Keep Mortgage Loan Promises ' or Else

If the lender's approval is to be “prior to” or “in advance,” then any proposed new lease, lease amendment or lease termination must be submitted to the lender, with any required information (such as a current rent roll), before the landlord signs that document, not just before that document is returned to the tenant. This means that the fully signed document then has to be separately sent to the lender.

Often, there is a concept of “Small Leases” that do not require lender approval for lease amendments or modifications. The lender's approval is generally required unless the terms of the new lease or lease amendment fully satisfy the definition of a Small Lease as defined in that mortgage. Frequently, there is a square footage factor in the definition of a Small Lease so that stores whose rented space is below the stated square footage satisfy that factor of the Small Lease definition.

Other common elements in the Small Lease definition are a specified rent per square foot and/or annual rent amount. If rent per square foot is a factor, then lender consent is often not required if the rent is below a stated annual rent per square foot. If the factor is annual rent not less than the fair market rental rate, then the attorney must exercise good judgment as to whether the rent is discounted (for example, because the tenant itself is paying for an expensive alteration to make the store in rentable condition) and seek lender consent in those circumstances.

Annual rent above a stated amount generally means the proposed transaction is not a Small Lease. The lender requires review and approval of leases and lease amendments involving leases that have a major impact on the rental income for the shopping center. Granting a rent reduction is a lease modification even if it is not stated in a document entitled “lease amendment.” Lease terminations, regardless of store size and rent paid, often require lender's prior approval, and any termination fee received may need to be paid to the lender, but not always with a Small Lease.

If a new tenant requires a Non-Disturbance Agreement that allows the tenant to remain pursuant to its lease if the mortgage is foreclosed, the mortgage may set a fee that must be paid to the lender, or it may require the borrower to pay whatever out-of-pocket costs the lender incurs. The borrower should be aware of such costs before agreeing to provide a non-disturbance agreement to a tenant. If the tenant is requiring that its form of non-disturbance agreement be used, borrower or its counsel should inquire if the lender and that tenant have previously negotiated that form in another location and agree to work from the negotiated document for the shopping center.

Alterations Promises

Alterations, whether done by the landlord as leases turn over to ready the store for a new tenant, by the tenant as tenant improvements, or by the landlord when all or a portion of the shopping center is redeveloped, have historically required the lender's prior approval for major, material or structural changes to the stores. But with CMBS (commercial mortgage backed securities) loans, a cap as to the maximum cost of alterations ' typically 10% of the original loan principal amount ' became a standard mortgage promise.

Alterations that exceed such monetary maximum amount are beyond the authority of the loan servicer to approve and can be modified only with protracted negotiation with multiple parties and payment of fees. Ten percent as applied to an original loan amount of $200 million allows a $20 million alteration, but a $5 million loan original amount only allows a $500,000 alteration. Or, the mortgage may allow alterations costing more than a specified amount only if cash is pledged as additional collateral or if a letter of credit is delivered to the lender for the estimated costs in excess of such stated amount.

Permitted Transfers Promises

Given the amount of money being lent, most lenders will want to know exactly with whom they are dealing. To that end, a lender may place restrictions on how the borrower may transfer its interest in the shopping center. One common provision is to require the borrower to be a single purpose entity, having as its sole purpose ownership and operation of the shopping center and entering into the mortgage loan. While this may be convenient for the lender, it opens up a slew of requirements and restrictions for the borrower. Such restrictions can include a limit on the amount of other debt the borrower can take out without prior consent of the lender and a floor on the amount of reserve capital the borrower maintains. The restrictions can also dictate how the entity operates and how its financial records are kept. Restrictions may specify whether minority equity interests can be transferred without lender consent.

In addition, the lender will often restrict the borrower's ability to sell, convey, or otherwise transfer the property. It can also mean the sale or transfer of any corporate stock, or the issuance of new stock, if the borrower is a corporation, or equity interest for other types of entities such as limited liability companies, or any change in the structure of the borrower, including who are the managers. If the borrower merges, consolidates, or dissolves, that action can be considered a transfer, triggering an event of default. A mortgage can specifically allow such transfers, if prior approval of the lender is given, or if the borrower meets certain requirements placed in the mortgage designed specifically to satisfy the lender that its investment is secure.

Maintenance Promises

Many mortgages require the borrower to maintain the property and any improvements thereon. Although such a practice would seem consistent with attracting customers to a shopping center, the borrower may have a contractual duty under the mortgage to ensure that any improvements and equipment are not diminished, destroyed, removed, or altered in any way without prior consent of the lender. The borrower also agreed not to commit any “waste” at the mortgaged property and to replace or repair any mortgaged property that is either destroyed or that may become worn over time. Waste means failing to maintain or repair the property, and can also mean failing to pay any taxes or special assessments, or failing to keep any required insurance on the mortgaged property. Some mortgages may require the borrower to expressly warrant that the mortgaged property is in good repair and free of any damage, and can even go so far as to allow the lender to enter and examine the property to ensure the property is in good repair.

Insurance Promises

Most insurance provisions seek to give the lender the best of both worlds: having the borrower pay for all insurance premiums while at the same time having the lender retain control over any insurance proceeds in the event of a casualty. The borrower may be required to insure the property in an amount equal to at least one hundred percent of the full replacement cost of all improvements and equipment located on the property, despite the fact that such an amount could be greater than the loan amount secured by the mortgage (but some states, including Massachusetts, limit required insurance to replacement value).

On top of this, various other insurances can be required, including terrorism, flood, general liability, rental loss, insurance for secondary mortgage market transactions, and any other insurance the lender may require. Hopefully the insurance will be limited by a qualifier such as “reasonably required” or that which is typical for similar properties in that state. Often, the lender will be named as the loss payee and will have a security interest over the proceeds of any payout. In the event of a casualty resulting in an insurance payout, the lender can exert significant control over the proceeds, either by requiring the proceeds to be used to pay down the loan, or by overseeing any reconstruction.

Although some lenders will allow the borrower more control over the proceeds absent an event of default, or for proceeds of less than a stated amount, it is important to know what the borrower's rights are to the proceeds, particularly when the borrower has spent significant sums improving the property, and the leases require insurance proceeds be made available for restoration. The ability to use insurance proceeds to reconstruct can be crucial to the borrower, but of little importance to a lender seeking only to be repaid.

What Is Pledged

What was pledged in the mortgage to the lender is probably everything and anything remotely relating to the shopping center held by the borrower. The mortgage often permits items replaced with similar items to be discarded, but that is because the mortgage gives such permission, not that the borrower has unfettered discretion to do what makes business sense. A mortgage may also limit the pledge to specific collateral, thus reducing the borrower's ability to substitute what it may consider to be equal collateral, and also reducing the borrower's ability to prepay or refinance a loan.

Mortgages can contain a defeasance clause, whereby the existing collateral can only be released if the lender is provided specific replacement security. Often, that replacement security comes in the form of Treasury bills. A borrower will be required to purchase enough Treasury bills such that the yield from the T-bills will provide the lender with the same income stream. Given the low yield of Treasury bills, it is often too expensive to purchase enough T-bills to make defeasance financially sound. Thus, even though a mortgage can allow for defeasance, it can become a practical impossibility.

Determining whether something is pledged as collateral to the lender is not always simple. For example, in Blue Hills Office Park LLC v J.P. Morgan Chase Bank, 477 F.Supp. 2d 366 (D. Mass. 2007), the borrower received a settlement payment for litigation involving a property abutting the borrower's mortgaged property, but the borrower distributed the settlement funds without regard to the mortgage. In that particular mortgage, the definition of mortgaged property specifically included causes of action that related to the mortgaged property. The Blue Hills court determined that the proceeds from the litigation were mortgaged property because the borrower's standing to intervene in the litigation came solely from its status as owner of the mortgaged property. Ultimately, the borrower's action not only breached the mortgage covenants, but also resulted in personal liability for breach of a non-recourse carve-out and made the loan fully recourse.

Conclusion

The Blue Hills case is significant in that it serves as a reminder that if something can be pledged as collateral for a loan, it probably is, and that courts will take a narrow view of negotiated contracts. Ignoring the pledge of an asset can land a borrower and/or guarantor not only in default of the mortgage, but also potentially on the hook for the entire loan balance, plus any interest, attorneys' fees, or penalties as dictated in the mortgage.

Be certain to read the loan documents each time a question arises, especially for actions or events that could trigger the non-recourse carve outs.

Jo-Ann Marzullo is a partner and Brian Atherton is an associate with Posternak Blankstein & Lund LLP in Boston, where they represent both landlords and tenants as part of their practice drafting and negotiating retail leases and closing and administering mortgage loans.

The terms of, and promises made in, a mortgage loan for a shopping center control the operation, ownership of and disposition of that shopping center so long as that loan remains outstanding. Those handling the leasing, operation, transfer of minority interests and sale of the shopping center need to be aware of what actions are permitted without need of consent, what requires prior approval of the lender and what cannot be done at all or only with a protracted negotiation and/or payment of fees.

The promises made and terms of the mortgage loan include: 1) what is pledged to the lender; 2) insurance to be maintained; 3) what happens to insurance proceeds if something happens at the shopping center; 4) payment of real estate taxes, assessments and ground rent; 5) what new leases, lease amendments and lease terminations the borrower may sign without prior approval of the lender; maintenance of the shopping center; 6) permitted alterations of the buildings in the shopping center; 7) permitted transfers of the real estate itself or in the entity that owns the shopping center; and 8) whether the loan can be prepaid early voluntarily. These terms are most likely to be found in a mortgage, but could also be found in an assignment of leases and rents, a promissory note, or a loan agreement, so read all of the loan documents even though this article only refers to the mortgage.

Leasing Promises

If the lender's approval is to be “prior to” or “in advance,” then any proposed new lease, lease amendment or lease termination must be submitted to the lender, with any required information (such as a current rent roll), before the landlord signs that document, not just before that document is returned to the tenant. This means that the fully signed document then has to be separately sent to the lender.

Often, there is a concept of “Small Leases” that do not require lender approval for lease amendments or modifications. The lender's approval is generally required unless the terms of the new lease or lease amendment fully satisfy the definition of a Small Lease as defined in that mortgage. Frequently, there is a square footage factor in the definition of a Small Lease so that stores whose rented space is below the stated square footage satisfy that factor of the Small Lease definition.

Other common elements in the Small Lease definition are a specified rent per square foot and/or annual rent amount. If rent per square foot is a factor, then lender consent is often not required if the rent is below a stated annual rent per square foot. If the factor is annual rent not less than the fair market rental rate, then the attorney must exercise good judgment as to whether the rent is discounted (for example, because the tenant itself is paying for an expensive alteration to make the store in rentable condition) and seek lender consent in those circumstances.

Annual rent above a stated amount generally means the proposed transaction is not a Small Lease. The lender requires review and approval of leases and lease amendments involving leases that have a major impact on the rental income for the shopping center. Granting a rent reduction is a lease modification even if it is not stated in a document entitled “lease amendment.” Lease terminations, regardless of store size and rent paid, often require lender's prior approval, and any termination fee received may need to be paid to the lender, but not always with a Small Lease.

If a new tenant requires a Non-Disturbance Agreement that allows the tenant to remain pursuant to its lease if the mortgage is foreclosed, the mortgage may set a fee that must be paid to the lender, or it may require the borrower to pay whatever out-of-pocket costs the lender incurs. The borrower should be aware of such costs before agreeing to provide a non-disturbance agreement to a tenant. If the tenant is requiring that its form of non-disturbance agreement be used, borrower or its counsel should inquire if the lender and that tenant have previously negotiated that form in another location and agree to work from the negotiated document for the shopping center.

Alterations Promises

Alterations, whether done by the landlord as leases turn over to ready the store for a new tenant, by the tenant as tenant improvements, or by the landlord when all or a portion of the shopping center is redeveloped, have historically required the lender's prior approval for major, material or structural changes to the stores. But with CMBS (commercial mortgage backed securities) loans, a cap as to the maximum cost of alterations ' typically 10% of the original loan principal amount ' became a standard mortgage promise.

Alterations that exceed such monetary maximum amount are beyond the authority of the loan servicer to approve and can be modified only with protracted negotiation with multiple parties and payment of fees. Ten percent as applied to an original loan amount of $200 million allows a $20 million alteration, but a $5 million loan original amount only allows a $500,000 alteration. Or, the mortgage may allow alterations costing more than a specified amount only if cash is pledged as additional collateral or if a letter of credit is delivered to the lender for the estimated costs in excess of such stated amount.

Permitted Transfers Promises

Given the amount of money being lent, most lenders will want to know exactly with whom they are dealing. To that end, a lender may place restrictions on how the borrower may transfer its interest in the shopping center. One common provision is to require the borrower to be a single purpose entity, having as its sole purpose ownership and operation of the shopping center and entering into the mortgage loan. While this may be convenient for the lender, it opens up a slew of requirements and restrictions for the borrower. Such restrictions can include a limit on the amount of other debt the borrower can take out without prior consent of the lender and a floor on the amount of reserve capital the borrower maintains. The restrictions can also dictate how the entity operates and how its financial records are kept. Restrictions may specify whether minority equity interests can be transferred without lender consent.

In addition, the lender will often restrict the borrower's ability to sell, convey, or otherwise transfer the property. It can also mean the sale or transfer of any corporate stock, or the issuance of new stock, if the borrower is a corporation, or equity interest for other types of entities such as limited liability companies, or any change in the structure of the borrower, including who are the managers. If the borrower merges, consolidates, or dissolves, that action can be considered a transfer, triggering an event of default. A mortgage can specifically allow such transfers, if prior approval of the lender is given, or if the borrower meets certain requirements placed in the mortgage designed specifically to satisfy the lender that its investment is secure.

Maintenance Promises

Many mortgages require the borrower to maintain the property and any improvements thereon. Although such a practice would seem consistent with attracting customers to a shopping center, the borrower may have a contractual duty under the mortgage to ensure that any improvements and equipment are not diminished, destroyed, removed, or altered in any way without prior consent of the lender. The borrower also agreed not to commit any “waste” at the mortgaged property and to replace or repair any mortgaged property that is either destroyed or that may become worn over time. Waste means failing to maintain or repair the property, and can also mean failing to pay any taxes or special assessments, or failing to keep any required insurance on the mortgaged property. Some mortgages may require the borrower to expressly warrant that the mortgaged property is in good repair and free of any damage, and can even go so far as to allow the lender to enter and examine the property to ensure the property is in good repair.

Insurance Promises

Most insurance provisions seek to give the lender the best of both worlds: having the borrower pay for all insurance premiums while at the same time having the lender retain control over any insurance proceeds in the event of a casualty. The borrower may be required to insure the property in an amount equal to at least one hundred percent of the full replacement cost of all improvements and equipment located on the property, despite the fact that such an amount could be greater than the loan amount secured by the mortgage (but some states, including Massachusetts, limit required insurance to replacement value).

On top of this, various other insurances can be required, including terrorism, flood, general liability, rental loss, insurance for secondary mortgage market transactions, and any other insurance the lender may require. Hopefully the insurance will be limited by a qualifier such as “reasonably required” or that which is typical for similar properties in that state. Often, the lender will be named as the loss payee and will have a security interest over the proceeds of any payout. In the event of a casualty resulting in an insurance payout, the lender can exert significant control over the proceeds, either by requiring the proceeds to be used to pay down the loan, or by overseeing any reconstruction.

Although some lenders will allow the borrower more control over the proceeds absent an event of default, or for proceeds of less than a stated amount, it is important to know what the borrower's rights are to the proceeds, particularly when the borrower has spent significant sums improving the property, and the leases require insurance proceeds be made available for restoration. The ability to use insurance proceeds to reconstruct can be crucial to the borrower, but of little importance to a lender seeking only to be repaid.

What Is Pledged

What was pledged in the mortgage to the lender is probably everything and anything remotely relating to the shopping center held by the borrower. The mortgage often permits items replaced with similar items to be discarded, but that is because the mortgage gives such permission, not that the borrower has unfettered discretion to do what makes business sense. A mortgage may also limit the pledge to specific collateral, thus reducing the borrower's ability to substitute what it may consider to be equal collateral, and also reducing the borrower's ability to prepay or refinance a loan.

Mortgages can contain a defeasance clause, whereby the existing collateral can only be released if the lender is provided specific replacement security. Often, that replacement security comes in the form of Treasury bills. A borrower will be required to purchase enough Treasury bills such that the yield from the T-bills will provide the lender with the same income stream. Given the low yield of Treasury bills, it is often too expensive to purchase enough T-bills to make defeasance financially sound. Thus, even though a mortgage can allow for defeasance, it can become a practical impossibility.

Determining whether something is pledged as collateral to the lender is not always simple. For example, in Blue Hills Office Park LLC v J.P. Morgan Chase Bank, 477 F.Supp. 2d 366 (D. Mass. 2007), the borrower received a settlement payment for litigation involving a property abutting the borrower's mortgaged property, but the borrower distributed the settlement funds without regard to the mortgage. In that particular mortgage, the definition of mortgaged property specifically included causes of action that related to the mortgaged property. The Blue Hills court determined that the proceeds from the litigation were mortgaged property because the borrower's standing to intervene in the litigation came solely from its status as owner of the mortgaged property. Ultimately, the borrower's action not only breached the mortgage covenants, but also resulted in personal liability for breach of a non-recourse carve-out and made the loan fully recourse.

Conclusion

The Blue Hills case is significant in that it serves as a reminder that if something can be pledged as collateral for a loan, it probably is, and that courts will take a narrow view of negotiated contracts. Ignoring the pledge of an asset can land a borrower and/or guarantor not only in default of the mortgage, but also potentially on the hook for the entire loan balance, plus any interest, attorneys' fees, or penalties as dictated in the mortgage.

Be certain to read the loan documents each time a question arises, especially for actions or events that could trigger the non-recourse carve outs.

Jo-Ann Marzullo is a partner and Brian Atherton is an associate with Posternak Blankstein & Lund LLP in Boston, where they represent both landlords and tenants as part of their practice drafting and negotiating retail leases and closing and administering mortgage loans.