It is common knowledge that a borrower has to make its monthly payments on time if it wants to keep its commercial mortgage loan in good standing, however, what may not be as obvious is that a loan can go sideways even if those monthly payments are made on time.
Commercial loan documents invariably contain a variety of non-monetary obligations called “covenants,” which are promises by the borrower to do, or not do, certain things during the term of the loan. Lenders put covenants into their loan documents in order to manage the risk of lending to a borrower. Depending on the size of the loan, the type of property financed, and whether the loan will be held on the lender’s books or securitized (a process by which commercial mortgages are pooled as securities in order to sell the aggregate cash flow to investors), covenants can be relatively mild or quite stringent.
Failure to honor covenants can create a variety of problems for a borrower if the lender determines that such failure is an Event of Default. Once a loan is in default, the lender has a variety of rights and remedies at its disposal, including the imposition of default interest and the suspension of any borrower rights that are conditioned on the loan being in good standing. In addition, certain very serious defaults can open up the borrower and any guarantors to personal liability. For this reason, a borrower will want to fully understand the covenants in its loan documents, which may touch upon some or all of the following big picture issues:
Borrower’s Legal Existence and Organizational Structure: Lenders evaluate the soundness of a proposed borrower’s organizational structure when underwriting a loan. Once a borrower’s organizational structure is approved by the lender, subsequent changes can increase the lender’s risk of not being repaid. For this reason, a lender will tend to require covenants aimed at limiting the changes the borrower may make to its organizational structure without first obtaining the lender’s consent (and making it a default if such consent is not first obtained). For example, if the lender approves the borrowing entity as a single member Delaware limited liability company, lender consent would typically be necessary before the sole member can change or additional members can be added.
Separateness and Bankruptcy-Remoteness: Commercial lenders guard against bankruptcy-related risks through covenants that require the borrowing entity to be structured and do business in a way that reduces the likelihood that the borrower will file bankruptcy or be dragged into the bankruptcy proceeding of an affiliate. These covenants can range from requiring the borrower to have no assets other than the mortgaged property and no debts other than the loan, to things as seemingly mundane as using its own stationery and filing its own taxes.
Transfers: A transfer of the mortgaged property will always require lender consent under a mortgage loan, and most mortgages will contain a “due on sale” clause that provides for the loan becoming due and payable upon the mortgaged property being transferred without lender consent. In addition, commercial lenders often impose restrictions on the type of equity transfers that can be made with respect to the ownership of the borrowing entity. The reason for this is simple: when underwriting a loan, lenders factor in the financial resources, sophistication and expertise of the individuals who ultimately own and control the borrower. If control of the borrower changes, so too can the lender’s prospects of being repaid. Accordingly, equity transfers that result in a change of control of the borrower will typically be prohibited without the lender’s consent.
Alterations: A borrower should review its loan documents before altering, renovating or upgrading the mortgaged property, as there will likely be limitations on its ability to do so without lender consent. These limitations are intended to protect the value of the mortgaged property by allowing the lender to ensure that the work is fully and adequately completed and does not result in any liens on the property from unpaid contractors. Alteration provisions can be nuanced so it is difficult to draw generalizations, but as a rule of thumb, alterations that affect the structure, exterior or major mechanical systems (such as HVAC) of the property will likely require lender consent, as will alterations that exceed a certain monetary threshold established by the loan documents.
Often times, a borrower will default on its loan not because it missed a payment but because it hasn’t read the loan documents and is unaware of the covenants it had to keep. The first step towards keeping a loan in good standing is carefully reading the loan documents and being mindful of the covenants they contain. Other times, a default will occur because the borrower misreads or misinterprets the loan documents; when in doubt about what action is permitted under the loan documents, borrowers can avoid major missteps and expenses by consulting an attorney and/or seeking input from their lender before acting.
Gustavo (“Gus”) Schneider is a real estate attorney with Am Law 100 firm Polsinelli. Gustavo works with clients on a variety of real estate finance transactions including commercial mortgage-backed securities, Capital Markets Execution and portfolio loan originations, assumptions, modifications and defeasances.
