After execution of a commitment letter in connection with a commercial real estate financing transaction, the loan documents invariably present new issues that need to be addressed. In negotiating loan documents, lenders should consider the following common issues:

Recourse vs. non-recourse: It is critical that the lender choose the appropriate level of recourse against a borrower and any guarantors, with an eye toward protecting itself and providing proper incentives for the borrower and guarantors. However, the lender should be careful not to demand terms that are inconsistent with the nature of the financing and terms commonly offered in the marketplace. Construction lenders usually require completion guaranties, principal or limited principal guaranties, and perhaps debt service and carry guaranties. Completion guaranties usually terminate once the project is completed, as defined in the guaranty. The definition of completed is often negotiated. In addition, lenders often agree that the interest and carry guaranty terminates after satisfaction of certain conditions such as the foreclosure or deed in lieu of the property. Such guaranties are standard and prudent due to the risky nature of construction lending. However, permanent loans offered by the conduit lenders and insurance companies are usually non-recourse with respect to borrowers and guarantors, except with respect to bad boy acts (also known as non-recourse carve-outs) such as intentional misrepresentation of facts, misappropriation of rents, failure to pay taxes and insurance, failure to turn over security deposits and the voluntary filing of bankruptcy. In such cases, liability is usually limited to the extent of losses incurred by lender. However, with respect to the voluntary filing of a bankruptcy and violation of transfer clauses and single-purpose entity covenants, borrowers and guarantors are typically subject to full recourse liability.

With respect to environmental liability, lenders usually require that the borrower and all or some of the guarantors sign an environmental indemnity agreement with no limit on liability. In certain situations, lenders will agree to waive the execution of such indemnities by guarantors provided that adequate environmental insurance is provided to the lender. Nevertheless, regardless of which parties execute the indemnity, lenders should require such indemnity to survive repayment of the loan.

Transferability: It is critical to some borrowers that the loan documents provide flexibility to make transfers of interests in borrower. Nevertheless, in certain financings, such as construction loans, lenders should insist that key parties remain in control with a significant economic interest in the borrower. However, with respect to permanent loans where the property is already constructed and there is less risk to the lender, the lender should be more flexible (subject to rating agency restrictions in the case of conduit loans) and should consider allowing non-controlling interests (i.e. less than 50 percent of the interests in the borrower) to be transferred. In addition, permanent lenders will often allow an assumption of the loan provided that an assumption fee is paid and the party assuming the loan meets certain criteria.

Leasing terms: Although every borrower desires to retain the right to lease a certain minimum amount of space without the consent of lender, lenders should seek approval rights over the form lease, any lease over a certain square footage and any material change to the form lease. Lenders may also want to be able to approve the identity and creditworthiness of certain major tenants. Lenders should work with borrowers to identify a square footage threshold for lease approvals and identify other key issues and reasonable leasing restrictions.

Application of casualty and condemnation proceeds: In connection with a construction loan, it is customary and reasonable for lenders to agree to release casualty and condemnation proceeds for construction of the project provided that certain reasonable criteria are met, such as that the project can be constructed on time and on budget. However, with respect to permanent loans, lenders usually desire control over the proceeds, especially if the casualty or condemnation is substantial or if the project will be adversely affected as a result of the casualty or condemnation. Permanent lenders typically will agree that if proceeds are below a certain threshold, they will release proceeds for reconstruction, provided certain minimum criteria are satisfied. Such criteria include, but are not limited to, the following: there remain in place enough leases so that the project meets a minimum debt service coverage ratio after reconstruction; there are adequate insurance proceeds to finish the restoration; and the loan does not mature within 12 months after the time of the anticipated completion of restoration. With respect to proceeds over such a threshold, the lenders typically will desire the right to settle claims and apply proceeds to the loan. Permanent lenders should not be forced to act as construction lenders, which is the practical effect of releasing proceeds and monitoring construction for a major restoration. A permanent lender may not be equipped to handle construction loans and may not want the risks associated with construction loans. Accordingly, permanent lenders should control insurance proceeds where there is a substantial casualty or condemnation.

In the event insurance proceeds are applied to a loan, the issue arises as to whether a prepayment penalty should be due. Borrowers are typically required to pay yield maintenance when prepaying permanent loans. However, it is arguably unfair to charge a yield maintenance premium for involuntary payments.

Default provisions: There are numerous possible default provisions, most of which are customary in loan documents. Borrowers often are most concerned with grace and cure periods. Although some conduit lenders are inflexible with respect to providing grace or cure periods, some grace and cure periods are usually given, especially with respect to non-monetary defaults. The death of the guarantor is a typical default that should be noted. This may seem unnecessary, especially if a loan is not in default. However, failure to proceed against the deceased guarantor’s estate within approximately one year after such party’s death can result in a loss of claim against the estate. Therefore, this provision can become difficult to negotiate.

The above issues are just a few of the many issues that arise in a typical loan negotiation. With the assistance of competent counsel, lenders should be able to use customary modifications to certain loan provisions or employ other creative solutions to avoid negotiation impasses.

Lenders Have Much to Consider When Negotiating Loan Docs

by Banker & Tradesman time to read: 4 min
0