Summary Of HUD’s New Draft LEAN Loan Documents, December 21, 2012

by Pepper Hamilton LLP
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On September 7, 2012, the Federal Housing Administration (FHA) published new regulations for the Section 232 Healthcare Facility Insurance Program in the Federal Register. FHA had previously proposed new regulations and loan documents on May 3, 2012. On November 21, 2012, the U.S. Department of Housing and Urban Development (HUD) released revised draft loan documents to match the final regulations released on September 7, 2012. Below are highlights of the new draft loan documents, summarizing how some of the changes will affect borrowers, operators and mortgagees.

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

The first noticeable change from the current documents is that HUD has combined the Security Instrument and Owner Security Agreement. The document closely resembles the multifamily mortgage in style and substance, including the exculpation language concerning the key principal identified in the Mortgagor’s Regulatory Agreement. We made a number of comments suggesting that provisions are redundant, inapplicable or problematic (such as including the operator’s license as collateral for the Security Instrument) but anticipate the final version will be substantially similar to this draft.

Note

Unsurprisingly, the Note is very similar to the new multifamily note.

Owner Regulatory Agreement

While the multifamily regulatory agreement serves as the base for this new form, there are a number of noteworthy items that only apply to healthcare facilities, and they should be highlighted. The first item of note is: 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. This approach seems nonsensical to us, and we have commented accordingly to ORCF. It is also noteworthy that the annual financial reporting required for an owner becomes a quarterly requirement for owner-operators per the terms of the Operator Regulatory Agreement. Another interesting provision that we have asked HUD to explain affects non-profit borrowers; namely, if a non-profit borrower is underwritten at the more conservative numbers required of a for-profit borrower, there are still special distribution constraints that do not apply to for-profit borrowers (See Section 16(e)).

Additional provisions include: (i) owners must obtain written cost estimates for work that costs more than 5 percent of the facility’s Gross Annual Revenue; (ii) owners must notify HUD and their lender within two days of any notices they receive that are G-Level or higher; (iii) a key principal carve-out similar to the multifamily regulatory agreement; and (iv) HUD’s new requirements for any management agreement.

Operator Regulatory Agreement

The most significant new provision requires that all operators must create a Risk Management Program. So far 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. Additionally, 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. If a facility is running a negative working capital balance, then the operator is not permitted to take any distributions. Additionally, the operator must provide quarterly financials and YTD 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. Lastly, 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.

Operator Security Agreement

There are a number of changes to the Operator Security Agreement. The most significant change comes from the Fannie Mae model of requiring the operator to execute and record an Assignment of Leases and Rents. This new Assignment is Attachment 1 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 is now requiring that all operators provide and attach a Cash Flow Chart to the Security Agreement even if there is no account receivable financing. Lastly, Exhibit C to the 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

On the whole, 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 ignores 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.

Subordination, Non-Disturbance and Attornment (SNDA) Agreement – Operating Lease

The latest form documents contain two different 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 Addendum

The new draft loan documents have attempted to simplify and create uniform Master Lease requirements. The belief is that so long as the form Master Lease Addendum is attached to a Master Lease, the pain and time required to negotiate an entire master lease will be 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 version that has been making the rounds for nearly a year now, is that the current draft removes all references to Account Receivables financing, and provisions concerning the ownership of a facility’s furniture, fixtures and equipment (FF&E). Additionally, the most current 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.

Master Lease Subordination, Non-Disturbance and Attornment (SNDA) 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.

Intercreditor Agreement and Rider

After HUD received significant backlash from Account Receivable Lenders regarding the first draft of the revised Intercreditor Agreement, HUD made substantial improvements. The latest draft 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. Lastly, the new document 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 which allowed for FHA and non-FHA facilities to be on the same AR line of credit.

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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