Part I of this article took a broad look at changes and similarities in commercial real estate finance structures and relationships over the past 20 years. Part II of this article will cover changes in the capital stack, loan workouts, nonrecourse carveout guaranties, dual collateral pledges, and lender liability.
The capital stack has always started with mortgages. It expanded to include mezzanine loans. Going beyond that, preferred equity, even more opportunistic, has become a far more prevalent financing form than it was 20 years ago. Commercial real estate mortgage “loans” (whether to capture return on investment, or equity) are now often structured as preferred equity in the sponsor entity. Indeed, in some hybrid transactions one private equity “lender” makes a mezzanine loan to the members of the entity and its affiliate acquires preferred equity in the sponsor.
This way, the private equity shadow lenders who provide the preferred equity investments potentially achieve the outsized return their investors want. This well recognized and broadly accepted financing device simply did not exist in commercial real estate 20 years ago.
These new sources of capital, new regulatory pressures, and other changes in the world have led to sea changes in the market, especially for larger transactions and borrowers that want to borrow as much as they possibly can. That trend has continued unabated and undeterred in the decade since the Great Financial Crisis—and in a market that historically has not experienced cycles longer than seven years.
After the Great Financial Crisis, we heard that CMBS 2.0 would be more rigid and conservative. The new risk retention rules under Basel III, which took effect in December 2016, are changing how we view CMBS and its pricing and profitability. Smart investment bankers and their smart counsel are creating in each new CMBS transaction new ways for the sponsor to “hold” on its balance sheet 5 percent of the debt. The mortgages themselves aren’t all that different, though.
Commercial real estate lenders and lawyers also need to deal with workouts and foreclosures, which have ebbed and flowed over the years. Although all documents and deal structures must fully cover the possibility that the borrower will default, the actual frequency of defaults has stayed low. That was true even during the Great Financial Crisis.
At one point not too long ago, borrower defaults often led to borrower bankruptcies. In that strange world, a bankruptcy judge would often “cram down” the lender’s lien, rewriting it to equal the temporarily impaired value of the collateral. Then, when markets recover, as they inevitably do, any future increase in value would belong to the “reorganized” borrower, its principals and equity investors. It was a great borrower-side play while it lasted.
In the last decade or two, the bankruptcy risk has been almost completely squeezed out of commercial real estate finance. Lenders learned to demand that the principals of commercial real estate borrowers agree to become personally liable for the loan (full recourse) if a borrower filed bankruptcy or committed other “bad acts.” Until then, single asset real estate bankruptcies were a way of life in distressed real estate. We lived through them, and counseled around them. The bankruptcy was filed—it was an obligatory (some would say automatic) borrower tactic—to avoid receivership or to stop foreclosure, often for years and often causing great pain to lenders. For fully nonrecourse loans, the “shield” of bankruptcy protection became a weapon, wielded often and very successfully in court and in negotiations.
That changed completely with the advent of nonrecourse carveout guaranties. We now see these guaranties in virtually every commercial real estate loan, even if it is otherwise nonrecourse. The carveouts are sometimes negotiated, sometimes heavily (especially in the last few years, when excess liquidity has been chasing fewer available projects), and with varying success. But full recourse for a voluntary bankruptcy remains a sacrosanct element of commercial real estate finance, one that until quite recently has been rarely negotiated, let alone waived.
Because courts tend to enforce full recourse carveout guaranties, those guaranties have essentially eliminated single asset real estate bankruptcies. Sponsors in 2009 knew where to find the bankruptcy courts. But they steered clear of them then, since then, and now. That is fact. The carveout guaranty works.
In late 2018, we started to see the most prominent and coveted sponsors begin to negotiate for—and obtain—a limitation on their guarantors’ full recourse, even for the most commonplace of “full recourse bad acts” such as bankruptcy. Partial recourse—say $25 million on a $100 million loan secured by a $150 million asset—signals to the lending community that a sponsor’s reputation and track record for performance is pristine; the equity cushion in the asset is large and secure; partial recourse, or recovery, from the guarantor is all the lender will ever need to achieve to be made whole; and, if the lender requires full recourse on these facts, the sponsor will ably and easily find financing from some other institutional lender down the street with more relaxed and borrower-friendly underwriting criteria.
We shall see, this late in the real estate cycle, whether this “partial bad boy recourse” will become market, or continue to be an aberration, sparingly available only for loans secured by the best, most secure (from a collateral value perspective), “trophy”-type income producing real estate projects.
Outside of full recourse for bankruptcy, carveout guaranties have seen more change in the last 20 years than virtually any other area of mortgage loan documents and negotiations. First they ballooned as smart lawyers came up with great new carveouts. Then those balloons blew up in guarantors’ faces when opportunistic loan buyers asserted, often with success, entirely uncontemplated theories of carveout liability—many times inconsistent with and going far beyond the principles that motivated the carveouts in the first place. In response, many lenders have agreed to trim the carveouts back to a more sensible level.
Any borrower now knows the first conversation about any loan proposal should cover the specific scope, and the exact wording, of the nonrecourse carveouts—right after rate, proceeds, and term, and before lesser economic issues such as prepayment or yield maintenance. We have recently seen extensive negotiations on scope and magnitude of nonrecourse carveouts. Borrowers and guarantors, having heard the voice of the courts on the side of the lenders (a “contract is a contract” even if it produces absurd results), have focused on “intentionality.”
A few courts have held that a subordinate mortgage, or a mechanic’s lien, may rise to the level of an impermissible transfer (or encumbrance) triggering full recourse. Mindful of that, guarantors’ counsel studiously try to trim back anything that might trigger liability for encumbrances that are otherwise “unintentional” or involuntary. “Single purpose entity covenants” have also become fertile ground for unintended surprises for guarantors, and hence a major focus in any discussion of carveouts. That discussion sometimes goes a step further and addresses the proposition that the borrower should have the affirmative right to walk away from an investment that turned out badly, and eliminate any further accrual of guarantor liability. The walkaway conditions then become a new battleground, with lenders trying to make them so restrictive that walkaway becomes nearly impossible without lender cooperation.
Commercial real estate lenders that look ahead to the rigors and delays of judicial foreclosure have always wondered if there might be a better way. Yet they have continued to resist the temptation to obtain equity pledges as additional collateral for their mortgage loans—a “dual collateral” technique that would replace the ordeal of mortgage foreclosure (a slow judicial process in many states, especially New York) with a stunningly fast personal property foreclosure procedure under the Uniform Commercial Code.
A recent New York case slightly opened the door to the use of that technique. Few commercial real estate finance lawyers are willing to rely on that case, though. They worry that courts will apply the time-honored doctrine that “equity abhors a forfeiture” and might decide that a dual-collateral structure somehow “clogs the borrower’s equity of redemption” in the property. Thus, until an appellate court endorses that quasi-favorable decision or delivers more judicial guidance on the topic, commercial real estate lenders will continue to live with mortgage foreclosure as the exclusive remedy for commercial mortgage loans.
In that world of mortgage foreclosure, lenders have recently faced an entirely new category of defenses and “lender liability” claims, spawned by the Great Financial Crisis, the avalanche of residential foreclosures that accompanied it, and a widespread backlash against the lenders that drove those foreclosures. “Judicial sympathy” (mortgage foreclosure is an equitable proceeding in a court of equity) drives “judicial scrutiny.”
In short, although the judiciary has seen, and adjudicated, virtually every type of classic lender liability defense or claim, in the last decade or so the courts have faced anew, pondered, and adjudicated a saucy brew of “new lender liability” claims coming from the world of residential foreclosures.
Classic lender liability historically included theories (and once in a while facts) like: (i) breach of the covenant of good faith and fair dealing implied in every contract; (ii) reversal of established course of conduct (in the context of past waivers of defaults or enforcement and concessions); (iii) duty to act consistently; (iv) creation of a false sense of security (e.g., inducing a borrower’s principals or new investors to contribute new equity); (v) detrimental reliance (someone contributes that new equity); (vi) selective enforcement, targeting particular sponsors or asset classes; (vii) fraud, duress, overreaching, and unconscionability, as defined after the fact; (viii) waiver; (ix) a lender’s excessive oversight and control of the borrower, cash flow, or mortgaged property; (x) misrepresentations or misleading statements by lenders; (xi) tortious interference with contract (e.g., frustrating a potential favorable sale by the borrower); (xii) breach of fiduciary duty; (xiii) unequal bargaining position; and (xiv) champerty (the notion that it is somehow bad to sell a loan to someone who plans to sue to recover the debt).
The casebooks are filled with these defenses and claims. Many merely reflect the results of a scrivener’s creative word processing and borrowers’ delay tactics. The reported judicial decisions have broadly rejected most of these theories, or found them unsupported by the facts. Occasionally they have prevailed, though, just often enough to cause caution and concern among lenders and their counsel.
Today we have a new flavor of lender liability, a new form of judicial sympathy, and a new set of techniques to stave off foreclosure when a borrower decides not to repay its loan. These new claims and theories first appeared in a cascade of Great Financial Crisis residential foreclosure actions throughout the country. Their borrower-friendly outcomes do bring the potential leverage of stare decisis to the commercial setting.
They include a wide range of mostly procedural defenses and arguments: (1) standing to sue (proof of ownership of the note and the underlying debt); (2) chain of title (the lender must hold notes evidencing all debt secured by all mortgages being foreclosed); (3) lack of affiant’s personal knowledge (in the complaint and the affidavits) of the debt and the defaults, evidenced by “robo-signing” and “robo-verifying”; (4) predatory lending; (5) expiration of the statute of limitations (failure to “de-accelerate” within the time allowed to start an action); (6) “loan to own” predation; (7) impossibility of performance (“credit tsunami”); (8) alleged unsuitability of loan participants or syndicate members (whose unanimous consent is required for major decisions); (9) lender’s duty to ascertain borrower’s financial wherewithal to service and repay the loan; (10) the doctrine of “deepening insolvency”—fraudulent extension of the life of a dying entity by doing nothing; (11) rejection of an “allonge endorsement” attached to a note by a paper clip; and (12) tortious interference with prospective contractual advantage.
We shall see how these new and still largely untested defenses and claims unfold, as they find their way into commercial mortgage litigation.
Undeniably, real estate finance structures, participants, underwriting, credit enhancement, and lenders’ rights and remedies have changed in other important ways the last couple of decades. Suffice it to say, commercial real estate finance today is quite different from decades past. To us, this continues to make commercial real estate an exhilarating—and often fascinating—asset class to finance.
Joshua Stein is a member of the American College of Real Estate Lawyers and a commercial real estate lawyer at Joshua Stein PLLC. Richard Fries is a member of the American College of Real Estate Lawyers and a global finance and real estate partner at Sidley Austin LLP.