A Mortgage Loan Documentation Pitfall

A consequence of the COVID-19 pandemic is that many companies are unable to operate their businesses partially or completely. As a result, they have been compelled to seek relief from their landlords, vendors and lenders.

This has imposed tremendous strain on property owners which themselves have debt to service. In order to preserve precious liquidity, property owners may need relief (deferral, forbearance, restructuring, extension) from their lenders and real property owners may consider withholding payment on their mortgage indebtedness.

Now is the time for owners of real estate to review their mortgage documentation, especially with regard to the assignment of rents. Defaulting on mortgage indebtedness can divest the owner of the ability to use the rental income and place the owner in a weaker bargaining position with its lender. Furthermore, it may make a Chapter 11 reorganization more difficult.

A commercial mortgage lender often obtains a direct interest in the rents flowing from income producing property [that it has financed] to itself in the event of the borrower’s default. An assignment of rents – a standard loan document or component of the mortgage or security agreement – assigns the property’s leases and all rent and other income to the mortgagee. In addition, it is also common for all rent and other income to be required to be deposited into a dedicated lockbox account that is pledged to the lender. In many instances, the assignment is automatic and default notice is not required.

There are three general types of rental assignments: (a) absolute assignment, (b) absolute assignment conditional upon default, and (c) assignment for security purposes. However, only absolute assignments commonly are used in commercial mortgages today.

The absolute assignment is an assignment of all leases and rents that immediately transfers to the lender the right to receive rents from the encumbered property for the term of the mortgage. When an absolute assignment is used, the lender typically grants the borrower a license to collect the property’s rental income until some triggering event.

The mortgagee’s rights under an assignment of rents clause depends upon, among other things, the state’s interpretation of mortgage law, which will determine to what extent the agreement negotiated by the parties will be enforced and to what extent the mortgagee will be able to reach the rents of the encumbered property.

Does the mortgage loan provide for cash management provisions that require tenants to pay rent into a dedicated lockbox, and, if so, does the lender have the right to cut off the borrower’s access to those funds in the event of a mortgage default? Commercial mortgage loans often include hard or springing lockbox protections for the lenders. A hard lockbox prohibits the borrower from having unfettered access to the rents and other income on day one of the loan, a springing lockbox cuts off the borrower’s access upon the occurrence of a trigger event, like a payment default or a breach of a financial covenant.

The majority of states take the approach that the parties may bargain for a provision granting the mortgagee a right to rents and profits upon default. Examples of triggers are:

• Failure to make any payment.
• Failure to perform or observe any term or condition of the mortgage, the note or any other loan document.
• Any representation, statement or warranty made by or on behalf of Mortgagor to Mortgagee at any time shall be materially incorrect, incomplete or misleading when made in any respect
• Judgments, warrants or tax liens.
• Casualty.
• Any spill, discharge, disposal, seepage or release of any Regulated Substances.
• Impermissible encumbrance.
• Covenant breach.
• Any other typical default.

In Chapter 11, a debtor (borrower) typically will seek permission of the bankruptcy court to use the income (rents) generated by the property for maintenance and operation of the property. However, if the license to use rents was terminated prior to bankruptcy because of the type of trigger described above, the rental income no longer is considered property of the debtor. Therefore, the bankruptcy court is not able to permit its use over the objection of the lender.

Chapter 11 provides powerful tools to a borrower. It is a tool that a prudent borrower should never inadvertently surrender.

Commencement of a chapter 11 case requires advance planning. Moreover, the borrower must anticipate and prepare for the relief that the lender is likely to seek from the bankruptcy court. Being equipped to commence a well thought out chapter 11 case is a valuable tool to avoid chapter 11.

Chapter 11 is not necessarily a panacea for either side. For lenders Chapter 11 may foreclose the ability to receive current interest or principal payments. Bankruptcy judges also may recognize the inequity of granting relief to lenders to enable them to foreclose at a low point in the market. For borrowers, it is a race against time that can be contentious and expensive- especially if the market recovery or property recovery takes an extended period of time.

In coping with Covid19, property owners need to be knowledgeable of their applicable loan documentation – including a rent assignment agreement- before developing a negotiating strategy with the lender. The borrower also should assure that no triggering event occurs without proper planning. Otherwise, the outcome may be very negative.

Reprinted with permission from the April 29, 2020, issue of GlobeSt.com. © 2020 ALM Media Properties, LLC. All Rights Reserved. Further duplication without permission is prohibited. ALMReprints.com – 877-257-3382 - reprints@alm.com.

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