Attorneys are often engaged to advise a party to a commercial real estate loan on certain key issues that are neither purely business issues nor purely legal issues. The following is a summary of some of those key issues.
Borrowing Entity. Most borrowers hold title to property in an entity formed specifically for that purpose, commonly referred to as a single purpose entity (SPE). Most SPEs are either limited liability companies or limited partnerships. The primary advantage to the use of an SPE is to protect the real estate from both tort and contract claims arising from the owner’s other business operations, including other commercial properties. The lenders appreciate this isolation from non-property business risks of borrower’s owners.
Usury. Under the California Constitution’s usury provisions, lenders are limited in the amount of interest they can charge. Generally the California Constitution prohibits charging interest of more than the greater of (a) 10% per annum, or (b) 5% per annum in excess of the rate established by the Federal Reserve Bank of San Francisco for advances to its member banks. Failure to comply with California usury law can have severe ramifications for lenders, including in some cases punitive damages, however there are broad categories of both exempt lenders and transactions that are exempt from usury claims. As an example, state and national banks, insurance companies and pension funds, are exempt lenders. In addition, there is an exemption for loans for business purposes to substantial or sophisticated legal entities.
Credit Enhancement. In order for the borrower to obtain the loan or in certain cases the best terms on the loan, the borrower may be required to provide the lender with some measure of credit enhancement. Credit enhancement can include personal guaranties, additional real property security and letters of credit.
Recourse. One of the biggest issues in a real estate loan is the extent to which a lender will have recourse to assets of the owner in addition to the encumbered property. It refers to the right of the lender to obtain a deficiency judgment against the borrower if the foreclosure of the real property collateral nets less than the amount owing under the loan. Most commercial real property loans in California are to some degree made on a “non-recourse” basis, where the borrower cannot be held personally liable and the lender is limited to its rights against the real property security. Even where the lender agrees to make the loan on a “non-recourse” basis, it frequently requires continuing liability for environmental contamination, fraud, waste and misappropriation of rents and insurance proceeds. Although a loan may not be contractually “non-recourse,” practically speaking it may be legally “non-recourse” due to the impact on the loan of the “one form of action” rule and California “anti-deficiency” statutes, discussed below.
One Action Rule. State foreclosure law is derived from the common law principles preventing a lender from simply taking possession of a borrower’s property upon default. Obligations secured by a lien on real property located in the state of California are subject to the “one-action rule.” This means that the single enforcement remedy available to a lender with a secured real estate loan in default is foreclosure. The lender is cannot ignore the security and bring an action against the borrower. The practical effect of the one-action rule is to require a lienholder to include all of its collateral in the foreclosure proceeding. If some collateral is omitted from the foreclosure, the omitted security will likely be discharged from liability for the obligation. An action to attach the borrower’s assets is a violation of the one-action rule, as is an offset by the lender against other assets of the borrower, such as a deposit account.
Foreclosure and Anti-deficiency Statutes. Once the decision to foreclose is made, the lender has two foreclosure alternatives: nonjudicial foreclosure using the private power of sale included in the deed of trust, and judicial foreclosure.
Nonjudicial foreclosure if by far the most popular remedy. It is relatively quick, taking approximately 120 days, and relatively inexpensive. The foreclosing creditor can credit bid up to the amount of the secured obligation, and other bidders must bid cash to the lien being foreclosed. Title following the sale is conveyed to the foreclosure sale purchaser free and clear of junior liens and any right of the borrower to redeem, however the foreclosing lender is precluded from seeking a deficiency judgment against the borrower.
A judicial foreclosure requires the filing of a complaint naming all parties with a record interest in the property. Following a trial, the court will issue judgment of foreclosure and issue a writ of sale. The issuance of the writ begins a process of recording a notice of levy, a notice of sale and the eventual sale. Following a judicial foreclosure sale, a borrower has a post-sale right to redeem the property, which expires three months after the sale if no deficiency judgment is involved, and expires twelve month after the sale if a deficiency judgment is sought. The cost, time and the cloud on title presented by the post-sale redemption rights in almost all circumstances drive lenders to pursue the nonjudicial foreclosure procedure.
Prepayment. Under California law, unless the right to prepay the loan is established in the loan documents, the borrower does not have a prepayment right. Lenders seek to avoid prepayment as it impacts their expected return on the loan. Unless the interest rate of the loan is adjustable, in which case the borrower often has the unfettered right to prepay, most loans seek to control the right to prepay and often require that any prepayment be conditioned on the payment by the borrower of a prepayment fee. Generally, prepayment fees are either computed as a percentage of the amount being prepaid or tied to some kind of yield maintenance formula. Where the prepayment fee is based upon a yield maintenance formula, the fee is the discounted value of the payments the borrower would have paid under the loan absent prepayment, less the discounted value of the amounts the lender could earn on the prepayment amount over the remaining term of the loan. The key terms for negotiation in a yield maintenance formula are (i) the index interest rate presumed for the reinvestment of the prepayment amount (i.e. Treasury bills) and (ii) the discount rate.
Defeasance. While conduit loans are normally at lower rates than other loans, one of the major disadvantages to a conduit loan is the fact that the borrower is prohibited from prepaying the loan. In an attempt to provide some way for the borrower to prepay a conduit loan, conduit lenders have introduced the concept of “defeasance,” whereby the borrower delivers lender a series of United States government securities which will replace the cash flow required to pay the real estate loan to maturity, including interest and principal when otherwise due on the loan.
Due on Transfer. Closely tied to the concept of a prohibition on prepayment is the “due-on-transfer” clause which is included in most loans. Enforceable under federal law enacted in 1982 to supersede any state law restrictions, due-on-transfer clauses allow the lender to call the loan in the event that the property is, or interests of the borrower are, transferred. Sometimes these clauses are expanded to also cover situations in which the borrower further encumbers the property. These can be particularly onerous where the prepayment of the loan carries with it a substantial premium, such as a yield maintenance fee. Common compromises are to allow the transfer of the property to a creditworthy buyer upon loan assumption and the payment by the borrower of a transfer fee to lender, and to permit transfers of ownership interests in Borrower for estate planning purposes or death.
Conclusion. Although lenders and borrowers have different interests to protect in the process, both are invested in assuring that the contemplated transaction closes efficiently and effectively. Experienced counsel on both sides are critical to a successful closing.
This article was written by Alfred M. Clark, III, a partner in the Los Angeles office of Locke Lord LLP, and a member of the firm’s Board of Directors. Additional information can be found at lockelord.com.