Casualty and Condemnation Provisions in Loan Agreements

Every mortgage loan agreement contains provisions that address casualty and condemnation (i.e., eminent domain) affecting the property.  All such provisions give the lender some degree of control over the proceeds and identifies what happens to the proceeds, and are usually given scant attention. However, these provisions often can be negotiated, at least with respect to how the proceeds are handled for any restoration of the property.

As a borrower, a property owner doesn’t want to be hamstring with red tape if the proceeds are not material, and a lender shouldn’t want that either. However, a lender needs to protect its security interest in the property.  The trick is to determine where to draw the line.

Typically, the loan agreement includes casualty and condemnation provisions that simply provide all proceeds from such events go to the lender, which may be applied to paying down principal on the loan.

Consider the following scenario, a new storm sewer is scheduled for construction along the road where mortgaged property is located. Eminent domain is being utilized to take a tiny sliver of the properties adjacent to the road. The amount of property to be taken has no material impact on the value of the mortgaged property and accounts for maybe 1-2% of the property.  However, if the loan agreement’s condemnation provision does not include a materiality threshold then the borrower will need to notify the lender, pay a few thousand in fees to the lender to cover its legal fees and contend with red tape over the use of the proceeds.

Typical approaches to identifying what condemnation or casualty events are material include a dollar threshold and a percentage of the property that is affected. When such an event does not trigger these thresholds then the borrower will retain all or some level of control over how the insurance or condemnation proceeds are spent.

For example, a restoration threshold will typically be set at around 5% of the outstanding principal balance on the mortgage loan. Therefore, if the proceeds the result from the casualty or condemnation event do not exceed that threshold then the lender is more likely to permit borrower to keep the proceeds.

Additionally, a lender will want to look at how the property is functionally affected by such events. For example, if the land taken by eminent domain is less than 10%, the percentage of leases that remain in full force and effect after a casualty event exceeds 75% or the less than 35% of the improvements were destroyed, then the lender will be more likely to permit the borrower to restore the property and, depending on other criteria, receive the proceeds for restoration.

When negotiating loan agreements, borrowers should give some attention to the casualty and condemnation (eminent domain) provisions, with the goal of obtaining as much flexibility as possible.
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CBMS Loan Negotiation--Proactive Approach Could Save Time and Money

CMBS loans (loans that will be packaged with similar loans and securitized as commercial mortgage backed securities) continue to be popular despite their rigid structure and higher costs. Many commercial real estate owners like CMBS loans for their nonrecourse nature, absent the commission of certain ‘bad acts’ by the owner/guarantors, and will pay the extra costs to limit their exposure on the loans.

 

When considering a CMBS loan there are a few items to address early on in the process that could have significant impact on the costs for closing the loan. 

 

Borrower Structure—CMBS loans rely on the mortgaged asset being held in a bankruptcy remote entity that meets specific criteria in how the borrower is structured and operated. A lender wants to protect the asset from being consolidated with the assets of other related entities that may become bankrupt.  The borrower should provide copies of its organizational documents earlier on in the process. Time is needed for lender and its counsel to review and provide comments on the documents and for the borrower and its counsel to revise as necessary. Sometimes, the ownership structure itself is a problem and new entities will need to be formed. If this process is delayed until later in the loan process, then extra fees will be incurred to pay for expedited processing of the new entities in time for closing.

 

Independent Managers/Springing Members—Depending on the size of the CMBS loan, the lender may require an independent manager be retained whose sole responsibility is to vote on whether the borrower should file for bankruptcy protection or not. Springing members are often required when the borrower is a single member LLC. If the sole member of an LLC were to cease to exist, it would trigger the automatic dissolution of the borrower entity. Under Delaware law, the LLC can provide in its operating agreement for a new member to ‘spring’ into place and keep the LLC in operation.  Since retaining an independent manager requires paying fees to a service provider for someone qualified to act in this role, a borrower would want to have this requirement waived whenever possible. If the loan is small enough, the borrower will likely be successful in obtaining a waiver. Regarding the need for a springing member, loan size again may dictate who can serve as the springing member. Some lenders will allow any individual associated with borrower to serve as the springing member, aka “special member.” Others require that the springing member be unaffiliated. The borrower would then incur additional fees to retain someone to act in that capacity; typically from the same service provider who provides the independent manager.

Governing Law—CMBS loan documents are typically governed by New York law, which then leads to the requirement for certain enforceability legal opinions from a New York attorney and also for the need of an agent located in New York to receive service of process on the borrower’s behalf. If the loan is small enough, and the borrower raises the issue with the lender, the governing law might be changed to the state where the property is located, eliminating the need for an additional legal opinion ($5,000+ saved) and an agent in New York for service of process ($1,000+ saved). At a minimum, many lenders will waive the need for the agent in New York on smaller loans.

Legal opinions—CMBS loans typically require more legal opinions in their financing opinion letters than local banks might require. The more complex the legal opinions, the more time required of the borrower’s counsel and therefore the higher the fee. Also, if the property is in a different state from where the borrower and its counsel are located, then a legal opinion from counsel in the real property state will also be required (add a few thousand more to the closing costs). Further, depending on loan size, ownership structure and the policies of a lender, additional legal opinions may be required, some of which can be quite expensive.  It’s important that the borrower confirm early in the loan process exactly what the lender will require. Some of the opinion letters may require extensive case law research to be conducted plus the retention of counsel in other states. Sufficient time needs to be provided for this.

Clearing/Lockbox Accounts—CMBS loans will also require some level of cash management to protect the lender’s security interest in the rents collected from tenants.  Selection of the bank to handle the clearing account (i.e., lockbox) can take some time.  Because an agreement will need to be negotiated among the lender, the clearing bank and borrower, negotiations often break down when the clearing bank wants changes that a CMBS lender is not able to give. This results in the borrower scrambling around to find a new bank who will sign the lockbox agreement. The paperwork needed to set up a bank account these days is not simple and it can take a couple days before the account is in place for closing.

 

Because of the above and other issues, negotiation of a CMBS requires a proactive approach by the borrower and its attorney. A failure to establish exactly what will be required or not early in the loan process can lead to delays in closing later and added costs to the borrower.

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CMBS Litigation: The Guarantor Actually Wins One

On April 7, 2014, the US District Court in the Southern District of New York granted summary judgment in favor of the Guarantor in CP III Rincon Towers, Inc. (Plaintiff) v. Richard Cohen (Defendant) (No. 10 Civ. 4638 (DAB).   The substance of the court action revolved around a CMBS mortgage loan on property located in San Francisco, CA that had gone into default. The Plaintiff was attempting to recover the full outstanding amount owed under the loan from the Defendant alleging that the violation of certain “bad boy” provisions under the Guaranty executed by the Defendant triggered full recourse liability.

The borrower on this loan was delinquent on certain owner’s association fees, the amount of which it was disputing with the owner’s association. The borrower had also not paid certain contractor invoices due to a dispute over the work completed. These disputes, combined with nonpayment of the related invoices, resulted in liens being filed on the mortgaged property. 

The Plaintiff, in filing its action against the Defendant, alleged that the resulting liens on the property violated three full recourse provisions in the Guaranty: the “voluntary Lien, Indebtedness (without lender’s prior consent) and Transfer.”   The Defendant moved for summary judgment in its favor stating that the liens in question did not fall under either of these 3 provisions and therefore did not justify the Defendant being subject to full recourse liability.  

The Court agreed with the Defendant.  

In negotiating the Guaranty with the Plaintiff’s predecessor who negotiated the loan, the Defendant and his counsel were quite aggressive in pushing back on the form language in the agreement. Kudos to the Defendant’s counsel for doing his job well.  The takeaway for any would-be borrower or guarantor is to not blindly accept the CMBS loan documents and assume there is no room for negotiation. There is. The so-called bad boy provisions that trigger loss recourse and full recourse on the CMBS loans are broadly drafted and, from the perspective of a borrower or guarantor, need to be tightened up. Borrowers and guarantors who sign commitment letters and term sheets with these provisions already contained within the commitment document are acting foolishly, as they have pulled the rug out from under their lawyers and have undercut their ability to do their job.  

In this court action, the Plaintiff had attempted to argue that the actions or inactions of the borrower, by not paying invoices on time and/or disputing amounts, where voluntary choices and therefore the resulting liens should be categorized as “voluntary.”  The court didn’t buy into the Plaintiff’s argument, finding instead that mechanic’s liens arise by force of statute, not by an agreement of the parties. The court also held that judgment liens are imposed on the losing party and again, cannot be construed as voluntary. Strike one against the Plaintiff.  

Second, while both parties agreed that the resulting liens on the mortgaged property was properly viewed as indebtedness, the loan agreements clearly limited the full recourse trigger to indebtedness that was incurred without the lender’s prior written consent. The court interpreted this to mean it only addressed situations where a lender’s prior written consent is required before entering into the indebtedness, liability or obligation. The borrower did not need lender’s consent before starting construction or paying association fees, therefore the court held that the circumstances in this case did not fall under the full recourse provision.  

Finally, the Plaintiff argued that the liens on the property should be considered a “Transfer” which was broadly defined in the loan documents to include acts that “encumber” the mortgaged property. The court reviewed the interpretations argued by both parties and found the language to be ambiguous. It then looked outside the terms in the loan documents and revised the negotiations of borrower and lender prior to entering into the loan. Based on such external (i.e. “extrinsic evidence”), the court held that the parties clearly never intended these sorts of liens to trigger full recourse liability. 

The bottom line for parties on CMBS loans—Negotiate to protect your interests. It is important to clarify what will and will not trigger full recourse or loss recourse liability. From a borrower perspective, narrower, more specific provisions are better. A borrower also needs to review how these provisions might be unwittingly triggered by borrower’s standard operational procedures or even the simple desire to restructure ownership for estate planning purposes. Finally, work to ensure the language in the agreements clearly reflects everyone’s intentions. Otherwise, a court will interpret it for you.

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CMBS "Bad Boy" Clauses: More Fallout From Court Decisions

As we have addressed in prior blog posts about “bad boy” clauses in a CMBS loan, if any of these provisions are violated, the nonrecourse nature of the loan will be partially or completed negated depending on which provision is violated.

 

Courts typically interpret these clauses very strictly and that has come back to bite both the borrowers and guarantors and the lenders.  For example, in Euclid Housing Partners, Ltd., et al. vs. Wells Fargo Bank, NA, as Trustee, 2012 Ohio Misc. Lexis 16 (Ohio Ct. of CP 2012), the guarantor had loaned funds to the borrower, likely in a vain attempt to keep the borrower and mortgaged property solvent and prevent a payment default. However, the loan agreement prohibited the borrower from incurring any other debts and the guarantor’s loan was made without obtaining lender’s prior consent. Because guarantors are often majority owners of the borrowers, it’s not surprising that the guarantor in this case provided the funds to the borrower.  However, that one action cost the guarantor more than he bargained for. It violated one of the “bad boy” provisions and subjected him to full recourse liability. Ironically, had he just put the money into the borrower as a capital contribution instead of a loan, the loan would have remained nonrecourse.

 

On the flip side, in GECCMC 2005-C1 Plummer Street Office Limited Partnership vs. NRFC NNN Holdings, LLC, 204 Cal. App. 4^th 998, 2012 Cal. App. LEXIS 366 (2012), it was the lender that had to live strictly by the loan terms and was unsuccessful in seeking full recourse against the guarantor.  The mortgaged property was leased to Washington Mutual Savings and Loan (“Washington Mutual”). When Washington Mutual went out of business and abandoned the property, the lender foreclosed on the mortgage and then pursued the guarantor for the deficiency balancing claiming that Washington Mutual’s leaving the property was tantamount to a termination of the leases without lender’s consent, a violation that would trigger full recourse against the borrower and the guarantor. The court disagreed, finding the lender’s interpretation to be stretching it a bit. The borrower did not take action to terminate the lease, and the court found that the lease continued to exist despite the tenant’s abandonment.

 

Despite the significant consequences if these “bad boy” clauses are not followed, many borrowers and their attorneys give inadequate attention to their terms. Worse, some CMBS lenders are putting these critical loan provisions in their term sheets, and the borrowers and guarantors are signing the term sheets before bringing their lawyers into the deal. This effectively ties the lawyers’ hands and prevents them from taking steps to protect the borrowers and guarantors.