Posted on May 28, 2009 by Keith H. Mullen

Evaluating Material Adverse Change (MAC) Clauses in the Loan Default Context (Part 2 of 2)

Guest Writer - Christopher T. Nixon, Winstead PC

In my earlier posting, I introduced this topic, and addressed several “challenges” in the meaning of the MAC clause itself in the particular factual setting of a distressed debt: is the change “material?” is the change “adverse?”
I then noted that a lender should be prepared for the borrower to contest such default declaration in the event the answer to any of the following questions is “Yes.”
Here are several more questions:

2. Do the loan documents contain a subjective MAC clause and require the lender to act reasonably or in good faith?
If the loan documents contain a subjective MAC clause, the borrower should review the loan documents to determine if the lender has a duty to act in "good faith" in determining whether a "material adverse change" has occurred, or whether such determination must be "reasonable." Furthermore, in interpreting the meaning of a subjective MAC clause, the parties should each determine whether "reasonableness" and "good faith" standards are implied by the particular state laws governing the loan documents.

3. Are there multiple inconsistent MAC clauses in the loan documents?
In the event the loan documents contain multiple inconsistent MAC clauses, a question of fact may arise as to whether the MAC clauses are enforceable.

4. Is the language of the MAC clause unclear?
The parties should pay particular attention to word choice and consider every word in the MAC clause in light of the circumstances of the particular transaction. Exacting language is particularly critical with respect to any negotiated carve-outs from the MAC clause. In addition, all applicable definitions must be carefully examined.

Please post a comment with any questions, comments or you own experience – real or hypothetical!
 

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Posted on May 15, 2009 by Keith H. Mullen

Into the Looking Glass: MBA Servicing & Technology Conference - day two

Yesterday (Thursday) was the second, and my last, day of the conference.  As I did with the first day of the conference, I summarize some of the sessions.  So, here's the executive summary:

From a session on bankruptcy issues:

  • as reported by the Commercial Mortgage Securities Ass'n in its press release, the bankruptcy court in the General Growth Property bankruptcy issued a good ruling on Wednesday.  The ruling recognized the integrity of the special purpose vehicle (or single purpose entity; also called "SPE") utilized by GGP in the ownership of each mall in its portfolio. (Recall that many GPP malls are owned by a SPE subsidiary of GGP.)
  • for detail on the importance of the SPE structure to the commercial mortgage lending industry, and for an understanding of the structure itself, take a look at the brief filed by the CMSA in the case.
  • briefly, the debtor-in-possession financing recognized the validity of the SPE structure: it did NOT place a lien on each mall (which are owned by separate SPEs) and the first-lien holders of each SPE-owned mall were given a first-priority lien on the cash collateral from their mall collateral
  • next step of interest in the case: the hearing on the bad faith filing issues.  Was it proper for the solvent SPE to be included in the bankruptcy of the parent GGP?

From a session on the challenges in complex transaction structures:

  • one of the first tasks in handling a distressed loan is identifying the parties and their issues.  For example: (1) who\what are the creditor & borrower issues? (2) who\what are the co-lender issues? (3) and if there is a separate servicer, what are the terms of the servicing agreement? The answers: find the documents.  Read the documents.
  • the many, varied structures of the credit stack present challenges simply in understanding the relationships between all of these parties.  Here is a short list of common structures: 1st lien & mezzanine debt (with one or more mezz debt positions; and each mezz debt could have all of the following structures); A note and B note (and the A note might be securitized); A1, A2 and A3 note (and the A1 note might be securitized); "true" participations of any of these notes (if not securitized); etc. Some of these credit stack structures will give you a head ache.  And often the borrower has NO knowledge of them - although a sophisticated borrower might recognize some of the clues pointing to a complicated credit stack.
  • for credit stacks that include securitized debt, the rating agency faces multiple challenges: (1) post-closing surveillance (in that it often does not have access to loan documents covering discrete loans in the credit stack); (2) issuing confirmation letters ("no down-grade letters") can be problematic for the same reason; (3) intercreditor agreements and loan documents might not comply with rating agency requirements
  • special servicers in securitized loan pools are being changed by the controlling class holders and the B note holders.  This can result in two different special servicers: one appointed by the controlling class holders for the entire pool; and a second by the B note holder as to the notes that it has first-risk loss.  Another complication, of course, is that the special servicer must be approved by the applicable rating agency.  And to further complicate it all, often the intercreditor agreement(s) have a higher rating standard than the standard required by the rating agency monitoring the pool.
  • some of the credit stacks are so complicated, that it is difficult for the servicer to determine "who" should receive notice of a change in servicing (or "who" should receive any other notice).  One answer is to follow the money: if the master servicer is the paying agent for the pool, the servicer's treasury group has contact information.
  • against this complicated back drop, borrower's often communicate to the incorrect lender! And have difficulty in indentifying "who is who" among this confusing group of players.
  • in a prior posting, we commented on the question of whether a borrower should intentionally default a loan that has been put in a securitized pool.  The panel noted these dire consequences for a borrower in special servicing: (1) default interest will accrue; (2) late fees will accrue; and (3) workout land is NOT "borrower friendly" - and if borrower does not obtain its desired result, there is no "free pass" back to the safety of master servicing.
  • for loans with "springing" lock box features: borrowers are refusing to do the paper work to create lock boxes.  This results in a covenant default under the loan, which triggers a transfer of the loan to special servicing.  Also, on several loans, local banks (who have long-standing relationships to the principal behind the borrower) have closed dormant, "springing" lock box deposit account - which is a real problem when the lockbox "comes to life" and the master servicer attempts to implement the lockbox structure.

From a session on loan surveillance:

  • each point of the mortgage compass is requiring more and better information: bond holders, rating agencies, federal and state regulators, investment committees, etc.
  • loans are being reviewed more often (even monthly)
  • all of this is a major difference from the late '80s & early '90s
  • what are some of the warning signs of a loan going "bad"? (1) exhausting a debt service reserve (recall: this type of reserve was used when a project was not stabilized); (2) exhausting a contingency line item (in a construction loan); (3) change in ownership of any portion of the credit stack (this is often difficult to monitor); (4) low utilization\occupancy of space by tenants; and (5) ___________
  • surveillance needs to have a "forward" looking component, such as: (1) future lease rollover; (2) local market information and trends (new construction of competing projects; tenants looking for space; etc.); (3) sponsor level debt information (amount; maturities; etc.); (4) free rent and rental rate trends in the market; and (5) _________
  • use "free" resources available on-line
  • one problem for servicers: each lender seems to have their own, unique reporting form
  • one lesson in this "new" economy: real estate really is unique.  Thus, people need to understand and evaluate each tenant, project, market and principal.
  • one panelist briefly mentioned the all-important "mortgage experience adjustment factor" - which is a risk-based capital concept governing insurance companies who hold commercial mortgage debt.  Some time in the near future we'll blog on that mind-boggling concept - and the draconian effect that it has upon insurance companies and their mortgage portfolios.  It is horrible.

This is my last posting on the conference.  It met my expectations.  Everyone agreed: it was the "best" servicing conference in years - undoubtedly because this is the worse real estate market in years.

Today it is back to the office, and the nitty-gritty of workout world.

Please post your comments, suggestions or questions below.

P.S.: back to the restaurant review thing - although there are "cooler" places to go in New Orleans, if you stay at the Hilton Riverside (the conference hotel), then you're immediately adjacent to the Riverwalk Marketplace mall.  The Crazy Lobster (504.569.3380) is a free-standing bar and restaurant on the Riverwalk.  It is a good place to catch a breeze and a change of pace.  Like many places in NO, it has live entertainment in the evenings.  We escaped the conference for several lunches at the Crazy Lobster.  It is a short (100 yards?) walk from the Hilton.  (And yes, it is a GPP mall - and probably owned by an SPE.) (See discussion above on GPP and SPEs.)

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Posted on May 7, 2009 by Keith H. Mullen

Evaluating Material Adverse Change (MAC) Clauses in the Loan Default Context (Part 1 of 2)

Guest Writer - Christopher T. Nixon, Winstead PC

In an earlier posting we briefly covered the importance distinction between a “monetary” default and a non-monetary default. One non-monetary clause getting increased attention in the “material adverse change” clause. This is the first of a two-part series on this topic.

Commercial lenders often include Material Adverse Change (MAC) clauses in their loan documents, especially in transactions involving the release of funds over time, such as credit facilities, revolving lines of credit or cash advances on asset-based transactions or in real estate transactions, earn-outs or some other form of future funding. A MAC clause is typically broad and provides that the occurrence of a "material adverse change" constitutes an event of default by the borrower under the loan documents. A “material adverse change” is then defined to include changes in business, operations or the financial condition of the borrower.

Lenders typically are cautious in declaring that a borrower default under commercial loan documents has occurred as a result of a “material adverse change." The more broad the MAC clause, the more uncertainty the lender has in evaluating whether the MAC clause is applicable to the alleged "material adverse change."

Case law may also deter lenders from declaring a borrower default based solely on a broad MAC clause. Courts have not yet developed a standard test in evaluating MAC clauses. Courts will carefully review the language of the MAC clause and the extrinsic evidence, if necessary, to determine whether the MAC clause is applicable.

In the event the lender declares that a borrower default under the loan documents has occurred as a result of a “material adverse change,” a lender should be prepared for the borrower to contest such default declaration in the event the answer to any of the following questions is “Yes”:

1. Is it unclear whether the change at issue is “material” and “adverse?”

While determining whether a particular change is "adverse" is somewhat straightforward, determining whether the change is "material" is typically a challenge in the context of a broad MAC clause.

Lenders intentionally do not define the term "material" in the MAC clause. Lenders want the MAC clause to cover all unknown and unforeseen adverse changes.

Materiality is a fact-based determination and highly dependent on the circumstances of each case. There is no baseline percentage or threshold amount that is deemed to be "material," absent specific language in the document. Given the fact-sensitive nature of the issue and the broad language of a typical MAC clause, courts typically consider a broad MAC clause to be ambiguous and require extrinsic evidence to determine the parties' intent as to what types of changes the clause was intended to cover. Any litigation on the issue will likely require a full-blown trial because summary judgment cannot be obtained under these circumstances.

Each party should carefully review the loan documents to determine whether any specific objective thresholds are included in the loan documents with respect to whether a particular change is "material" under the MAC clause.

Each party should also determine whether the loan documents contain any specific exclusions to the MAC clause. In the event specific changes are expressly excluded from the MAC clause, and the particular change deemed by the lender to be “materially adverse” is not an express exclusion, a court may view such non-excluded change to be subject to the MAC clause.

Each party should review its file with respect to prior loan document negotiations. If the borrower requested that the particular change deemed by the lender as being “materially adverse” be excluded from the MAC clause (and such requested exclusion was ultimately not accepted by the lender), the exclusion may be used by the lender as evidence of the parties’ intent that the MAC clause cover the requested exclusion.

In my next posting, I’ll explore several other aspects of dealing with a MAC clause.

Please post a comment with any questions, comments or you own experience – real or hypothetical!
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Posted on May 5, 2009 by Keith H. Mullen

Loan Defaults - Monetary vs. Non-Monetary

So, you can readily see that your collateral is headed south. Your job is to jump on it and come up with some solutions. Before you jump into action, it would be wise to take a breath and consider what the default situation is and why you have the right to start taking action – now, as opposed to later.

Types of Defaults
Generally, borrower defaults fall into one of two buckets – monetary and non-monetary. Monetary defaults involve the borrower's failure to pay money to the noteholder. Non-monetary defaults involve the borrower's taking some action which is prohibited or failing to take some action which is required by those lengthy "covenants" that appear in the loan documents. Depending on what your loan documents say, either type of default may be automatic – without any sort of warning notice – or may require formal notice and a period of time for the borrower to cure the shortcoming. Generally, loan agreements require more from the noteholder in the way of advance notice and time for cure when non-monetary defaults occur than when monetary defaults occur.

Creditor rights are limited before default
It seems simple, but worth stating – your borrower is entitled to own and operate the collateral property without lender interference, so long as she is living up to the terms of the deal reflected in the loan documents. This is true, even if you know the crash and burn is inevitable. The noteholder has no right to interfere with the collateral and its operations unless and until there has been a borrower default. That bright line event is important to a myriad of rights between borrower and noteholder, including whether the debt can be accelerated, the right to collect and hold rent and income from the collateral, and whether default interest begins to accrue – to name just a few.

Bright line of default
Since so many issues turn on default, careful loan servicers will strictly comply with loan document terms before asserting loan document rights. When possible, act only on clear-to-identify (and prove in court, if it should come to that) defaults. Between borrower and noteholder – the easiest to identify and prove is a monetary default. Either the borrower has paid or it has not. Declaring a default and taking your workout to the next level of hostilities on non-monetary, covenant breach defaults is often a risky proposition. Many of these defaults are subject to second guessing and after-the-fact paper grading. – and are therefore harder (and more costly) to prove if you are ever put to the test in a court of law.

Convert the non-monetary to monetary
Although it may take some time and additional effort, many non-monetary defaults will become monetary with some additional notices and time. For example, if the collateral is not being properly maintained in your opinion, you may be able to give notice of non-monetary default. But you can be assured of an argument about this subjective call if your borrower or guarantors have any fight in them. Consider adjusting (in strict compliance with the loan documents) the monthly amount of the borrower's reserve for replacement escrow to ensure that sufficient funds are available to spend to maintain the collateral. Chances are good that the circumstances could then mature into a monetary default – which will be much easier to defend in the future.
 

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