Whether you are considering a minority investment or a whole company carve-out transaction, buyers and sellers should be aware of the following five issues that may pose transaction risk for buyers and sellers in US mortgage company investments.
(1) Is cross default risk a concern?
Buyers may consider whether an equity investment in a Fannie Mae or Freddie Mac (the “GSEs”) seller/servicer or a Ginnie Mae issuer would pose “cross default” risk with another servicer or issuer under common ownership or control with the target company. The Ginnie Mae Mortgage-Backed Securities Guide (the “Ginnie Mae Guide”), Fannie Mae Selling and Servicing Guides and Freddie Mac Seller/Servicer Guide (together with the Ginnie Mae Guide, the “Guides”) include cross default provisions applicable to parties under common ownership or control. The cross default provisions provide that a default under the applicable Guide or servicing agreement by one entity may be deemed to be a default with respect to another entity under common ownership or control.
The determination as to what constitutes “common ownership” or “common control” varies among Ginnie Mae and the GSEs. Freddie Mac and Ginnie Mae traditionally defer to FAS-57; however, according to accounting professionals, the current standard for evaluating related-party relationships may be ASC-850, a different accounting standard. Fannie Mae does not provide specific guidance with respect to common ownership or control. In connection with related due diligence efforts, buyers in mortgage M&A transactions may consider whether the target has any corporate guaranties, waivers, special approvals and/or unique requirements imposed by the GSEs or Ginnie Mae, including higher net worth or liquidity obligations beyond those set forth in the Guides.
In addition to cross default provisions set forth in the Ginnie Mae Guide, Ginnie Mae has, in the past, exercised discretionary authority to limit or prohibit common ownership or control of multiple issuers with the same issuer approval type regardless of whether the parties enter into a cross default agreement. While the Ginnie Mae Guide only requires 30-days advance notice of a change of ownership, buyers and sellers evaluating cross default risk may treat Ginnie Mae as a “required approval” for closing based on Ginnie Mae’s broad authority to review and approve common ownership or control of multiple issuers with the same issuer approval type. Moreover, Ginnie Mae may not be able to evaluate the proposed transaction in such 30-day period, and so the parties may prefer to provide a longer “runway” to address any questions raised by Ginnie Mae. If Ginnie Mae does not approve the issuers for continued participation prior to consummation of the transaction and/or imposes conditions on such participation, the parties will typically enter into discussions with Ginnie Mae to curtail activities or surrender one of the issuer approvals within a specified period of time.
Cross default provisions may pose heightened risks for private equity and hedge fund investors depending on how the proposed investment will be structured and where the target company will be located within the applicable fund structure. Cross default risk across multiple funds could cause investors in one fund silo to be exposed to regulatory risk based on the acts or omissions of an approved entity held in a completely different fund silo. As a result, careful analysis of common ownership or control is of particular importance for fund investors.
While buyers should be aware of the cross default risks, sellers may likewise be concerned as a matter of transaction risk. For instance, the presence of multiple Ginnie Mae issuers on the buyer’s side may impede or delay change of control approval from Ginnie Mae while a cross default agreement is finalized. More generally, the possibility of cross defaults may “spook” a potential buyer. As a result, sellers may consider inquiring as to other issuers and seller/servicers held in the buyer’s ownership structure to ensure that these potential risks are identified early in the negotiation process.
(2) Why should I worry about employee classification issues?
Employers are obligated to designate employees as either “exempt” or “nonexempt” from the overtime regulations of the federal Fair Labor Standards Act1 (“FLSA”) and similar state laws. Employees are classified depending on their applicable job duties and on the basis of their salary and income level. An exempt or nonexempt classification determines whether an employee is entitled to receive overtime pay for hours worked over 40 in a week (or eight in a day in some jurisdictions).
The determination as to whether an employee is exempt or nonexempt is based on a somewhat subjective analysis and can be difficult. The classification analysis for loan officers and underwriters is particularly tricky becauseit is possible that persons in these roles may fall within either the “administrative” exemption or the “outside salesperson” exemption. The administrative exemption requires that the employee’s duties include the exercise of independent judgment and discretion. This is a fact-specific inquiry that depends on the loan officer’s actual duties and responsibilities. Similarly, the outside sales exemption requires that the employee’s primary duty is “making sales” (as defined by the FLSA) and “who is customarily and regularly engaged away from the employer’s place or places of business in performing such primary duty.”2 This, too, is a fact-specific inquiry.
If an employer misclassifies employees, the employer may be at risk for individual claims or class action lawsuits. The FLSA has a two-year statute of limitations for ordinary violations and a three-year statute of limitations for willful violations. A common remedy for FLSA violations is the payment of back pay—the difference between the pay the employee actually received and the amount that the employee should have received— looking back over a two- or three-year period. In addition, liquidated damages in the amount of twice the backpay amount may also be available. Certain state laws impose even stronger penalties. For instance, the California Labor Code3 provides for monetary penalties for waiting time violations, wage statement violations, meal and break period violations and pay period violations.
When considering an equity investment in a mortgage company, even for a minority stake, buyers may carefully review the target’s employee census to consider how employees are classified. If employees are misclassified, buyers may consider requiring the seller to take mitigating steps to reduce risk, request a special indemnity in the purchase agreement or make adjustments post-closing.
Note that misclassification of employees may also present concerns for purchasers in asset sales. Buyers of substantially all of the assets of a mortgage company (or a significant portion thereof) should be aware of the potential for successor liability in employment actions because courts have held transferees in asset sales liable for employee misclassification claims under the FLSA and similar state laws.4
As a matter of “good housekeeping,” sellers may consider performing an employee classification audit and taking corrective actions prior to soliciting investments or positioning for an asset sale in order to prevent this issue from posing transaction risk during negotiations.
(3) Why do I need “change of control” approval for non-voting equity?
It may be surprising to learn that the acquisition of non-voting stock or non-voting equity interest investments also may require “change of control” approval as its relates to Ginnie Mae, the GSEs and certain state mortgage finance licensing laws and may require personal disclosures of the ultimate indirect owners of the licensee. The determination of whether the change of control provisions apply may be based on the form of organization of the licensee or entities in the chain of ownership. Debt structures also may warrant change of control analysis depending on the extent of the debt holder’s ability to exercise control over, or direct the management or policies of, the licensee.
Some states require approvals for any change of 10 percent or more in the direct or indirect ownership of a licensee, including in connection with preferred, non-voting interests. Other states draw the line at a change of 25 percent or more in the indirect or direct ownership of the licensee. Some states further require personal disclosures (e.g., personal financial statements, fingerprints, etc.) from any individuals holding more than the requisite threshold of indirect ownership interests of the licensee and/or of an entity seeking to acquire an interest in a licensee. Some states exempt public shareholders up the ownership chain.
Personal disclosures may be burdensome and intrusive, so buyers and their investors may carefully consider what information is required to be disclosed and by whom. Hedge funds, strategic investors and private entity firms should analyze this issue carefully because their principals may be required to make such disclosures. (Our licensing team can help navigate the change of control analysis and consider whether disclosures will be required based on the form of investment proposed, the organizational charts of both buyer and seller and the state licensees held by the licensee.) Similarly, sellers may carefully evaluate whether the proposed ownership structure poses transition risk in the event that certain of a potential buyer’s direct or indirect owners may be hesitant to provide personal disclosures, which could delay or adversely impact the issuance of state approvals necessary to proceed with the transaction.
(4) Loans originated pre-crisis don't pose repurchase risk, right?
Surprising as it may be, residential mortgage companies continue to face private-investor repurchase claims for mortgage loans originated prior to the financial crisis in 2008. Repurchase risk for loans sold more than 10 years ago is difficult to diligence, especially if prior repurchase claims are sporadic such that they would not suggest a pattern of origination or underwriting defects upon review of historic repurchase logs.5 Similarly, a review of sample loan files from recent years and a review of origination and underwriting practices may not be helpful. We would expect current regulatory compliance policies and procedures to differ from pre-crisis models based on changes required by the Dodd-Frank Act.6 Repurchase risk is a matter for consideration by equity investors and asset purchasers alike. Certain private investor repurchase claimants have asserted repurchase demands against asset purchasers based on a theory of successor liability, even in circumstances where a business unit has been bought and sold through multiple asset sales since the financial crisis. Considering the potential challenges with respect to diligence of legacy repurchase claims in both equity and asset transactions, buyers may consider requesting a special indemnity in the applicable purchase agreement to cover legacy repurchase liabilities.
(5) Where is my R&W policy?
While strategic investors and private equity purchasers generally expect R&W insurance coverage in M&A deals, representation and warranty coverage remains uncommon in mortgage M&A transactions. Historically, financial services has been a challenging area for representation and warranty insurers to underwrite policies, particularly with regard to asset level and regulatory compliance matters. Other areas, such as employment and intellectual property matters, are more easily covered across industry sectors. The primary areas of risk in mortgage deals pertain to loan-level representations, repurchase demands and regulatory compliance concerns—areas that few insurers are willing to cover. That said, we understand that certain insurers are seriously considering new products to address mortgage-related risks. This could be an emerging area for insurers able to grapple with the related underwriting challenges and loan repurchase questions. For now, however, indemnification and repurchase continue to be the mainstay remedies in many mortgage M&A deals.
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As the above questions and answers illustrate, both buyers and sellers may consider these unique but important matters when contemplating a mortgage company investment, and working with a trusted advisor with experience in these matters can assist in moving the transaction forward.