Emerging Trends in Commercial Mortgage Lending During COVID-19
Real Estate Alert 05/27/20 Rasha Elganzouri Gad, Everett S. Ward
On May 5, 2020, Quarles & Brady and the Chicago Mortgage Attorneys Association hosted a webinar titled: “Emerging Trends in Commercial Mortgage Lending During COVID-19.”
Rasha Elganzouri Gad and Everett Ward, Chicago based Partners in the firm’s National Real Estate Group, discussed emerging trends for lenders and borrowers in light of the pandemic. The following are key takeaways from the webinar.
Closing Committed Deals
While 23 States have adopted Remote Online Notary (RON) legislation, and several more have authorized RON during the coronavirus emergency, there are varying degrees of acceptance at the county levels. If you are closing a loan, you need to check with the applicable state and county authorities to determine if RON is accepted. For example, in Illinois, Governor Pritzker issued an Executive Order in Response to COVID-19 which effectively suspends the requirement that a person appear in-person before an Illinois-commissioned notary public. The in-person notary may be satisfied remotely via two-way audio-video communication technology. Also, the notary and customer must be physically located within Illinois while performing the notarial act.
Given there are state, county and city closures, lenders and borrowers must initiate early discussion with the title companies on each transaction during the COVID-19 pandemic and take into consideration the various obstacles created in its wake. If the recorder’s office is closed and electronic recording is not accepted, you can expect additional title company requirements, including a borrower providing a modified gap indemnity. Even if the mortgage can be recorded electronically, if the county’s electronic indexing system cannot be updated, the title company will not have the ability to update title immediately prior to closing. This will prevent the title company from ensuring that no other instruments have been recorded prior to the related mortgage. Construction loan closings or other instances where there will be subsequent draw requests and title date downs (e.g., tenant improvement work) are especially under scrutiny if the county’s electronic indexing system cannot be updated.
Borrower’s Wish List – What Borrower Needs to Do Prior to Forbearance/Loan Modification Requests
If you are a borrower seeking relief from a lender, you should make a written request containing all key information necessary to assist the lender in making a decision. Transparency is key and instrumental towards a successful workout. Borrowers should consider including the following information in the written request:
- A statement of the reasons for, and requested duration of, the loan forbearance, together with any relevant correspondence from commercial tenants;
- Financial projections for the next 12 months;
- 2019 year-end property financial statements and rent roll;
- Current borrower and guarantor financials; and
- Steps the borrower is taking to mitigate losses (e.g. has the borrower applied for a CARES Act loan or other form of financial assistance?)
Due Diligence – Do Your Homework!
Proper due diligence by the lender and borrower are essential ingredients to successfully negotiating and documenting a loan workout. This is a fact gathering exercise. Lenders should reexamine all loan documents for completeness and for defects or gaps in information. Likewise, the borrower should attempt to anticipate lender demands and prepare to rectify any property deficiencies. Both parties should pay specific attention to any post-closing covenants or conditions and whether they have been satisfied.
Next, review the loan documents for critical terms and determine whether an event of default exists. Key provisions to review include:
- Representations/Warranties - Are any no longer true, accurate, or compete?
- Borrower Covenants - Review debt service covenants, loan to value requirements, and net worth covenants. Also, you should consider whether the loan imposes a springing cash management that is triggered on occurrence of an event of default.
- Lender Consent Requirements - For example, is lender consent required prior to borrower amending a lease or entering into a Paycheck Protection Program (PPP) Loan?
- Events of Default - Triggers for default include payment default and cross-defaults, cessation of business, interruption of business, failure to meet liquidity covenants, and failure to comply with financial reporting requirements.
- Notice Provision - Make sure all written requests comply with the notice provision. In particular, check the notice provision to determine if email constitutes proper notice.
MAC Clause – Should Lenders Invoke a MAC Default?
In considering if the impact of COVID-19 constitutes a material adverse change (MAC), courts’ interpretation of the term require the party relying on the provision to meet a high burden of proof to show that the pandemic has had a substantial adverse impact on borrower’s financial condition and such impact will continue for a significant period of time. Given the high standard for demonstrating a MAC and the fact that the long-term effects of COVID-19 are still unknown, arguing that the disruptions caused by the pandemic constitute a MAC may be challenging for lenders. Further, in order to protect against lender liability claims, it may be prudent for lenders to avoid invoking a MAC clause as an event of default under the loan documents.
Pre-Negotiation Agreements – Key Terms
Before any significant workout negotiations start, a prudent lender will require that the borrower sign and deliver a pre-negotiation agreement. The intent of the pre-negotiation agreement is to preserve the status quo and provide an open forum for productive discussions without the fear of litigation. The agreement itself should not be adversarial. It should not demand admissions from either party that defaults have occurred, or that rights under loan documents are waived, although lenders will often seek comfort from borrowers that there are no claims by borrower against the lender. Pre-negotiation agreements are not always needed. We have seen instances where a lender simply responds to a borrower request with a simple forbearance letter without the need for the pre-negotiation agreement. Whatever the situation, a lender should avoid making promises it may not keep or exerting undue influence over the borrower’s business. If workout negotiations then fail, lender liability claims could be raised. Protecting against such claims should be a priority for a lender.
The key provisions of a pre-negotiation agreement include:
- Discussions are non-binding until a written agreement is signed by both parties;
- Discussions and correspondence are confidential in nature and not admissible in court;
- No waiver of either party’s rights and reservation of rights and remedies;
- Either party can terminate the negotiations at any time without incurring liability;
- Any full or partial debt service payment accepted by the lender after default is not a waiver or amendment of any loan document; and
- Statement regarding which party pays for negotiation and drafting of workout documentation.
Lender Response: Default Letter/Reservation of Rights Letter, Forbearance Agreement, Loan Modification and “Hybrid” Agreements
Depending on the facts and circumstances, the lender’s response to a borrower request for debt service relief can include the following:
- Default Letter/Reservation of Rights Letter
A lender may send a notice of default letter and/or reservation of rights letter after the occurrence of an event of default. The reservation of rights letter acknowledges the existence of the default and acknowledges that the lender does not waive any remedies available to it.
- Forbearance Agreement
Forbearance agreements (or standstill agreements) are agreements in which the lender agrees to hold off from pursuing a foreclosure or otherwise enforcing its remedies. It can be in a form of a short form letter to borrower or written agreement. At a minimum, the forbearance agreement should address the following:
- Acknowledgement by parties of key facts and loan terms;
- The term of the forbearance period (we are seeing 60-90 day forbearance periods);
- The forbearance period termination events;
- Borrower’s obligations going forward (e.g. cash management matters, agreed budget, modified financial reporting, debt service, additional equity or prohibition on distributions);
- Deferral or modification to debt service payment schedule; and
- Reaffirmation of representations/warranties and guaranties.
Where circumstances allow, additional credit enhancements or more robust lender remedies could include any of the following, among others:
- Additional recourse guarantees
- Supplemental collateral
- Waivers of defenses by the borrower in relation to key lender remedies
Lenders should also consider whether there should be additional borrower requirements specific to recent COVID-19 legislation at the federal and state level. For example, should there be additional covenants regarding social distancing strategies and sanitization requirements? The consensus was that lenders should rely on the compliance of law provisions of loan documents and avoid specific COVID-19 requirements or conditions, especially since the pandemic is fluid and there will likely be changes and updates to existing orders and legislation going forward.
- Loan Modification Agreement
If a lender is considering a waiver of an event of default and/or making adjustments or changes to the loan terms, then an amendment to the loan agreement or loan modification may be negotiated.
The lender’s wish list for a loan modification agreement include:
- Principal paydown of principal portion of the loan;
- Implementation of a cash management system (if cash management was not in place at closing due to strong financial performance of the property, the lender should consider whether the current situation merits a hard lock box with lender in control of cash);
- Interest rate benchmarks such as Libor rate change to SOFR and new interest rate floor;
- Addition of further guarantors of the loan or the modification of existing non-recourse carve-out guaranties into full repayment guaranties or other “springing” guaranties;
- Termination of any further funding obligations or creation of new conditions precedent or other phasing to such future funding; and
- Additional collateral (other real property or pledges of revenue or membership interest of borrower).
The borrower’s wish list for a loan modification include:
- Reset financial terms (e.g. reduction of interest rate, payment of interest only with a moratorium on principal payments for a specific period of time);
- Extended maturity date with extension options;
- Renegotiation of borrower covenants (e.g. modification of existing loan to-value, debt service coverage ratios, or other financial or liquidity tests for borrower or guarantors); and
- Avoid or minimize additional equity contributions required by the lender.
- "Hybrid" Agreements
Many lender/borrower agreements may be "hybrid" agreements that contain standard forbearance provisions, as well as substantive loan document modifications necessitated by the economic impact of COVID-19 on the borrower's business operations. These modifications may include changing the timing of monthly principal payments going forward (e.g. quarterly, rather than monthly), revising debt service coverage tests, adjusting payment of required tax and insurance impounds, and repair and capital expenditure escrows.
CARES Act Implications
The following are some of the loans available to eligible borrowers under the Coronavirus Aid, Relief and Economic Security Act (CARES Act):
- PPP Loan. For additional guidance, refer to Q&B Client Alert: CARES Act – SBA Administered Paycheck Protection Program and CARES Act – “Paycheck Protection” Loan Program Opens April 3
- Economic Injury Disaster Loan (EIDL). For additional guidance, refer to Q&B Client Alert: SBA Offers Disaster Assistance Loans to Small Businesses Impacted by COVID-19
- Main Street Lending Program. For additional guidance, refer to Coronavirus Stimulus Bill for Businesses Over 500 Employees
Two important tips:
- If an eligible borrower is considering applying for a loan under the CARES Act or any other financial assistance program, a prudent borrower should review its loan documents to determine if lender consent is required. Most loan documents contain prohibitions against incurring additional indebtedness without the prior written consent of the lender.
- Lenders should avoid requiring a borrower to apply for a PPP Loan as a condition of loan forbearance or other loan workout terms. First, while the program is helpful, the PPP funding under the CARES Act will likely not cover the vast demand from businesses seeking financial assistance. Second, some but not all of the loan may be forgiven, and the borrower would be incurring additional debt service payments that would impose additional financial hardship on the borrower and its business. Finally, even if the borrower receives a PPP loan, there are restrictions on the application of loan proceeds. The PPP Loan program is primarily intended to cover payroll expenses, and at least 75% of loan proceeds must be used for payroll to be forgiven. This does not prevent lenders from requesting information from borrowers about whether they have applied for financial assistance as part of the workout analysis and requiring that to the extent funds can be used for debt service, imposing a requirement that borrowers must apply funds to debt service.
While most loan workouts involve discussions between the lender and its borrower, in order for the workout to be successful, one needs to consider additional parties that will likely be involved.
Key parties include:
- Equity investors
- Principal tenants
- Senior lenders
- Subordinate lenders
- Mezzanine lenders
- Property managers
- Members of the lending syndicate (co-lenders)
- Unsecured creditors
In the case of multiple lenders, thought should be given to the approvals and consents necessary prior to execution of a loan forbearance or modification agreement.
How Can Lawyers Help?
The webinar contains some tips for attorneys (both outside counsel and in-house attorneys) as to how to provide "best in class" service to their respective clients as lenders and borrowers navigate the forbearance/loan modification process. Obtaining and sharing with clients current market knowledge and best practices, and offering alternative pricing for outside counsel legal services are two examples of how counsel can differentiate themselves and create opportunities for obtaining additional work.
See Quarles & Brady's events page (Emerging Trends in Commercial Mortgage Lending During COVID-19) to view the full webinar.
For more information regarding Commercial Mortgage Lending during the COVID-19 pandemic, please contact your Quarles & Brady attorney or: