the exact legal name of the borrower, and assumed names used by the borrower, the authority of the borrower to incur debt, and the persons signing the 3-8 RUSSR

11 loan documents to sign such documents. Bankers will benefit from a thorough understanding of Basic Business Entities in Chapter 1. At a minimum the loan file should include the documents below for the types of borrowers, cosigners or guarantors indicated: INDIVIDUALS: The Bank should confirm that the borrower is 18 years old or older and therefore has the legal capacity to contract. Where the individual has used multiple variations of his/her name a Same Name Affidavit is recommended. A sample form is located at the end of this chapter. Example: A debtor s exact full legal name as reflected on his driver s license is John Lee Doe. He goes by J.L. Doe. His nickname is Bubba Doe. The UCC-1 should list the debtor as John Lee Doe. CAUTION: UCC 9.503(a)(4) in a majority of states provides that the name of an individual debtor on a financing statement filed sufficiently identifies the individual debtor only if that name matches the name shown on his or her most recently issued and unexpired driver s license or unexpired personal identification card (a ID Card ) issued by the same office that issues driver s licenses. Revised UCC 9.503(a)(5) provides that if the state has not issued a driver s license or ID Card to an individual, or it has expired, then the financing statement must reflect either (i) the individual name of the debtor (if he or she has only one name) or (ii) the surname and first personal name of the debtor. The UCC in a minority of states provides that the debtor s driver s license name, the debtor s actual name or the debtor s surname and first personal name may be used on the financing statement. This has been called the safe harbor approach, in contrast to the only if approach reflected in a majority of states. Bankers should check their states version of 9.50(3)(a)(5). CAUTION: Banks often are presented with Matricula Consular cards as identification. A Matricula Consular is an official I.D. card, which is issued by the Mexican Government through its Consular Offices. The document ONLY proves that the bearer is of Mexican nationality and is living outside of Mexico. The Bank Secrecy Act Customer Identification Program permits use of any government issued document evidencing nationality or residence and bearing a photograph or similar safeguard. Many view this as allowing 3-9 RUSSR

12 a Bank to accept a Matricula Consular card as a form of identification. Although the cards are permissible ID, you may still want a secondary source of ID if you have reason to doubt the authenticity of the card. Matricula cards are not acceptable in mortgage lending because social security numbers are required for home loans. Social security numbers also provide background and credit history for loan decisions. Thus, acceptance of Matricula Card creates the need for another method of review of creditworthiness. BUSINESS ENTITIES: Chapter 1 provides a detailed discussion of Business Entities and Other Commercial Borrowers and their related Authorization Documentation. A brief summary is provided below. Authorization Documentation for a Sole Proprietorship includes: Most states require Assumed Name County/Parish Certificates Sole Proprietorship Resolution of Authority Authorization Documentation for a General Partnership includes: Partnership Agreement Partnership Resolution of Authority Assumed Name Certificate required in most states Authorization Documentation for a Limited Partnership includes: Limited Partnership Agreement Certificate of Limited Partnership or Certificate of Formation Partnership Resolution of Authority Comptroller/State Treasurer? Certificate of Authority to Transact Business if conducting business outside its state of formation Assumed Name Certificate, if appropriate Authorization Documentation for a Limited Liability Company includes: Articles of Organization or Certificate of Formation Regulations or Company Agreement (content similar to Bylaws) Certificate of Formation Status Certificate of Franchise Tax Account Status Resolutions of the Members Certificate of Authority to Transact Business in all states outside its state of formation where it conducts business Assumed Name Certificate, if appropriate RUSSR

13 Certificate of Formation or Articles or Certificate of Incorporation Bylaws Certificate of Corporate Status confirming that the corporation validly exists in the state of formation Certificate of State Tax Status confirming that the corporation has paid all required state tax Resolutions of the Board of Directors Certificate of Authority to Transaction Business in all states outside its state of formation in which it does business Assumed Name Certificate, if appropriate Authorization Documentation for a Professional Association includes: Articles of Organization or Certificate of Formation Bylaws Certificate of Formation Status Entity Authorization Assumed Name Certificate, if appropriate Authorization Documentation for a Cooperative Association includes: Certificate of Formation Bylaws Certificate of Formation Status Resolutions Assumed Name Certificate Authorization Documentation for a Real Estate Investment Trust includes: Certificate of Formation or Declaration of Trust Bylaws Certificate of Formation Status Entity Authorization Assumed Name Certificate CHURCHES: Most religious organizations have constitutions, Books of Order or Books of Discipline that describe how local churches are to be governed (whether or not they are incorporated as a nonprofit corporation). These typically identify the entities or persons within the local church that are authorized to purchase, sell or encumber property or borrow money on behalf of the church. In most 3-11 RUSSR

14 instances, these functions are performed by a board of trustees, church counsel or similar committee. In some congregational denominations, the local churches make their own rules which are set forth in bylaws or similar documents. If the local church cannot show you the language upon which they are relying to establish that the signatories on the loan documents have the authority to bind the borrower, they should be able to put the Bank in touch with a central agency for the denomination that deals with these matters. (For example, in the United Methodist Church, there is a General Council of Finance and Administration in Chicago, which has attorneys on staff who, among other things, guide local churches and their attorneys through issues like this.) If the borrowing entity is part of a larger denomination, it is very important to accurately identify the borrower and the people that have the authority to bind the borrower and to understand whether the local church must hold all of its property in trust for the denomination as a whole. The Bank should account for the possibility that some larger entity has an interest in the local church property. The Bank should obtain a copy of the church s governing documents and a resolution signed by its trustees or council members. If the church is formally incorporated as a nonprofit corporation, all the authorization documentation for a corporation should be obtained. If it is not a corporation the authorization documentation for an unincorporated nonprofit association should be obtained. It is also strongly recommended that the Bank obtain personal guarantees from one or more of the church s largest contributors, a copy of the annual budget and copies of all pledge cards. ESTATES: Lending to estates is governed by the probate statutes of the state of residence of the decedent s estate at the time of death. As a general rule Banks should obtain a copy of the Will and an order or other document from the Probate Court where the estate is pending, which gives the executor the authority to borrow money, guaranty indebtedness and/or pledge the estate s property as collateral. NOTE: In the case of an intestacy (i.e., no will) consult Bank Counsel. CAUTION: UCC provides that if collateral is being administered by the personal representative of a deceased debtor, 3-12 RUSSR

15 the name of the debtor on the UCC financing statement is sufficient only if the financing statement provides, as the name of the debtor, the name of the deceased debtor and, in a separate part of the financing statement, indicates that the collateral is being administered by a personal representative. A safe harbor for determining the name of a deceased debtor is the name of the deceased debtor appearing on the order appointing his or her personal representative issued by the court having jurisdiction over the collateral. TRUSTS/ CUSTODIAN: When lending to a Trust, the purported Trustee is required to state that he or she is a trustee under a valid and existing trust created. The Bank must obtain a copy of the Trust Agreement to determine if it gives the Trustee authority to borrow money, guaranty indebtedness and/or pledge the trust s property as collateral. A Trust Authorization located at the end of this Chapter should also be obtained. This document specifically references borrowings from the Bank. Collateral in the name of a trustee, guardian, personal representative, custodian under the Uniform Transfers to Minors Act (a minor being a person younger than 21 years of age) or other fiduciary should not be accepted as collateral for a loan to the fiduciary unless the loan proceeds are applied for the benefit of the beneficiary and only if the authority of that fiduciary to pledge the collateral is documented. CAUTION: If a debtor trust is not a registered organization, revised UCC provides that the financing statement will sufficiently reflect the name of the debtor only if the financing statement reflects (i) the name specified in the document that creates the trust or (ii) if no name is specified, the name of the settlor or testator. If the name of the trust debtor is determined pursuant to clause (i), the financing statement also must indicate that the collateral is held in trust. If, however, the name of the trust debtor is determined pursuant to clause (ii), there must be information to distinguish the debtor trust from other trusts to which the named settlor or testator is acing in the same capacity and, if not otherwise so indicated, also an indication that the collateral is being held in trust. The Bank should exercise caution in lending to the beneficiary of a trust. Many trusts are so-called spendthrift trusts which specifically prohibit the beneficiary from pledging the trust interest as collateral for a loan and protect the trust interest from the beneficiary s creditors. The Trust Agreement should be carefully 3-13 RUSSR

16 reviewed to determine the extent to which the beneficiary s interest can be pledged. The Bank may, for example, make a loan to a trust beneficiary (based on his or her trust income) to buy a car or home and take a security interest in the car or home (but not the trust interest). MUNICIPALITIES: Lending to Municipalities is covered in Chapter 12. Authorization Documentation varies by state. A Bank may need to obtain a copy of the charter and review the charter to confirm that the city has the authority to borrow the amount and for the purpose stated in the council resolution. It should obtain a copy of the resolution or ordinance of the city council signed by all council members which authorizes the execution of the loan documents and designates the council member(s) authorized to sign the documents. The Bank should consider requiring a legal opinion which states that the municipality is authorized by the state legislature to borrow money for the purpose stated in the city council resolution or ordinance and a copy of the resolution or ordinance signed by all council members which authorizes the execution of the loan documents and designates the council member(s) authorized to sign the loan documents. Approval by the state attorney general may be required. XI. POWERS OF ATTORNEY OVERVIEW: CONTENT: If the Bank allows an individual (the agent) other than the borrower or guarantor (the principal) to sign the loan documents under a Power of Attorney, the Bank should obtain the original Power of Attorney for the Bank s file. The Power of Attorney should be signed by the principal and notarized. In some states it must be filed in the real property records of the county where the principal resides. Many states proscribe a broad durable Power of Attorney form. The Bank should confirm that the individual who signed the Power of Attorney is still alive and, if the power of attorney is not a durable power of attorney, that the individual has not been declared mentally incompetent. At closing, the Bank should have the signer/agent 3-14 RUSSR

17 execute an Agent Certification of Continuing Power of Attorney. A sample form is located at the end of this Chapter. XII. EVIDENCE OF INSURANCE OVERVIEW: The Bank should obtain Evidence of Insurance on all tangible collateral and general liability coverage for all businesses. Business interruption insurance should also be considered. If the Bank is a licensed insurance agent, the Bank may not offer to sell insurance (other than credit life) on the collateral until after it has agreed to make the loan. A Customer Insurance Disclosure must be given to the borrower advising him that he may obtain insurance from an entity other than the Bank. A Sample form is located at the end of this Chapter. Form Security Agreements typically contain a covenant requiring the debtor to maintain insurance coverage on the collateral. For example, homeowners insurance on a house, collision insurance on a car, etc. Certain types of collateral have special insurance such as crop insurance on farm products. COLLATERAL PROTECTION INSURANCE: Collateral protection insurance should be required on loans secured by tangible personal property and improved real estate. In addition to insurance on the improvements to real estate and the contents thereon, other types of insurance are often warranted, including comprehensive liability coverage on commercial loans, credit life and disability insurance on residential loans and crop insurance on loans secured by real estate on which crops are grown. The Bank can and should require that the borrower maintain insurance. An Agreement to Provide Insurance is a document in which the borrower contractually agrees to the type and amount of coverage and specifies the insurance company providing the coverage. A sample Agreement to Provide Insurance form is located at the end of this Chapter. Standard loan document forms contain provision which allow the Bank to purchase collateral protection insurance on behalf of the borrower if the borrower fails to maintain coverage and charge the cost to the borrower. CREDIT LIFE DISABILITY AND A Bank can require credit life insurance for a loan, but a Bank cannot require that the insurance be purchased from it or any affiliate 3-15 RUSSR

18 INVOLUNTARY UNEMPLOYMENT INSURANCE: according to the federal anti-tying laws [12 USC 1972, 12 CFR 225]. The form Federal Credit Application Insurance Disclosure advises the borrower of the prohibition on tying. It must be provided at the time a consumer applies for a loan. Under Reg B a creditor cannot refuse to extend credit and may not terminate an account because credit life, health, accident, disability, or other credit-related insurance is not available on the basis of the applicant s age. OPTIONAL INSURANCE: INSURANCE SOLD BY BANK OR AFFILIATE: COMPREHENSIVE LIABILITY COVERAGE: If credit life, disability or other insurance is not required to obtain credit, but the Bank will obtain and finance coverage at the borrower s request, a Credit Insurance Addendum is appropriate to document the agreement. An Additional Insurance and Third Party Payment Addendum may also be necessary when the Bank will receive a commission on the placement. If credit life, disability or involuntary unemployment insurance is not required as a condition of a mortgage but is being financed by the Bank, some states require a Notice to the Applicant which discloses the estimated premium cost and notifies the borrower of a 30 day right to cancel for a full refund. If the borrower does purchase insurance from the Bank or its affiliate, the Bank must disclose to the borrower in writing that the insurance is not government insured (except Federal Flood or Crop Insurance) or guaranteed by the Bank. The liability insurance of a commercial business borrower should be reviewed to determine if the following coverage is in effect: Workers compensation insurance to cover claims for workrelated injuries made by regular employees, temporary employees, or employees of uninsured contractors used by the borrower. Automobile liability insurance for bodily injury or property damage arising out of the use of automobiles. Even if the borrower has no owned or long-term leased automobiles, the foundation needs hired and non-owned automobile liability insurance to over itself against claims arising out of the use of automobiles by employees, volunteers and others working on behalf of the borrower. General liability insurance covering liability for bodily injury to others, property damage to non-owned property, loss of use of that property, and listed personal injuries such as 3-16 RUSSR

19 libel, slander, defamation, and invasion of privacy. Umbrella or excess liability policy or coverage providing increased coverage beyond the limits of the aforementioned policies. Professional liability insurance covering financial losses to third parties arising out of errors or omissions made by the board in day-to-day operations. This policy or coverage specifically excludes bodily injury, property damage, or personal injury covered by the general liability policy. Professional liability insurance may be purchased as a standalong policy or as part of a management liability policy. Employment-related practices liability insurance for mental or financial injury to employees typically including, but not limited to, discrimination, wrongful termination, and sexual harassment. Directors and officer s liability insurance covering directors responsibilities for financial loss to stakeholders arising out of mismanagement of the business entity itself. This is usually the core coverage provided by management liability policies. Internet liability and crime policy to cover risks arising from online technology and may require separate policies. GENERAL LIABILITY EXCLUSIONS: FLOOD: The exclusions section of general liability policies typically includes liquor liability, pollution liability, aircraft liability, watercraft liability, property leased or rented to others, parking and rental property. Flood insurance is discussed in Basic Real Estate Documentation, Chapter 7. CROP: Crop insurance is discussed in Agricultural Lending, Chapter 10. XIII. KEY PERSON LIFE INSURANCE LIFE INSURANCE OVERVIEW: Face value or term life insurance on a key individual whose death would adversely affect the ability of the borrower to repay the loan should be considered as additional security for a loan. The present cash surrender value, if any, is not usually considered a part of the 3-17 RUSSR

20 collateral. NOTE: Cash value or whole life insurance policies are excellent collateral for loans if policies are properly supervised because the funds are always available. However, because the insurance company typically will loan against the policy it is rarely used as Bank collateral. CASH SURRENDER VALUE LIFE INSURANCE: The insurance company will pay to the insured or the assignee the cash value of the policy if the policy is surrendered prior to the death of the insured. NOTE: Current cash value is extremely important in determining the acceptability of a policy as collateral. Most policies contain a table for computing cash value; however, the accepted figure should be taken from a questionnaire to be obtained by the Bank from the insurance company since dividends may have accumulated on the policy. See the Life Insurance Assignment Questionnaire form included at the end of this chapter. A follow up questionnaire should be obtained from the insurance company annually to verify the cash value. The following are the most common types of cash value life insurance policies: * Ordinary Life - Protects the insured for his or her entire life. The insured pays the premiums either for a specific period or until death. The premiums paid by the insured make up the cash value of the policy. This is the type of policy most commonly used for insurance loans. * Endowment - Provides for the payment of a specific premium over a term of years. At the end of the term, the insured receives payment. The beneficiary receives payment if the insured dies before the end of the term. * Juvenile - Cash value policy written on the life of a minor. Juvenile policies should be handled with extreme care. The owner of a juvenile policy usually has authority to exercise policy rights until the insured attains maturity. The Bank must verify that any assignment to it is enforceable prior to lending against such a policy RUSSR

21 FACE VALUE LIFE INSURANCE: There is no specific collateral value to face value life insurance. The following are the most common types of face value life insurance: * Term Insurance - Protects the insured for a specific period of time rather than for his or her whole life. The cash value, if any, of such policies is minimal. * Annuity Policy - Provides for specific periodic payments to the insured or the beneficiary during the insured s lifetime or for a certain period of years. There are two types of annuities -- immediate and deferred. Once annuity payments begin under such policies, the policies have a declining cash or loan value. CAUTION: At least one court has held that an annuity is a general intangible. Therefore, a UCC-1 Financing Statement should also be filed. CONSIDERATIONS APPLICABLE TO ASSIGNMENT: * Group - Provides insurance on lives of individuals who are part of a recognized group, such as employees of a business or members of a social organization. Premiums are generally based on the average age of the persons in the group. These policies generally provide that a specific amount is paid upon the death of the insured. Group policies are a form of term insurance. They have no cash value and are not assignable. * Industrial - Pays a small amount at death. Premiums are paid at least monthly, sometimes weekly. * Family Income - On the death of the insured, pays a monthly income to the beneficiary. (Combination of cash value and term.) * National Service (i.e., government policies issued to veterans and military personnel) - Some of these policies contain provisions which permit borrowing from the government. These policies are not assignable. For a valid security interest in an insurance policy, the Bank must receive an assignment of the policy from the owner; the beneficiaries must sign the assignment, when required (see discussion below); the Bank must notify the insurance company of its interest in the policy and should take possession of the policy and all endorsements. Assignability of the Policy. The Bank should check the policy to determine whether assignability is one of the rights of the insured. If this right is not spelled out clearly, the Bank should contact the insurance company for clarification RUSSR

22 Ownership of the Policy. Since the assignment must be executed by the owner, it is extremely important to determine who owns the policy. Usually, the insured is the owner; however, businesses may have policies covering key employees or one spouse may have a policy covering the other spouse. Once a loan secured by a life insurance policy has been paid in full, a new assignment must be obtained and filed with the insurance company before making a new loan even if the policy never left the Bank. If the owner is pledging his/her policy as collateral for a loan to another borrower, the loan officer must verify that this is allowed under the terms of the policy. BENEFICIARIES CONSENT TO ASSIGNMENT: The beneficiary will receive payment in the event of the insured s death. The owner s assignment may or may not be binding on the beneficiary. The owner can assign a policy without the signatures of all the beneficiaries only when: 1. The estate of the owner is the sole beneficiary; or 2. Under the terms of the policy, the owner has reserved the right to change beneficiaries and the policy states not only that the owner has the right to assign the policy without the consent of the beneficiaries, but also that the rights of beneficiaries are subordinate to claims of assignees of the owner. NOTE: In any event, it is good practice to have the beneficiaries of a policy join in the assignment to avoid any misunderstandings in the event of the insured s death. ASSIGNMENT IN SPECIAL CASES: Minors or Incompetents. If the beneficiaries are minors or are not legally competent, the insured s estate or a competent adult must be named as the beneficiary before the Bank accepts the policy as collateral. Trustees. If the owner of the policy is a trustee (such as a bank) under an irrevocable trust arrangement, the policy cannot be accepted as collateral unless the loan proceeds are payable to the trust or refinance a loan from which the trust directly benefits RUSSR

23 Community Property States. If the owner of the policy resides in a community property state (Texas, Washington, Idaho, California, Nevada, New Mexico, Arizona, Louisiana or Wisconsin), the owner s spouse may have a vested interest in the policy and should join in the execution of the assignment. Corporate Ownership. For a corporate owner to execute a valid assignment, the corporation must have the right to assign the policy or change the beneficiary without the consent of the insured or must obtain such consent. The Bank should also obtain the usual corporate authorization documentation, including certified corporate resolutions authorizing the assignment. EXISTING ASSIGNMENTS: POLICY PROVISIONS: If there are existing assignments on the policy, this information may be found on the questionnaire completed by the insurance company. If there are pre-existing assignments, they are considered to be prior liens against the policy. The Bank may desire to increase the size of the loan and advance additional funds to pay off prior policy loans rather than be subject to the prior assignments. The following discussion raises questions with respect to certain features which may be contained in an insurance policy and which will positively or negatively affect its desirability as collateral. The existence or nonexistence of such features must be confirmed by the insurance company. * How will settlement be made by the insurance company? The policy should reflect the terms of settlement. From the Bank s point of view, the best settlement is the payment of a lump sum to the assignee and the balance to the beneficiaries. If the policy provides for settlement in installments, the insured must change the option to lump-sum settlement before the Bank accepts the policy as collateral. * Can the insured borrow against the policy? The policy should provide that the owner of the policy or the Bank as assignee can borrow against it so that the Bank can borrow against the policy rather than cashing it in if a default occurs. The insurance would be terminated if the policy is cashed in, leaving the insured or his/her beneficiaries with no coverage and the Bank without a good share of its collateral. The questionnaire filled out by the insurance company will indicate any amounts that have been borrowed by the insured before the Bank takes the policy as collateral RUSSR

24 * When are payments due? Will the insurance company verify payments made on due dates? What are the payment amounts and where are they payable? Some policies provide that rights of an assignee continue until 10 days after the assignee receives notice of nonpayment; however, this provision may not apply to policies with monthly premium payments. * What are the non-forfeiture provisions (not applicable to paid-up policies)? Insurance policies lapse if premiums are not paid within a specific grace period; however, policies usually have non-forfeiture provisions which give the owner several options if he/she defaults in payment of premiums. The policy must be examined to identify these default provisions and to ascertain which provisions prevail if the owner fails to select an option. Some policies provide that cash value is forfeited or reduced after lapse. To avoid this result, a policy must not be accepted as collateral unless: The policy has an automatic non-forfeiture provision which guarantees continuing cash value, or An adequate grace period is allowed after default during which election for cash value may be made. * Are automatic premium loan provisions included in the policy? If so, they must be eliminated before the Bank accepts the policy as collateral; otherwise, delinquent premiums can be deducted from cash value. * Is cash value reduced through disability clauses? If so, the policy cannot be accepted as collateral. DEATH OF INSURED: Upon the death of the insured, the Bank should: * Contact the insurance company to obtain forms for submitting a death claim. Most insurance companies require a certified copy of the insured s death certificate. * Forward required documents and the policy to the insurance company. * Retain the assignment until the settlement check is received. * If the beneficiary will not sign the claim papers, request that the settlement check be made payable to the sole order of the Bank RUSSR

25 * Upon receipt of the settlement check, the lending officer should: determine total amounts owing to the Bank and secured by the assignment, and in the event that the insurance company disburses all proceeds to the Bank, be careful to determine whether the beneficiary or other assignees are entitled to any proceeds and to assure that the funds are released to the appropriate assignees or beneficiary. PERFECTION: Since security interests in life insurance policies are not covered by the UCC, the assignment must be filed with and accepted by the appropriate insurance company in order to perfect the security interest. Advances cannot be made until the insurance company has acknowledged to the Bank receipt, recording and priority of the assignment. The Bank may only obtain an effective security interest in a life insurance policy by properly obtaining an assignment given by the owner (and the beneficiaries, in most instances), and by notifying the insurance company of the assignment. UCC-1 Financing Statement filings are neither required nor effective. When the loan is paid in full, the Bank should notify the insurance company that its lien has been released. When key person life insurance is required on the estate the following documents should be in the loan file: Life Insurance Assignment Questionnaire. See sample form included at the end of this Chapter. Assignment of Life Insurance Policy as Collateral. A sample Assignment of Life Insurance Policy as Collateral is located at the end of this chapter. Typically each life insurance company has its own form. The Bank should request a form in its initial contact with the life insurance company. CAUTION: It may be necessary to have the beneficiaries sign the assignment RUSSR

26 Life Insurance Policy. The Bank should take possession of the policy for the term of the loan in order to protect the Bank s collateral position. XIV. OTHER BASIC DOCUMENTS BUSINESS PURPOSE STATEMENT: A Business Purpose Statement (if the loan proceeds are used for a business purpose) is used to document that a Truth-in-Lending Disclosure Statement is not required. A sample form is located at the end of this Chapter. When a loan is made to an individual for under $50,000 and it is for a business rather than personal, family or household use it is best practice to obtain a business purpose affidavit or statement. REG Z AND OTHER CONSUMER DISCLOSURES: Consumer lending is heavily regulated. Anytime a loan is made to an individual the Bank needs to assess the purpose of the loan and what state and federal disclosures and rules may apply. The most basic of federal consumer lending disclosures is a Truthin-Lending Disclosure Statement and Amount Financed Itemization [15 U.S.C et seq./12 C.F.R. Part 226]. It should be given if the loan is made to a consumer for personal, family or household purposes and (i) is $50,000 (as of July 21, 2011)* or less, or (ii) is over $50,000 (as of July 21, 2011)* and is secured by real property (whether homestead or not) or by personal property used or expected to be used as a principal dwelling of the consumer whether or not attached to real property (i.e., boats, manufactured homes and trailers) or is a private education loan. Amounts area adjusted annually for inflation. This Guide does not cover consumer lending laws in great detail. Chapter 20 does highlight the federal consumer lending laws and should be reviewed in connection with consumer lending. Bank counsel should be consulted on state law. GUARANTY: Guaranties are often required from the owner of a business when the business is a separate legal entity. A guaranty is a credit enhancement document. The guaranty itself can be secured by collateral of the guarantor or unsecured. Guarantees are discussed in further detail in Chapter RUSSR

27 ARBITRATION AGREEMENTS: Arbitration Agreements became popular in the 1980 s when large jury verdicts against Banks on lender liability theories were a significant risk for Banks. Today, jury waivers in commercial loan documents are enforceable in many states. This, coupled with the expense of arbitration has made arbitration agreements less popular. The Bank should consider entering into an Arbitration Agreement with commercial borrowers wherein the parties agree to arbitrate any dispute relating to the loan documents. A sample form is located at the end of this Chapter. LEGAL OPINIONS: The Bank may wish to obtain a Legal Opinion from a commercial borrower s legal counsel regarding the borrower s corporate power and existence (if appropriate), enforceability of the debt and perfection of the Bank s lien. Legal opinions are expensive and often not requested on loans under $5 million. XV. FORMS The Forms referenced in this chapter appear in the following order: Same Name Affidavit Agreement to Provide Insurance (API-GEN) (6/13/2000) Credit Application (UCA) (11/1/2012) Credit Application Addendum Confirmation Form (UCA-ADD- CON) (2/15/2012) Commercial Loan Application (COMM-APP) (6/15/2010) Commercial Loan Application - Summary (CLAS) (12/12/2007) Financial Statement (FS) (11/1/2000) Statement of Financial Information (SFI) (10/11/2000) Commercial Security Agreement (SA-SUS-TX)(10/24/2003) Trust Authorization (AUTH-TRUST) (7/20/2010) Agent Certification of Continuing Power of Attorney (ACC- POA) (8/1/2006) Personal Property Lien Subordination Agreement (LIEN-SUB- PP) (11/15/1999) Debt Subordination Agreement (SUB-DEBT 2/15/2001) Business Purpose Statement (BPS) (2/20/2007) Arbitration Agreement (ARBITATELAZ) (3/11/2008) Assignment of Life Insurance Policy as Collateral (M-170) 3-25 RUSSR

28 (7/29/97) Life Insurance Assignment Questionnaire (MBA-17A) (1/80) 3-26 RUSSR

29 THE STATE OF COUNTY OF SAME NAME AFFIDAVIT BEFORE ME, the undersigned authority on this day personally appeared the undersigned, known to me, and being duly sworn, did dispose and say: My full name is JANE ANNE DOE. I am also known as JANE ANNE SMITH and JANE A. DOE, and I am one and the same person as the JANE A. DOE who executed each of the following documents, individually and on behalf of the entities therein identified: A. that certain First Extension of Promissory Note, Security Interests and Confirmation of Guaranties dated as of by and among, a Texas general partnership (the Borrower ),, (the Bank ) and the undersigned, among others, as guarantor; B. that certain Revolving Credit Note dated, in the face amount of $, executed by, payable to the order of the Bank together with certain certificates, affidavits and other documents related thereto. FURTHER Affiant sayeth not. JANE ANNE DOE This instrument was ACKNOWLEDGED, SWORN TO AND SUBSCRIBED TO BEFORE ME, the undersigned authority by JANE ANNE DOE on this day of, 20. Notary Public in and for the State of Printed Name of Notary: My Commission Expires: 3-27 RUSSR

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