Pitfalls of Non-Recourse Loans During the COVID-19 Pandemic | Bass, Berry & Sims PLC
Mortgage borrowers often prefer non-recourse loans, which can eliminate or reduce the risk of having to meet a default judgment if a project goes awry. However, most non-recourse loans have exceptions or exceptions to the non-recourse aspects of the loan. The project leader must guarantee these exceptions, which generally fall into one of the following two categories:
- The first category of exemptions includes elements that could affect the value of the guarantee. For this category, the liability of the guarantor is generally limited to the actual losses of the lender resulting from such depreciation. Examples include the wasting of collateral by a borrower or non-payment of property taxes.
- The second category of non-recourse exceptions includes events that compromise a lender’s ability to realize the collateral. Lenders will only accept the concept of a non-recourse loan if they have unimpeded access to that collateral in the event of default. Therefore, events which prevent a lender from exercising its recourse on its guarantee generally trigger a full recourse. A common full recourse case would be a borrower’s bankruptcy filing which maintains the lender’s ability to seize collateral.
Since a non-recourse lender’s remedies are limited to the secured property, the lender will also want the ability to control the cash flow of the property, especially in the event of default or erosion of the financial performance of the property. guarantee. Non-recourse loans may therefore also include cash management arrangements whereby cash receipts from the collateralized property are to be deposited into an account controlled by the lender for enforcement in accordance with a contractually agreed “cascade” of payment of real estate expenses, cash payments. debt service and reserve requirement payments, with the remaining balance (if any) paid to the borrower. Cash management may be required at the outset of the loan or triggered by certain events, such as the borrower’s failure to meet a debt service or return on debt coverage ratio or default. other financial covenants; major or key tenants terminating or failing to renew their leases or defaulting; or a payment default occurring.
Impact of COVID-19
The COVID-19 pandemic will have significant ramifications for the non-recourse exclusion (loss only and full recourse) and cash management provisions. Some of them will result from the dire financial impact of the pandemic on many tenants, especially brick and mortar retailers. For example, tenant rent defaults can result in “burst” financial covenants or a “material adverse change”, triggering either cash management or possibly default. “Large tenant” lease terminations can also lead to cash management or, depending on the loan’s terms, even default on payment. During this period, it is also possible for borrowers to “be at fault” under their loan documents by negotiating with tenants by not obtaining the required approvals from the lender for any lease modification or termination.
These tenant issues quickly become landlord issues, creating a new source of exposure to exclusion without recourse for building owners. For example, if a borrower does not pay all real estate expenses or debt service to the extent that he has the cash to do so – for example, in an effort to save money in the short term – this will likely constitute a “misuse of rents” on the part of the property, a common exclusion of losses without recourse (in addition to being a default).
The borrower’s actions could trigger recourse
In addition, in settlement negotiations with lenders, borrowers will be tempted to paint a grim picture of their situation. However, borrowers should note that their admission of insolvency or inability to pay debts may constitute a full recourse case in many non-recourse loans, and therefore they should exercise caution before making such statements. . Borrowers who enter into practice negotiations with their lenders will be well advised to execute pre-negotiation letters offering both parties protections against the use of their practice communications against them.
Likewise, a borrower’s failure to maintain its status as a single purpose entity (SPE) may also trigger full recourse, at least to the extent that this default is a factor in the borrower’s substantial consolidation with another. bankrupt entity. Many SPE requirements will be impacted by the financial performance of the property and therefore by the pandemic. For example, SPE requirements often require the borrower to pay its normal course debts within a certain period of time, maintain sufficient capital for its operations, and maintain a sufficient number of employees for its business operations. Borrowers should confirm whether these types of requirements are present and, if so, whether they are limited to the extent that the property generates sufficient cash flow to comply with them.
In fact, one of the first steps non-recourse borrowers should take during this period is to determine whether failure to pay certain real estate expenses or meet certain SPE requirements triggers a non-recourse exclusion only if the property generates sufficient cash flow to pay for these items or meet such requirements. If this is the case, and if the borrower is in control of the cash flow of the property, the borrower should consider whether to pay the real estate expenses that are due first. not subject to this qualification. In doing so, any shortfall is allocated to the categories subject to such qualification.
Borrowers without recourse must ultimately weigh the likelihood that they will be able to hold onto distressed real estate versus having to return it to the lender. In the former case, concerns related to the operation of the building and the rental may outweigh legal issues, at least in some cases. However, if the borrower anticipates having to return the property to the lender, managing the situation to minimize the exposure of any guarantor to non-recourse exclusions and full recourse events becomes extremely important.