Commercial Mortgage-Backed Securities 3.0: Structuring Commercial Mortgage Securitized Loans in an Evolving CMBS Market Navigating New Structures, SPE Covenants, Cash Management and Other Loan Provisions Today’s faculty features: 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10. THURSDAY, MARCH 19, 2015 Presenting a live 90-minute webinar with interactive Q&A Allen Dickey, Shareholder, Munsch Hardt Kopf & Harr, Dallas Dan Flanigan, Department Chair, Polsinelli, Kansas City, Mo.
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Commercial Mortgage-Backed Securities 3.0: Structuring Commercial Mortgage Securitized Loans in an Evolving CMBS Market Navigating New Structures, SPE Covenants, Cash Management and Other Loan Provisions
Unlike an A Note, which is always cross-defaulted with the B Note (i.e., a
default under the B Note constitutes a default under the A Note and vice-
versa), a mortgage loan is typically not cross-defaulted with the
mezzanine loan (i.e., a default under the mezzanine loan does not, in and
of itself, constitute a default under the mortgage loan); the mezzanine
loan, however, is cross-defaulted with the mortgage loan (i.e., a default
under the mortgage loan automatically constitutes a default under the
mezzanine loan)
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“LIFE IS JUST A BOWL OF (SOUR) CHERRIES” FROM CHERRYLAND
NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE
(Thanks to my POLSINELLI colleague Aaron Jackson
for his help with the research for this Section.)
NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE
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As illustrated by the list of cases attached, Borrowers and Guarantors have fared
very poorly in carveout and springing recourse cases, and even worse for them,
Lenders have even managed to obtain, in the Cherryland and Gratiot cases,
windfall benefits that the drafters of the loan documents never intended.
The “document means what it says (or what we say it says), however irrational”
approach of the Cherryland and Gratiot courts has provoked well-represented
Borrowers and Guarantors to carefully analyze every nuance and implication of
the language of the carveout, exculpation, and springing recourse provisions.
NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE
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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE
Accordingly, in CMBS 2.0 and 3.0, counsel for Borrowers and Guarantors have
sought to clarify such ambiguous words and phrases as “solvency,” “failing to
pay liabilities as they come due,” “failure to maintain SPE status,” and to insist
more than before that Lenders suffer true negative consequences before they are
allowed to take advantage of “foot faults” to obtain deficiency judgments when
their Borrowers and Guarantors may be “insolvent boys” or even “stupid boys” but
not “bad” ones.
But none of this is easy, and different Lenders, and different counsel for Lenders,
have different approaches and different tolerance levels for changes in their
documents and it can be very hard to tie up and tie off all the trip wires.
But even CMBS lenders themselves should not want their “product” to be seen as
one festooned with booby traps that make a mockery of the premise of
nonrecourse financing.
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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE
The following are some selected important issues in loan documentation that
have surfaced in light of the Cherryland and Gratiot cases. This summary is
meant to be suggestive only and not by any means a comprehensive
identification of all the problems. Moreover, the curative language offered may
not actually solve the problems, or, being language, may just not be able to get
us all the way there. In short, this discussion is to provoke thought, not offer
ironclad solutions.
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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE
– Limit number of items that cause full recourse to as few as possible (when, in
fact, the springing recourse items have proliferated over the years).
– Some particularly problematic examples: solvency, violation of reporting
provisions, violation of any SPE covenant (“You did not have separate
– Waste: Intentional, physical waste only. No requirement to maintain property
if cash not available. One of many possible variations on protective
language: "provided, however, that Borrower or Guarantor shall be liable for
waste only to the extent of physical waste and then only to the extent that
[during the preceding twelve (12) months] the Property generated sufficient
Gross Revenue to pay the Operating Expenses, Taxes, Insurance Premiums,
Debt Service, and costs of maintenance and repair, but Borrower failed to
apply the Gross Revenue to such purposes;"
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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE
– Solvency etc.: At mercy of value decline? One of many possible variations
on protective language: "No provision of this [Schedule, Loan Agreement,
Guaranty, etc. where SPE provisions appear] shall be construed to require
Borrower or any member of Borrower to contribute additional funds or capital
to Borrower or the property, and no member of Borrower or other person
guaranteeing to Lender the performance of Borrower shall be required to pay
or provide any funds (other than Borrower’s own funds) to cause Borrower to
remain solvent or to pay Borrower’s debts or liabilities or otherwise maintain
adequate capital."
– Definitions of “trade payables”: realistic thresholds, ability to cure a default
after notice, indemnification only, NOT springing recourse.
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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE
– “No harm, no foul” for breach of separateness covenants: “Borrower
breaches Section __ and a court of competent jurisdiction renders a final
nonappealable decision that such breach is a substantial contributing factor to
the substantive consolidation of the Borrower with ____________________.”
– Why should Guarantor ever incur full springing recourse for a violation that
does not result in actual substantive consolidation? And the truth is that even
actual substantive consolidation is not likely to cause any damage to the
Lender because its lien will almost surely be preserved and its position no
worse than if consolidation does not occur, just one example of the incredibly
fuzzy and unsophisticated thinking that has made substantive consolidation a
modern day Boogey Man that otherwise intelligent, sophisticated CMBS
players will do anything to avoid, including, incredibly, forego an actual
guaranty of payment in fear that it might create some remote risk of
substantive consolidation. (But good luck with that. Think Galileo.)
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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE
– Bankruptcy: Springing recourse if Guarantor does not have control of
Borrower decision to file? Takeover by Mezzanine Lender followed by filing?
Guarantor partners remove Guarantor and file?
– Conflict of Guarantor who has springing recourse upon bankruptcy filing but
possible fiduciary duty to partners or LLC members. Obtain exculpation from
partner and members in governing documents.
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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE
– LLC Provisions
Limitation of Liability of Other Member. Notwithstanding any other
provision of this Agreement, if a Member or any of the Member’s
employees, officers, Affiliates or consultants (collectively, the “Related
Parties”) performs any services for or on behalf of the Company, neither
the Member nor any of the Related Parties of such Member acting on
behalf of such Member shall be subject to any liability therefor except in
the case (and only to the extent) of Misconduct. To the fullest extent
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– LLC Provisions (continued)
permitted by law, including Section 18-1101 of the Act, and notwithstanding
any other provision of this Agreement, any other agreement contemplated
hereby or related hereto, or applicable provisions of law or equity or
otherwise, the Members hereby (i) agree that no Member or Managing
Member shall have any fiduciary duty to any other Member, the Company,
any Managing Member, or any other party to this Agreement, and (ii) allow
each Member and Managing Member to act solely in the interests of such
Member or Managing Member (and their respective affiliates) with respect
to any act, election or omission that could result in any liability of such
Member or Managing Member under any guaranty or similar document
including ______________; provided, however, the foregoing shall not
eliminate the implied contractual covenant of good faith and fair dealing, to
the extent such covenants are not waivable under the Act.
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– LLC Provisions (continued)
Loan . . . [Developer/Sponsor] shall be obligated to provide Lenders
with any guaranty, non-recourse carve-out guaranty, environmental
indemnity, or other guaranty or indemnity or credit enhancement required
in connection with the Loans, and [JV Partner] shall not be obligated to
provide Lenders with or be obligated to Lenders under any guaranty or
indemnity except with respect to certain bankruptcy actions taken by the
Company at [JV Partner’s] direction or with its collusion or approval
(provided that, pursuant to the Indemnity Agreement, [JV Partner] shall
indemnify [Developer/Sponsor] for certain liabilities that may arise under
the non-recourse carve-out guaranty to be provided by
[Developer/Sponsor] for the benefit of the First Mortgage Lender, subject
to the terms of the Indemnity Agreement).
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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE
– Materiality and Material Adverse Effect. Both are important. “Materiality”
refers to the quality of the breach itself, “Material Adverse Effect” refers to the
consequences of the breach.
– General indemnity of Lender in Loan Agreement by Borrower as carveout
item. Exposure potentially huge and beyond Guarantor or even Borrower
control.
– Springing recourse for “resistance” to enforcement efforts. Is it beyond
Guarantor’s control? Good faith self-defense vs. bad faith hostage-taking.
– Lender’s enforcement costs even where there is no resistance.
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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE
– Should a Guarantor be able to terminate its liability if Borrower offers to
tender deed in lieu (subject to clean title and clean environmental).
– Anticipate Transfer and Assumption: Will new Guarantor be required to be
liable for violations prior to transfer? Will initial Guarantor be let off the hook
for future acts and omissions? Negotiation power is entirely different (and
can approach non-existence) at assumption compared to origination.
Servicer will be resistant to changes in carveout language because Servicer
cannot justify since there is often no demonstrable benefit to Lender.
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BORROWER RESPONSE TO LENDER DRAFT
Here is an example of Borrower’s first round of comments to what was, on the
whole, a relatively speaking not unreasonable first draft from the Lender:
Exculpation. Subject to the qualifications below, Lender shall not
enforce the liability and obligation of Borrower to perform and observe the
obligations contained in the Loan Documents by any action or proceeding
wherein a money judgment shall be sought against Borrower, except that Lender
may bring a foreclosure action, an action for specific performance or any other
appropriate action or proceeding to enable Lender to enforce and realize upon its
interest and rights under the Loan Documents, or in the Property, the Rents or
any other collateral given to Lender pursuant to the Loan Documents; provided,
however, that, except as specifically provided herein, any judgment in any such
action or proceeding shall be enforceable against Borrower only to the extent of
Borrower’s interest in the Property, in the Rents and in any other collateral given
to Lender, and Lender shall not sue for, seek or demand any deficiency judgment
against Borrower in any such action or proceeding under or by reason of or
under or in connection with any Loan Document. The provisions
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of this Section 10.1 shall not, however, (i) constitute a waiver, release or
impairment of any obligation evidenced or secured by any Loan
Document; (ii) impair the right of Lender to name Borrower as a party defendant in
any action or suit for foreclosure and sale under the Mortgage; (iii) affect the
validity or enforceability of any of the Loan Documents or any guaranty made in
connection with the Loan or any of the rights and remedies of Lender thereunder;
(iv) impair the right of Lender to obtain the appointment of a receiver; (v) impair the
enforcement of the Assignment of Leases and Rents; (vi) constitute a prohibition
against Lender to commence any other appropriate action or proceeding in order
for Lender to fully realize the security granted by the Mortgage or to exercise its
remedies against the Property; or (vii) constitute a waiver of the right of Lender to
enforce the liability and obligation of Borrower, by money judgment or otherwise, to
the extent of any actual out of pocket loss, damage, cost, expense, liability, claim
or other obligation incurred by Lender (including attorneys’ fees and costs
reasonably incurred) arising out of or in connection with the following (all such
liability and obligation of Borrower for any or all of the following being referred to
herein as “Borrower’s Recourse Liabilities”):
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(a) fraud, willful misconduct or intentional misrepresentation by or on
behalf of Borrower, Sole Member, Guarantor, or any Person owning an interest
(directly or indirectly) in Borrower, Sole Member or Guarantor, or any of their
respective agents or representatives in connection with the Loan, including by
reason of any claim under the Racketeer Influenced and Corrupt Organizations Act
(RICO);
(b) the forfeiture by Borrower of the Property, or any portion thereof,
because of the conduct or purported conduct of criminal activity by Borrower or
Guarantor or any of their respective agents or representatives in connection
therewith;
(c) intentional physical waste of the Property or any portion thereof,
resulting from the acts or omission of Borrower, provided, however, no liability shall
arise under this subsection if sufficient revenues are not available to Borrower from
the Property, which, after payment of other bona fide expenses including the items
required to be paid pursuant to this Section 10.1, to prevent such waste, or after an
Event of Default the removal or disposal of any portion of the Property outside the
ordinary course of operating the Property;
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(d) any Proceeds paid by reason of any Insured Casualty or any
Award received in connection with a Condemnation or other sums or payments
attributable to the Property not applied in accordance with the provisions of the Loan
Documents (except to the extent that Borrower did not have the legal right, because
of a bankruptcy, receivership or similar judicial proceeding, to direct disbursement of
such sums or payments);
(e) all Rents of the Property received or collected by or on behalf of
the Borrower after an Event of Default and not applied to payment of Principal and
interest due under the Note, andor to the payment of actual and reasonable
operating expenses of the Property, as they become due or payable (except to the
extent that such application of such funds is prevented by bankruptcy, receivership,
or similar judicial proceeding in which Borrower is legally prevented from directing
the disbursement of such sums);
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(f) misappropriation or conversion by or on behalf of Borrower
(including failure to turn over to Lender on demand following an Event of Default) of
any gross revenues (including Rents, security deposits, advance deposits, any other
deposits, rents collected in advance, funds held by Borrower for the benefit of
another party and Lease Termination Payments);
(g) the failure to pay Taxes and Insurance Premiums to the extent that
the revenue from the Property, after payment of other bona fide expenses including
items required to be paid pursuant to this Section 10.1, is sufficient to pay such
amounts, and provided Borrowerthat no liability shall not be liablearise under this
subsection to the extent funds to pay such amounts are available in the Tax and
Insurance Subaccount and Lender failed to pay same or provided the _____ Tenant
is obligated to pay same pursuant to the ____ Lease;
(h) the failure to pay Common Charges [not defined] to the extent that
the revenue from the Property, after payment of other bona fide expenses including
the items required to be paid pursuant to this Section 10.1, is sufficient to pay such
amounts or the failure to comply with the requirements of Section 5.33(b), (d) and (e)
hereof;
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(i) the breach of any representation, warranty, covenant or
indemnification in any Loan Document concerning Environmental Laws or
Hazardous Substances, including Section 4.21 hereof and Section 5.8 hereof, and
clauses (viii) through (xi) of Section 5.30 hereof; or
(j) Borrower’s setting forth a defense, seeking judicial intervention or
injunctive or other equitable relief of any kind or asserting in a pleading filed in
connection with a duly exercised and prosecuted judicial proceeding any defense
against Lender or any right in connection with any security for the Loan which the
court in such action or proceeding determines does not on its face state a defense
(and therefore is dismissible with prejudice as a matter of law or subject to being
stricken) or is frivolous or in bad faith following an Event of Default and the
acceleration of the Debt;
(k) the breach of Borrower’s obligations under Section 3.7(b) hereof
with respect to any letter of credit issued in lieu of a Security Deposit; and/or
(l) Borrower’s indemnification of Lender set forth in Section 9.2
hereof.
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Notwithstanding anything to the contrary in this Agreement or any of the
Loan Documents, (A) Lender shall not be deemed to have waived any
right which Lender may have under Section 506(a), 506(b), 1111(b) or
any other provisions of the U.S. Bankruptcy Code to file a claim for the full
amount of the Debt or to require that all collateral shall continue to secure
all of the Debt in accordance with the Loan Documents, and (B) Lender’s
agreement not to pursue personal liability of Borrower as set forth above
SHALL BECOME NULL AND VOID and shall be of no further force and
effect, and the Debt shall be fully recourse to Borrower in the event that
one or more of the following occurs (each, a “Springing Recourse
Event”):
(i) an Event of Default described in Section 8.1(f) hereof
shall have occurred;
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(ii) a material breach of any of the representations set forth in the
“Recycled SPE Certificate” delivered to Lender in connection with the Loan or a
breach of the representation set forth in Section 4.1(b) hereof or a breach in the
covenants set forth in Section 5.13 (exclusive of clause [(I)(x) and (I)(xviii) and
(II)(vi)]24 and (II)(xiii)]21of the definition of “Special Purpose Bankruptcy Remote
Entity” in Schedule 5 annexed hereto) and, as a result of such breach or breaches
of covenant, a court of competent jurisdiction determines in a final nonappealable
order that such breach or breaches are the basis for the substantive consolidation
of the assets and liabilities of Borrower with those of any other Person pursuant to
the Bankruptcy Code and Lender has diligently and in good faith contested such
determination and Lender suffers a material adverse effect as a result of such
substantive consolidation;
(iii) Borrower is substantively consolidated with any other Person;
unless such consolidation was involuntary and not consented to by Borrower or,
Guarantor, or Lender; and/or
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(iv) (A) Borrower, and/or Sole Member files a voluntary petition under
the Bankruptcy Code or any other Insolvency Law; (B) the filing of an involuntary
petition against Borrower, and/or Sole Member under the Bankruptcy Code or any
other Insolvency Law by any Person in which Borrower, and/or Sole Member, any
Key Principal, any Guarantor or any Affiliate of the foregoing colludes with or
otherwise materially and affirmatively assists such Person, and/or Borrower, Sole
Member, any Key Principal, any Guarantor and/or any Affiliate of the foregoing
solicits or causes to be solicited petitioning creditors for any involuntary petition
against Borrower, Sole Member by any Person; (C) Borrower, and/or Sole Member
files an answer consenting to, or otherwise materially and affirmatively acquiescing
in, or joining in, any involuntary petition filed against any of them by any other Person
under the Bankruptcy Code or any other Insolvency Law; (D) other than at Lender’s
request or initiation, Borrower, Sole Member, or any Affiliate consents to, or
materially and affirmatively acquiesces in, or joins in, an application for the
appointment of a custodian, receiver, trustee or examiner for Borrower or any portion
of the Property; (E) Borrower, Sole Member makes an assignment for the benefit of
creditors.
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TRENCH WARFARE
– The black is the Lender’s original draft.
– The red are the Borrower’s initial proposed revisions.
– The blue and the cross-outs are the Lender’s response to the Borrower’s
proposed revisions.
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TRENCH WARFARE
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TRENCH WARFARE
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TRENCH WARFARE
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TRENCH WARFARE
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TRENCH WARFARE
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TRENCH WARFARE
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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE
In conclusion, it is well to remember that the liberalization of language that is
being achieved now will not change the thousands of loan documents out there
with the old language in them and that the curative legislation passed in Michigan
reversing the Cherryland decision controls nothing beyond Michigan’s borders.
There are many state and federal courts in many jurisdictions before which these
issues may surface, especially in the next three years when the Wall of Maturities
discussed below inevitably results in many unrefinanceable loans and ensuing
litigation.
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NONRECOURSE CARVEOUT AND SPRINGING RECOURSE
CASES
Federal Deposit Insurance Corporation v. Prince George Corporation, 58 F.3d
1041 (4th Cir. 1995): Court held partner of Borrower who filed involuntary
bankruptcy petition against Borrower was liable for deficiency judgment.
First Nationwide Bank v. Brookhaven Realty Associates et al., 223 A.D.2d 618
(N.Y. App. Div. 1996): Borrower’s bankruptcy case was ultimately dismissed but
after the 90 day window provided for in the carveout provision. Borrower and
partners held liable for deficiency judgment.
Heller Financial , Inc. v. Harry F. Lee and L. Joe VanWhy, 2002 WL 1888591
(N.D. Ill. Aug. 16, 2002): Individuals held liable for deficiency judgment for all
remaining debt post-foreclosure due to violation of "no additional liens" covenant.
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NONRECOURSE CARVEOUT AND SPRINGING RECOURSE
CASES
LaSalle Bank N.A. v. Mobile Hotel Properties, LLC, et al., 367 F.Supp.2d 1022
(E.D. La. 2004): Borrower amendment of articles of incorporation to eliminate
single purpose entity status triggered full recourse provision.
Blue Hills Office Park LLC v. J.P. Morgan Chase Bank, 477 F.Supp.2d 366 (D.
Mass. 2007): Failure of developers to pay over $2 million in proceeds to which
Lender was entitled caused guarantys to "spring," resulting in judgment against
them for $17 million.
Princeton Park Corporate Center, LLC v. SB Rental I, LLC, 980 A.2d 1 (N.J.
Super. Ct. App. Div. 2009): Violation of a covenant not to encumber resulted in
springing recourse and judgment for deficiency against Borrower and Guarantors.
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NONRECOURSE CARVEOUT AND SPRINGING RECOURSE
CASES
111 Debt Acquisition LLC v. Six Ventures Ltd., 2009 WL 414181 (S.D. Ohio Feb.
18, 2009): Filing of voluntary bankruptcy by Borrower resulted in full recourse
liability against Guarantors.
Monroe Center II Urban Renewal Co. LLC v. Strategic Performance
Guarantors held liable for full amount of debt due to Borrower’s bankruptcy filing.
Bank of America, NA, et al. v. Lightstone Holdings LLC and David Lichtenstein,
Index No. 601853/2009, Supreme Court, New York County, New York, July 14,
2011: In a case arising out of the Extended Stay bankruptcy, summary judgment
entered in favor of Lender against Guarantor for $100 million (that is not a typo)
due to voluntary bankruptcy of Borrower.
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NONRECOURSE CARVEOUT AND SPRINGING RECOURSE
CASES
U.S. Bank v. Kobernick, 454 Fed. Appx. 307 (5th Cir. 2011): Affirming summary
judgment on behalf of Lender when Borrower attached the collateral to a
voluntary bankruptcy triggering a full recourse liability provision.
51382 Gratiot Avenue Holdings, LLC v. Chesterfield Development Company,
of Lender imposing full recourse liability clause when Borrower violated covenant
to remain solvent and pay liabilities as they become due merely by defaulting on
the loan.
Gratiot was appealed to the 6th Circuit. Before any action by the Court, the case
was settled and, upon stipulation of the parties, the judgment was set aside.
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NONRECOURSE CARVEOUT AND SPRINGING RECOURSE
CASES
Wells Fargo Bank, NA v. Cherryland Mall Limited Partnership, 812 N.W.2d 799, 295
Mich. App. 99 (Mich. Ct. App. 2011): Affirming entry of money judgment against
Borrower where mortgage provision stated that loan would be full recourse to Borrower if
Borrower failed to maintain its status as single purpose entity by remaining solvent and
Borrower, in fact, failed to remain solvent.
Cherryland was appealed to the Michigan Supreme Court, which remanded the case
back to the Court of Appeals for reconsideration in view of the passage of the Michigan
Nonrecourse Mortgage Loan Act, which attempted to reverse the Cherryland and Gratiot
decisions or any similar future decision. Wells Fargo Bank, N.A. v. Cherryland Mall Ltd.
2012). The constitutionality of the Act had been questioned. On remand the Court of
Appeals decided, among other things, that the Act did not violate the U.S. Constitution’s
contracts clause or the due process protections of the Fifth and Fourteenth Amendments.
Wells Fargo Bank, NA v. Cherryland Mall Ltd. P’ship (On Remand), 835 N.W.2d 593
(Mich. Ct. App. 2013). The decision was not appealed to the Michigan Supreme Court.
In February 2015 the U.S. Sixth Circuit Court of Appeals issued a similar decision
upholding the Michigan Act in Borman, LLC v. 18718 Borman, LLC, No. 14-1419, 2015
WL 424548 (6th Cir. Feb. 3, 2015).
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NONRECOURSE CARVEOUT AND SPRINGING RECOURSE
CASES
Wells Fargo Bank, N.A. as successor by consolidation to Wells Fargo Bank MN,
N.A. as Trustee for the registered holders of Banc of America Commercial
Mortgage Inc., Commercial Mortgage Pass-Through Certificates, Series 2003-2,
by and through its Special Servicer, ORIX Capital v. Mitchell's Park, LLC et al.,
2012 WL 4899888 (N.D. Ga.): The applicable document imposed personal
liability if the Borrower failed to maintain the specified SPE requirements including
the following: “be solvent and pay its liabilities from its assets ... as the same shall
become due,” to be “a legal entity separate and distinct from any other entity ...
uti-liz[ing] a separate telephone number and separate stationery, invoices, and
checks,” to “establish and maintain an office through which its business shall be
conducted separate and apart from those of any of its affiliates,” to “file its own
tax returns,” and to “maintain adequate capital for the normal obligations
reasonably foreseeable in a business of its size and character.” Defendant did
not contradict Lender’s summary judgment allegations that each of these had
been violated. Citing Gratiot and Cherryland among others, the Court ruled in
favor of Lender, imposing personal liability for a deficiency in excess of $4
million. [Note “separate stationery” breach]
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NONRECOURSE CARVEOUT AND SPRINGING RECOURSE
CASES
Appeal of Ga. case docketed No. 14-14130 (11th Cir. Sept 12, 2014).
And these two unusual cases with pro-Borrower outcomes:
GECCMC 2005-C1 Plummer Street Office Limited Partnership v. NRFC NNN
Holdings, LLC, 204 Cal. App. 4th 998, 140 Cal. Rptr. 3d 251 (2012) (Lender was
unable to show an actual breach).
ING Real Estate Finance (USA) LLC v. Park Avenue Hotel Acquisition LLC, 907
N.Y.S.2d 437 (N.Y. Sup. Ct. 2010) (Court held, resolving ambiguous language in
favor of Guarantor as required by New York law, that Borrower cured the violation
(failure to pay a tax when due) before springing recourse “sprung.”)
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The Wall of CMBS Maturities
2015-2017
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The Wall of CMBS Maturities
2015-2017
CMBS issuance volumes were higher than ever in 2005, 2006, and 2007 with a
peak volume of about $230 billion in 2007.
The great majority of this issuance was made up of ten year balloon loans,
creating a wall of maturities from 2015 to 2017.
Over the next three years, more than $300 billion in Conduit CMBS loan balance
will mature, which is more than 2.5 times the amount that matured from 2012 to
2014.1
1 The above statistics are from Trepp’s Research Report, “The Wall of Maturities:
Something’s Gotta Give,” November 13, 2014.
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The Wall of CMBS Maturities
2015-2017
When originally recognized several years ago, this situation was expected to
produce yet another financing crisis, or more accurately, it was assumed that a
limping recovery from the 2008 debacle would be crushed by the wall (or
“drowned,” because the metaphor back then was not a “wall” but a “tsunami”) of
hopelessly undervalued loans.
Nobody then (and that was not so long ago) believed that either the CRE market
or the CMBS market would recover nearly as strongly as they have.
Assuming no new crisis erupts due to exogenous macro events, CMBS 3.0
should greatly help mitigate any crisis caused by the wall of maturities.
However, as the Trepp Report cited above shows, many of the legacy 2005-2007
collateral properties cannot meet certain important current underwriting
standards, especially the current DSCR and LTV requirements.
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The Wall of CMBS Maturities
2015-2017
But this, again subject to exogenous macro events, does not create a general
crisis; it creates opportunities.
It especially creates opportunities for lawyers and their capital provider clients as
well as real estate entrepreneurs.
The next 3 years looks like one of the best of all worlds, where both the DOWN
escalator (defaults, workouts, and some loan enforcement litigation due to the
maturities of loans that cannot be easily refinanced) and the UP escalator
(numerous refinancing and restructuring transactions) ARE BOTH FULL!
There will be much room for interesting and creative deal-making for all kinds of
debt and equity providers, providing good work for the lawyers on both sides of
the transactions.
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SUBORDINATE DEBT
(A-B, Mezzanine, Preferred Equity)
“The report of my death was an exaggeration.”
Mark Twain
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SUBORDINATE DEBT
(A-B, Mezzanine, Preferred Equity)
For the basic features of A-B and Mezzanine loan structures see the Slides
presented by my co-presenter Allen Dickey.* I will not belabor those here but will
focus on some special issues of each structure.
After suffering horribly and ending up pretty much written off for dead in the wake
of the Crash, subordinated debt in CMBS deals, as Allen Dickey points out in his
materials, has made a powerful comeback. It is likely to play an increasingly
prominent role as we begin swimming in the waters of the CMBS Maturity Flood
(you can only work so much with the “Wall” metaphor).
*For in-depth analysis of Mezzanine, see the Polsinelli Guide To Real Estate
Mezzanine Finance (Peppercorn Press, 2008) and Dan Flanigan and Michael
Hickman, “Subordinate Finance in Real Estate Transactions,” Business Workouts
Manual (Thomson Reuters, November 2013).
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The yield tends to move upward from A-B to Mezz to Preferred Equity.
A-B is a lien on the real estate.
Mezz is a lien on the ownership interests in the entity that owns the real estate.
Preferred Equity is an ownership interest in the entity that owns the real estate or
an upper tier parent of the ownership entity, sometimes also secured by a
security interest in some or all of the other ownership interests.
It is perceived, and the perception is at least roughly accurate, that one gains
more control as one moves from A-B to Mezz to Preferred Equity.
COMPARATIVE ADVANTAGES AND
DISADVANTAGES
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COMPARATIVE ADVANTAGES AND
DISADVANTAGES
After being fairly popular in CMBS 1.0, A-B notes are not so popular these days
due, among other things, to a hunt for higher yield and a perception that the B
Note holder has less control over its destiny than Mezz. Although some of this
ground might be made up by negotiating new provisions more friendly to B Note
holders in new deals (that is, if Rating Agencies be willing), it will be hard to
overcome the fact that, despite its security in the real estate, it is just a tail on the
A dog. The thought would be that it is better to be the Mezz Omega dog than no
dog at all.
The senior-sub relationship in the A-B context is documented through a Co-
Lender Agreement, in the Mezz context by an Intercreditor Agreement, and in
Preferred Equity by a Recognition Agreement.
Another disadvantage to the B Note holder vs. the Mezz holder is that the Co-
Lender agreement in the A-B context provides for the possibility that the small
amount of control that the B may initially possess can be eliminated through
“appraisal reductions” if the property deteriorates in value so that the B position’s
value deteriorates below a certain percentage of its original principal amount
(usually 25%).
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Another disadvantage to the structure, this time to the A Note, is that the
bankruptcy court will treat the A-B as one note for purpose of fixing the debt and
valuing the collateral, thus increasing the likelihood that the A position, as well as
the B, will be deemed to be undersecured in the bankruptcy case and thus not
entitled to postpetition interest or attorneys’ fees.
Real estate foreclosure vs. UCC sale of ownership interests vs. contractual
removal or subordination of Manager by Preferred Equity.
COMPARATIVE ADVANTAGES AND
DISADVANTAGES
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SENIOR-SUB ISSUES
Litigation against a common Guarantor.
Do Mezz Nonrecourse Carveouts interfere with Senior Lender remedies? E.g.
springing recourse under Mezz upon a voluntary transfer (deed in lieu) to senior
lender, a bankruptcy, or a collusive receiver appointment, eliminating any
incentive Borrower and Guarantor may have to an efficient and prompt resolution
with the Senior Lender.
Qualified Transferee Issues:
– Changing fortunes.
– What must transferee prove and to whom?
– UCC Sale Commercial Reasonableness Issue.
– What restrictions should there be on transfer of Senior?
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Do Mezz Lender approval rights conflict with Senior Lender interests?
– Property Modifications
– Property/Ownership Transfers
– Lease Modifications/New Leases
– Property Manager
– Annual Budget
– Refinancing of Senior Loan
Stuy Town Resolution
New Guarantor Issues Upon Exercise of Mezz Remedies
– Old “CMSA” Form: Only if Guarantor removed
– Automatic guaranty liability?
– Must deliver Gty now?
– Condition Precedent to Foreclosure?
Senior Loan Extension Options
SENIOR-SUB ISSUES
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MEZZ REMEDIES
Note: a UCC sale of mezzanine collateral is an acquisition of ownership interests
of an enterprise with no reps and warranties, no indemnifications, and no due
diligence.
UCC Commercial Reasonableness Issues
Mezz “Deed In Lieu”/Strict Foreclosure
Control Provisions
Receiver Appointment
Taking Advantage Of Certain Helpful UCC Provisions
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DELAWARE STATUTORY TRUSTS
(THE NEW TICs)
(Thanks to my POLSINELLI colleague Brandon Bartee who did
most of the research and analysis for this Section.)
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DELAWARE STATUTORY TRUSTS
(THE NEW TICs)
Even TIC Borrowers, perhaps the most disfavored of all non-felonious Borrowers
in CMBS 2.0, are making a limited comeback in CMBS 3.0. And their better bred
cousins, Delaware Statutory Trusts (“DSTs), are mingling with the other guests at
the party.
Moreover, the huge number of problematic loans comprising the bricks of the
impending Maturity Wall discussed above will include a very large number of
loans with TIC Borrowers made in 2005-2007 before TICS became pariahs. And
DST’s are thought to be a possible rescue vehicle for troubled TICs. While the
Parachute LLC discussed below is one rescue approach, the TIC investors lose
their 1031 eligibility on a future sale while 1031 eligibility is maintained in a
conversion to a DST.
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DELAWARE STATUTORY TRUSTS
(THE NEW TICs)
The problems with TICs included--
– The unwieldiness of dealing with up to 35 individual Borrowers on one loan,
each of whom might file a partition lawsuit or an individual bankruptcy
proceeding imposing an automatic stay of Lender action and potentially
exposing the Lender to a large number of separate bankruptcy reorganization
plans restructuring various slivers of TIC debt in perhaps impossibly
inconsistent and irrational ways.
– The cost of post-default enforcement actions against a number of TIC
Borrowers for one loan.
– Complexity of servicing administration, e.g., processing transfers of TIC
interests.
– Cumbersome governance including severe limitations on the ability and
willingness of TIC owners to contribute additional capital for necessary
improvements or rescue.
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DELAWARE STATUTORY TRUSTS
(THE NEW TICs)
DST’s do not eliminate all but do eliminate some of the major problems with
TICs—
– Title to the property is held by a single entity, not up to 35 individuals.
– The Lender makes one loan to one Borrower.
– The DST is bankruptcy remote. The Lender need be no more concerned
about the bankruptcies of individual beneficiaries than of LLC members or
corporate shareholders.
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DELAWARE STATUTORY TRUSTS
(THE NEW TICs)
DSTs Generally
– A DST is a trust created under Delaware law that is regarded as a legal entity
separate from its owners or beneficiaries. DSTs may have an unlimited
number of beneficiaries (as opposed to the 35 co-owner limit imposed by TIC
regulations), though securities laws generally limit the number to 500. The
trustee (or “signatory trustee” as it is commonly known) is responsible for the
management of trust assets and distribution of profits to the beneficiaries.
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DELAWARE STATUTORY TRUSTS
(THE NEW TICs)
Revenue Ruling 2004-86 and Section 1031 Eligibility
– In Rev. Rul. 2004-86, the IRS explained the circumstances under which a
DST would be treated as a “fixed investment trust” (rather than a business
entity*) for tax purposes and whether the beneficial interests in such a trust
were Section 1031 eligible. The IRS found it critical that the powers of the
trustee were limited so that the trust acted as a mere conduit between profits
generated by the property and the beneficiaries, rather than an entity that
managed and operated the real property for business purposes.* These
limitations have long been regarded as the “seven deadly sins” and are the
cornerstones of the DST/1031 exchange eligibility analysis:
After the initial offering has closed, there can be no future contributions to
the DST by current or additional beneficiaries.
The trustee cannot renegotiate the terms of the existing mortgage loan or
borrow any additional funds.
*This also raises the issue of whether a DST is a non-business trust and thus not
eligible to be a Debtor under the Bankruptcy Code
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DELAWARE STATUTORY TRUSTS
(THE NEW TICs)
The trustee cannot sell the property and reinvest the proceeds into the
DST (DSTs cannot be “recycled” borrowing entities).
The trustee is limited to making minor repairs or structural improvements
to the property (unless required by law).
The trustee may establish reserves and hold cash between distribution
dates to the beneficiaries, but may only invest such funds in short-term
debt obligations.
All cash (excluding reserves) must be distributed to the beneficiaries on a
current basis.
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DELAWARE STATUTORY TRUSTS
(THE NEW TICs)
The trustee cannot enter into new leases (unless the tenant files
bankruptcy or becomes insolvent).
The trustee cannot renegotiate existing leases (unless the tenant files
bankruptcy or becomes insolvent).
So long as the trustee does not run afoul of the foregoing, ownership of beneficial
interests in the trust will be deemed to be direct ownership in the real estate
owned by the trust for income tax purposes, and thus, acceptable property for
Section 1031 exchange purposes.
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DELAWARE STATUTORY TRUSTS
(THE NEW TICs)
DST Structures in Lending Transactions.
The following sections describe the key players in a typical DST structure and
other unique characteristics of DST loan transactions.
– DST Borrower
A bankruptcy remote, special purpose entity (SPE). The trust agreement
should contain standard separateness covenants and restrictions against
activities that could trigger one of the “seven deadly sins.” Lender’s consent
required for any amendment to the trust agreement.
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DELAWARE STATUTORY TRUSTS
(THE NEW TICs)
– Signatory Trustee
The signatory trustee is often a single-member LLC owned by the
sponsor/Guarantor. It is preferable that the signatory trustee be an SPE and
limited to acting as the trustee of the DST Borrower. In certain instances (i.e.,
where the property is leased to a single credit tenant pursuant to a triple-net
lease), the signatory trustee may act as the property manager, provided it has
assigned all of its obligations to a third-party property manager pursuant to a
sub-management arrangement. The signatory trustee is entitled to receive
compensation for its role in administrating the trust. The signatory trustee
should own at least a 0.5% of the beneficial interests in the DST after the
offering has closed.
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DELAWARE STATUTORY TRUSTS
(THE NEW TICs)
– Delaware Trustee
DSTs are required to maintain at least one trustee located in the State of
Delaware for service of process. The Delaware trustee need not have an
active role in the management of trust assets. Most major corporate service
companies offer Delaware trustee services.
– Depositor
In most instances, the property has been pre-acquired by an affiliate of the
sponsor known as the depositor. Simultaneously with the closing of the
mortgage loan transaction, the depositor will contribute money to the trust in
exchange for 100% of the beneficial interests in the DST. The depositor
recoups this contribution from the proceeds of the sale of the interests to the
investors/beneficiaries of the trust pursuant to a private offering.
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DELAWARE STATUTORY TRUSTS
(THE NEW TICs)
– Guarantor/Sponsor
The Guarantor is an entity/individual selected by the Lender (usually owned
and controlled by the sponsor) to serve as the non-recourse carveout
Guarantor and to indemnify the Lender from losses resulting from
environmental conditions related to the property.
– Beneficiaries
The beneficiaries of the trust are strictly passive investors. They have no
ability to control the actions of the trustee or the property. Because of this
limitation, they cannot commit “bad boy” acts and will not be required to
execute a non-recourse carveout guaranty. In fact, a full payment guarantee
by a beneficiary of the loan can be viewed as an obligation to make an
additional capital contribution to the DST, and thus prohibited by Rev. Rul.
2004-86.
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DELAWARE STATUTORY TRUSTS
(THE NEW TICs)
– “Parachute” LLC
If the property were to be in jeopardy or if there was a default under the
mortgage loan, the trustee is prevented from taking any action to remedy the
situation pursuant to Rev. Rul. 2004-86. Under these circumstances, the
trustee is authorized (pursuant to the terms of the trust agreement) to convert
the DST to a limited liability company (a “Parachute LLC”). The trustee
becomes the managing member of the Parachute LLC and the beneficiaries
its members. The Parachute LLC must be an SPE whose operating
agreement is pre-approved by the Lender and is typically attached as an
exhibit to the trust agreement. The conversion provides the trustee/managing
member with an opportunity to address any issues related to the property.
The initial 1031 property exchange is not adversely affected by the
conversion but the members lose the 1031 exchange status with respect to
their membership interests. It is always possible for the Parachute LLC to
later convert to a DST.
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DELAWARE STATUTORY TRUSTS
(THE NEW TICs)
Use of a Master Lease
– One of the disadvantages of a DST structure is the limitation imposed on the
trustee with respect to the management and operation of property. Unless
the existing tenant has filed bankruptcy or is declared insolvent, the trustee
cannot renegotiate existing leases or enter into new leases. If the property is
leased by a single-credit tenant pursuant to a triple-net lease for a term
extending beyond maturity of the mortgage loan, this risk is diminished.
However, for loans secured by multi-family apartment complexes, office
buildings, or retail shopping centers, the Lender must require the DST to
master-lease the property to an SPE affiliate. The master tenant may then
sublease the property to the ground tenants and function as a traditional
landlord. The master lease must be subordinate to the mortgage loan and
the master tenant assigns its interest in the leases and rents to the Lender.
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DELAWARE STATUTORY TRUSTS
(THE NEW TICs)
Multi-Property DST Transactions
– Multi-property DST offerings are possible through the use of a master DST
structure. It is preferred that a separate DST hold title to each individual
property, but it is possible for multiple properties to be contributed to a single
DST-Borrower. In either case, the depositor transfers up to 99.5% of its
interest in the Borrower DST to an “offering DST” who then sells its own
beneficial interests to investors pursuant to a private placement
memorandum. Through this structure it is possible for the investors to own
an indirect interest in multiple properties and, provided the requirements of
Rev. Rul. 2004-84 are satisfied by all DSTs in the structure, the interests in
the offering DST will be Section 1031-eligible. The transfer of the Borrower-
DST’s interest to the offering DST should be a pre-approved transfer in the
loan documents.
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DELAWARE STATUTORY TRUSTS
(THE NEW TICs)
Benefits and Risks
– When compared to traditional TIC transactions, DST structures offer the
following benefits:
The Lender need only underwrite the DST, signatory trustee, sponsor,
and any related parties (i.e., master tenant and Guarantor). Only
beneficiaries owning in excess of 20% of the trust must be underwritten.
Title to the property is held by a single entity. The Lender makes one
loan to one Borrower, reducing complexity and transactional costs.
The beneficiaries have no role in governance of the DST and its property,
thus allowing for true centralized and presumably professional
management of the DST’s affairs without interference pesky owners.
The DST is bankruptcy remote. The property is not subject to claims of
beneficiaries’ creditors. Unlike TICs, individual bankruptcy filings or
partition actions by beneficiaries are not of concern to the Lender.
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DELAWARE STATUTORY TRUSTS
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DSTs structures do introduce special risks into a loan transaction, many of
which can be mitigated by creative use of the Master Lease structure:
– The trustee’s lack of control over the property or the underlying lease.
– The inability of the trustee to restructure the DST’s debt or otherwise work
with the Lender if a default should occur. This risk is mitigated by the
Parachute LLC provisions; however, the Lender is still reliant on the trustee to
complete the conversion.
– The inability of the trustee to refinance the mortgage loan creates a refinance
risk. In most cases the trustee will seek to liquidate the property as an exit
strategy.
– The beneficiaries may not make additional capital contributions to rescue the
property.
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Drafting Considerations and Other Requirements
– DST structures necessitate revisions to the structural aspects of a CMBS loan
as well as to standard CMBS loan documents. The following list is not
intended to be exhaustive but indicates the kind of special consideration that
DST loans require—
The DST, Master Tenant, and preferably the signatory trustee, must be
SPEs subject to standard separateness covenants.
Signatory trustee should maintain a minimum interest in the DST
(typically no less than 0.5%).
Beneficiaries may not be liable for the obligations of the DST and cannot
act as Guarantors of nonrecourse or springing recourse carveouts.
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The sponsor and its affiliates may only guarantee nonrecourse or
springing recourse carveouts but cannot provide an unconditional
guarantee of the loan (something that is in any event not usually present
in CMBS loans due to substantive consolidation risk concerns).
Permitted transfer provisions in the loan documents should be tailored to
permit (a) the transfer of interests in the trust to third party investors (up
to 20% to any one individual without Lender consent) and between the
depositor and an offering DST, and (b) the transfer of the property (or
conversion of the Borrower-DST) to a Parachute LLC.
Non-recourse carveouts should be considered to mitigate various special
risks including for unauthorized amendments to the DST’s organizational
documents, or failure to convert to a Parachute LLC when required.
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If the property tenant is not a single-credit tenant under a triple-net lease,
the DST must incorporate a master-lease structure as described above.
While early DST deals were generally limited to single tenant properties,
CMBS Lenders have since closed and securitized loans secured by multi-
family apartment complexes, office buildings, and shopping centers using
a master lease. The master lease term must extend beyond the loan
term and be subordinate to the Lender’s interest in the property.
Special nonrecourse carveouts and springing recourse need to be
considered for such things as filing of bankruptcy by the Master Tenant or
rejection of the Lease in the Master Tenants’ bankruptcy.
The Lender must be aware of the complications introduced by the Master
Lease structure, such as the fact that the Master Tenant is the owner and
thus must be the assignee of the tenant leases (actually subtenant
leases) that will furnish the underlying income supporting debt payments.
The Master Tenant will also be the owner of, and thus must be the
grantor of security interests in, any related personal property that is
acquired during the Master Lease term.
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Reserves for taxes, insurance premiums, replacements and rollover costs
are especially important given the limitations on additional owner equity
contributions.
The loan documents should be revised generally to ensure the
Borrower’s compliance with Rev. Rul. 2004-86. The signatory trustee
and offering DST (if applicable) should be considered “Borrower parties”
under the loan documents. It is recommended that the signatory trustee
and offering DST execute a joinder agreement to the loan agreement
acknowledging and agreeing to comply with its terms.
Failure to comply with the Parachute LLC provisions should be springing
recourse events.
Consider what special opinions of counsel should be required.