This post was written by Maura O’Connor an attorney with Seyfarth Shaw LLP. I have subscribed to RSS feeds with Globe Street for a long time. This article and other posts will be of great benefit to those of you who are upside-down on commercial properties. Read-On:
Continuing from last week, here are more points of potential leverage for borrowers facing potential workouts or foreclosures. A borrower should figure out its position and points of leverage before proposing a workout to its lender.
Review the loan documents (including guaranties and correspondence). Or have new counsel do so. It’s a good idea to bring in new counsel to look at the deal documents, because new counsel will bring in fresh eyes, and will be able to see what’s actually written in the loan documents, rather than what counsel that did the original deal thinkswas done. (It’s simply human instinct to see what one thinks is there.) Obviously the new counsel should be experienced in real estate workouts in the state where the property is located, as there are lots of subtle legal issues that are state-specific in this area. (See my response to Selina Parelskin’s letter on the first week’s post for some of the California issues and a war story — the names have been omitted to protect the guilty. In the current market, we’re unfortunately seeing a lot of real estate and other transactional lawyers — even former municipal law lawyers — reinventing themselves as workouts lawyers. While it is certainly possible to learn a new area, in many states including California, the law about how to enforce loans secured by real estate is technically very complex and quite difficult, and we’re frequently dismayed by the low caliber of advice given by some lawyers to their borrower or lender clients in this arena — it is very common to see basic issues simply missed altogether.)
It is not uncommon for loan documents to contain flaws that could affect their enforceability — or could at least give the borrower some leverage in a workout. About 1 out of every 2 or 3 deals we see has had at least one major documentation problem that could be used by a borrower to increase its leverage. For example, a few problems I’ve seen over and over in 20 years of practice are the failure to attach the proper legal description; inadequate or ineffective guaranty waivers (there’s one of 3 needed waivers that is frequently missed in California); and incorrect UCC filings (very important in loans secured by certain asset types: you can’t run a hotel after foreclosure without its beds, furniture, etc.).
Also, sometimes correspondence with the lender will disclose that the lender agreed to do certain things, and has not done so; this can provide leverage to the borrower.
Basically, a business and legal review of the property and the loan documents should be done to fix any potential defaults or similar problems the borrower can fix (such as a failure to deliver required information that could trigger a default) and to develop leverage. That allows the borrower to make a proposal reflecting a practical solution to the problems facing the property that is likely to be accepted by the lender.
Maintenance and waste. Early in a workout, a key issue for borrower/owners will be to make sure that the property is not wasting (generally having its value significantly diminished by lack of care).
Specifically, borrowers should assess and confirm that the condition of the property doesn’t deteriorate to where it triggers covenant breaches that make it more likely the lender will foreclose rather than doing a workout.
Also, it’s fairly common for “non-recourse” loans to have a carve-out, reimposing personal liability, for some grave defaults often including significant waste. In such cases, it’s in the borrower’s interest not to risk personal liability by letting the improvements start to fall apart.
Insurance coverages. Financed owners should check their casualty and liability insurance coverage for the property, to confirm that adequate coverage is in place; premiums are paid; and all needed policies are up to date, in force, and sufficient to satisfy any loan covenants about mandatory minimum coverage.
Other areas of personal or pass-through liability. Another set of issues, where the borrower should analyze the situation and try to get ahead of the game, is any other loan document clauses that give the lender direct right against assets beyond the property itself … like the borrower’s principal (if the borrower is a corporation, LLC or other entity) or any guarantors.
At the outset of a possible workout, a borrower should carefully check whether:
- There is an unfulfilled capital contribution obligation, a possibility of future mandatory capital calls.
- There is an argument that the property’s ownership vehicle is undercapitalized and can be ignored (sometimes called “veil-piercing”), and liabilities passed through to the next level of ownership.
- There is personal liability for real estate taxes.
- There is a guaranty (or arrangement that amounts to a guaranty) that can be called.
- The legal fees incurred by one party in a default or workout must be reimbursed by, or can be demanded from, the other side.
- If an investor and developer are in partnership (or similar arrangement), what further calls or liability can be placed on the investor.
- Officers, directors or partners have personal liability for actions taken or not taken … and whether there is directors and officers insurance in place to address those risks.
- What exactly has been granted as collateral for the loan? There may be omissions that the lender will wish to see corrected. A borrower can sometimes agree to correct such omissions in order to negotiate for concessions it needs to work out the loan and return the project to profitability.
Only a thorough legal review up front by experienced local real estate workouts counsel will give the borrower the understanding of its situation and potential liability that will allow it to do a thorough business review and to then understand what the best possible outcome is — and negotiate a workout that moves as much in that direction as possible under the circumstances.
More on workouts from the lender side to follow, and a new thread shortly. If you have ideas for topics to be addressed, questions, concerns, agreement/disagreement or other comments, just let me know.