Client Alert
COVID 19: Key Commercial Mortgage Loan Issues
It is obvious that the COVID-19 pandemic will have far reaching implications for commercial property stakeholders including owners, tenants and lenders. As early April debt service payment dates are quickly approaching, many commercial property owners will face not only economic challenges, but other complex decisions and concerns. Commercial property owners will need to consider the key issues highlighted below as they navigate the complicated loan documents that govern commercial mortgage loans.               

Events of Default/Guaranty Liability

First and foremost, default provisions contained in the loan documents must be carefully scrutinized. Typical events of default include, but are by no means limited to, breaches of representations, warranties and covenants, defaults of guarantor covenants (including failure to meet net worth and liquidity tests), and financial testing defaults (see discussion of financial covenants below), bankruptcy and insolvency events. An inextricably linked issue, and perhaps the primary concern of this entire discussion, is to understand the interplay between the loan default provisions and if, and to what extent, a particular default possibly triggers either partial or full recourse personal liability under any loan guaranties (most commonly, non-recourse carve out or “bad boy” guaranties delivered by owner principals in connection with the loan). It is vital to always keep in the forefront of the analysis that certain defaults may trigger partial recourse liability while others, such as bankruptcy and violation of “No Transfer” terms may activate springing full recourse personal liability under the guaranty. It is therefore crucial for the borrower and its principals to get a good handle on these provisions in order to formulate a cohesive strategy and prepare for what will likely brought to bear in future discussions and negotiations with the lender AND, as a first priority, to avoid the triggering of personal liability under the loan documents.

Financial Covenants

Commercial mortgage loan agreements almost invariably provide that borrower must meet certain formulaic financial tests that compare a borrower’s available cash with its current debt service and reserve obligations. These tests most often come in the form of tests of Debt Service Coverage Ratios or Debt Yield. These tests assist lenders in evaluating the property’s financial performance and is one indicator of a borrower’s financial wherewithal and ability to repay the underlying debt. Needless to say, a drop in property revenue will result in a decrease in DSCR or DY, and may result in defaults of one or more financial covenants of borrower. Likewise, as property revenues dip and property values decline, loan to value ratios will erode and may also lead to defaults of the financial covenants of borrower. As a result of a financial covenant default, cash management/restricted account mechanisms will likely be triggered resulting in future property cash flow be controlled by the lender. It goes without saying that borrowers need to stay on top of these financial covenants and be prepared for the consequences and for complicated discussions that will ultimately take place with the lender. 

Representations, Warranties, and Non-Financial Covenants 

Representations, warranties and non-financial covenants under the loan documents must be scrutinized to determine whether any breach of such representations, warranties and covenants have occurred. Borrowers should also review any provisions that impose a duty on a borrower to inform lender of any breaches of representations, warranties and covenants. 
 
Material Adverse Change/Material Adverse Event

Typically, commercial loan documents will contain one or more provisions whereby a borrower is deemed to be in default upon the occurrence of (i) a material adverse change in the financial condition of the borrower or guarantors or (ii) upon the occurrence of a material adverse event affecting the property or its operation. Moreover, many loans require the borrower to affirmatively notify the lender if a Material Adverse Change/Event occurs and the failure to provide such notice is usually a default in and of itself. While the ensuing arguments often focus on the question of materiality, in dire circumstances such as these, it is almost certain that the materiality standard will be satisfied. Borrowers need to carefully examine the Material Adverse Change/Event to fully understand the particular terms of their loan documents and the possible consequences, and to determine their obligations including with respect to notice.

Going Dark

Going hand in hand with Material Adverse Event provisions, many loans provide that if a property “goes dark” – is not occupied or utilized for some continuous period of times (usually more than 30 days), it is a default event. Cure periods are often provided but in situations such as presented by the Covid-19 virus, it will be difficult if not impossible in many cases for borrowers to cure. These “Going Dark” provisions particularly impact the hospitality industry where hotel owners are being forced into temporary closings as room revenue dwindles to nearly zero and where insurance claims for business interruption or other loss of income insurance will no doubt be protracted and hotly contested by insurance companies and, in many cases, ultimately denied.

Lender Consent

Borrowers will not be addressing loan issues in a vacuum. Many other considerations will simultaneously present themselves. In dealing with third parties, borrowers must pay close attention and often must obtain the lender’s prior written consent for matters such as rent abatements to tenants under leases, modification of leases and termination of leases (these same consent requirements will very likely also apply to other commercial agreements relating to the property such as management, brokerage, construction, franchise and license agreements). It is critical to note that the failure to obtain lender consent may violate the “No Transfer” provisions of the loan documents and inadvertently activate springing full recourse personal liability under a guaranty. This is a result that must definitely be avoided. 

Force Majeure

Although very few, if any, commercial loan documents will contain borrower friendly force majeure provisions, borrowers must still review their loan documents to analyze whether there are circumstances where certain obligations and covenants may be suspended. Borrower should also consult with counsel to determine where common law legal doctrines such as impossibility or frustration of performance may be invoked.

Conclusion

Property owners and other commercial property stakeholders must consider the above issues as they begin to digest the dramatic economic effects of the COVID-19 pandemic and the global economy enters into uncharted territory. The issues discussed above are by no means an exhaustive list and will not apply to every situation, but are meant to be a helpful starting point in thinking about the myriad issues that will result from this unprecedented crisis and the complicated conversations in which the stakeholders will inevitably engage.

In these unusual and trying times, we wish you well. Our team at EGS is available to support you.

*        *        * 

If you have questions or would like additional information, please contact Michael A. Dinowitz ( mdinowitz@egsllp.com ), (646) 895-7127, Partner in EGS’ Real Estate Group, or Melanie Chieu ( mchieu@egsllp.com ), (646) 895-7171, Of Counsel in EGS’ Real Estate Group, or the primary EGS attorney with whom you work.  

1345 Avenue of the Americas
New York, NY 10105

www.egsllp.com
This memorandum is published solely for the informational interest of friends and clients of Ellenoff Grossman & Schole LLP and should in no way be relied upon or construed as legal advice.