In our prior three articles, we discussed the potential impact of the recent bank shutdowns on cash management arrangements and guarantor financial covenants in commercial real estate lending. The issues we identified could make it appear that loan documents have no protection in the event a lockbox bank or cash management bank suffers distress. But, that is not the case. Loan documents generally contain a requirement that accounts be “Eligible Accounts” and that the accounts be held at “Eligible Institutions”. These definitions are meant to be the primary protection for both lenders and borrowers that all funds flowing through the cash management system are held in a safe manner.

Let’s look at sample definitions of “Eligible Account” and “Eligible Institution”.

“Eligible Account” shall mean a separate and identifiable account from all other funds held by the holding institution that is either (x) an account or accounts maintained with a federal or state-chartered depository institution or trust company which complies with the definition of Eligible Institution, or (y) a segregated trust account or accounts maintained with a federal or state chartered depository institution or trust company acting in its fiduciary capacity that has a rating of at least “[XX]” and which, in the case of a state chartered depository institution or trust company, is subject to regulations substantially similar to 12 C.F.R. §9.10(b), and having in either case a combined capital and surplus of at least $[XX]. An Eligible Account will not be evidenced by a certificate of deposit, passbook or other instrument.

“Eligible Institution” shall mean (a) a depository institution or trust company insured by the Federal Deposit Insurance Corporation (i) the short term unsecured debt obligations or commercial paper of which are rated at least “[XX]” (or its equivalent) from each of the Rating Agencies (in the case of accounts in which funds are held for thirty (30) days or less) and (ii) the long term unsecured debt obligations of which are rated at least “[XX]” (or its equivalent) from each of the Rating Agencies (in the case of accounts in which funds are held for more than thirty (30) days) or (b) such other depository institution otherwise approved by Lender from time-to-time.

The key qualifying criteria for both definitions are the minimum ratings required for the institution holding the relevant account.

So, how do those ratings work?

Ratings are issued by nationally recognized statistical ratings organizations (NRSROs) such as Fitch, Inc., Moody’s Investors Service, Inc., S&P Global Ratings, and others. NRSROs communicate their ratings to the general public through announcements, which are distributed to major financial newswires, and by publication on NRSRO websites. Many NRSROs also issue periodic ratings reports. Banks often include these ratings on their own websites.

An NRSRO can update or withdraw its ratings at any time. A material a negative (or positive) credit event is likely to trigger a ratings reassessment. In advance of such a credit event, an NRSRO may issue an anticipatory statement, such as a downgrade (e.g., from “stable” to “negative”) or an upgrade, or place a rated entity “on watch”. These predictive actions put parties on notice that something may happen.

As we know from recent experience, however, credit events can be sudden, with little or no advance warning. And, no NRSRO can predict the certainty of a credit event occurring. Consequently, many updates to ratings are reactive, and not proactive. Hence, a lag. Recently closed banks had high ratings at the time of shutdown, and the ratings for each were not updated until after the FDIC had intervened. In those cases, the update was that the ratings for each were withdrawn.

Did the ratings requirement in the customary Eligible Account / Eligible Institution definitions provide the protection as intended in this instance? No, and it is not clear that they could have. NRSRO ratings are not always able to serve as a canary in the coal mine. So, what is a lender to do? While this may be an issue without a definitive fix, here are some things to consider:

• Should the financial criteria used in “Eligible Account” definitions be adjusted?
• Should the ratings used for assessing “Eligible Institutions” be modified?
• Should additional criteria be added to “Eligible Institution”, such as requiring that no receivership or insolvency proceedings exist?
• Should a lender have the right to take action based on a negative credit event, such as a downgrade, even if a bank’s minimum rating requirements remain satisfied?
• Some loan documents pre-approve specifically named banks. Should a specifically named bank still be subject to minimum ratings and/or not under receivership criteria?

Lots to think about here, and likely no right answers – but definitely some wrong answers, and maybe some better answers. In sum, ratings serve a variety of watchdog purposes in financing transactions, but they do come with the risk of a lag. And, when the monetary lifeblood of a commercial real estate deal is at stake, the lag really can be a drag.