In recent years, Argentina and other Latin American countries have faced some significant macro-economic and financial crises. These crises generated related losses, but also notable business opportunities. This article considers the acquisition of a large portfolio of distressed debt, particularly certain legal, tax and accounting issues. The recent worldwide financial crisis may generate similar opportunities, and the experience noted in this article may be useful for potential investors and sellers.
1. Analysis of Business Issues
1.1 Advantages of transfers of non-performing loans
Traditionally, procedures for the recovery of loans are not carried out by the originators of the loans (mainly banks) in an efficient manner. Employees in charge of these assignments deal with too many matters and their compensation is not tied to the success of their actions. As a matter of fact, banks do not assign their most talented staff to deal with the recovery of defaulted loans. Banks are more concerned in complying with internal procedures (taxes to discourage opportunistic conduct) and with regulatory laws than in collecting defaulted loans. This "one size fits all" approach carried out by banks, impedes the creation of recovery policies specifically tailored based on the unique characteristics of each class of debtor or loan.
Facing this inefficiency, a first option employed by banks for the management of their "defaults portfolio" was the creation of subsidiaries exclusively dedicated to the collection of loans. This would allow banks to maintain control over the collection policies applied (and therefore to protect the client relationship) and to retain key information regarding the reasons for default. Nevertheless, these measures were not an effective way to purge the balance sheet, nor to eliminate the contingencies arising from judicial and extra-judicial collections.
Alternatively, banks sought to direct their collection procedures towards the hiring of third parties through law firms (for those non-performing loans which were already at a judicial stage) and collection agencies (for those non-performing loans in respect of which no judicial claims had yet been made). This approach was not successful either, as similar inefficiencies occurred when attempting to control these external actors.
The procedures of buyers of non-performing loans differ from procedures performed by banks in the following regards:
- buyers do not have any obligation to treat all similar debtors in an identical manner. The buyer possesses absolute flexibility to extract value from the acquired assets. The only limit is compliance with applicable law;
- at some point, financial entities have their hands tied with regard to collecting their defaulted loans for the following reasons:
- moral hazard concerns in extra-judicial collection procedures (e.g. difficulty of monitoring, problems of agency between a bank and its officers);
- collection of defaulted loans is not the core-business of banks. Banks know how to lend and invest, but they are inefficient when it comes to collection;
- the relationship of banks with their clients, far from being a one-off interaction, is a lasting one. This means that it is not constructive for banks to show themselves as "unmerciful" in front of their clients, as would be the impression if it were to be publicized that a bank was to auction defaulted debtors of loans from mortgages granted for the construction of homes. On the other hand, a bank cannot present itself to its clients as being overly flexible. If this were so, performing debtors would find themselves extremely tempted to stand by the side of the non-performing debtors. In a nutshell, a bank cannot show itself to its clients as being either too aggressive or too permissive. Buyers of non-performing loans do not experience any of these constraints;
- banks are subject to regulatory restrictions with regard to granting offers for lower payments; and
- there is a broad discretion with regard to choosing the destination of payments. For example if there is a renegotiation, the first payments received may be deducted as expenses and capital, and once these have been paid, they may be deducted as interest, thereby minimizing the impact of VAT and income tax.
As a matter of fact, none of the alternatives pursued by banks for the handling of a default portfolio seems to be effective. It is in this context that the sale of non-performing loan portfolios to professionals exclusively devoted to their recovery appears as an alternative that promises interesting returns.
Actually, the service that buyers may provide exceeds the mere collection of non-performing loans. The service will consist of an integral process to be projected on three different fronts:
- purchase of non-performing loan portfolios, which will take place through the participation in an auction-type processes that Argentine financial entities carry out. More specifically, the assignee would be appointed as buyer of a portfolio of mortgage loans the "purchase" of which would be instrumented through a Financial Trust Agreement, without public offer;
- normalization of the assets and non-performing loans of the portfolio, including a purging of the assets (e.g. insurance and maintenance payments) and segmentation of non-performing loans by amount, location and collection stage (judicial or extra-judicial); and
- collection of non-performing loans. These collection efforts focus on collecting non-performing loans (direct procedures or through law firms or collection agencies), the sale of non-performing loans individually, or by group, and the sale of collateral assets of certain non-performing loans.
Finally, the financing entities can improve their balance sheets through the sale of their portfolios in debt situations. In fact, through this mechanism, banks are allowed to liquidate unproductive assets and show an accounting guarantee for them. Moreover, through this mechanism, there is a release of regulated capital and liquidity that can be applied.
The management of a bank has an incentive to sell portfolios of non-performing loans so as to be able to show an accounting profit from an asset which, from a financial perspective, did not have any value. This often has a favourable influence on the bonuses awarded to high-level managers of banks.
2. Main Legal Issues Posed by Acquisitions of Large Distressed Portfolios in Argentina and Latin America
2.1. The problem of lemons
The assignment of loan portfolios is a perfect example of information asymmetry problems, where one party has more or better information than the other and such imbalance provides more negotiating leverage for one party at the expense of the other. Considering that performing due diligence with regard to all the loans in a portfolio is essentially impossible, legal due diligence is commonly limited to a sample and thus is a rather limited tool.
George Akerlof, in "The Market for 'Lemons'1, demonstrated that informational asymmetries can give rise to adverse selection on markets. In sales of loan portfolios, this could imply a moral hazard situation where sellers will try to retain their best loans and assign only the bad ones. From the side of the buyer, the uncertainty as to the quality of the loans that the buyer is acquiring would lead to the payment of a lower price. In any event, considering the transaction as a whole, the size of the pie will grow smaller as the uncertainty grows.
Reducing this information asymmetry is one of the most relevant objectives for the legal advisors of sellers and buyers. In the case of the seller, limiting the uncertainty will imply a higher price. For buyer, it will simply allow the deal to be done.
The reputation of the seller is one of the most relevant issues analysed by a prospective buyer, but is not sufficient. There are general and specific tools that were developed for loan portfolios assignment agreements, including (1) representations and guarantees and (2) put-backs.
The following representations and guarantees are usually included in assignment agreements:
- the seller is the creditor under the loans and is able to assign them (i.e. title to the loans);
- the loans analysed under the due diligence procedure are standard loans and fairly represent the general portfolio to undertake the sample-type due diligence;
- the loans exist (i.e. are not totally or partially legally or materially cancelled or terminated for whatever reason);
- there are no claims by debtors against the seller; and
- in some cases, it is relevant to make representations and warranties regarding the loan origination process (permitting the buyer to analyse the quality of the portfolio).
Put-backs are a rather specific tool that deals specifically with the problem of lemons, and allows the parties to mitigate the adverse selection and moral hazard problems. Stated briefly: if certain loans do not reflect the general features declared or guaranteed by the seller (e.g. if a loan was totally or partially repaid), the specific loan is returned along with the price paid for such loan (in some cases the parties could agree to the replacement of such loan with a new one). As many sellers are reluctant to continue to devote time and efforts to the transferred non-performing loans, it is common to limit put-back rights to a fixed period of time.
2.2. Third-party claims; contingency related to third parties (including debtors) claims against seller and assignee; cause of the claims
It is relevant to identify portfolio buyer's liability regarding lawsuits that can be filed against it (e.g. incorrect information provided to the loan reporting system of the central bank or other information bureaus, or lawsuits initiated with or even without legitimate right, for example because the loan was already repaid or did not exist at all). Banks that sell a portfolio typically attempt to transfer to the buyer any responsibility from potential lawsuits filed by debtors.
As the buyer may use a special purpose vehicle for the acquisition of non-performing loans, and the assets of such vehicle decrease in relation to the non-performing loans (collections proceeds are distributed to investors), the seller will require other guaranties not depending on the acquiring vehicle, such as a direct guaranty from the investors and the servicer.
It is necessary to clearly state in the assignment agreement how the burden of these liabilities will be distributed between the seller and buyer (e.g. cut-off dates, caps).
2.3. Agreements with collection agencies and law firms
Lawyers in charge of collection with regard to a distressed portfolio, have an incentive to claim their legal fees, considering that any agreed cap with the seller, is not enforceable by the acquirer of the portfolio unless the lawyers has consented to such transfer. As the lawyer would see the buyer as a one-off player, the lawyer will typically attempt to maximize his or her fees.
When a non-performing loan is assigned in a judicial stage, the agreement with the lawyer in charge of the lawsuit should also be assigned.
The possibility of replacing those lawyers/agencies that do not agree to continue the relationship with the buyer under equal conditions as those agreed with the seller, could be considered. However, taking into consideration the length of these processes (moreover when they are judicial) and that the lawyer has been involved during the entire process, sometimes the replacement of a lawyer could generate significant costs.
2.4. Assignment costs
An item that is commonly analysed by people in charge of appraising non-performing loans, is the assignment costs, particularly those derived from notification to debtors (Argentine law requires a "public act" for certain loans). In order to reduce theses costs, it is advisable to have the assignment agreement provide that notifications will be delivered only when strictly necessary, and meanwhile the seller will grant an irrevocable power of attorney to the buyer in order to allow it to service the loans and collect payments.
3. Tax Issues
Acquisitions of large distressed portfolios pose many different tax issues in Latin American countries -- some of which, if not properly addressed, can make the transaction impossible. Below, the authors consider Argentine tax issues that are most representative of those normally arising in the region.
3.1. Income tax: general rules, valuation of loans, bad debt allowance
The Income Tax Law establishes a national tax on worldwide net income at a rate of 35%. In principle, a tax deduction is allowed for all ordinary and necessary expenses incurred in earning taxable income (including interest, salaries and taxes). However, the Income Tax Law provides specific rules for discharging uncollectible loans as "bad debts". The Income Tax Law Regulatory Decree provides that the discharge of uncollectible loans as bad debt will be allowed only if certain events occur, namely:
- the debt arises from a business transaction;
- the bad debt is deducted in the corresponding fiscal year; and
- uncollectible indices are proved.
The uncollectible index includes the commencement of legal action. However, in many cases, especially in the case of large portfolios, the commencement of legal action is inefficient, when comparing the size of the debt with the legal costs involved.
The Income Tax Law does not contain specific provisions regarding the purchase of distressed debt portfolios. The main tax issue related to the purchase of a distressed debt portfolio is the valuation of the debt and its relation to the application of bad-debt rules and the market. In this context, there are generally three positions:
- the loans should be recorded at their nominal value. At the end of the fiscal year, the assignee should record the loans at their nominal value. This alternative implies that the assignee should recognize, in the year of the acquisition of the loans, taxable income arising from the difference between the acquisition cost and the nominal value of the loans. This position would make the transaction impossible, as it would oblige the recognition of massive and fictitious gains and, in general, is not followed by taxpayers that are engaged in this type of business;
- the loans should be recorded at their acquisition value. The loans should be recorded at their acquisition value and a bad debt allowance deduction is allowed only when the uncollectible index applies to the buyer. For instance if the portfolio includes loans that are being legally foreclosed, the acquirer would need another index (which is often impossible); and
- if the loans show an uncollectible index at the moment of acquisition, the assignee may deduct the acquisition cost of the loan as a bad debt. This position implies an immediate deduction and is the one that is most consistent with the business; in practice, it implies taxation on a cash basis rather than on an accrual basis, but does pose other issues. Generally, in large portfolio acquisitions there is no valuation of single loans; instead, the valuation corresponds to baskets of loans. For instance an overall price is established for mortgage loans, another for pledge loans and another for consumer loans without any type of collateral. Depending on the case, a whole basket may be considered as a bad debt, or further analysis may be required
3.2. Value added tax
In Argentina, unlike most other Latin American countries, financial transactions are subject to VAT. The difference between the final value of a loan and its purchase price is considered an "interest" subject to VAT. In other words, the discount is subject to VAT at a rate of 21%. The assignee would have a VAT tax debit (because the assignee is financing the seller), and the seller would have a VAT tax credit. The amount of VAT involved in the type of transaction may make the transaction impracticable. Say for example the final value of the loan is 1,000 and the purchase price is 100; the difference of 900 would be subject to VAT at a rate of 21%. In this case VAT would be 189. The amount of VAT to be remitted to the tax authorities (189) is higher than the purchase price (100).
The solution that was selected by the market was to perform this transaction through a financial trust because this structure has different legal and regulatory advantages and, under trust law, the assignment of loans to a trust is not subject to VAT. A financial trust is the vehicle that is generally used in Argentina to carry out this type of transactions.
Under trust law, a trust agreement is formed when a person (trustor) transfers specific assets to another person (trustee), who is required to exercise the rights to such assets for the benefit of a third party or parties designated as such in the agreement (beneficiary) and, upon termination of the trust, to transfer the trust assets to the trustor, the beneficiary or the trustee as provided by the agreement. A financial trust agreement is a form of trust agreement that is characterized by having a financial entity or a company specially licensed by the Argentine Stock Exchange as trustee, and the holders of the debt securities or the certificates of participation backed by the trust assets as beneficiaries.
Under trust law, if a trust is properly formed, the trust assets form a separate estate from the assets of the trustee, the trustor and other trusts held by the same trustee. The property of a trust may not be reached by claims brought by creditors of the trustee or the trustor, except in cases of fraudulent conveyance.
3.3. Turnover tax
Turnover tax is a local tax on sales. Each Argentine province and the City of Buenos Aires have their own legislation. In general, the taxable event for turnover tax purposes is the usual performance of an activity for value in the jurisdiction, and the tax base is the profit obtained for the performance of such activity. For the assignment of loans, the tax rate varies depending on the jurisdiction, but generally ranges from 4% to 5.5%. As in the case of income tax, there are differing positions regarding the determination of the profit arising from this transaction, the most significant of which are that (1) the profit of the transaction should be recognized loan-by-loan or (2) the profit of the transaction should be recognized globally.
For example the loan portfolio includes Loan A, Loan B and Loan C. The assignee collects only Loan C and does not collect any amount on Loan A or Loan B.
If the profit of the transaction should be recognized loan-by-loan, the assignee would have to pay turnover tax on Loan B even if globally, the assignee did not recover the investment. The assignee collected 12 and the purchase price was 3, therefore he or she obtains a profit of 12 subject to turnover tax. However, globally, the assignee invested 14.25 and recovered only 12.
If the profit of the transaction should be recognized globally, the assignee would not have to pay turnover tax because the profit of the transaction is determined globally. The assignee collected 12 and the purchase price was 14.25. Therefore, the assignee did not obtain a profit for turnover tax purposes.
The second alternative reflects the business more accurately. The assignee acquires a distressed debt portfolio as whole, rather than individual loans.
3.4. Stamp tax
Transaction costs could be very relevant when assigning a large portfolio of distressed loans. These costs include stamp tax. Stamp tax is a local tax levied on contracts for consideration, evidenced in writing, which are executed in the relevant jurisdictions within Argentina, or which are executed abroad, when their effects are produced in one or more relevant jurisdiction within Argentina. The definition of "effects" varies under different local tax codes. However, the definition in most codes includes acceptance, protest and negotiation of the agreement, performance, and the commencement of enforcement proceedings.
The tax basis for the assignment of loans is the greater of the purchase price or the nominal value of the loan. The tax rate is generally 1%, although a higher rate of 1.5% may be applicable for assignments of loans guaranteed by a mortgage. As this tax may imply a significant cost for this type of transaction, there is a well-developed practice in Argentina in connection with the execution of agreements whereby they are entered into through an offer followed by a separate acceptance by which no instrument subject to stamp tax would be created. There are many judicial precedents (including the Argentine Supreme Court) that confirm that this structure works. However, this strategy is not useful with certain type of loans the assignment of which requires a public deed (e.g. mortgage loans). In these cases, other alternatives could include cash-flow assignment or assignment under a judicial procedure in the case of loans that are the subject of litigation.
* Marval O'Farrell & Mairal, Buenos Aires.
*** Recovery SA, Buenos Aires.
1. George A. Akerlof, "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism", 84 The Quarterly Journal of Economics 3 (August 1970), at 488.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.