Highlights Of HUD’s New Section 232 LEAN Closing Documents, April 9, 2013

On September 7, 2012, the Federal Housing Administration (FHA) published in the Federal Register new regulations for the Section 232 Healthcare Facility Insurance Program, which became effective as of October 9, 2012. In order to institute the new regulations, FHA drafted new loan closing documents. The first drafts of the new closing documents were released on May 3, 2012. After providing an opportunity for discussion and industry comment, revised loan document drafts were circulated on November 21, 2012. Following another round of comments and review from both the industry and U.S. Department of Housing and Urban Development (HUD) staff, on March 14, 2013, HUD released final new loan documents to match the final regulations (the Closing Documents).

HUD has publicly stated that the new LEAN documents must be used if a facility receives its commitment on or after April 9, 2013. Much like when the new MAP documents were released, we anticipate many waivers will be requested for at least those deals currently in an application queue. Our sources at HUD have told us that while headquarters has not told the field counsel how such waivers will be handled, HUD will be paying particular attention to ensure that if a request to use the previous form of documents effects a new regulation, that a formal regulatory waiver will be required.

In addition to the new Closing Documents, there are also new Lender Narratives, production certifications, construction documents and asset management documents (Additional New Documents) that must be used for all applications submitted on or after July 12, 2013. HUD encourages these new documents now; however, HUD is requiring that applications submitted between now and July 12 must include either the complete use of new documents or the complete use of the old documents – a lender cannot mix the new documents and old documents when submitting an application.

This Update discusses the substantive provisions in the new Closing Documents. Below we highlight provisions in some of the Closing Documents that we believe are of particular interest to Borrowers, Operators and Mortgagees. While this article covers only some of the new Closing Documents, all of the Closing Documents and the Additional New Documents can be found online. Those documents discussed below can also be found by clicking on the headings in this article for a direct link to the document.

Mortgage, Assignment of Leases, Rents and Revenue and Security Agreement

The first noticeable change from the current mortgage to the new form is that HUD has combined the security instrument and Owner security agreement. The new security instrument closely resembles the new MAP security instrument in style and substance, including the exculpation language concerning the key principal identified in the Mortgagor’s Regulatory Agreement. The most significant change in the new Security Instrument is the inclusion of the Operator’s license (whether the Operator is an affiliate or not) as collateral for the Security Instrument.

Note

The Note is very similar to the new MAP note with one notable difference, the time for assessing late charges under the LEAN Note is 15 days, as opposed to 10 days for the MAP program.

Owner Regulatory Agreement

While the MAP regulatory agreement serves as the base for this new form, there are a number of items that only apply to healthcare facilities that we want to highlight. The first item is of importance for Borrowers who self-operate their facility; the entity will be required to execute both the Owner and Operator Regulatory Agreements as well as the Operator Security Agreement. While all Owners must submit an annual financial audit, if the Owner is also the Operator of the facility, it must submit quarterly financial reports per the terms of the Operator Regulatory Agreement.

Another interesting provision affects non-profit borrowers; namely, if a non-profit borrower is underwritten at the more conservative numbers required of a for-profit borrower, the non-profit borrower must adhere to special distribution constraints that do not apply to for-profit borrowers. HUD takes the stand that it has long required non-profit borrowers to maintain residual receipt accounts rather than allowing them to make distributions of surplus cash. Given that HUD was frequently willing to waive or modify that policy, HUD has stated that if it is a 223(a)(7) refinancing, and the non-profit borrower was previously treated as a for-profit borrower and permitted to distribute surplus cash, the non-profit can select to be treated as a for-profit entity for distribution purposes.

In regards to withdrawing surplus cash from the facility, if an Owner withdraws surplus cash during a reporting period (as is now permitted) and the financial statements at the end of the period show that there is negative surplus cash, the Owner must restore the amount of funds taken from the facility to return it to a positive balance.

Additional provisions include: (i) Owner must submit an annual financial audit within 90 days after the close of its fiscal year; (ii) Owners must obtain written cost estimates for work that costs more than 5 percent of the facility’s Gross Annual Revenue; (iii) Owners must notify HUD and their lender within two days of any notices they receive that are G-Level or higher; (iv) a key principal carve-out similar to the MAP regulatory agreement; and (v) HUD’s new requirements for any management agreement.

Operator Regulatory Agreement

As in accordance with the new regulations, 24 CFR 232.1003, the Operator must be a single-asset entity. While this is a change in the requirements, HUD makes clear through the regulations that they will be willing to grant waivers of this requirement. We anticipate in particular that deals being refinanced pursuant to 223(a)(7), and in states where obtaining a new license is incredibly difficult, that HUD will be open to waiver requests when one Operator operates multiple facilities. At the LEAN Training in March, HUD stated that directors are authorized to grant the single-asset entity Operator waivers.

Another significant new requirement is that all Operators must now create a Risk Management Program. HUD’s only indication of what must be included in the Risk Management Program came from a short blurb in the December 19, 2012 LEAN Blast and we await further direction from HUD as to the requirements. In addition to the Risk Management Program, if a facility is running an operating deficit, the Operator must hire a consultant to review the operations of the facility and, after discussing the recommendations with the Owner, Lender and HUD, it must determine which of the consultant recommendations to implement.

The Operator must provide quarterly financials and year-to-date certified financials; the financial statements do not have to be audited unless the facility is Owner-operated and then only the annual financial statement must be audited. While the Operator is permitted to pull surplus cash from the facility at any time, these quarterly financial reports are designed to ensure that the facility has a positive cash flow. If a facility is running a negative working capital balance, then the Operator is not permitted to take any distributions until a positive balance is restored.

Other items of note are that the Operator has two business days to deliver notices that are G-Level or higher, or any financial/operating reports as requested by HUD or the Lender; commercial leases can have terms up to five years; and the definition of Material Term has been revised to permit certain Account Receivable modifications that have already received HUD approval to change without further HUD approval.

Operator Security Agreement

There are a number of changes to the Operator Security Agreement; the most significant change is that the Operator, whether a related entity or not, must pledge its assets as collateral to the Owner’s loan. HUD has stated they now want the Operator’s collateral to be loan collateral because HUD has a strong interest in the operation of the facility and regards all funds derived from the operation of the facility as project funds. This pledge is not only in the Operator Security Agreement but now, as an exhibit, HUD is requiring the Operator to execute and record an Assignment of Leases and Rents. This new Assignment is an attachment to the form Operator Security Agreement and provides notice of the Lender’s security in the rents, leases, government receivables, provider agreements and residential leases.

Additionally, HUD now requires that all Operators provide and attach a Cash Flow Chart to the Operator Security Agreement even if there is no account receivable financing. Lastly, Exhibit C to the Operator Security Agreement requires the Operator to identify any other names it has used in the previous five years, any assets acquired in bulk transfer in the previous five years and the Operator’s rights in investment property, letters of credit, chattel paper, tort claims, deposit accounts and instruments (including promissory notes).

Addendum to Operating Lease

The Addendum to Operating Lease is similar to the current form document; however, there are a few interesting revisions. First, the Operator must be a Special Purpose Entity (as defined by Program Regulations). This requirement is in addition to the language from the new Regulations, 24 CFR 232.1003, which is silent about a requirement for the Operator to be a special purpose entity and instead focuses on the Operator as a single asset entity. Second, at the termination of the operating lease, the Borrower will have the opportunity to purchase the Operator’s personal property “at book value,” an arrangement that we believe will not be popular with third-party Operators. Third, the discussion of material Account Receivable terms has been removed from the Operating Lease Addendum.

Despite not being stated in the Operating Lease Addendum, HUD still requires that there be at least a 1.05 DSC in the rental payments to the Mortgagor.

Subordination, Non-Disturbance and Attornment Agreement – Operating Lease

There are now two different form SNDAs, one for the Operating Lease and a separate SNDA for the Master Lease. The only relatively interesting new requirement in the Operating Lease SNDA is that if the Operator gives a notice of default under the operating lease, it must also provide that notice to the Lender for the notice to be valid and effective.

Master Lease Subordination, Non-Disturbance and Attornment Agreement

The Master Lease SNDA includes Operator requirements that for an unknown reason, are not included in the Operating Lease SNDA. For example, the Master Lease SNDA includes the requirements for dealing with an operating deficiency, as also stated in the Operator’s Regulatory Agreement but not part of the SNDA for the Operating Lease. The Master Lease SNDA does permit the master tenant to cure an Operator default provided there is no material risk of termination, project operating deficiency or payment default under the loan documents. The Master Lease SNDA also sets forth the terms in which a facility may be released from the Master Lease.

Master Lease Addendum

An entirely new document is the form Master Lease Addendum, which is designed to be attached to a current Master Lease that will incorporate all of HUD’s required forms. Of course, as all have experienced, most of the time when HUD requires a Master Tenant, such a structure does not currently exist and therefore the Master Tenant and the Master Lease are strictly created to satisfy the HUD requirement. It is everyone’s hope that a simple Master Lease with the attached Master Lease Addendum will make the pain and time required to negotiate an entire Master Lease a thing of the past.

The new Master Lease Addendum includes many of the sections that we have been negotiating with HUD for the past few years. The difference between the new form and the proposed addendum that had been making the rounds for the past year is that the current draft removes all references to Account Receivables financing and those provisions concerning the ownership of a facility’s FFE. Additionally, the final promulgated version removes the requirements that the Master Tenant have a risk management plan, enter into the facility’s deposit account control agreement or be a special-purpose entity.

HUD clarified a number of items at the LEAN Training in March; it was confirmed that if there is currently a HUD-approved Master Lease in place, any facilities added to that Master Lease do not require the new addendum. In addition, the cross-default provisions are designed so that surplus cash from one facility will be used to support a poor performing facility on the Master Lease.

Intercreditor Agreement and Rider

After HUD received significant backlash from AR Lenders regarding the first draft of the new Intercreditor Agreement, HUD made substantial improvements to the promulgated Intercreditor Agreement. The final version of the Intercreditor Agreement requires that the FHA Lender provide notice at least 30 days prior to declaring a default that would cut-off the AR Lender’s priority (the first version required no advance notice). Additionally, if an AR Lender continues to advance funds to a facility, even after the FHA Lender has declared a default, for reasons the AR Lender deems necessary to preserve and protect its collateral (such as to keep the facility operating) the additional funds are protected as AR Lender collateral and the AR Lender can still collect repayment of those funds. The Intercreditor also permits the AR loan to be extended, and the interest rate revised within certain pre-approved parameters, without having to obtain HUD’s approval at the time of the modifications. It is also worth noting that HUD has removed the language from the Rider that allowed for FHA and non-FHA facilities to be on the same AR line of credit and HUD now requires a separate Intercreditor Agreement for each facility.

Please note that if the facility is being refinanced pursuant to 223(a)(7), and there is already an Intercreditor Agreement in place, that Intercreditor Agreement may remain and the new form is not required.

Management Certification

The Management Certification is very similar to the MAP Form 9839. This certification is not required unless the facility has a manager; if there is only a separate Operator, the form is not required. The certification sets forth requirements for the manager and must also be executed by ORCF, in which the management agreement and management fees are officially approved.

Master Tenant Security Agreement

Another new document that HUD is requiring be recorded is the Master Tenant Security Agreement; unlike the Operator Security Agreement, the entire document will be recorded. Much like the Operator Security Agreement, the Master Tenant agrees in this document to secure the obligations of the loan documents and the borrower’s mortgage.

Master Tenant Regulatory Agreement

The Master Tenant Regulatory Agreement is very similar to the Operator Regulatory Agreement – it also includes the Risk Management Program requirements.

A/R Financing Certification

The Accounts Receivable Financing Certification is the document in which the Account Receivable Borrower certifies: (i) it has provided HUD with copies of all of the documents evidencing the accounts receivable loan; (ii) it has not commingled government receivable funds with non-government receivable funds; (iii) that the account receivables collateral does not secure any obligations to projects that are not FHA insured; (iv) there is no identity of interest between the accounts receivable borrower and accounts receivable lender; and (v) there is not a conflict of interest with the accounts receivable lender.

Topics:  Closing Documents, FHA, Healthcare, Healthcare Facility Insurance Program, HUD, Loan Documentation

Published In: General Business Updates, Finance & Banking Updates, Health Updates, Commercial Real Estate Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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