Commercial Real Estate Loans: Structuring …media.straffordpub.com/products/commercial-real-estate...2013/11/26 · Commercial Real Estate Loans: Structuring Covenants, Events of

Commercial Real Estate Loans: Structuring Covenants, Events of Default Provisions and MAC Clauses Negotiating Agreement Provisions to Maximize Borrower Protection and Lender Remedies

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TUESDAY, NOVEMBER 26, 2013

Presenting a live 90-minute webinar with interactive Q&A

Christopher W. Rosenbleeth, Esq., Partner, Stradley Ronon Stevens & Young, Philadelphia

Mairi V. Luce, Partner, Duane Morris, Philadelpia

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Structuring Loan Covenants, Events of Default and MAC Clauses

Effective Provisions to Maximize Borrower Protection and Lender’s Remedies

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Christopher W. Rosenbleeth Stradley Ronon Stevens & Young 215.564.8051 [email protected]

Mairi V. Luce Duane Morris 215.979.1538 [email protected]

Overview

• Loan Covenants

• Events of Default

• MAC Clauses

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Nature of Loan Covenants

• Relate to future actions

• Limitations on actions that adversely affect: • Ability of Borrower to repay debt

• Rights of Lender or ability of Lender to enforce its rights

• Often the most negotiated provisions in loan documents (along with defined terms)

• Generally speaking, all business points

• Negotiating at commitment stage vs. loan document drafting stage

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What are covenants?

• Promises from Borrower • Covenants can be:

• Affirmative (“Borrower will…”) • Negative (“Borrower will not…”) • Financial (i.e., requirements for financial performance)

• Incurrence: Borrower must not take an action that pushes a financial ratio beyond a specified level.

• Maintenance: Borrower must maintain at all times a certain financial ratio

• Collateral (i.e., requirements with respect to collateral)

• Covenant “Lite” vs. Covenant Heavy • First Tier Loans That Emerged From Default Q4 2008-Q1 2011

• Covenant “Lite”-89.6% • Covenant Heavy-81.5% • Source: Moody’s “Covenant-lite Defaults and Recoveries: Seeing Where it

Hurts”; June 7, 2011

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What are covenants?

• Power Balance Between Lender and Borrower

• Appropriate limits vs. Operational Flexibility.

• Covenant Violation=(Technical) Default

• Power Shifts to Lender to Determine Remedial Steps

• Limit Borrower’s Ability to Maneuver In Light of Weak Financial Performance

• Generate Fees For Lenders/Create Distractions For Borrowers

• Overarching Issues Between Lender and Borrower

• Relationship to credit/underwriting

• Materiality and reasonableness

• Extra obligations

• Extra burdens

• Flexibility

• Third parties

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What are covenants?

• Overarching Issues Between Lender and Borrower (con’t)

• Strengthening borrower bargaining position

• Manage risk

• Use credible data to back up requests

• Build relationships

10

Affirmative Covenants

• Typical examples:

• Financial Reporting

• Collateral Reporting

• Payment of obligations

• Taxes

• Notices

• Affirmative covenants should not require the borrower to do something it is not already doing.

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Affirmative Covenant: Financial Reporting

• What must be delivered?

• Financial statements

• Tax returns

• Rent roll

• Timing of delivery

• Audit vs. review vs. internally prepared

• Borrower Considerations:

• Preparation Time

• Costs

• Auditor certification of “No Defaults” 12

Affirmative Covenant: Payment of obligations

• All other obligations must be paid, as and when due

• Other debt secured by collateral

• Contractual obligations

• Taxes

• Protection against other creditors

• Materiality of Debt

• Grace Periods

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Affirmative Covenant: Notices

• Things Lender should (or wants to) know:

• Default/Event of Default

• Impairment of collateral

• Litigation against a credit party or with respect to collateral

• Borrower Considerations

• What constitutes notice

• How to give

• Where to send

• Frequency/limitations

• Required forms and attachments

• Accompanying certifications

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Affirmative Covenant: Insurance

• Borrower to carry insurance covering:

• Property damage (Lender named as mortgagee/loss payee)

• Liability (Lender named as additional insured)

• Premiums paid in advance

• Escrowing premiums


• Broker Review of Insurance Provision

• Industry Standards For Types of Insurance and Coverage Limitations

• Business Interruption

• Property and collateral specific issues (flood certifications)

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Affirmative Covenant: Inspections

• Physical inspection of Premises

• Environmental testing

• Tenants

• Borrower Considerations:

• Type and Frequency

• Advance Notice

• Party conducting inspection

• Confidentiality and privacy issues

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Negative Covenant: Debt

• Rationale: Lender decision to make loan based on financial wherewithal of Borrower at closing

• Keeps Borrower from becoming over-extended

• Protection against other creditors

• Borrower Considerations • Capital structure

• “Permitted Indebtedness” • Leasing Costs

• Brokerage commissions, tenant improvements

• Carve-Outs for Disputes • Taxing authorities

• Vendors/Suppliers

• Other Financing Arrangements 17

Negative covenant: Liens

• Rationale: Protect collateral from actions by other lienholders

• Lender always first mortgage holder

• Some standard exceptions

• Borrower Considerations • Title insurance policy

• Existing zoning and building ordinances and land use regulations

• Liens in favor of Lender

• Approved leases

• Tax and assessment liens

• Liens approved by Lender

• Carve-Outs for Disputes

• Subordinated debt

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Negative Covenant: Transfers

• No sale, lease, transfer of ownership interests

• Rationale: Protect Collateral

• Other Rationale: Lender comfort with equity group

• Regulatory concerns: PATRIOT Act


• Permitted Transfers • Notice to and consent of Lender

• Permitted mergers: 1) of subsidiaries into borrower; 2) of subsidiaries into each other; 3) where borrower is surviving entity

• Transfers among existing equity holders • Notice to Lender

• Change of control triggers

• “Know Your Customer” compliance

• Requirements for continued ownership

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Negative Covenant: Organizational Documents

• No amendments to organizational documents

• Rationale: Maintain lien priority

• Second rationale: Borrower structure “vetted” by Lender


• Clean-up issues in conjunction with loan closing

• Advance notice to and consent of Lender for post-closing changes

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Negative Covenants: Leasing

• Typically, leases pre-approved or terms pre-approved

• Underwriting varies based on property use

• Rationale: Lender makes loan based on assumptions about income

• Borrower Considerations • New leases or modifications/amendments to existing leases

• Defining parameters pursuant to which Lender’s consent will not be “unreasonably withheld”

• Assignment of leases to Lender

• Borrower’s performance under leases

• Tenant estoppel notices

• Security deposits 21

Financial Covenants

• Pre-2007-08: Real estate loans soft on financial covenants

• Post-2007-08: Proliferation of financial covenants in CRE

• Typical:

• Debt Service Coverage Ratio

• Guarantor Liquidity


• Length of loan vs. financial projections

• Seasonality issues

• Testing frequency and periods 22

Financial Covenant: Debt Service Coverage Ratio • Rationale: Ensure property generates sufficient cash flow to

service debt

• Net Operating Income • Gross income or revenues, but excluding any unearned income,

proceeds from hazard insurance or condemnation awards, security deposits, and prepaid rent, less (ii) all operating expenses.

• Exclude loan receipts and payments from calculation

• Debt Service • Principal and interest payments on Loan

• Include subordinated debt secured by real property

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Financial Covenant: Guarantor Liquidity

• Rationale: Ensure Guarantor(s) has sufficient liquidity to repay debt

• Typically, cash and cash equivalents

• Marketable securities?

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Events of Default

• Generally, dictates when a Lender can exercise remedies No automatic acceleration, except upon bankruptcy

Lender concerns

• If transaction has guarantors, Events of Default should cover both Borrower and Guarantors

• Can be heavily negotiated, though standard terms are fairly well-developed

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Events of Default (cont’d)

• “Default” vs. “Event of Default”

• “Event of Default”

Defined set of circumstances

Cannot be cured

Repeat: CANNOT BE CURED

• “Default”

Any event, occurrence, condition which, with giving of notice or passage of time or both, would constitute Event of Default

Can be cured

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• “…and is continuing…”

Again, Events of Default cannot be cured

• What if Borrower insists?

The occurrence of any one or more of the following events shall constitute an “Event of Default” hereunder (which shall be deemed continuing until waived in writing by Lender)

Lender, not Borrower, makes this determination

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• Borrower Considerations • Lender reluctance to negotiate

• Curable events of defaults

• Monetary events of default • Limited number of notices/year

• Notice before certain remedies are exercised

• Fees

• Non-monetary events of default • Notice and opportunity to cure

• Limited cure opportunities

• Threshold limitations

• Material adverse change

• Cross-defaults • Scope and materiality of the agreements triggering cross-default

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Events of Default: Cross-Defaults

• Default under other debt gives rise to Event of Default

• Another reason to limit additional indebtedness


• Other debt owed to lender

• Debt owed to third party

• Triggering events

• Cure opportunities

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Events of Default: Insolvency

• Voluntary vs. involuntary bankruptcy

• Automatic acceleration of debt


• Timing issues for involuntary bankruptcy filing or other remedies exercised against borrower

• Insolvency of other entities (principal, guarantors, major tenant)

• Borrower’s “nuclear” option: bankruptcy

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Events of Default: Change of Control

• Rationale: Lender wants to know its Borrower

• PATRIOT Act concerns


• Consistency with “No transfers covenant”

• Same considerations

• Transfers among existing equity holders

• Notice to Lender

• Change of control triggers

• “Know Your Customer” compliance

• Continued ownership

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Events of Default: Material Adverse Change • Pre-2007: Not prevalent in CRE • Post-2008: Increasing presence in CRE deals

• “Material Adverse Change” means a material adverse change in (a) the condition (financial

or otherwise), operations, assets, liabilities, business, or prospects of the Borrower and its Subsidiaries, taken as a whole, or (b) the ability of the Borrower to repay the Obligations or the ability of any Subsidiary to perform their respective obligations under the Loan Documents, or (c) the rights and remedies of the Lender under the Loan Documents, or (d) the legality, validity or enforceability of any Loan Document or (e) the Liens granted the Lender pursuant to the Security Documents.

• “Material Adverse Effect” means (a) a material adverse change in, or a material adverse effect upon, the operations, business, properties, condition (financial or otherwise) or prospects of the Borrower, any Material Subsidiary or the Borrower and its Subsidiaries taken as a whole; (b) a material impairment of the ability of any Loan Party to perform its obligations under any Loan Document to which it is a party; or (c) a material adverse effect upon the legality, validity, binding effect or enforceability against any Loan Party of any Loan Document to which it is a party; or (d) a material adverse effect upon (i) the perfection or priority of any Lien granted under any of the Collateral Documents; provided that the Collateral covered by such Lien has a fair market value, individually or in the aggregate, in excess of $1,000,000.

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Events of Default: Material Adverse Change

• Difficulties for Lender in calling MAC event of default

• “Industry standard’ for pure real estate loans?

• Define thresholds for the definition of “material” the scope of this possible Event of Default

• Borrower’s options for MAC

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