In this challenging and rapidly changing environment, real estate players are dealing with the effects of COVID-19 on real property operations in real time. As they make decisions at an accelerated pace, they should bear in mind the interplay of these decisions with prohibitions and provisions in relevant commercial mortgage loan documents. We previously discussed the importance of reviewing loan covenants and will now discuss the importance of being mindful of any recourse carve-outs, which may trigger liability to borrowers and/or guarantors for losses incurred by lenders or, in certain instances, for full recourse under the mortgage loan documents. We will discuss several carve-outs which may be seen in mortgage loan documents. Real property owners and mortgage lenders should review each set of documents governing their non-recourse debt in making these decisions, noting that the particulars of the recourse triggers under the carve-outs are not standard across the mortgage lending industry and can often be highly-negotiated. The parties should consider entering into a pre-negotiation agreement when addressing actions that may trigger the recourse carve-out.
Disclosures of Cash Flow Issues
Certain non-recourse loans contain a carve-out triggering full recourse liability if the borrower files for bankruptcy or colludes with third-party creditors in an involuntary bankruptcy proceeding. In some loans, this bankruptcy carve-out trigger can extend to situations where a borrower has admitted in writing its inability to pay its debts as they come due, which means the parties need to be careful in their communications in the absence of a binding pre-negotiation and/or forbearance agreement.
Special Purpose Entities
Some non-recourse loans include special purpose entity (“SPE”) covenants, which, among other things, require that the borrower maintain its operations separate from those of its affiliates and other third parties. Among these SPE covenants are often those that require the borrower to pay its own debts only out of its own assets, those that prohibit the borrower from commingling its cash with that of its affiliates, and those that prohibit the borrower from making loans to or receiving loans from its affiliates. SPE covenants exist in part to prevent the borrower from being drawn into the bankruptcy of an affiliate and are often given teeth through the inclusion of a carve-out that may result in the borrower and/or guarantor being liable for the lender’s costs or losses, or liable for all or a portion of the principal amount of the loan, in the event one or more of the SPE covenants are violated. In the face of the challenges posed on business operations by COVID-19, it may be tempting to “rob from Peter to pay Paul”, but there may be additional ramifications under the loan documents that need to be considered when making such determinations.
Mortgage loan documents will often require that the borrower obtain the lender’s consent before entering into or modifying all or certain leases. Failure to do so may result in an event of default under the loan documents. In addition, non-recourse loans may contain a recourse carve-out in the event the property is transferred in violation of the terms and conditions of the loan documents. The term “transfer” may be defined broadly in the loan documents, such that “transfers” can include entering into or modifying leases. Property owners should therefore consider the interaction of these provisions with the carve-outs when considering tenants’ requests for rent relief or other lease modifications. Agreeing to such requests may require the lender’s consent under the loan documents and ignoring such requirements may trigger recourse liability, depending on the particular carve-out language. Similarly, lenders should be mindful of any “deemed consent” language in the leasing restrictions provisions of the applicable loan documents and consider taking appropriate steps to ensure that the lender is able to receive, process and respond to consent requests in a timely manner.
Another common carve-out in mortgage loan documents is waste. Historically, waste is a common law concept that occurs when two parties have a real property interest in the same property (for example, a property owner and its mortgagee), only one of those parties has possession of that property, and the party in possession, whether through action or inaction, harms the interest of the party not in possession (or the value of that interest). One possible example of waste is failure to maintain a roof, resulting in water damage to the improvements on the property. Another possible example could be the failure by the owner of a property under construction to secure the property to prevent spoilage of construction and other materials, which may be of particular relevance at present where construction has been halted by governmental order in certain areas. In analyzing whether some actions or inactions could result in recourse liability, a careful review of the loan documents is important. The carve-out trigger for waste can differ throughout the industry and may be limited to physical waste, to waste caused by the borrower, to waste that could have been prevented using cash flows from the property, or to some combination of these and/or other limitations.
Leasehold mortgage loan documents may include an unqualified or conditional recourse carve-out for failure to pay ground rent when it comes due and/or for modifications of the underlying ground lease without the lender’s consent. With a number of space lease tenants now withholding (or threatening to withhold) rent, ground lessees may be tempted to withhold rent under the ground lease for the same period. Even if the ground lessor is willing to agree to a rent abatement, all parties should be sure that the agreement is memorialized in writing. The ground lessee should also review its loan documents to confirm whether lender’s consent to such agreement is required under the loan documents and consider the interaction between the particular terms of any such agreement with the ground lessor and the specific language of any associated recourse carve-out.
The above list is by no means exclusive, and we again recommend that borrowers and lenders alike review their loan documents, including any recourse carve-out provisions contained therein, to understand how they may be triggered.