This practice note discusses borrower default and lender remedy provisions in commercial real estate financing documentation used in Pennsylvania and provides an overview of commonly used workout options. Where appropriate, this note includes negotiation tips for counsel to the borrower and the lender.

For further guidance, see Commercial Real Estate Financing Transactions (PA), Foreclosure of Real Property, Bankruptcy Issues Affecting Real Estate Loan Transactions, and Workouts of Commercial Real Estate Loans.

For related forms, see Mortgage, Assignment of Leases and Rents, Security Agreement, and Fixture Filing (PA) and Promissory Note (Acquisition Loan) (Pro-Lender) (PA).

Background and Preliminary Considerations

As in any commercial transaction, the front-end negotiation of terms in a commercial real estate loan transaction is critical. Clarity should be the objective. This will ensure that the loan documents clearly state all material considerations, the parties are in a meeting of the minds, and the transaction can proceed in a smooth and efficient manner to realize the parties' respective business objectives. However, best-laid plans in business often do go awry. In these instances, where a lender has lent money, there must be a process that protects the parties' diverging interests while mitigating the damage of default. To that end, there are certain remedies available to the lender and corresponding protections available to the borrower. Some of these remedies are dependent on the inclusion of express terms in the underlying loan documents. Others derive from caselaw or statutory authorities. Regardless, the parties should consider, during the initial negotiation process, what should happen if material changes in circumstances occur. This will give the parties the opportunity to structure their agreement in a way that protects their respective interests and streamlines resolution processes. If the parties fail to consider these issues at the start, the way forward may be uncertain, with the only certainty being increased risk and cost.

Loan Terms and Covenants

An initial area of negotiation should involve loan covenants, which are terms that require the borrower to fulfill certain conditions or avoid certain actions. They may be financial covenants tied to the borrower's operations, such as maintaining a certain debt-to-equity ratio, level of cash flow, or earnings before interest, taxes, and depreciation. The commercial real estate lender needs to ensure that the business attendant to the real estate will service the debt through full and timely payments and fulfill other obligations. These covenants, which are essentially canaries in the coal mine, are material and can trigger events of default if the borrower fails to comply with them. They are therefore integral to the ongoing relationship between the lender and the borrower. Note that numerous factors, including loan-to-value ratio, the current state of the market and availability of credit, and the track record of the property, may affect the terms and covenants that a lender requires in a given transaction

Lender Type

Loan terms and covenant requirements may also vary based on the type of lender involved. So-called hard money lenders—usually private investors or a pool of passive investors creating a managed fund—may take a different approach than conventional lenders. Hard money lenders may invest in individual loans or in a fund that manages a portfolio of loans. Their loans are customarily shorter term, such as six months or one year, and the loan terms, including the principal, rate of interest, and down payment (sometimes 20% to 30%), may be more directly tied to the collateral. This differs from conventional lenders—such as banks or credit units—which usually tie such loan terms to the borrower's ability to repay from ongoing income. If the loan defaults, hard money lenders often expect to be repaid by taking the collateral and selling it. In doing so, they foreclose on the entire real property serving as collateral and forfeit interest payments that the borrower may have made in the future.

Non-recourse and Recourse Loans

Lenders tend to structure commercial real estate loans as non-recourse loans. A non-recourse loan is secured by real estate and possibly other collateral. When a loan is structured as non-recourse debt, the borrower is not personally liable for the debt or the lender's losses except in the case of specific bad acts (e.g., fraud or misappropriation of rents or assets). These bad acts are called non-recourse carve-outs.

Of course, the borrower in a commercial real estate transaction may be a single purpose entity (SPE), set up to own and operate a single real estate asset. In such circumstances, recourse from the borrower may be inherently limited in any event. The lender may therefore require the sponsor to provide a guaranty, known as a non-recourse carveout guaranty or a bad boy guaranty, to cover the lender's losses resulting from the borrower's bad acts.

The loan documents for a non-recourse loan may limit the lender's enforcement of the loan to an action in foreclosure. Further, they may require the lender to look solely to the real property and other collateral securing the loan and limit the lender's potential recovery to the amount of the debt. Bad boy carve-outs to this non-recourse feature may extend the borrower's and guarantor's liability to the lender's actual losses resulting from an impairment of the collateral's (such as waste of the collateral or failure to pay property taxes) or for events that impair the lender's ability to realize upon the collateral (such as a borrower's bankruptcy that stays foreclosure proceedings).

Commercial lenders typically just want to be repaid and do not want to take ownership of the real property. Acquiring other real estate owned (OREO) property (i.e., property that the bank acquires in satisfaction of debts and does not use to conduct its business) generates carrying costs and raises specific accounting and banking regulatory issues. See, for example, the regulations that the Office of the Comptroller of the Currency has issued covering OREO activities for national banks and federal savings associations. These and other regulations, which seek to mitigate the impact of real estate losses and ensure the safety and soundness of the banking institution, can trigger additional reserves against capital, which in turn may limit further lending capacity. For these reasons, commercial lenders usually do not want to own and operate real property and may instead be inclined to pursue a loan workout with the borrower.

When a commercial loan is structured as recourse debt, on the other hand, the borrower is personally liable for the debt. If money remains due after the mortgaged property is sold through a judicial foreclosure, the lender may pursue a deficiency judgment against the borrower for the balance. This allows the lender to collect what is owed for the debt even after the lender has foreclosed on the mortgaged property.

For more information on recourse carve-out guaranties, see Developments in Recourse Carve-Out Guaranties and Guaranty and Indemnification Agreements in Acquisition Loan Transactions.

Sureties and Guarantors

Sometimes, a surety or guarantor can guarantee performance or payment of the loan. This gives the lender additional recourse, upon the borrower's default, against the surety or guarantor and its available assets.

The parties should be aware that Section 1691(a)(1) of the Equal Credit Opportunity Act (ECOA) ( 15 U.S.C. § 1691(a)(1)) protects individual spouses who guarantee a debt merely due to their marital status. A lender may not discriminate against an applicant based on his or her marital status or require a spousal guaranty or co-signor if the applicant qualifies under the lender's standards of creditworthiness for the amount and terms of the credit requested (except in specific circumstances). See Section 202.7(d)(1) of Regulation B, 12 C.F.R. § 202.7(d)(1). A lender may not require a spouse to sign a credit instrument unless (1) the spouse and the applicant are joint applicants or (2) the lender has determined that the applicant is not creditworthy. It is unclear, however, whether the spousal discrimination defense of the ECOA applies when a spouse has been asked to sign a guaranty securing the debt of a business entity rather than that of the other spouse (e.g., if spouses are guaranteeing the debt of a business entity). See Commonwealth v. Buhler, 2019 Pa. Commw. Unpub. LEXIS 382. Regardless, to avoid liability under the statute, the lender should act in strict compliance with the ECOA and properly document the circumstances of the transaction. For more information on the ECOA and other fair lending laws, see Fair Lending Laws and Enforcement Trends.

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Originally published by LexisNexis

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