Common Pitfalls in Real Estate Loan Documents: A Top Ten List – Part 2

At a recent conference with San Jose and Silicon Valley real estate owners and lenders, Attorneys Jack Easterbrook and Tamara Pow presented their “Top 10 List” of issues that commonly arise in commercial real estate loan transactions. Having been involved in countless real estate and commercial loan transactions, Tamara and Jack developed the list to share with the participants key points to be attentive to when entering into a real estate transaction. The Top 10 List assumed that the basic business terms of the transaction had been decided, so the focus was on items that can arise in the documentation phase and create issues or obstacles in getting a deal to closing.

A previous blog presented three items from this Top 10 List, including: (1) inconsistency between a borrower’s state of registration and a lender’s requirement; (2) the special purpose entity and the independent direct/manager requirements of the lender; and (3) the personal guaranty. Here are three more items to keep in mind when negotiating a commercial real estate loan:

No. 4: Treatment of Other Creditors, Including Any Mezzanine Lender.

Comment: Are other creditors or lienholders involved, and will intercreditor or subordination agreements be necessary? If the answer is “yes,” these agreements will need careful scrutiny. The recent trend in the case law continues on the path of strictly construing the terms of such agreements. This includes Bank of America v. PSW NYC LLC, in which it was held that an agreement between a senior secured lender and a mezzanine lender prevented a foreclosure by the mezz lender until it cured payment defaults in the senior secured lender’s loan. The bottom line: other creditors of the owner/purchaser, whether new or existing when the deal is done, can significantly affect getting a transaction to closing. It is very worthwhile to have a strategy concerning them worked out early.

No. 5: Prohibition on Transfers, Including Transfers of Fractional Interests in a Borrowing Entity.

Comment: Standard loan documents often contain language that says that the borrower is in default if the property securing the loan, or any interest in the property, is transferred. However, an owner or borrower should not think it is safe from this provision if the title to the property is held in an entity, such as an LLC, just because the title is not changing. Many loan documents also provide that if an interest – perhaps even a small interest – in the ownership entity changes, a default is triggered. An owner or borrower is wise to not ignore these provisions. Borrowers should carefully consider whether they will need to (or want to) transfer partial ownership interests in the future and lenders should consider the magnitude of such changes that may be acceptable. A transfer of an ownership interest could occur as a result of estate planning needs, in connection with a management transfer, or perhaps the unforeseen death of someone in an ownership group, such as an LLC member. If the parties don’t address these provisions before loan documents are finalized, subsequent events may trigger an unexpected and immediate default with unknown future implications.

No. 6: Prohibition on Changes in Management of the Borrower.

Comment: Are the borrower’s short-and medium-term management plans prohibited by the loan agreement? Make sure the loan documents accommodate planned future changes in managers of the owner. For example, a family owned LLC may be intending to pass management to the next generation or a key employee long before the maturity date of the loan. Like prohibited transfers of ownership interests, loan documents may prohibit transfers of management power. Pay attention to these provisions and make sure intended changes are not prohibited by the loan documents. It may also be prudent to have potential future managers pre-approved by the lender.

Watch for our next blog for the remaining items addressed in the presentation.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

 

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