structuring real estate loan covenants, events of default...

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

Structuring Real Estate Loan Covenants,

Events of Default Provisions, and

Representations and Warranties Negotiating Agreement Provisions to Maximize Borrower Protection and Lender Remedies

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, MAY 11, 2016

Mairi V. Luce, Partner, Duane Morris, Philadelphia

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

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Structuring Representations and Warranties, Loan Covenants, Events of Default and MAC Clauses

Effective Provisions to Maximize Borrower Protection and Lender’s Remedies

Overview

• Representations and Warranties

• Loan Covenants

• Events of Default

• MAC Clauses

6

Representations and Warranties

• Nature of Representations/Warranties: It’s a story. • Information to enable Lender to make credit decisions

• What’s included? • Corporate/organizational

• Financial

• Operations (e.g., payment of taxes and claims)

• Title

• Condition of Property

• Environmental

• No other liens, etc.

7

Reps and Warranties (cont’d)

• Other things for Lenders to consider: • Reps and Warranties are risk-shifting mechanism

• Part of the consideration for Lender’s agreement to extend credit

• A breach is an Event of Default; may give rise to fraud claim

• Not about knowledge

• Borrower Considerations • Knowledge/Verification

• Right person in company with institutional and historical knowledge

• M&A Environment: alignment of purchase reps and warranties with credit reps and warranties

• Materiality Issues

• When in doubt, disclose? Or withhold? 8

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

9

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

10

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

11

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

• Build to manage anticipated operational issues

12

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.

13

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” 14

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

15

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

16

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)

17

Affirmative Covenant: Inspections

• Physical inspection of Premises

• Environmental testing

• Tenants

• Borrower Considerations:

• Type and Frequency

• Advance Notice

• Party conducting inspection

• Confidentiality and privacy issues

• Per diem costs and charges

18

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


• Capital structure

• “Permitted Indebtedness” • PMSI and Capital Leases

• Real Property Leasing Costs • Security deposits, brokerage commissions, tenant improvements

• Carve-Outs for Disputes • Taxing authorities

• Vendors/Suppliers

• Other Financing Arrangements 19

Negative covenant: Liens

• Rationale: Protect collateral from actions by other lienholders

• Lender always first mortgage holder

• Some standard exceptions


• Permitted indebtedness

• 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

20

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

21

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

22

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 23

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

• Predictable business fluctuation issues (e.g., seasonality)

• Testing frequency and periods

• Reporting and certification 24

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

25

Financial Covenant: Guarantor Liquidity

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

• Typically, cash and cash equivalents

• Marketable securities?

26

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

27

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

28


• “…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

29


• 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

30

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

31

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, account debtors, major tenant)

• Borrower’s “nuclear” option: bankruptcy

32

Events of Default: Change of Control

• Rationale: Lender wants to know its Borrower

• Underwriting issues, business dependent upon ownership and/or management team

• 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

33

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.

34

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

35

Thank You

Mairi V. Luce

Duane Morris

[email protected]

Christopher W. Rosenbleeth

Stradley Ronon Stevens & Young

[email protected]

36

mailto:[email protected]

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