HIDDEN CASH FLOW DISTRIBUTION RESTRICTIONS IN LOAN DOCUMENTS (COMPARATIVE ANALYSIS FOR BORROWERS AND LENDERS)May 8, 2018
When a borrower places a lien on a commercial real estate (“CRE”) asset as part of a lending transaction, part of the collateral granted includes an assignment of the rents generated by the asset (often defined broadly in the loan documents, “Rents”). Unless a CRE loan is made subject to some form of pre-default cash management/clearing or some other restriction on budget or cash flow, a borrower receives, manages and distributes Rents without lender oversight or restriction unless and until there is a loan default. Consistent with this status quo, the loan documents will often provide that the borrower has a license to collect, receive and enjoy Rents until there is a default under the loan, at which point the lender has the right to revoke such license. For purposes of this article, we will refer to a loan that is not subject to cash management/clearing as an “Ordinary CRE Loan.”
In some cases, loans are being marketed as an Ordinary CRE Loan but contain provisions in the assignment of Rents that subject a borrower and, where applicable, a carve-out guarantor to a form of cash management and a restriction on distributions. These restrictions may not be obvious which is why they can result in a hidden cash flow/distribution restriction. In order to make sure a borrower and carve-out guarantor do not unknowingly agree to a distribution restriction, Borrower’s counsel should consider some of the following sample provisions that illustrate potential problematic provisions in an assignment of Rents. We collected the following samples from loan documents (see italicized provisions below) issued by a wide range of commercial real estate lenders (life companies, regional lenders and large banks) for loan sizes ranging from $2M – $200M.
Sample of Problematic Loan Document Provision
Collection of Rents. Prior to written notice given by Lender to Borrower of an Event of Default, Borrower shall collect and receive all Rents of the Property as trustee for the benefit of Lender and Borrower, and apply the Rents so collected first to the payment of taxes, assessments and other charges on the Property prior to delinquency, second to the cost of insurance, maintenance and repairs required by the terms of this Deed of Trust, third to the costs of discharging any obligation or liability of Borrower under the Leases, and fourth to the indebtedness secured hereby, with the balance, if any, so long as no such Event of Default has occurred, to the account of Borrower.
Here are some reasons we think a provision resembling the above should be revised:
- First, the language permitting the borrower to collect, receive, enjoy and distribute the Rents is missing. If you have been around commercial real estate loans long enough, you have likely seen the notorious “collect, receive and enjoy” clause with respect to what Borrower is permitted to do with Rents prior to a loan default. In fact, we found a case in New York dating back to 1936 that remains good law where the court confirmed a borrower was entitled to collect, receive, have, enjoy and distribute Rents prior to a loan default since the lien instrument in question included such language.1
- Second, the reference to Borrower holding Rents as trustee for the benefit of Lender creates potential issues. Is this an attempt to force Borrower to hold rents in a constructive trust?
- Third, the provision provides that Rents have to be applied to taxes, insurance, maintenance, repairs, Lease obligations and the loan. However, none of these items are qualified to confirm that only those items due and payable in any given month or other relevant time period have to be paid before proceeds are distributed.
- Finally, if a carve-out guaranty provides that guarantors are on the hook for misapplication of Rents (for example), we would prefer to avoid the situation where a lender claims that a carve-out guarantor is liable for all Rents not held in trust or applied to future payment obligations the Borrower may have.
Samples of Loan Document Provisions That Differ from Problematic Provision
To secure performance of the Obligations by Assignor and any other person liable to Assignee under the Loan and the Loan Documents, the Assignor does hereby absolutely assign, convey, pledge and transfer to Assignee all their present or future respective interest in the Leases and all Rents, subject to the license of Assignor to enforce, collect, receive and enjoy the same in accordance with the terms of the Leases and Section 4 hereof.
As you can see in the underlined language, unlike the problematic provision, Sample 1 clearly confirms the Borrower’s license to collect, receive and enjoy the Rents. Furthermore, there is no mention of the Borrower holding Rents in trust for the Lender.
Subject to the license described herein, this Assignment of the Leases and Rents is absolute, unconditional and immediate and is intended to transfer and convey to the Lender the present right to the Leases and the Rents, including any and all rights of the Assignor to collect Rents from any person who has guaranteed in whole or in part the obligations of any Lessee under such Lessee’s Lease. The rights provided to the Lender by this Assignment are primary and not secondary and are of equal parity to and arise and exist separate and independent of the Lender’s rights as beneficiary under the Deed of Trust. The assignment made hereby is neither collateral nor for additional security. Provided no Event of Default (as hereinafter defined) has occurred and is continuing, the Assignor shall have a license to collect, receive and enjoy all Rents and enforce all of Assignor’s rights under the Leases or in connection with the Rents. After an Event of Default has occurred and while continuing, the Assignor’s license to collect Rents shall immediately terminate, and the Lender automatically and without any affirmative action on the part of the Lender thereupon shall be entitled immediately and exclusively to collect all Rents.
Like Sample 1, Sample 2 also clearly confirms the Borrower’s license to collect, receive and enjoy Rents and does not include the concept that Rents are held in trust prior to an Event of Default.
It is intended by Borrower that this Assignment constitute a present, absolute assignment of the Leases, Rents, Lease Guaranties and Bankruptcy Claims as additional security for the Debt, and not an assignment for additional security only. Nevertheless, subject to the terms of this Section 2.1 and the Cash Management Agreement, so long as no Event of Default has occurred, Lender grants to Borrower a revocable license to collect, receive, use and enjoy the Rents, Bankruptcy Claims (and any proceeds thereof), and other sums due under the Lease Guaranties and to exercise all rights as landlord under the Leases. Borrower shall hold such Rents and all sums received pursuant to any Lease Guaranty, or a portion thereof sufficient to discharge all current sums due on the Debt, in trust for the benefit of Lender for use in the payment of such sums.
Sample 3 is similar to Sample 1 and Sample 2 with respect to clarifying Borrower’s right to collect, receive and enjoy the Rents. Although there is mention of a trust in the last sentence, the difference in Sample 3 versus the problematic provision is that Sample 3 clarifies that the only Rents held in trust are those sufficient to discharge all “current sums” due on the loan.
Subject to the terms and conditions of this Assignment, so long as no Event of Default has occurred hereunder, Assignor shall have a license (“License”) to manage the Property, to collect, receive and use all Rents and Profits, except as otherwise set forth in Section 7(b) hereof, in the ordinary course and in accordance with the terms of the Leases; to let the Property and to take all actions which a reasonable and prudent landlord would take in enforcing the provisions of the Leases and Contracts; provided, however, that all amounts so collected shall be applied toward operating expenses then due, real estate taxes and insurance relating to the Property then due, capital repair items necessary to the operation of the Property as determined in the reasonable business judgment of Assignor, and the payment of sums due and owing under the Note, the Indenture, the other Loan Documents, this Assignment and the Related Agreements prior to any other expenditure or distribution by Assignor. From and after the occurrence of an Event of Default under the Note, this Agreement or the other Loan Documents (whether or not Assignee shall have exercised Assignee’s option to declare the Note immediately due and payable), the License shall be automatically revoked without any notice to Assignor or any other action by Assignee. Assignor hereby irrevocably authorizes and directs (i) each of the tenants under the Leases, upon receipt of a written notice from Assignee so demanding, to pay all Rents and Profits due or which becomes due under its Lease directly to Assignee, and (ii) each property manager of any part of the Property, upon receipt of a written notice from Assignee so demanding, to pay all Rents and Profits thereafter received by such property manager directly and promptly to Assignee. For the purpose of accounting, the books and records of Assignee shall be deemed prima facie correct. The Assignor may apply in writing to Assignee for a reinstatement of the Assignor’s right to collect rents, income and profits from the Lease or Contracts; however, the Assignee shall be under no obligation to do so.
Sample 4 is more restrictive than Samples 1-3. The Borrower’s right to enjoy or distribute Rents is not included in the language of the provision. However, unlike the problematic provision, Sample 4 does include language clarifying that only operating expenses, taxes and loan payments then due must be paid (as well as capital repairs necessary in borrower’s reasonable judgment).
Until an Event of Default has occurred and is continuing, but subject to the limitations set forth in the Loan Documents, Borrower shall have a revocable license to exercise all rights, power and authority granted to Borrower under the Leases (including the right, power and authority to modify the terms of any Lease, extend or terminate any Lease, or enter into new Leases, subject to the limitations set forth in the Loan Documents), and to collect and receive all Rents, to hold all Rents in trust for the benefit of Lender, and to apply all Rents to pay the Monthly Debt Service Payments and the other amounts then due and payable under the other Loan Documents, including Imposition Deposits, and to pay the current costs and expenses of managing, operating and maintaining the Mortgaged Property, including utilities and Impositions (to the extent not included in Imposition Deposits), tenant improvements and other capital expenditures. So long as no Event of Default has occurred and is continuing (and no event which, with the giving of notice or the passage of time, or both, would constitute an Event of Default has occurred and is continuing), the Rents remaining after application pursuant to the preceding sentence may be retained and distributed by Borrower free and clear of, and released from, Lender’s rights with respect to Rents under this Security Instrument.
Similar to Sample 4, Sample 5 clarifies that only amounts then due and payable and current costs have to be paid before the Borrower can “enjoy” (i.e. distribute or use) proceeds in Borrower’s discretion. Sample 5 has the added benefit of including express language permitting distributions free and clear of Lender’s lien.
Lender confers upon Grantor a revocable license (“License“) to collect and retain the Payments as they become due and payable, until the occurrence of a Default (as hereinafter defined). Upon a Default, the License shall be automatically revoked and Lender may collect and apply the Payments pursuant to that certain Section hereof entitled Application of Other Sums without notice and without taking possession of the Property. All payments thereafter collected by Grantor shall be held by Grantor as trustee under a constructive trust for the benefit of Lender. Upon satisfactory cure of any such Default as approved by Lender, the License shall be restored to Grantor. Grantor hereby irrevocably authorizes and directs the tenants under the Leases to rely upon and comply with any notice or demand by Lender for the payment to Lender of any rentals or other sums which may at any time become due under the Leases, or for the performance of any of the tenants’ undertakings under the Leases, and the tenants shall have no right or duty to inquire as to whether any Default has actually occurred or is then existing hereunder. Grantor hereby relieves the tenants from any liability to Grantor by reason of relying upon and complying with any such notice or demand by Lender. Lender may apply, in its sole discretion, any Payments so collected by Lender against any Secured Obligation under the Loan Documents, whether existing on the date hereof or hereafter arising. Collection of any Payments by Lender shall not cure or waive any Default or notice of Default or invalidate any acts done pursuant to such notice.
Although we don’t like Sample 6 as much as the other samples of less problematic provisions, we at least give the Sample 7 author credit for calling out that the intent is for borrower to be a party to a constructive trust. This is different from the problematic provision which attempts to bury the constructive trust concept in the provision.
Why Should Lender Care?
We hope lenders take the time to consider these points as well. First, reviewing this can allow lenders to better understand the reasons a borrower may request changes to similar provisions. Second, a lender would be remiss to expect that simply including language like that in the problematic provision we identify at the start of this article results in a pile of cash waiting for lender to grab in the event of a default. If the lender’s intent is to place controls on cash, simply throwing a provision like the one we identify as problematic for borrowers is not legally effective like other controls (control accounts, cash management or clearing, for example). Third, if a borrower was not told at the time of term sheet and marketing that cash flow would be restricted or Rents would need to be held in trust, it is extremely unfair to spring that on a borrower at the loan document stage (and a borrower may even consider if the lender is liable for inducing a borrower to agree to a loan under less than forthcoming terms).
1Chicago Title & Trust Co. v. Fox Theatres Corp., 14 F. Supp. 686