1 Presenting a live 90-minute webinar with interactive Q&A Commercial Real Estate Loans: Structuring Covenants, Events of Default Provisions and MAC Clauses Negotiating Agreement Provisions to Maximize Borrower Protection and Lender Remedies TUESDAY, NOVEMBER 26, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Christopher W. Rosenbleeth, Esq., Partner, Stradley Ronon Stevens & Young, Philadelphia Mairi V. Luce, Partner, Duane Morris, Philadelpia The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10.
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5 Structuring Loan Covenants, Events of Default and MAC Clauses Effective Provisions to Maximize Borrower Protection and Lender s Remedies Christopher W. Rosenbleeth Stradley Ronon Stevens & Young Mairi V. Luce Duane Morris
6 Overview Loan Covenants Events of Default MAC Clauses 6
7 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 7
8 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 Q Q Covenant Lite -89.6% Covenant Heavy-81.5% Source: Moody s Covenant-lite Defaults and Recoveries: Seeing Where it Hurts ; June 7,
9 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 9
10 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 10
11 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. 11
12 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 12
13 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 13
14 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 14
15 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 Borrower Considerations Broker Review of Insurance Provision Industry Standards For Types of Insurance and Coverage Limitations Business Interruption Property and collateral specific issues (flood certifications) 15
16 Affirmative Covenant: Inspections Physical inspection of Premises Environmental testing Tenants Borrower Considerations: Type and Frequency Advance Notice Party conducting inspection Confidentiality and privacy issues 16
17 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 Borrower Considerations Capital structure Permitted Indebtedness Leasing Costs Brokerage commissions, tenant improvements Carve-Outs for Disputes Taxing authorities Vendors/Suppliers Other Financing Arrangements 17
18 Negative covenant: Liens Rationale: Protect collateral from actions by other lienholders Lender always first mortgage holder Some standard exceptions Borrower Considerations 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 18
19 Negative Covenant: Transfers No sale, lease, transfer of ownership interests Rationale: Protect Collateral Other Rationale: Lender comfort with equity group Regulatory concerns: PATRIOT Act Borrower Considerations 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 19
20 Negative Covenant: Organizational Documents No amendments to organizational documents Rationale: Maintain lien priority Second rationale: Borrower structure vetted by Lender Borrower Considerations Clean-up issues in conjunction with loan closing Advance notice to and consent of Lender for post-closing changes 20
21 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 21
22 Financial Covenants Pre : Real estate loans soft on financial covenants Post : Proliferation of financial covenants in CRE Typical: Debt Service Coverage Ratio Guarantor Liquidity Borrower Considerations Length of loan vs. financial projections Seasonality issues Testing frequency and periods 22
23 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 23
24 Financial Covenant: Guarantor Liquidity Rationale: Ensure Guarantor(s) has sufficient liquidity to repay debt Typically, cash and cash equivalents Marketable securities? 24
25 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 25
26 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 26
27 Events of Default (cont d) 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 27
28 Events of Default (cont d) 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 28
29 Events of Default: Cross-Defaults Default under other debt gives rise to Event of Default Another reason to limit additional indebtedness Borrower Considerations Other debt owed to lender Debt owed to third party Triggering events Cure opportunities 29
30 Events of Default: Insolvency Voluntary vs. involuntary bankruptcy Automatic acceleration of debt Borrower Considerations Timing issues for involuntary bankruptcy filing or other remedies exercised against borrower Insolvency of other entities (principal, guarantors, major tenant) Borrower s nuclear option: bankruptcy 30
31 Events of Default: Change of Control Rationale: Lender wants to know its Borrower PATRIOT Act concerns Borrower Considerations 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 31
32 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,
33 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 33