By Michael Werner, Avi Feinberg, Janice Mac Avoy and Jeremy Chubak

Law360 (April 22, 2020, 5:07 PM EDT) --

Michael Werner

Avi Feinberg

Janice Mac Avoy

Jeremy Chubak

The COVID-19 pandemic has disrupted virtually every aspect of our personal and professional lives. Hotel and brick-and-mortar retail consumers are not purchasing services and goods, tenant businesses are not operating at optimal productivity (or at all), local governments are restricting, and, in some cases, shutting down construction, and no one can predict just how long these circumstances will endure.

Real estate borrowers should be prepared in how to respond to the carry-on impacts on their loans. Borrowers facing hardships caused by the COVID-19 pandemic can seek to work with their lenders and take certain actions to help mitigate the impact of the pandemic on their properties and their ability to fulfill their debt obligations.

Maintaining Communication With Your Lender

Borrowers impacted by or concerned about potential impacts of the pandemic should establish open lines of communication with their lenders and loan servicers.

Even if they are not facing particular hardship at the time of initial contact, their circumstances could change. The borrowers who maintain regular communication, are transparent about the changing facts at their property and do not "hide the ball" are more likely to garner sympathy and obtain relief, all things being equal.

Asset managers should review their loan covenants to make sure they timely send notices that the borrower is required to deliver to their lender (e.g., major tenant defaults; material communications received from tenants; notice of third-party manager default; and for construction loans, notice of the occurrence of a force majeure event that could impact performance milestones and/or cause cessation of construction, etc.).

Borrowers should seek to temporarily suspend formal notice requirements and establish with their lenders that email notices alone can suffice during this time.

For construction loans, even where there is not a requirement to do so, many borrowers are notifying lenders of force majeure to avail themselves of contractually negotiated extensions of performance milestones.

It is important for force majeure notices to state the nature of the force majeure (with reference to the defined term in the applicable loan documents) and describe the impact on the applicable loan obligation. In some cases, loan documents require the borrower to describe any mitigation efforts the borrower is undertaking, so borrowers should include any relevant details.

When a borrower notifies a lender about a potential impact on borrower's ability to repay a loan or comply with certain loan covenants, lenders will often respond by sending a prenegotiation agreement, or PNA, to the borrower. Borrowers should not panic when presented with a draft PNA from their lenders, as this is a fairly standard precursor to any substantive discussion of loan modification terms.

PNAs should merely preserve the status quo, so that borrowers and lenders can undertake nonbinding discussions without waiving their respective rights and remedies. To the extent possible, borrowers should resist admitting defaults, waiving defenses and granting any releases in favor of their lenders in a PNA or other agreement with the lender.

COVID-19-Related Effects on Monetary Obligations Under the Loan

Borrowers should understand that COVID-19-related force majeure will almost never excuse a borrower's obligation to pay debt service or other monetary obligations. However, borrowers can seek relief from their lenders to reallocate cash flow to keep their properties operating until such time as they are sufficiently stabilized.

If borrowers anticipate near-term operating shortfalls, they should discuss with their lender applying cash flow or built-up reserves (particularly regularly funded reserves for capital expenditure; furniture, fixtures and equipment upgrades, etc., that are less pressing needs for the project) in order to keep the lights on, pay taxes and insurance, and avoid liens.

For loans with hard cash management and debt service is prioritized ahead of other carry costs, borrowers should request a departure from the cash management waterfall to fund immediate operating needs. Indeed, if the property cannot operate, then there will not be cash to pay debt service before long.

Lenders may request that borrowers fund additional equity into a project to fund debt service and operating shortfalls. Borrowers need to assess, as a business matter, whether they have sufficient equity value in or long-term commitment to a project to warrant further equity investment, and also undertake a risk analysis of their recourse exposure if they are unwilling to fund additional equity.

Questions include: Is there a payment guaranty or carry guaranty? Is loss recourse for nonpayment of taxes and insurance subject to sufficiency of cash flow? Is there loss recourse for unpaid trade payables?

Additionally, borrowers will be under pressure from their tenants to offer rent relief, particularly for retail or restaurant tenants, who have been forced to shut down. Borrowers should check their loan documents to determine whether they need lender consent before agreeing to rent relief, and even if they are not granting rent relief, should be consulting with their lenders regarding the communications they are receiving from their tenants.

Financial Assistance for Borrowers Affected by COVID-19

Congress responded to the COVID-19 pandemic by passing comprehensive legislation meant to mitigate the long-term effects of the pandemic and directly assist those affected by it.

Additionally, several jurisdictions have issued orders or guidance to lenders regarding sound banking practices of providing 90-day forbearance of remedies for borrowers affected by the COVID-19 pandemic, including the New York State Department of Financial Services, which issued new regulations requiring New York state regulated financial institutions to provide a 90-day forbearance of payment due on a residential mortgage of a property located in New York available to any individual residing in New York who demonstrates financial hardship as a result of the COVID-19 pandemic.

Although the applicability of the DFS regulation is limited to residential mortgages, other borrowers can cite the regulations as possible guidance when discussing forbearance options with their lenders. Where applicable, borrowers should use the opportunity provided by new forbearance guidelines to approach their lenders with a request for forbearance of collection or exercise of remedies where appropriate.

Borrowers that were not otherwise impaired prior to COVID-19 and only impaired due to COVID-19 are likely to be more successful.

Under new guidelines, Fannie Mae and Freddie Mac are each permitting their servicers to provide forbearance of remedies for up to three consecutive monthly payment dates to certain borrowers impacted by COVID-19, subject to the satisfaction of certain conditions (including borrowers agreeing not to evict tenants based on the nonpayment of rent as a result of COVID-19-related hardships).

In what is perhaps the most comprehensive response to the COVID-19 pandemic, Congress passed the Coronavirus Aid, Relief and Economic Security, or CARES, Act on March 27, which, among other things, provides relief to a range of small and large businesses and individuals by offering funding for, and expanding eligibility under, certain existing U.S. Small Business Administration, or SBA, loan programs, subject to the satisfaction of specified conditions and eligibility requirements.

Borrowers should be aware that their loan documents may require lender consent to accept SBA loans issued pursuant to the CARES Act because they technically constitute prohibited debt, though we expect lenders to approve the cash infusion, as long as lenders control its distribution for the legislatively required purposes.

In order to assist in the interpretation of certain provisions under the CARES Act, including those that create a forbearance program for federally backed mortgage loans and permit financial institutions to suspend certain requirements under generally accepted accounting principles related to troubled debt restructurings, the Federal Reserve Board, the Office of the Comptroller of the Currency and the Conference of State Bank Supervisors, among others, issued guidance for financial institutions working with customers affected by COVID-19, which certain borrowers can use to their advantage.

The agencies encourage financial institutions to work prudently with borrowers who are or may be unable to meet their contractual payment obligations because of the effects of COVID-19. The Office of the Comptroller of the Currency took the extraordinary step of stating that loan modifications including "short-term modifications such as payment deferrals would not be considered troubled debt restructurings."

Borrowers should also talk to their insurance consultants to examine whether their business interruption insurance policies will cover any rent loss attributable to government shutdowns (e.g., indoor shopping malls), though we are hearing in most cases that coverage is not available.

To the extent that a borrower is able to collect under a business interruption (or other) insurance policy, the borrower should review the terms of their loan documents governing insurance proceeds to determine whether they are required to turn over such proceeds to their lender or if their lender has the right to determine how the proceeds are to be distributed.

Conclusion

Borrowers face unprecedented challenges as a result of the COVID-19 pandemic. Prudent borrowers should:

• Keep the communication lines open and work with their lenders to help mitigate the adverse effects of the pandemic on their loans and properties;
  
  
• Review the terms of their loan documents to ensure that they are aware of and complying with ongoing obligations under the loan;
  
  
• Quantify near-term operating shortfalls and request an appropriate reallocation of property cash flow from their lenders in order to pay necessary costs;
   
  
• Potentially consider investing additional equity into their projects;
   
  
• Investigate and take advantage of other mitigation sources such as government assistance and insurance coverage.

Borrowers who act swiftly to work with their lenders to not only protect the value of their assets, but also the relationship with their lender, will be better positioned to weather the impact of the pandemic.

---

Michael J. Werner, Avi David Feinberg and Janice Mac Avoy are partners, and Jeremy Chubak is an associate at Fried Frank Harris Shriver & Jacobson LLP.

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

For a reprint of this article, please contact reprints@law360.com.