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1 REAL ESTATE LAW AND PRACTICE Course Handbook Series Number N-638 CMBS and the Real Estate Lawyer 2016: Lender and Borrower Issues in the Capital Market Co-Chairs Joseph Philip Forte Meredith J. Kane To order this book, call (800) 260-4PLI or fax us at (800) Ask our Customer Service Department for PLI Order Number , Dept. BAV5. Practising Law Institute 1177 Avenue of the Americas New York, New York 10036

2 15 Creating the Securitized Asset: Key Post Crisis Issues for Special Purpose Entities and Non-Recourse Carve-outs (November 2015) Steven G. Horowitz Cleary Gottlieb Steen & Hamilton LLP The author wishes to acknowledge the assistance of Kimberly Blacklow, Alexandra Kelly, Joseph Lanzkron and Dana Lee for their assistance with the preparation of these materials. If you find this article helpful, you can learn more about the subject by going to to view the on demand program or segment for which it was written. 291

3 292 Practising Law Institute

4 I. SPECIAL PURPOSE ENTITIES ( SPE ) A. Background 1. An SPE is an entity, formed concurrently with or immediately prior to the subject transaction, that is unlikely to become insolvent as a result of its own activities and that is adequately insulated from the consequences of any related party s insolvency. 2 B. Post-GGP 3 /post-downturn changes to SPE requirements: 1. Independent Directors a) Independent directors may only be terminated for Cause (1) Acts or omissions that constitute systematic and persistent willful disregard of duties; (2) Indictment or conviction for any crime of moral turpitude or dishonesty or any legal violation; (3) No longer satisfies independence requirements; (4) Fees charged are excessive by comparison to other providers; and (5) For any other cause, with consent of the lender. b) Lenders require notice from borrower prior to replacing independent directors (typically 2 business days) (1) Lender consent to replacement of independent directors was an area of discussion following GGP; however, concern of lender liability resulting from excessive control and LLC operating agreement enforceability has caused lenders to generally not require consent. c) Use of national providers of independent managers/directors (1) Independent Director qualifications: (a) Employees of the national provider (range from administrative staff to senior-level executives depending on provider); 2. Section 4 of S&P U.S. CMBS Legal and Structured Finance Criteria. 3. In re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y 2009)

5 (b) Not required to have financing or real estate background but any material action the directors vote on is reviewed internally; and (c) In addition to internal review, national provider retains counsel and has relationships with experts, including bankruptcy attorneys and special Delaware counsel. (2) Jameson Case:4 national provider retained counsel when one of its independent directors was faced with a bankruptcy vote. (a) Borrower operating agreements permit independent directors to consider only the interest of borrower and its creditors; fiduciary duties to members and other affiliates should be specifically eliminated. This is as a result of the bankruptcy court in GGP applying the corporate family doctrine, treating affiliated GGP companies and the parent entity as a collective whole engaged in a common enterprise. Although not going so far as substantive consolidation, it is antithetical to the SPE structuring. 2. SPE covenants a) Covenants in loan documents are drafted more precisely (1) E.g., Borrowers typically mark-up covenants requiring Borrower to remain solvent, maintain adequate capital and pay liabilities out of its own funds to include a proviso that the covenant does not require the Borrower s members, partners or shareholders to make any additional capital contributions in order to maintain solvency (avoids creating unintended recourse liability) b) Increased focus on commingling of borrower funds (1) SPE covenants prohibit commingling of SPE borrower s funds and other assets with those of parent or other affiliates. (2) Cash management in loan documents increasingly reflects stricter standards: 4. In re: Jer/Jameson Mezz Borrower II, LLC, 61 B.R. 293, 298 (Bankr. D. Del. 2011)

6 (a) Tightening of hard lockboxes to comply with SPE covenants; preventing multiple SPEs under the same corporate umbrella from commingling revenues and payment of expenses; and (b) Increased reserves for taxes and insurance and greater scrutiny on segregation of funds by common property managers. (c) In recent competitive environment for loans, strong Sponsors may be able to negotiate less stringent cash management, particularly for repeat deals. II. NON-RECOURSE CARVE-OUTS A. Background 1. The growth of the CMBS market was instrumental in the evolution of non-recourse asset-specific lending. 2. The use of SPEs effectively limited recourse to the SPE s assets. 3. Pursuant to rating agency s standards, non-recourse mortgages are accompanied by non-recourse carve-outs backed by a guaranty. 4. In the months leading up to the financial crisis, lenders occasionally waived the requirement for a guarantor to be liable for recourse carve-outs leaving only the SPE borrower responsible. 5. Today, CMBS lenders typically require an affiliated creditworthy third party to be liable for the recourse carve-outs by guaranteeing the borrower s recourse liability. If no suitable guarantor is available, loan will not be eligible for securitization. B. Standard Carve-Outs 1. Above The Line - Guarantor is liable for actual loss or damages suffered by Lender as a result of a bad boy act. a) Intentional or grossly negligent physical waste b) Fraud or intentional misrepresentation c) Willful misconduct (interference with exercise of remedies) d) Misappropriation or misapplication of funds e) Any breach of representation or covenant regarding environmental matters 5 295

7 f) Prohibited Debt g) Failure to maintain insurance policies h) Removal of personal property from the mortgaged property in anticipation of an event of default i) Fees or commissions paid by Borrower to affiliates in violation of terms in the loan documents j) Failure of any SPE to have at all times have been an SPE k) The filing by any Person of a motion for substantive consolidation in bankruptcy 2. Below The Line In addition to any damages/actual loss suffered by Lender, Guarantor is liable for the full amount of the debt (fully recourse). a) Unauthorized transfer of the property or any collateral (including any unauthorized liens or encumbrances on the collateral) b) Prohibited change of control c) Voluntary bankruptcy filing by an SPE d) Collusion with creditors to cause an involuntary filing e) Termination of one or more independent directors other than for cause for the purpose of facilitating a bankruptcy filing f) Failure of any SPE to have at all times have been an SPE, which failure results in a substantive consolidation with any affiliate in a bankruptcy C. Trends in Non-Recourse Carve-Outs 1. Net Worth and Liquidity: Many loans now require guarantors to meet and maintain net worth and liquidity requirements during the term of the loan. a) Example: Guarantor shall at all times maintain an aggregate Net Worth of no less than $10,000,000 and aggregate Cash Liquidity Balances of no less than $10,000,000 (the Net Worth and Liquidity Requirement ). For purposes of this Section, Net Worth means total assets (excluding the Collateral) minus total liabilities (excluding the Loan and any contingent liabilities under this Guaranty or any other Loan Document), in each case, determined on a consolidated 6 296

8 basis in accordance with GAAP. Cash Liquidity Balances means Lien-free cash balances directly maintained by Guarantor in the conventional forms of demand deposits, money market account deposits and other cash equivalents reasonably acceptable to Lender. 2. Cap on Liability: Borrowers are now sometimes negotiating caps for liability, either a dollar amount or a percentage of outstanding loan amount. 3. Prohibited Debt and Unconsented Transfer: Borrowers will try to eliminate full recourse and try to distinguish between voluntary and involuntary violations. a) Example: Guarantor hereby acknowledges and agrees that Guarantor shall be fully and personally liable for the full amount of the Indebtedness and the timely satisfaction of all of the Obligations under the Loan Documents in the event that any of the following circumstances should occur: (1) Borrower fails to obtain Lender s prior written consent to any subordinate financing or other voluntary lien encumbering the Mortgaged Property, to the extent Borrower is required to obtain such prior written consent under the Loan Documents before consummating any such action; (2) Borrower fails to obtain Lender s prior written consent to any assignment, transfer, pledge or conveyance of the Mortgaged Property or any interest therein or of any direct or indirect ownership interest in Borrower, to the extent, in any such case, Borrower is required to obtain such prior written consent under the Loan Documents before the consummation of any such action; 4. Replacement Guarantor with Mezzanine Foreclosure: When there is also a mezzanine loan, Sponsors will want to require termination of guaranteed obligations under mortgage and mezzanine guaranties in connection with a mezzanine foreclosure to avoid liability for acts committed when the Borrower/Sponsor is no longer in control. (1) Example: Notwithstanding anything herein or in the Loan Documents to the contrary, Guarantor shall have no liability for Guaranteed Obligations or other matters 7 297

9 hereunder for (i) any action taken by any Person (other than Borrower, Guarantor or any other Person that, directly or indirectly, controls, is controlled by or is under common control with Guarantor) from and after Lender obtains title to the Property, whether by foreclosure, deed-in-lieu of foreclosure or otherwise in connection with any exercise of Lender s remedies pursuant to the Loan Documents, or any actions taken by any Person (other than Borrower, Guarantor or any other Person that, directly or indirectly, controls, is controlled by, or is under common control with Guarantor except if such action of Borrower, Guarantor or any other such Person is caused or required by a receiver, trustee, liquidator, conservator, Lender or applicable law) on or after the date on which a receiver, trustee, liquidator, or conservator is appointed, at Lender s request, to take control of the Property, or (ii) any action taken (a) by a mezzanine lender or any entity it controls under a Lender Required Mezzanine Loan during any period in which such mezzanine lender exercises control of any Required SPE, Borrower and/or the Property under the mezzanine loan documents or (b) from and after a mezzanine foreclosure or assignmentin-lieu thereof. (2) Mortgage lender will require mezzanine lender to provide suitable replacement guarantors in the event of a mezzanine foreclosure in the corresponding intercreditor agreement. 5. Qualifying Recourse Carve-Outs: Borrowers and Guarantors will negotiate further carve-outs from the non-recourse carve-outs (1) Post-Cherryland, Borrowers should review the drafting of non-recourse triggers more closely to avoid unintended triggers. (a) In these Michigan cases, courts imposed full recourse liability based on a violation of an SPE covenant related to solvency of the borrower. Wells Fargo Bank, N.A. v. Cherryland Mall Ltd. Partnership, et al, 493 Mich. 859 (2012) & Gratiot Avenue Holdings, LLC v. Chesterfield Development Co., LLC, 835 F.Supp.2d 384 (E.D.Mich.) (Jan. 24, 8 298

10 2012), appeal dismissed by stipulation of the parties April 19, (b) Specifically, the mortgage in Cherryland contained the following covenant as part of the Special Purpose Entity / Separateness provisions: Mortgagor is and will remain solvent and Mortgagor will pay its debts and liabilities... from its assets as the same shall become due. The court ruled that any failure to remain solvent resulted in a failure to maintain SPE status, thus triggering full recourse liability. (2) Guarantors negotiate to exclude Guarantor liability under a non-recourse guaranty for: (a) Failing to make capital contributions or loans to the borrower (i.e., the Guarantor is not required to keep the Borrower solvent) and (b) Inadequate financial performance of the property / insolvency (except to the extent caused by improper distributions or payments to the borrower and its parent companies) (i.e., simple failure of the business conducted at the property should not trigger recourse liability). Note that it may be difficult to determine whether inadequate financial performance or insolvency was caused by improper distributions. D. Litigation Related to Non-Recourse Carve-Outs Has Been Enforcement Favorable 1. Michigan: In response to Cherryland line of cases, Michigan legislature responded by passing the Nonrecourse Mortgage Loan Act (Public Act 67 of 2012), enacted March 29, 2012 ( NMLA ). This legislation prohibits post-closing solvency covenants in non-recourse loans from being used as non-recourse carve-outs or as the basis for actions against a borrower or any guarantor

11 2. Michigan Court of Appeals has upheld the constitutionality of the NMLA Ohio has also passed similar legislation: Ohio Legacy Trust Act, Ohio Rev. Code Note that servicers of CMBS loans in other jurisdictions may feel that they have a duty to pursue litigation in other jurisdictions in the event of a breach of a similarly drafted SPE insolvency covenant because of Michigan case law results prior to NMLA. 5. Wells Fargo Bank, NA v. Cherryland Mall L.P., 835 N.W.2d 593 (2013). See also Borman, LLC v Borman, LLC, (E.D. Mich. Mar. 11, 2014)

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Nuts and Bolts of Nonrecourse Carve outs 1

Nuts and Bolts of Nonrecourse Carve outs 1 In the aftermath of 2011 and 2012 cases, such as the Cherryland and Gratiot cases, which held that nonrecourse carve out provisions in real estate mortgage loans