1:15PM Seminar 20 SOFR Is the New LIBOR, Or Is It? Hot Topics In

Friday, October 25, 2019 12:00 PM – 1:15PM

Seminar 20

SOFR is the new LIBOR, or is it? Hot topics in commercial mortgage market

Presented to

2019 U.S. Shopping Center Law Conference Marriott Marquis San Diego Marina San Diego, CA October 23-25, 2019

by:

Jill D. Block Susan C. Cornett Partner Partner Norton Rose Fulbright US LLP Thompson Hine LLP 1301 Avenue of the Americas 10050 Innovation Drive, Suite 400 New York, New York 10019-6022 Dayton, OH 45342 – 4934 [email protected] [email protected]

State of the Market.

CMBS. CMBS originations are down in 2019. According to the Mortgage Bankers Association, issuance in the first quarter of 2019 was $16 billion, down from $19 billion during the same period of 2018. The Mortgage Bankers Association reports that CMBS loans account for approximately $466 billion, or about 14 percent, of commercial and multifamily mortgages.

Collateralized Loan Obligations (CLOs). According to LPC Collateral data, the CLO market grew to more than $600 billion in March of 2019.

LIBOR Replacements. LIBOR will be phased out by the end of 2021. Potential LIBOR replacements include:

Secured Overnight Financing Rate (SOFR). The Alternative Reference Rates Committee (AARC) announced on June 22, 2017 its identification of Secured Overnight Financing Rate (SOFR) as a consensus best practice rate. The daily SOFR is based on observable transactions in the Treasury repurchase market. Proponents find it preferable to LIBOR because there is extensive trading each day (about 1,500 times that of interbank loans as of 2018). Critics of SOFR point to the volatility of SOFR, time investment, considerable expenses and risks to participants in the derivative and cash markets (i.e., constructing the necessary protocols, implementing uniform procedures to properly calculate and cover the difference between the LIBOR rate and the secured risk-free SOFR rate, educating and convincing market participants that SOFR is a reasonable equivalent to LIBOR and developing uniform fallback rate triggers).

Bank Yield Index (BYI). BYI was introduced by ICE Benchmark Administration in January of 2019. BYI measures the average yields that investors are willing to invest over 1, 3, & 6-month periods. It is based on real commercial trades (i.e. certificate of deposit transactions) and considers more than overnight rates. However, there has been only one year of testing, and it is not ready for publication. ICE Benchmark Administration anticipates being ready to publish the rate in the first quarter of 2020.

AMERIBOR. AMERIBOR launched in December 2015 and is published by the American Financial Exchange. AMERIBOR reflects the borrowing costs for transactions between small and midsize U.S. financial institution members. It remains steady at month-end and year-end periods, unlike SOFR. Unlike LIBOR or BYI, it is geared more toward smaller U.S. bank financing conditions, so it’s global breadth and effect on multinational financial institutions is unknown.

Despite the impending disappearance of LIBOR, lenders and borrowers continue to enter into loans for terms outliving LIBOR with interest rates based on LIBOR. So, document provisions addressing the unavailability of LIBOR, while standard in loan documents for years, have become highly negotiated and important provisions. Key concepts for borrowers to address include:

Procedures for choosing the replacement rate: Borrowers should seek a seat at the table for the determination of the replacement rate. Although it is difficult to negotiate that the replacement rate is subject to the borrower’s approval, the lender may agree to determine the replacement rate in consultation with the borrower. If the lender will not allow the borrower to participate, the replacement rate should be selected based on what is customarily being used for commercial mortgage loans in the market.

Adjustment of Margin: Borrowers should attempt to provide for an adjustment of the interest rate margin so the replacement rate with the applicable margin immediately after the transition is equal to LIBOR with the applicable margin immediately prior to the transition. Alternatively, a lender may agree to use good faith efforts to adjust the margin in a manner that is equitable under the circumstances.

Term Sheets and Commitment Letters. Often, the borrower has the most leverage during the commitment letter stage, so the borrower should negotiate key deal points at this stage. If there are issues with the property or the borrower, they should be addressed early in the process. The borrower should review whether commitment and similar fees will be refundable if the loan does not close.

Other issues to think about including in the commitment letter include: (i) Choice of law and required opinions; (ii) Permitted transfers; (iii) Leasing restrictions and estoppel and SNDA requirement; (iv) Financial reporting requirements and financial covenants; (v) Other debt (including upstream equity pledges); (vi) Single purpose entity requirements (particularly if the borrower is not a new entity); and (vii) Non-recourse carve-outs.

Loan Documents

Transfer Restrictions.

Equity Transfers. Most transfer provisions restrict both direct and indirect transfers. Consider the upstream structure of the borrower and whether transfers over a certain level on the organizational chart should be unrestricted. Estate planning transfers are often permissible so long as there is no change of control. The borrower may want to transfers among members to be unrestricted. Transfers by passive members should be permitted.

Affiliate Transfers. The borrower should consider whether flexibility for intercompany transfers is necessary.

One-Time Transfers. The borrower may have a one-time right to transfer the property (or the ownership of the borrower) subject to certain underwriting conditions. The borrower should avoid conditions that permit the lender to impose new or different obligations on the assignee. Consider including a “Qualified Transferee” definition to reduce the lender’s discretion in approving potential transferees.

Easements. The borrower should have the right to grant routine easements without Lender’s consent.

Personal Property. The borrower should have the ability to dispose of personal property in the ordinary course of business and to replace such property only if required for the operation of the real estate.

Additional Financing.

Mezzanine Debt. Although not common, a borrower may be able to negotiate the right to obtain mezzanine financing in the future. Such right will likely be subject to several conditions such as the requirement for an acceptable intercreditor agreement and the satisfaction of certain financial tests.

Trade Payables and Equipment Financing. Typically, the borrower is permitted to incur trade payables and equipment financing subject to a capped amount.

Upstream Financing and Pledges. The borrower should look at transfer provisions in connection with any upstream financing that may include pledges of ownership interest.

Exit strategies.

Prepayment. Prepayment without penalty is more common with commercial banks and life insurance companies. Free prepayment windows tend to be very short on CMBS, CLO and fund transactions. If there is a prepayment penalty, the loan documents should specify the situations where it will not apply such as casualty or condemnation, prepayments required by the lender in connection with legal requirements and permitted partial releases.

Defeasance. Attempt to expand definition of defeasance collateral to include agency securities. Limit scheduled defeasance payments to stop on first day of open period. Permit the borrower to designate the successor borrower so the borrower may be able to negotiate a share of any residual value of securities.

Substitution of Collateral. Substitution is typically only found in multi-property portfolio deals. The lender will retain a great deal of discretion in underwriting the substituted property.

Partial Releases. Partial releases are common for multi-property portfolio transactions, but should also be considered for single property transactions where outlot sales are possible. In order to obtain a partial release, a borrower will have to satisfy several conditions including meeting financial covenants post-release. These should be carefully reviewed and borrowers should consider including an option to cure any deficits by additional payments or security.

Non-Recourse Carve-Outs. Avoid non-recourse carve out trigger tied to lack of cash flow caused by general economic conditions (as opposed to “bad acts” by the borrower, such as misapplication of insurance proceeds) .Avoid trigger of full recourse if any single purpose entity or separateness representation or covenant is breached and all continued or periodic down dates of any single purpose entity or separateness representations such that a breach triggers full recourse. Negotiate to achieve only limited recourse, based on damages. Full recourse should occur only if substantive consolidation occurs. In particular, avoid triggers of recourse if the borrower should become insolvent. Avoid full recourse due to “any transfer”. Scrutinize definition of “transfer” and “prohibited transfer” to avoid a de minimus “transfer” triggering full recourse. Exclude leases and easements subordinate to mortgage from transfers that trigger full recourse. Exclude liens, particularly if documents provide to Borrower the right to contest and/or cure. Avoid recourse if default is due to improper lender failure to make disbursements to the borrower (e.g., from reserves, cash trap, etc.). If the lender requires recourse for the borrower’s challenge of enforcement of the loan documents, limit the language as much as possible. If possible, limit to when the borrower or guarantor contests the lender’s exercise of remedies after the occurrence of an event of default (except to the extent that a court of competent jurisdiction makes a final determination that borrower or any guarantor had a valid legal basis for any such action). In workout context, include in pre- negotiation agreement protection against any sponsor injection of new money being characterized as trigger for recourse (e.g., evidence of the borrower’s failure to pay debts as they come due from borrower assets).

Single Purpose Entity Requirements.

The borrower should carefully review the single purpose entity requirements, as failure to comply often triggers recourse. Lenders often include backward looking representations as to single purpose entity matters which may be different than another prior lenders requirements or the borrowing entities organizational documents. Consider whether certain requirements like maintaining separate stationary are practical. Review requirements for independent directors and springing members.

Casualty/Condemnation. The borrower should have the right to adjust insurance claims under a specified amount. The threshold will vary by loan amount. The borrower should not be required to provide written notice to Lender of any casualty under a specified amount. The lender should agree to apply insurance and casualty proceeds to restoration so long as (a) there is no event of default, (b) leases exceeding a specified threshold shall not be terminated, (c) restoration will not take longer than a specified time complete, and (d) restoration will be completed prior to the last year or last 18 months of the term. The borrower should have the right to participate in condemnation proceedings unless there is an ongoing event of default. No prepayment penalty should apply if condemnation or casualty proceeds are applied to the loan.

Default and Remedy Provisions. Typical defaults include:

Failure to pay when due any amounts due to the lender: The borrower should attempt to limit to amounts due on regular payment dates. Include a carve-out if the lender fails to advance available reserve funds.

Failure to pay taxes / keep insurance policies in force: Default should be subject to the borrower’s right to contest. Include a carve-out if the lender fails to advance available reserve funds.

Prohibited transfer: The borrower should build needed flexibility into “permitted transfers.” The default should be limited to transfers within the borrower’s control. The default should be subject to notice and right to cure.

Breach of representations and warranties: Attempt to limit to breaches that are intentional or known to have been false when made. The borrower should attempt to include a materiality qualification. Although a breach of a representation may not be a curable default, the borrower should have the right to cure the condition causing such representation to be untrue.

Bankruptcy: There should be a distinction between voluntary and involuntary. Any involuntary bankruptcy should be subject to notice and right to cure.

Failure to complete construction by completion date: The default should be subject to force majeure. The borrower should receive notice and a right to cure. Include a carve-out if the lender fails to advance funds.

Any other default without specific notice and cure provisions: The default should be subject to notice and a 30 day cure period. The cure period should be extended if the borrower timely commences and diligently prosecutes the cure, up to an additional [90 – 120] days.

Typical remedies include:

Acceleration – may be automatic or upon notice/demand and typically triggers default rate on whole loan.

All remedies under loan documents, at law and in equity whether or not accelerated, and whether or not commenced foreclosure. The lender may (without obligation) perform on Borrower’s behalf at Borrower’s cost. A default may loosen restrictions on the lender’s right to sell the loan. A default may tighten restrictions on Borrower’s ability to manage project.

Remedies are subject to local law (one action rule, election of remedies rules).

Representations, Warranties and Covenants.

Compliance with Laws: Any representation and/or covenant to comply with legal requirements should have a materiality qualifier. Any representation should also have a knowledge qualifier. The borrower should have the right to contest legal requirements and taxes.

Liens: The borrower should have the right to contest liens.

Restrictive Covenants; Zoning: The borrower should have the right to subject the property to restrictive covenants that are normal and customary and that do not adversely affect the lien of the mortgage. The borrower should have the right to consent to a zoning change in the ordinary course of business. Any representation as to zoning should have a knowledge qualifier and should refer to the zoning report, if any.

Other Contracts (not leases): Any representation as to defaults under contracts should have a knowledge qualifier and a materiality qualifier. The lender’s consent rights as to other contracts, if any, should be limited to “Material Agreements.”

Litigation: Representations as to litigation should exclude anything covered by insurance or that would not materially affect the borrower or the property.

Alterations: The borrower should have the right to make alterations up to a specified amount without Lender’s consent. The threshold will vary by loan amount.

Environmental: All environmental representations should have a knowledge qualifier and a materiality qualifier and should except anything disclosed on the environmental reports. The lender’s right to conduct environmental investigations at the borrower’s cost should apply only during an event of default or when the investigation shows that there are violations of environmental laws. The borrower’s environmental indemnification should not apply to (i) events occurring after the loan is paid or the lender takes possession of the property or (ii) conditions that arise out of an affirmative act of the lender. The borrower’s environmental indemnification should expire one year after the expiration of the loan term.

Leasing Restrictions. Material Leases are typically defined as:

(A) one or more leases to one tenant (including affiliates)

(B) which, in the aggregate:

(I) constitute [__]% or more of the Property’s gross leasable area, or

(II) have a gross annual rent of [__]% or more of the total annual rents, OR

(III) demise a least [[____] square feet] / [a full floor]] of the Improvements.

The lender’s consent is usually required for entry into a proposed Material Lease, or a proposed renewal, extension or modification of any existing Material Lease. The borrower should attempt to include a time period for the lender review (10 business days) and specify what materials to be provided (lease / modification documentation, TI specs, proposed tenant’s financial and background info). The borrower should seek deemed approval if the lender fails either approve or disapprove, which may be limited to where there is no event of default. The loan documents should include parameters within which the lender approval of non-Material Leases will not be required (substantially in the form of approved standard lease form, rent at market rates, initial term not less than [x] and not more than [y], no option to purchase, self-operating subordination to mortgage and attornment to the lender). Other covenants regarding leases include a requirement of the borrower to:

(A) Observe and perform material obligations.

(B) Send copies to the lender of all notices of default sent or received.

(D) Not collect rents more than one month in advance.

(E) Not assign lessor’s interest therein except as contemplated in loan documents).

(F) Not modify any lease in a manner inconsistent with loan documents.

(G) Not convey or transfer the property so as to merge the estates of landlord and tenant.

(H) Not consent to assignment or subletting of any Material Lease without consent of the lender.

(I) Not cancel or terminate, or accept a surrender of, any lease without the consent of the lender.

Tenant Estoppel Certificates / SNDAs. Tenant estoppel certificates are a fundamental part of the lender’s due diligence – determine in advance minimum (number of tenants and square footage) required to close. The lender-approved standard lease form should provide for automatic subordination and attornment.

Property Management. If the lender has the right to approve a replacement property manager, consider including “Qualified Manger” definition, such as: A Qualified Manager shall mean a reputable and experienced management company which manages, together with its affiliates, at least 5 other properties similar to the property and which, in the aggregate, consist of at least 5,000,000 square feet of gross leasable area (including all anchor space), exclusive of the property. Avoid lender rights to terminate the property manager without cause or to decrease or eliminate compensation to property manager. The property manager should not be required to pay back any amounts received under the management agreement. The property manager should not be required to work for free; the lender should acknowledge property manager’s right to terminate the management agreement in the event management fees are not paid.

Cash Management and Reserves.

Terminology.

Standing or Springing: standing is effective immediately; springing is triggered into effect upon the occurrence of an event (event of default, DSCR test failure, termination of a major lease).

Hard or Soft -- who collects revenue? If the borrower or property manager collects and then deposits to a collection account, it is soft. If tenants are directed to pay rent directly to a collection account, it is hard.

Collection Account / Clearing Account / Lockbox Account: a blocked account into which rent is deposited, either directly from tenants or by the borrower or property manager, and from which amounts on deposit are swept daily.

Deposit Account / Cash Management Account: a blocked account into which the lockbox account proceed are swept, and from which amounts are released on the payment date to pay the borrower obligations and/or to fund subaccounts.

Subaccounts: accounts (which may be ledger or book entry accounts) into which funds are deposited at closing and/or periodically from deposit account proceeds through the waterfall. Subaccounts may include: Tax and Insurance Reserve (funded with monthly deposits from the Deposit Account to cover tax and insurance expenses as and when due).

Required Repairs Reserve (funded at closing for identified work to be completed within specified time period).

Cap Ex Reserve (funded with monthly deposits from the deposit account to to-be-determined capital repairs).

Loan Terms.

Cash Management Period: this is typically a time of instability during which the lender has a need for greater protection:

(I) may commence at closing and remain until stability (lease-up, target DSCR) is achieved, or

(II) may kick in in the future upon the occurrence of a destabilizing event (EOD, DSCR test failure, termination of a major lease), and end when stability is restored).

During a cash management period, the bottom rung of the waterfall will typically be a cash collateral account or a principal payment to the lender. During periods other than a cash management period, that bottom rung of the waterfall will be a release of net funds to the borrower. Deposit account and subaccounts are under the lender’s control; borrower has no right to direct the withdrawal of funds..The borrower will typically be given view only access to the deposit account.

Documentation.

Cash Management Agreement – a loan document between the lender and the borrower pursuant to which, among other things, the borrower typically grants to the lender a security interest in the deposit account and proceeds on deposit therein.

Deposit Account Control Agreement – a tri-party agreement among the lender, the borrower and the depository bank (typically on depository’s form); this agreement perfects the lender’s security interest in the deposit account and the proceeds on deposit therein.

Financial Reporting and Covenants. Although financial reporting is often seen as a business matter, the requirements should be carefully reviewed: Financial reporting requirements should be reviewed by the borrower’s accounting group. Audited financial statements should be required only if the borrower customarily has them prepared. If the lender has the right to approve a CPA, consider obtaining preapproval. Review the timing to provide monthly, quarterly and annual reports for practicality. Consider having the lender preapprove the form of reports. Any representations as to financial reports should have a materiality qualifier. When a loan party is required to meet financial covenants, the defined terms that are key to such covenants are often overlooked. For expense definitions, look for assumed amounts (such as reserve amounts, debt service payments and management fees) to confirm they are appropriate for the project. Consider whether non-recurring revenue or expenses should be included. Cure periods for breaches relating to both financial reporting and financial covenants are often short or non-existent. For financial reporting, a short notice and cure period is appropriate. For financial covenants, the borrowers should have the right to cure by paying down the debt or posting additional funds or security.

Secondary Market Transactions. Even when lenders indicate in the term sheet that a loan will be a balance sheet loan, most lenders require the flexibility to enter into secondary market transactions. Although it is difficult or impossible to eliminate these provisions, borrowers may negotiate changes that can prevent adverse effects. Borrowers will generally be required to cooperate with lender’s secondary market transactions, but some limitations are customary. Look for ways to limit the borrower’s expense. If the lender will not agree to pay the borrower’s cost, consider including a cap on the borrower’s obligations for such costs. Watch for unreasonably time limitations, as failure to timely comply could cause an event of default. Be careful for additional requirements that are difficult or costly, such as audited financials being required when they are not otherwise required for the loan.

Lender Diligence. Organizational Documents / Bankruptcy Remoteness.

State of Organization: Sometimes the state in which property is located, but Delaware is preferred.

Independent Directors: What constitutes “independent”? Consent of independent directors is required for certain actions, including bankruptcy.

Springing Members: May be required for single member limited liability companies.

Opinions.

Borrower’s counsel opinions:

(A) Due formation, valid existence, good standing, and due execution of loan documents, with respect to the borrower and guarantor.

(B) Authority to enter into the transaction, and to execute and deliver the loan documents, and that no other action by anyone is required.

Local counsel opinions:

(A) Enforceability of loan documents: given by counsel admitted in jurisdiction by which the loan documents are governed (may be one state with respect to “general” loan documents (loan agreement, note, guaranties) and another in which the property is located (which will, by necessity, be the governing law with respect to the property-specific documents (mortgage, assignment of leases).

Bankruptcy counsel opinions:

(A) Non-consolidation opinion - provides that there would be no reasonable likelihood of substantive consolidation of the assets of the special purpose entity Borrower with those of the parent or affiliate of the borrower in the event such parent or affiliate were to become a debtor in bankruptcy.

Delaware counsel opinions:

(A) Opinion that in order for a person to file a voluntary bankruptcy petition on behalf of the borrower, the written consent of the independent manager as provided for in the limited liability company agreement, is required, and the provision requiring the unanimous written consent of the independent manager to file a voluntary bankruptcy petition on behalf of the borrower, constitutes a legal, valid, binding and enforceable agreement.

(B) Opinion that a federal bankruptcy court would hold that Delaware law, and not federal law, governs the determination of what persons or entities have authority to file a voluntary bankruptcy petition on behalf of each of the Delaware entities.