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