Making Your Leases Work with Your Loan Documents

1. Lease Approval Requirements

Major Lease. Your loan documents will generally distinguish between categories of leases: “major” leases or “material” leases, on one hand, and “minor” leases, on the other, and give you more latitude in dealing with minor leases. The classification of a lease as “major” or “material” is often based on the size of the demised premises (or sometimes percentage of total rentals) and/or length of term. Your analysis, however, should not end there. You also need to review the criteria required for a lease to be considered a “minor” lease. (See page 2.) If a criterion is not satisfied (e.g., the lease does not provide for automatic subordination to your lender's mortgage), the subject lease may be effectively treated as a “major” lease, even though it does not exceed the initial size and/or term threshold. If the subject lease is a major lease, you should bear in mind the following:

(a) New Major Leases. Entering into a major lease will almost certainly require your lender's prior written approval.

(b) Amendments to Major Leases. Amending a major lease (not just entering into a new major lease) through a “material” modification may also require your lender's prior written approval and, in some cases, this approval will be
required even if the modification is not “material.” A “material” modification may include a reduction in term, modifying the renewal provision, granting of a purchase option, releasing a guarantor, reducing the security deposit, or expanding/contracting space.

(c) Renewals or Extensions. There is often an exception to the lender approval requirement for renewals or extensions in accordance with the existing lease, but since renewals or extensions are often not on exactly the same terms as provided in the existing major lease (e.g., the landlord offers the tenant free rent or an improvement allowance in connection with the extension), renewals or extensions usually require lender approval.

(d) Waivers. A waiver of a lease provision that would be considered “material” if it were the subject of a proposed modification will also likely require your lender's approval.

(e) Terminations. Terminating a major lease will typically require your lender's prior written approval.

(f) Other Major Lease Considerations. In some cases, the assignment of a major lease (including, possibly, a change in control in your tenant), the subleasing of the space subject to a major lease, or a change to any credit support instrument (such as guaranty or letter of credit securing the tenant's performance/payments under its major lease) will also require your lender's approval.

Minor Lease. The classification of a lease as “minor” is usually determined by reference to the definition of a major lease (i.e., a minor lease is any lease other than a major lease) or vice versa (i.e., a major lease is defined as any lease other than a minor lease). Simply because the subject lease is a minor lease does not mean, however, that you can ignore your loan documents; you should still take into account the following:

(a) New Minor Leases. Entering into a minor lease typically does not require your lender's prior written approval if certain basic criteria are satisfied such as: 1) it is written substantially in accordance with the form lease (see if your loan documents provide a carve-out for deviations from the form lease that are commercially reasonable and in comparable shopping center leases); 2) the rent is market; 3) the transaction is arm's-length; 4) the term is less than X years and not greater than Y years; 5) the lease is automatically subordinate to the loan; and 6) the lease does not contain any option to purchase, right of first refusal, right to terminate (with certain exceptions), or requirements for subordination or recognition agreements.

(b) Amendments to Minor Leases. Amending a minor lease will usually require your lender's prior written approval if the effect of the amendment is to make the minor lease a major lease (for example, by adding square footage).

(c) Terminations. Your loan documents may permit you to terminate a minor lease without your lender's prior written approval if it is commercially reasonable to do so in connection with an uncured material default or if you may do so without payment of any termination fee or incurrence of significant costs.

2. Other Lease Approval Considerations

In addition to working your way through the major versus minor lease distinctions in your loan documents and identifying the applicable lender approval requirements, consider a few other items.

(a) What Is a Lease? The definition of “leases” in your loan documents is typically very broad and may include subleases, assignment of a lease, license agreements, concession agreements, or other agreements providing for the right to use or occupy the shopping center.

(b) Standard of Approval. The approval standard of your lender is usually reasonable (versus sole and absolute discretion), and you should insist upon this standard of approval in your request to your lender.

(c) Deliveries of Leases Not Requiring Approval. Remember to deliver to your lender copies of minor leases not requiring your lender's prior written approval, if required (your loan documents may only require you to deliver notice of minor leases or copies of minor leases upon your lender's request). And also determine whether a certification as to satisfaction of the requirements of a minor lease must be delivered with the lease.

(d) Loan Documents. Check all of your loan documents for leasing covenants, not just the loan agreement or mortgage/deed of trust. You may be (unpleasantly) surprised to find, for instance, that the requirements in the mortgage/deed of trust do not precisely mirror those in the assignment of leases and rents.

Lease Approval Procedures (Potential Traps for the Unwary)

Technical Requirements

The procedure in your loan documents for submitting your approval request to your lender may consist of various technical requirements. Here are a few common ones.

(a) Notice Requirements in General. Before you submit your lease approval request to your Lender, double check to make sure you comply with the notice provision in your loan documents, including delivering the approval request to all required parties and using a permitted method of delivery of notices.

(b) Special Notice Requirements. If your loan documents provide for “deemed” approvals by your lender, you may also have to comply with special requirements for lease approval requests such as including reference to a specific section of the loan agreement or mortgage; inclusion of special, conspicuous, bold text in the transmittal letter; or the word “PRIORITY” on the envelope in order for the deemed approval procedure to be effective.

(c) Deliverables. You should include all required lease documents and supporting materials your lender will need to evaluate the leasing proposal. These may include the final draft of the new lease, a black-lined copy of the same against the approved form lease, a summary of material terms, financial and operation information regarding the proposed tenant, and a credit report for the tenant, if available. Tenant financials, either audited or certified by the tenant, may also be required.

Deemed Approvals

Your loan documents may provide that certain approval requests are deemed approved if your lender does not respond to the approval request within a certain number of days. There may, however, be exceptions to the deemed approval provision (e.g., terminations, rent reductions, accepting surrender, or shortening of term of a major lease) and unique requirements that must be included in the approval request, such as special notices. (See above.) Before relying on the operation of a deemed approval provision, check the number of days that must elapse before deemed approval is effective, and if there are any extensions of this time period (if, for example, the documents submitted for approval cannot be reasonably approved within the initial deemed approval period and your lender is diligently pursuing approval, or your lender requests additional evaluation materials).

Evidence of Approval

Review your “approval” letter carefully; your lender may include conditions to approval that effectively provide no approval at all (for example, a letter that provides approval is granted subject to your lender's satisfactory review of the applicable lease document and any other item your lender deems necessary). Also, lease approvals may be considered “notices” under your loan documents and therefore should be delivered in accordance with the notice provision (consider whether you should rely on a lender approval delivered by e-mail if e-mail is not a permitted method of delivering notices).

SNDAs

To be considered a minor lease, your loan documents usually require that an automatic, self-operative, subordination provision be included in the lease. (See above.) For major leases, you may be required to use commercially reasonable efforts to provide the SNDA on your lender's then-current form, or such other form as your lender may require. Try to manage the expectations of your lender (and your tenant, if your tenant requests the SNDA); in order to complete the negotiation of the SNDA successfully, all parties will need to be flexible to a degree. Also, for national tenants, consider using a prior SNDA negotiated by your lender and your tenant.

Lease Termination Payments

Remember to check your loan documents to see if lease termination payments must be applied to the outstanding principal balance of your loan or deposited into an existing leasing reserve account or lockbox account, if applicable.

Rent Payments

Be sure to send written notice to your tenants directing them to pay all rents and other amounts due under leases directly into the lockbox, if applicable.

Security Deposits

You may need to deposit cash security deposits under your leases into an account maintained by your lender or assign any security deposits held in the form of a letter of credit to your lender.

Assignment or Subletting

You will likely be restricted from consenting to the assignment of a major lease or any subletting of the premises under a major lease without the prior written approval of your lender (except as expressly contemplated by your loan documents).

Other Leasing Covenants

Your loan documents will contain several other covenants relating to leasing matters that you should bear in mind, such as the obligation to: 1) perform all material obligations of landlord under the leases; 2) promptly send notices of all material notices of default that you send or receive with respect to the leases (major leases and, if applicable, minor leases); 3) enforce all of the material terms against your tenants; and 4) not collect rents more than one month in advance (except for security deposits and first month's rent payable upon execution of the lease).

Financial Reporting

While not strictly a leasing matter, do not overlook the lease-related financial reporting covenants in your loan documents. They will likely include some obligation regarding the delivery of a rent roll, either periodically or only after request from your lender. If the former, be sure you understand and calendar the specific time intervals (i.e., monthly, quarterly, etc.) for this delivery and what lease summary terms must be included (if there is not an approved form rent roll). You may need to use commercially reasonable efforts to include such information with respect to subleases. In addition to a rent roll, your financial reporting obligations may also include a requirement to deliver leasing status reports and tenant sales reports. Remember that this delivery, as with other financial reporting deliveries, may need to be accompanied by an officer's certificate.

Establish and Adhere to Your Internal Processes

Coordination Between Leasing Counsel and Loan Counsel

If your practice is to use separate counsel for leasing matters and financings, make sure your leasing counsel is aware of your loan document requirements and, equally as important, your loan counsel understands your leasing practice. While not a substitute for reviewing your loan documents, consider asking your loan counsel to prepare a loan document compliance schedule regarding leasing matters that can be provided to your leasing counsel and your leasing administrators. In any event, a clear delineation of responsibility between your leasing counsel and your loan counsel is key.

Using Form Approval Requests

Consider asking your loan counsel to prepare a form lease approval request letter with bracketed sections to be completed by your leasing administrators, together with a completed sample and instructions. This form letter can be set up with alternative language and exhibit references to suit your particular request (e.g., approval of a new lease versus a lease amendment).

Conclusion

This article addresses some of the issues that you should consider in your effort to make your leasing practice work with your loan documents. A good understanding of your loan documents and consistency in your leasing procedures will go a long way toward achieving your compliance objectives.

Pablo L. Petrozzi is a transactional partner with real estate law firm Pircher, Nichols & Meeks, resident in its Chicago office.

As a general matter, you should be mindful of loan document compliance. You do not want to find yourself in a situation where you believe you are adding value to your project but have unwittingly put yourself at risk of being in default under your loan documents.

Among the various reasons for complying with your loan documents, the most compelling is the fact that the typical non-recourse carve-out for unpermitted “transfers” may include leases that are not approved in accordance with your loan documents. A violation of this restriction on unpermitted transfers could trigger recourse liability for losses, or full recourse. And the recent trend of courts to uphold the enforcement of full-recourse guaranties further punctuates this concern.

Know Your Loan Documents

1. Lease Approval Requirements

Major Lease. Your loan documents will generally distinguish between categories of leases: “major” leases or “material” leases, on one hand, and “minor” leases, on the other, and give you more latitude in dealing with minor leases. The classification of a lease as “major” or “material” is often based on the size of the demised premises (or sometimes percentage of total rentals) and/or length of term. Your analysis, however, should not end there. You also need to review the criteria required for a lease to be considered a “minor” lease. (See page 2.) If a criterion is not satisfied (e.g., the lease does not provide for automatic subordination to your lender's mortgage), the subject lease may be effectively treated as a “major” lease, even though it does not exceed the initial size and/or term threshold. If the subject lease is a major lease, you should bear in mind the following:

(a) New Major Leases. Entering into a major lease will almost certainly require your lender's prior written approval.

(b) Amendments to Major Leases. Amending a major lease (not just entering into a new major lease) through a “material” modification may also require your lender's prior written approval and, in some cases, this approval will be
required even if the modification is not “material.” A “material” modification may include a reduction in term, modifying the renewal provision, granting of a purchase option, releasing a guarantor, reducing the security deposit, or expanding/contracting space.

(c) Renewals or Extensions. There is often an exception to the lender approval requirement for renewals or extensions in accordance with the existing lease, but since renewals or extensions are often not on exactly the same terms as provided in the existing major lease (e.g., the landlord offers the tenant free rent or an improvement allowance in connection with the extension), renewals or extensions usually require lender approval.

(d) Waivers. A waiver of a lease provision that would be considered “material” if it were the subject of a proposed modification will also likely require your lender's approval.

(e) Terminations. Terminating a major lease will typically require your lender's prior written approval.

(f) Other Major Lease Considerations. In some cases, the assignment of a major lease (including, possibly, a change in control in your tenant), the subleasing of the space subject to a major lease, or a change to any credit support instrument (such as guaranty or letter of credit securing the tenant's performance/payments under its major lease) will also require your lender's approval.

Minor Lease. The classification of a lease as “minor” is usually determined by reference to the definition of a major lease (i.e., a minor lease is any lease other than a major lease) or vice versa (i.e., a major lease is defined as any lease other than a minor lease). Simply because the subject lease is a minor lease does not mean, however, that you can ignore your loan documents; you should still take into account the following:

(a) New Minor Leases. Entering into a minor lease typically does not require your lender's prior written approval if certain basic criteria are satisfied such as: 1) it is written substantially in accordance with the form lease (see if your loan documents provide a carve-out for deviations from the form lease that are commercially reasonable and in comparable shopping center leases); 2) the rent is market; 3) the transaction is arm's-length; 4) the term is less than X years and not greater than Y years; 5) the lease is automatically subordinate to the loan; and 6) the lease does not contain any option to purchase, right of first refusal, right to terminate (with certain exceptions), or requirements for subordination or recognition agreements.

(b) Amendments to Minor Leases. Amending a minor lease will usually require your lender's prior written approval if the effect of the amendment is to make the minor lease a major lease (for example, by adding square footage).

(c) Terminations. Your loan documents may permit you to terminate a minor lease without your lender's prior written approval if it is commercially reasonable to do so in connection with an uncured material default or if you may do so without payment of any termination fee or incurrence of significant costs.

2. Other Lease Approval Considerations

In addition to working your way through the major versus minor lease distinctions in your loan documents and identifying the applicable lender approval requirements, consider a few other items.

(a) What Is a Lease? The definition of “leases” in your loan documents is typically very broad and may include subleases, assignment of a lease, license agreements, concession agreements, or other agreements providing for the right to use or occupy the shopping center.

(b) Standard of Approval. The approval standard of your lender is usually reasonable (versus sole and absolute discretion), and you should insist upon this standard of approval in your request to your lender.

(c) Deliveries of Leases Not Requiring Approval. Remember to deliver to your lender copies of minor leases not requiring your lender's prior written approval, if required (your loan documents may only require you to deliver notice of minor leases or copies of minor leases upon your lender's request). And also determine whether a certification as to satisfaction of the requirements of a minor lease must be delivered with the lease.

(d) Loan Documents. Check all of your loan documents for leasing covenants, not just the loan agreement or mortgage/deed of trust. You may be (unpleasantly) surprised to find, for instance, that the requirements in the mortgage/deed of trust do not precisely mirror those in the assignment of leases and rents.

Lease Approval Procedures (Potential Traps for the Unwary)

Technical Requirements

The procedure in your loan documents for submitting your approval request to your lender may consist of various technical requirements. Here are a few common ones.

(a) Notice Requirements in General. Before you submit your lease approval request to your Lender, double check to make sure you comply with the notice provision in your loan documents, including delivering the approval request to all required parties and using a permitted method of delivery of notices.

(b) Special Notice Requirements. If your loan documents provide for “deemed” approvals by your lender, you may also have to comply with special requirements for lease approval requests such as including reference to a specific section of the loan agreement or mortgage; inclusion of special, conspicuous, bold text in the transmittal letter; or the word “PRIORITY” on the envelope in order for the deemed approval procedure to be effective.

(c) Deliverables. You should include all required lease documents and supporting materials your lender will need to evaluate the leasing proposal. These may include the final draft of the new lease, a black-lined copy of the same against the approved form lease, a summary of material terms, financial and operation information regarding the proposed tenant, and a credit report for the tenant, if available. Tenant financials, either audited or certified by the tenant, may also be required.

Deemed Approvals

Your loan documents may provide that certain approval requests are deemed approved if your lender does not respond to the approval request within a certain number of days. There may, however, be exceptions to the deemed approval provision (e.g., terminations, rent reductions, accepting surrender, or shortening of term of a major lease) and unique requirements that must be included in the approval request, such as special notices. (See above.) Before relying on the operation of a deemed approval provision, check the number of days that must elapse before deemed approval is effective, and if there are any extensions of this time period (if, for example, the documents submitted for approval cannot be reasonably approved within the initial deemed approval period and your lender is diligently pursuing approval, or your lender requests additional evaluation materials).

Evidence of Approval

Review your “approval” letter carefully; your lender may include conditions to approval that effectively provide no approval at all (for example, a letter that provides approval is granted subject to your lender's satisfactory review of the applicable lease document and any other item your lender deems necessary). Also, lease approvals may be considered “notices” under your loan documents and therefore should be delivered in accordance with the notice provision (consider whether you should rely on a lender approval delivered by e-mail if e-mail is not a permitted method of delivering notices).

SNDAs

To be considered a minor lease, your loan documents usually require that an automatic, self-operative, subordination provision be included in the lease. (See above.) For major leases, you may be required to use commercially reasonable efforts to provide the SNDA on your lender's then-current form, or such other form as your lender may require. Try to manage the expectations of your lender (and your tenant, if your tenant requests the SNDA); in order to complete the negotiation of the SNDA successfully, all parties will need to be flexible to a degree. Also, for national tenants, consider using a prior SNDA negotiated by your lender and your tenant.

Lease Termination Payments

Remember to check your loan documents to see if lease termination payments must be applied to the outstanding principal balance of your loan or deposited into an existing leasing reserve account or lockbox account, if applicable.

Rent Payments

Be sure to send written notice to your tenants directing them to pay all rents and other amounts due under leases directly into the lockbox, if applicable.

Security Deposits

You may need to deposit cash security deposits under your leases into an account maintained by your lender or assign any security deposits held in the form of a letter of credit to your lender.

Assignment or Subletting

You will likely be restricted from consenting to the assignment of a major lease or any subletting of the premises under a major lease without the prior written approval of your lender (except as expressly contemplated by your loan documents).

Other Leasing Covenants

Your loan documents will contain several other covenants relating to leasing matters that you should bear in mind, such as the obligation to: 1) perform all material obligations of landlord under the leases; 2) promptly send notices of all material notices of default that you send or receive with respect to the leases (major leases and, if applicable, minor leases); 3) enforce all of the material terms against your tenants; and 4) not collect rents more than one month in advance (except for security deposits and first month's rent payable upon execution of the lease).

Financial Reporting

While not strictly a leasing matter, do not overlook the lease-related financial reporting covenants in your loan documents. They will likely include some obligation regarding the delivery of a rent roll, either periodically or only after request from your lender. If the former, be sure you understand and calendar the specific time intervals (i.e., monthly, quarterly, etc.) for this delivery and what lease summary terms must be included (if there is not an approved form rent roll). You may need to use commercially reasonable efforts to include such information with respect to subleases. In addition to a rent roll, your financial reporting obligations may also include a requirement to deliver leasing status reports and tenant sales reports. Remember that this delivery, as with other financial reporting deliveries, may need to be accompanied by an officer's certificate.

Establish and Adhere to Your Internal Processes

Coordination Between Leasing Counsel and Loan Counsel

If your practice is to use separate counsel for leasing matters and financings, make sure your leasing counsel is aware of your loan document requirements and, equally as important, your loan counsel understands your leasing practice. While not a substitute for reviewing your loan documents, consider asking your loan counsel to prepare a loan document compliance schedule regarding leasing matters that can be provided to your leasing counsel and your leasing administrators. In any event, a clear delineation of responsibility between your leasing counsel and your loan counsel is key.

Using Form Approval Requests

Consider asking your loan counsel to prepare a form lease approval request letter with bracketed sections to be completed by your leasing administrators, together with a completed sample and instructions. This form letter can be set up with alternative language and exhibit references to suit your particular request (e.g., approval of a new lease versus a lease amendment).

Conclusion

This article addresses some of the issues that you should consider in your effort to make your leasing practice work with your loan documents. A good understanding of your loan documents and consistency in your leasing procedures will go a long way toward achieving your compliance objectives.

Pablo L. Petrozzi is a transactional partner with real estate law firm Pircher, Nichols & Meeks, resident in its Chicago office.