Unintended Potential For Disaster In Gov't Economic Lifelines

By Joseph Jones
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Law360 (April 20, 2020, 4:45 PM EDT) --
Joseph Jones
Business owners of all types and sizes are rushing around in a mad dash for cash applying for the economic lifelines offered by the Coronavirus Aid, Relief and Economic Security, or CARES, Act; Small Business Administration programs such as the Paycheck Protection Program; the enhanced Economic Injury Disaster Loan program; or any other economic relief offered by local, state or federal funding sources.

No one could have anticipated the impact, momentum and trajectory that COVID-19 has had on the economy and commercial real estate.

To mitigate the near supersonic economic decline, federal, state and local governments are patching together stimulus legislation and relief programs of all sizes and shapes. Daily, guidance is being revised and dispatched by the SBA, the U.S. Department of the Treasury, and state and local officials, changing today what we knew yesterday. Trying to keep up, lenders and loan processors are retooling and revamping forms, policies, and lending diligence at a frenetic pace.

Likewise, increasingly desperate borrowers are submitting whatever is asked of them and signing whatever lands in front of them just to get relief. Now more than ever, borrowers must carefully consider the consequences of borrowing any stimulus or relief funding.

During the last downturn, many unwary borrowers and guarantors learned very costly lessons about prohibitions on subordinate financing, whether or not collateralized, and the effect it had on creating personal liability when the assets became distressed.

Before diving into the details, a brief background on commercial mortgage-backed securities.

From an overview of 30,000 feet, CMBS are nothing more than fixed income investment products, i.e. bonds, which derive their revenue from the cash flow from commercial loans secured by mortgages on commercial properties. Once made, these loans are pooled together with other loans and different classes of bonds are issued for sale to investors based on the pool. Bond pricing aligns with the risk tolerance of each investor in the payment priority stack, generally with top-down payment priority and bottom-up loss priority.

Once pooled and bonds are issued, whether and to what extent individual loans can be modified are governed by servicing agreement and servicing standards. In general, loans cannot be significantly modified to resolve defaults, thus the distressed borrower has only a narrow scope of options available to them when requesting forbearance. The strict construct is attractive to many borrowers for one major reason: the loans are made nonrecourse, i.e. with no personal liability provided the borrower refrains from certain bad acts.

If a borrower follows the rules and simply cannot debt service, the lender will look only to the collateral for repayment and the borrower, in parlance, can "hand over the keys and walk away." It follows, then, that the lender will do all it can through its loan documents to lock up and isolate its collateral to mitigate the risk of diminishing value and maximize the return to the bondholders if the borrower defaults and walks away without recourse.

To do so, lenders use labyrinths of cross-references; provisions such as "Notwithstanding the foregoing, but subject to romanette (ii)- (iv)(A) of Section ___, excluding only the last clause of of (iii)(B)" and the ever-elusive definitions of defined terms. This leaves many borrowers uncertain of what they can and cannot do after the dust from closing settles. That uncertainty, coupled with the sudden economic collapse, is creating a perfect storm for borrowers who are grasping for every lifeline of economic relief available.

The single, well-intended act of doing what everyone else is doing, that is, borrowing until the dreaded curve flattens, could trigger recourse and make the borrower and guarantor personally liable for the entire loan. As tragic and counterintuitive as that seems, that is the deal that borrowers made, whether or not they realize it.

Consider this — less than 60 days ago, money was plentiful, rates were favorable, terms were optimal and defaults were rare. It seemed as though the new normal with CMBS 2.0+ was really good, maybe better than before. Suddenly, retail tenants are closed and unable to pay rent; shopping center and mall tenants are shuttered; student housing tenants have all breached their leases and gone home; and hoteliers are staring at near zero vacancy rates with no end in sight. For the borrower, the ability to debt service is gone. Now what?

Many borrowers are writing letters to their "lender" saying something like, "Due to the disaster of the coronavirus, we regret to inform you that we cannot pay you … but would like a forbearance … ." Some borrowers are sending interest-only payments. Some borrowers don't call, write or make any payments, hoping this will all go away and worst case they pay a late fee. Other borrowers are signing and returning the infamous "pre-negotiation letters," some of which are already including admissions of default and waiver of defenses while others are more akin to an invitation to negotiate.

Across the board, though, every borrower we speak with tells us the same thing: they are filling out the applications to get stimulus loans. Our response, usually met with dead silence, has been, "Have you made sure that the loan you are applying for won't cause a default under the 'bad-boy' carveouts of your loan?"

As Paul Harvey said, now for the rest of the story. Most borrowers vaguely know about the recourse events, which are often called the "bad boy carveouts." The recourse events were perhaps the most litigated and the most leveraged aspect of CMBS foreclosures during the last downturn. Scores of defaulted borrowers tried to "hand over the keys" but instead were sued on their personal guarantees. Unfortunately for many, personal judgments resulted which to this day haunt borrowers and guarantors.

Briefly, every CMBS loan we have seen has some form of bad boy carveout, typically in two tiers: partial recourse for those acts that trigger liability for only the actual losses incurred by the lender and full recourse for those acts that trigger liability for the entire amount of the loan.

The list is far more expansive than it used to be. The normal course fraud, misrepresentation, bankruptcy and ABC acts are now joined by many acts which contributed to lender losses the last time around. The focus here is on three particular bad boy acts which could trigger full recourse when borrowing money through stimulus and relief loans.

First, borrowers are prohibited from incurring indebtedness or liabilities other than: (1) unsecured trade payables; (2) unsecured ordinary course expenses; and (3) the CMBS loan.

As shown in the clip from a typical loan agreement, even those allowable items are conditioned on six things: (1) they are "normal and reasonable"; (2) they cannot exceed two percent of the original loan amount; (3) they are not evidenced by a note; (4) they are paid when due; (5) they are paid no later than 60 days from incurring; and (6) they cannot be secured by the property (which is generally defined as everything the borrower had at loan inception and later acquires).

Any violations will be an event of default. Whether a single-purpose entity covenant violation is a partial or full recourse trigger changes from loan to loan, but for certain it will be one or the other.

Single-Purpose Entity Covenants

Borrower shall have no indebtedness (including any PACE Loan) or incur any liability other than (i) unsecured debts and liabilities for trade payables and accrued expenses incurred in the ordinary course of its business of operating the Property; provided, however, that such unsecured indebtedness or liabilities (A) are in amounts that are normal and reasonable under the circumstances, but in no event to exceed two percent (2%) of the original principal amount of the Loan, and (B) are not evidenced by a note and are paid when due, but in no event for more than sixty (60) days from the date that such indebtedness or liabilities are incurred, and (ii) the Debt. No indebtedness (including any PACE Loan) other than the Loan shall be secured (senior, subordinated or pari passu) by the Property.

Second, borrowers are prohibited from further encumbering, assigning, mortgaging or pledging any collateral given to the CMBS lender. Remember, a borrower is required to be a single asset and single-purpose entity, which means that everything a borrower has is pledged to the lender as collateral, so anything the borrower uses as collateral for secondary obligations (which are already prohibited) is per se prohibited as a further encumbrance, thus a prohibited "transfer."

And third, borrowers are prohibited from transferring or pledging any interests in the borrower. Thus, vehicles such as mezzanine loans are also deemed a prohibited "transfer."

It would be unusual if violations of these provisions were not full recourse triggers.

Restrictions on Alienation and Further Encumbrances

Borrower acknowledges that Lender has relied upon the principals of Borrower and their experience in owning and operating properties similar to the Property in connection with the closing of the Loan. Accordingly, notwithstanding anything to the contrary contained in Section 8.6 hereof, neither the Property, nor any part thereof or interest therein, shall be sold, conveyed, disposed of, alienated, hypothecated, leased (except to Tenants under Leases which are not in violation of Section 4.10), assigned, pledged, mortgaged, further encumbered or otherwise transferred, nor shall Borrower be divested of its title to the Property or any interest therein, in any manner or way, whether voluntarily or involuntarily, nor shall Borrower enter into or subject the Property to any PACE Loan (any of the foregoing, a "Transfer"), in each case without the prior written consent of Lender being first obtained, which consent may be withheld in Lender's sole discretion. For the purposes of this Agreement and the other Loan Documents, a Transfer shall also include (and each of the following shall also be prohibited without the prior written consent of Lender being first obtained in each case, which consent may be withheld in Lender's sole discretion): (i) transfers of direct or indirect ownership interests in Borrower, and the creation of new or additional ownership interests in Borrower, or in any Constituent Entity of Borrower, (ii) an installment sales agreement with respect to the Property or any portion thereof, (iii) a Lease of all or substantially all of the Property other than for actual occupancy by a space tenant thereunder, (iv)any sale or assignment of any of Borrower's right, title and interest in, to and under any Leases or Rents and Profits, other than to Lender, (v) if Borrower or any Constituent Entity of Borrower is a partnership or joint venture, the addition, change, removal or resignation of any general partner, or the transfer or pledge of any interest (whether as a general partner or limited partner) of any general partner in such partnership, or the transfer of control of such general partner, and (vi) if Borrower or any Constituent Entity of Borrower is a limited liability company, (A) the addition, change, removal or resignation of any manager or managing member, (B) the transfer or pledge of any interest (whether as a managing member or otherwise) of such manager or managing member in such limited liability company, (C) the transfer of control (as defined in Section 4.27) of such manager or managing member in such limited liability company or (D) the division of any assets and liabilities of such entity amongst one or more new or existing entities (whether pursuant to Section 18-217 of the Delaware Limited Liability Company Act (if such limited liability company's state of formation is Delaware) or otherwise).

Finally, the exculpation provision. The exculpation provision explains what acts are bad boy carveouts and specifies which acts trigger partial recourse and which acts trigger full recourse. As shown below, any unapproved subordinate financing, further encumbrance on the "property" or "transfer" is a full recourse event.

Exculpation provisions are strictly read. If it says that lender permission is required, it is required. If it says that you cannot do it, you cannot do it. It won't matter if the lender knew until well after the fact or if the lender was not damaged. The completion of the act is the trigger.

For example, one court imposed full recourse of $13 million on borrowers that placed a $400,000 second mortgage on the property which they repaid a full year before the CMBS foreclosure. Rejecting the "no harm, no foul" approach, the court stated, "It matters not, as defendants argue, that they eventually cured the very breach that triggered their personal liability and that no harm accrued to plaintiff as a result thereof … defendants may not now escape the consequences of their bargain." Other similar examples exist.


Furthermore, notwithstanding the foregoing provisions of this Section 8.16 or anything to the contrary in the Loan Documents, THE LOAN SHALL BE FULLY RECOURSE TO BORROWER (and the exculpatory provisions above shall be of no force or effect) upon the occurrence of any of the following: (A) Borrower fails to obtain Lender's prior written consent to any subordinate financing or other voluntary lien encumbering the Property or the ownership interests in Borrower (including with respect to a PACE Loan), if such consent is required by the Loan Documents; (B) Borrower fails to obtain Lender's prior written consent to any Transfer, if such consent is required by Loan Documents; (C) the first Monthly Payment Amount (together with all required payments for Reserves due concurrently therewith) is not paid in full when due; (D) a bankruptcy or insolvency petition is filed by, consented to, or acquiesced in by Borrower (or Borrower takes similar voluntary action under any comparable state or federal law); or (E) Borrower or Guarantor (or any Equity Holder or Affiliate of either of the foregoing) shall have made or colluded with creditors of Borrower (other than Lender) to cause an involuntary bankruptcy filing with respect to Borrower (or similar action under any comparable state or federal law).

It is unclear to what extent, if any, collateral or personal guarantees will be required for the new or enhanced stimulus and relief programs. For example, as of today the new Paycheck Protection Program from the SBA will require no collateral or personal guarantees. But, as with any loan, the borrower is required to make a promissory note to incur the indebtedness. Will it matter if the loan gets forgiven under the program terms? Difficult to say.

The SBA's economic injury disaster loans, which provide up to $2 million in working capital, require personal guarantees if the loan is larger than $200,000 and require collateral if the loan is larger than $25,000. As detailed, a CMBS borrower likely does not have any collateral to give that is not already given to the CMBS lender, so what then?

Could these guarantee and collateral requirements trigger recourse? Likely. Could the act of signing a promissory note trigger recourse? Perhaps. What of the new Main Street Lending Program designed for businesses up to 10,000 employees or $2.5 billion in 2019 annual revenues? It is impossible to imagine that collateralization will not be required.

For now, no substantive guidance exists. Although it is hard to imagine a special servicer standing in front of a judge arguing that the borrower and guarantors should be personally liable for the entire multimillion-dollar loan because the borrower took a CARES Act, SBA or Main Street loan to save the business and its employees, we have seen stranger things. Whether the judge ultimately agrees cannot be predicted, but for borrowers the risks and costs will be high.

Now for the good news — with the possible exception of borrowers in the multifamily space, everyone is in the same boat. Virtually no borrower can debt service. Lenders, master servicers and special services are inundated with requests and trying to ramp up and establish uniform procedures to handle this economic anomaly.

Some borrowers have been assigned to special servicing while others are still dealing with their master servicers. Some sub-servicers have suddenly popped up. Historically, being assigned to special servicing where "no" was the answer before the question was even asked was usually the death knell. For now, though, we are hopeful that this time will differ from the previous downturn and special servicers are either mandated to take the loan or are just additional hands to ease the burden on the master servicers.

Early indications are encouraging and tell us that cooperation and collaboration with the lenders, whether master or special servicers, are producing favorable results. To avoid problems and achieve the relief you need, preparedness, proactivity and communication with the lender may yield positive results.

Asset managers, whether at the master or special servicing level, are receiving forbearance requests, modification requests and requests for approvals by the tens of dozens each day and the easier any borrower can make it for the asset manager to arrive at yes, the more likely they will do so and move to the next file in the stack.

When making a request to the lender, we recommend:

1. Be concise: Send the information they need and send it the first time.

2. Be proactive: Don't wait for the lender to ask, anticipate.

3. Be realistic: Don't overpromise and underperform. Likewise, make reasonable requests. Time is too short to haggle.

4. Be honest: Tell the lender what you need and plan to do.

5. Be a good steward: Tell the lender about what you are doing to protect its collateral, including whatever cash flow is coming through the door.

6. Be knowledgeable about your loan: Take downtime to read and understand your loan documents. It will be much easier to make requests and understand responses.

7. Be meticulous with your records: If it isn't in writing, it never happened.

8. Always consult with knowledgeable counsel: The CMBS world is complicated so get the help you need to get the relief you seek.

Joseph Jones is a partner at Berger Singerman LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

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