Part V | Not It!

In the wake of the FDIC bank shutdown actions taken last month, we have written about cash management arrangements, account naming conventions, financial covenants and rating requirements in typical commercial real estate loans with 20/20 hindsight. Our prior analyses often required connecting the dots across multiple defined terms, various provisions and more than one loan document to try to fully understand the implications of a bank closure. In this article, we’ve delved into a much more direct topic: what do customary commercial real estate loan documents say about liability with respect to funds in various deal-required bank accounts? Here’s a hint – probably less than you think!

We reviewed a wide sampling of commercial real estate loan agreements – from balance sheet loans, to SASB deals to conduit paper – and here is what we found:

• Many loan agreements are completely silent regarding who is liable with respect to amounts on deposit in the various accounts set up under a loan (which we will call, generically, “Reserve Funds” for purposes of this article).
• Some loan agreements, however, do contain indemnity language similar to these two examples:

Ex. 1 - Borrower shall indemnify Lender and hold Lender harmless from and against any and all Losses arising from or in any way connected with the Reserve Funds Account, the sums deposited therein or the performance of the obligations for which the Reserve Funds Account was established.

Ex. 2 - Borrower shall indemnify and hold Lender harmless from and against any and all actions, suits, claims, demands, liabilities, losses, damages, obligations and costs and expenses (including attorneys’ fees and expenses) arising from or in any way connected with the Reserve Funds Account and/or the Reserve Funds Lockbox Agreement (unless arising from the gross negligence or willful misconduct of Lender) or the performance of the obligations for which the Reserve Funds Account was established.

An indemnity from the borrower – that’s good, right? Lenders are covered, right? Well, an indemnification obligation from borrower to lender doesn’t directly get at the issue of who is liable in a situation where there is a bank shutdown and FDIC insurance is insufficient to cover the full amount of Reserve Funds. If the Reserve Funds are the property of the borrower, and it is the borrower who suffers the “loss”, then query what it means for a borrower to indemnify the lender from losses…?

In the second example, above, note the carveout for gross negligence of the lender. This is fairly typical language.

• Some loan agreements contain clear language that the lender is not liable for certain kinds of losses:

Ex. 1 - Lender shall not be liable for any loss sustained on the investment of any funds constituting the Reserve Funds.

Ex. 2 - Lender shall not be liable for any loss sustained on the investment of any funds constituting the Reserve Funds so long as such investment was not expressly prohibited by this Agreement or the Reserve Funds Agreement.

While these and similar provisions protect lenders from claims relating to losses sustained by the investment of Reserve Funds, they still do not address a situation where there is insufficient FDIC insurance.

• The best provisions we found were better at limiting a lender’s liability for risk of loss relating to Reserve Funds more generally, although they were still not completely on point. Below are two of these more protective examples:

Ex. 1 - In no event shall Lender be liable either directly or indirectly for losses or delays relating to the Reserve Funds resulting from any event which may be the basis of computer malfunctions, interruption of communication facilities, labor difficulties or other causes beyond Lender’s reasonable control or for special, consequential, treble or punitive damages except to the extent of Lender’s gross negligence, willful misconduct, fraud or illegal acts.

Ex. 2 - Except as otherwise provided in this Agreement or as required by applicable law, Lender will have no duty as to any Reserve Funds, as to ascertaining or taking action with respect to calls, conversions, exchanges, maturities, tenders or other matters relative to any Reserve Funds, whether or not Lender has or is deemed to have knowledge of such matters, or as to the taking of any necessary steps to preserve rights against any parties or any other right pertaining to any Reserve Funds.

Given the banking industry events of last month, and the potential losses that depositors were facing due to the cap on FDIC insurance proceeds, loan documents should be clear as to the allocation of liability when Reserve Funds are at risk. (From a lender’s perspective, the answer to who’s on the hook is, of course, “not it”!)