MARCH 17, 2010 – APRIL 6, 2010
T
Consider capital call strategies
he ripple effects of declining
commercial real estate values
are beginning to reach owners of all real estate classes. Loanto-value ratios that were more than
comfortable two years ago are cutting close to the bone and lenders are
applying pressure to comply with the
loan-to-value and debt-service-coverage ratio covenants under the mortgage loan documents. Refinancing
is no longer a viable alternative due
to the combined negative effects of
decreased property values and higher
loan-to-value ratio requirements on
new loans. As a result, equity owners
of all classes of leveraged real estate
ventures may receive the ominous
call from the managing member or
general partner for an “additional
capital contribution” this year or next
to make up shortfalls or pay down
the loan. After the principals have
depleted their personal reserves, new
investors or new subordinate debt
may be the only avenues available
to existing owners to hold onto their
shrinking equity and maintain compliance with loan covenants or pay
off maturing debt.
Most modern loan documents
require the maintenance of specific
loan-to-value and debt-service coverage ratios measured on a continuous
basis or at least quarterly. If these covenants are violated, the lender will
require a capital infusion, additional
collateral or a partial principal payment to “cure” the covenant violation.
Obviously, it is best to anticipate the
need for additional capital at an early
stage. Many property owners, however, are finding out that, notwithstanding prudent property management, they are just one conservative
appraisal update or lease termination
away from violating these covenants
and scrambling for cash. The earlier
the need is identified, the greater and
more flexible the options will be for
raising new capital or debt.
If a loan restructuring with the
senior lender is not available or will
not fully address the issues, the three
primary options to remedy the distressed capital call situation and put
the asset on a more secure financial
footing include: third-party equity
investment; mezzanine debt; and
subordinate secured debt.
Each of these options has benefits
but each may require the existing
principals to relinquish some control over the asset and disclose any
adverse issues relating to the property and existing debt to any new
investors or lenders.
n New investor equity. The most
straightforward option is to seek new
equity investors. Obviously, the sale
of new equity will dilute the existing
owners’ ownership, but this is better than being completely wiped out
through foreclosure or bankruptcy.
In selling equity (or the issuance of
new equity) in the borrower entity,
the principals must be cognizant of
federal and state securities laws and
federal tax laws. In general, private
equity offerings not made by any
form of general solicitation or general
advertising and made only to “accredited investors” are exempt from the
registration requirements under the
Securities Act of 1933 so long as the
equity offering complies with the
other requirements of Regulation
D. Accredited investors generally
includes, among other categories of
investors, individuals with income of
more than $200,000
(or joint income
with a spouse of
more than $300,000)
in each of the last
two years (with a
reasonable expectation of reaching
the same income
level in the current
year) or individuals
with a net worth (or
Stephen J.
joint net worth with
Ismert
Attorney, Kutak
a spouse) of more
Rock LLP, Denver
than $1 million.
Seeking investors
who are not “accredited investors”
requires compliance with specific disclosure requirements or compliance
with registration requirements. The
failure to disclose material matters
relating to the offering, the property or the financial condition of the
borrower or project (regardless of
whether the investors are accredited
investors) could expose the entity
and the individual principals to
fraud claims and securities law violations. Additionally, the entity also
may need to take measures to avoid
being characterized as a “publicly
traded partnership” under the federal
tax laws (often this is accomplished
by limiting the number of beneficial
owners of the equity securities of the
borrowing entity to less than 100)
and to avoid being characterized as
an investment company under the
Investment Company Act of 1940
(through a limitation on the number
of investors or heightened investor
suitability requirements).
Other factors to consider when
bringing on new investors are the
“transfer restrictions” and “change in
control” requirements under the loan
documents (typically found in the
deed of trust or mortgage). These provisions can be very tricky and often
are vague in the lender’s favor. In
most loan documents, the borrower is
not permitted to sell or transfer material portions of the equity interests in
the borrower in a single transaction
or series of transactions without the
lender’s prior written consent. An
equity sale without the consent of the
lender could trigger a breach of these
covenants and potentially expose the
nonrecourse guarantors, if any, to
personal liability for the full loan
amount.
As negotiations with the new investors progress, the issue of liability
sharing among the investors eventually will arise. Since the primary
loan already is in place at this point,
the lender may not always require
that new investors execute additional
guarantees. However, the investors
should properly document their reimbursement liability to one another in
the event some or all of the guarantors fail to pay, or are not required to
pay, on any existing loan guarantees.
The situation is more acute when
the guarantors’ liability is “joint and
several” and not all investors have
the means to pay their proportionate shares. The investors with money
will pay on their respective guarantees first and then they will have the
unpleasant task of chasing their fellow investors for their proportionate
shares.
Alternatively, if less than all of the
principals sign new or existing guarantees, the principals who do provide
lender guarantees can be compensated with a “guarantee fee.” Under this
arrangement the investors signing a
guaranty will at least be compensated
for taking the additional risk at the
outset. Those signing the guaranties
should carefully consider requiring
additional control over actions by the
borrowing entity that could trigger
release liability (e.g., transfers, bankruptcy, application of funds).
The documentation of the sale of
additional equity typically involves
a disclosure statement, subscription
agreement, amendments to existing
operating agreements or shareholder
agreements, liability sharing agreements and certificates representing
the equity interest being issued. The
new investors may require a preferential return, indemnities for existing
financial and physical property conditions and super voting rights.
Those contemplating the sale of
equity should allow at least a 30to 60-day due diligence period by
potential investors for their review
of entity formation documents and
preparation of the investment disclosure and offering materials. After the
prospective investors are identified,
the borrower should allow at least
another 30 days to document the
equity sale and collect the proceeds.
The dollar size of the offering and the
complexity of the existing ownership
structure will affect the above time
periods.
n Mezzanine financing. The second option, mezzanine financing,
works pretty well in most distressed
asset situations due to its hybrid
structure. Under a typical mezzanine debt structure, the mezzanine
lender makes a loan to the borrower
entity and/or its principals; the loan
is secured by the all the principals’
equity interest in the borrower entity
(i.e., their limited liability company, partnership or stock interests).
This collateral is secured by a pledge
agreement and perfected by filing
a UCC 1 financing statement with
the applicable secretary of state.
In the event of a default (typically
cross defaulted with the underlying
senior mortgage loan), the mezzanine
lender could foreclose on the equity
interest in order to become the sole
equity owner of the borrower entity
and thus control the property. The
mezzanine lender would then control the liquidation of the property
or seek refinancing (assuming the
senior lender is willing to allow this
opportunity).
Since the exercise of the mezzanine
lender’s remedies may result in a
“transfer” or “change in control” of the
borrower, the prior written consent of
the senior lender must be obtained. In
this market, the senior lender is usually pleased with “new money” coming
into the project although senior lenders will be very careful not to allow
real estate collateral to be encumbered by the mezzanine lender. The
mezzanine lender and senior lender
typically will enter into an intercreditor agreement,which provides for the
senior lender’s consent and gives the
mezzanine lender the right to cure
the senior loan and perhaps purchase
the senior loan upon a default after
taking control of the borrower entity.
Private equity firms, venture funds
and other opportunistic lenders are
good sources for mezzanine loans.
Borrowers should expect to pay hefty
origination fees, interest rates and
other costs and significant restrictions
on voting rights for these “high-risk”
loans.
Mezzanine lenders commonly
require a junior lien on the real property as “additional collateral” for the
mezzanine loan. Whether this collateral is available will be almost entirely up to the senior lender. Under
this structure, the mezzanine lender
would have two basic remedies upon
a default: a foreclosure on the equity
interests of the principals and a foreclosure on the real property (subject
to the lien of the senior lender).
Since mezzanine loans are secured
by each principal’s respective equity
interest in the ownership entity, the
proper documentation of the formation and ownership of the entity is
crucial. The mezzanine lender will
fully scrutinize the entity formation
documents to make certain that the
equity interests were properly issued
and currently owned by the principals. Each principal will be required
to provide representations and warranties concerning ownership of his
respective interest. Any deficiencies
in the entity formation documents
should be remedied before presentation of such documents to the prospective mezzanine lender. Mezzanine
lenders may also require some level
of repayment guaranty (depending
on the equity in the project).
n Second or junior loan. The
third option is a second loan secured
by a second or junior lien on the property. In the distressed situation, this
option may not be possible without
additional collateral for the junior
lender. Such “additional collateral”
could include a letter of credit, liens
on other properties owned by the
principals or other liquid assets of the
principals. If such additional collateral is available, a junior loan may be
the fastest and least expensive option
from a legal perspective.
More often than not, a lender providing a junior loan would require
a full personal guarantee by each of
the principals of the borrower entity
(or at least the majority principals).
The financial strength of the guarantor will be a primary factor in the
underwriting of the junior loan given
the thin equity in the property. Under
most bank guaranties, the lender is
not required to first exhaust its remedies with respect to the collateral,
but rather the lender may pursue
its remedies immediately against the
guarantor. If the guarantee or junior
loan is joint and several, the parties should properly document their
respective liabilities to one another.
The senior lender will certainly be
involved in any junior lien situation.
Almost all mortgages expressly prohibit junior liens without the express
prior consent of the lender. Under
most nonrecourse guarantees of securitized loans, the violation of this covenant can trigger full personal liability for the guarantor. Under current
market conditions, a senior lender
may be more than willing to consent
to a junior loan given its alternative of
foreclosing on the property. The risk
of not obtaining the senior lender’s
consent is too great to ignore.
There are certainly combinations
and derivations of the foregoing
alternatives that should be explored
to achieve the goals of the property
owner, the principals and lenders. All
these options require the parties to be
flexible and to cooperate in a good
faith with full disclosure.s