Stephen J. Ismert, Kutak Rock LLP
The ripple effects of declining commercial real estate values are beginning to reach owners in all real estate classes. Loan-to-value ratios that were more than comfortable two years ago are cutting close to the bone and lenders are applying pressure to comply with the loan-to-value and debt service coverage ratio covenants under the mortgage loan documents. Refinancing is no longer a viable alternative for many owners due to the combined negative effects of decreased property values and higher loan-to-value ratio requirements on new loans. As a result, equity owners of all classes of leveraged real estate ventures may receive the ominous call from the managing member or general partner for an “additional capital contribution” this year or next to make up shortfalls or pay down the loan. After the principals have depleted their personal reserves, new investors or new subordinate debt may be the only avenues available to existing owners to hold onto their shrinking equity and maintain compliance with loan covenants or pay off maturing debt.
Most modern loan documents require the maintenance of specific loan‑to‑value and debt service coverage ratios measured on a continuous basis or at least quarterly. If these covenants are violated, the lender will require a capital infusion, additional collateral, or a partial principal payment to “cure” the covenant violation. Obviously, it is best to anticipate the need for additional capital at an early stage, but many property owners are finding out that, notwithstanding prudent property management, they are just one conservative appraisal update or lease termination away from violating these covenants and scrambling for cash. The earlier the need is identified, the greater and more flexible the options will be for raising new capital or debt.
If loan restructuring with the senior lender is not available or will not fully address the issues, the three primary options to remedy the distressed capital call situation and put the asset on a more secure financial footing include:
(i) third‑party equity investment;
(ii) mezzanine debt; and
(iii) subordinate secured debt.
Each of these options have benefits but each may require the existing principals to relinquish some control over the asset and disclose any adverse issues relating to the property and existing debt to any new investors or lenders.
New Investor Equity
The most straightforward option is to seek new equity investors. Obviously, the sale of new equity will dilute the existing owners’ ownership, but this is better than being completely wiped out through foreclosure or bankruptcy. In selling equity (or the issuance of new equity) in the borrower entity, the principals must be cognizant of Federal and State securities laws and Federal tax laws. In general, private equity offerings not made by any form of general solicitation or general advertising and made only to “accredited investors” are exempt from the registration requirements under the Securities Act of 1933 so long as the equity offering complies with the other requirements of Regulation D. Accredited investors generally includes, among other categories of investors, individuals with income of over $200,000 (or joint income with a spouse of over $300,000) in each of the last two years (with a reasonable expectation of reaching the same income level in the current year) or individuals with a net worth (or joint net worth with a spouse) of over $1,000,000. Seeking investors that are not “accredited investors” requires compliance with specific disclosure requirements or compliance with registration requirements. The failure to disclose material matters relating to the offering, the property or the financial condition of the borrower or project (regardless of whether the investors are accredited investors) could expose the entity and the individual principals to fraud claims and securities law violations. Additionally, the entity may also need to take measures to avoid being characterized as a “publicly traded partnership” under the Federal tax laws (often this is accomplished by limiting the number of beneficial owners of the equity securities of the borrowing entity to less than 100) and to avoid being characterized as an investment company under the Investment Company Act of 1940 (through a limitation on the number of investors or heightened investor suitability requirements).
Other factors to consider when bringing on new investors are the “transfer restrictions” and “change in control” requirements under the loan documents (typically found in the Deed of Trust or Mortgage). These provisions can be very tricky and are often vague in the lender’s favor. In most loan documents, the borrower is not permitted to sell or transfer material portions of the equity interests in the borrower in a single transaction or series of transactions without the lender’s prior written consent. An equity sale without the consent of the lender could trigger a breach of these covenants and potentially expose the non‑recourse guarantors, if any, to personal liability for the full loan amount.
As negotiations with the new investors progress, the issue of liability sharing among the investors will eventually arise. Since the primary loan is already in place at this point, the lender may not always require that new investors execute additional guarantees. However, the investors should properly document their reimbursement liability to one another in the event some or all of the guarantors fail to pay, or are not required to pay, on any existing loan guarantees. The situation is more acute when the guarantors’ liability is “joint and several” and not all investors have the means to pay their proportionate shares. The investors with money will pay on their respective guarantees first and then they will have the unpleasant task of chasing their fellow investors for their proportionate shares.
Alternatively, if less than all of the principals sign new or existing guarantees, the principals who do provide lender guarantees can be compensated with a “guarantee fee.” Under this arrangement the investors signing a guaranty will at least be compensated for taking the additional risk at the outset. Those signing the guarantees should carefully consider requiring additional control over actions by the borrowing entity that could trigger release liability (e.g., transfers, bankruptcy, application of funds).
The documentation of the sale of additional equity typically involves a disclosure statement, subscription agreement, amendments to existing operating agreements or shareholder agreements, liability sharing agreements and certificates representing the equity interest being issued. The new investors may require a preferential return, indemnities for existing financial and physical property conditions, and super voting rights.
Those contemplating the sale of equity should allow at least thirty to sixty day due diligence period by potential investors for their review of entity formation documents and preparation of the investment disclosure and offering materials. After the prospective investors are identified, the borrower should allow at least another thirty days to document the equity sale and collect the proceeds. The dollar size of the offering and the complexity of the existing ownership structure will affect the above time periods.
The second option, mezzanine financing, works pretty well in most distressed asset situations due to its hybrid structure. Under a typical mezzanine debt structure, the mezzanine lender makes a loan to the borrower entity and/or its principals which is secured by the all the principals’ equity interest in the borrower entity (i.e., their limited liability company, partnership or stock interests). This collateral is secured by a pledge agreement and perfected by filing a UCC‑1 financing statement with the applicable Secretary of State. In the event of a default (typically cross‑defaulted with the underlying senior mortgage loan), the mezzanine lender could foreclose on the equity interest in order to become the sole equity owner of the borrower entity, and thus control the property. The mezzanine lender would then control the liquidation of the property or seek refinancing (assuming the senior lender is willing to allow this opportunity).
Since the exercise of the mezzanines lender’s remedies may result in a “transfer” or “change in control” of the borrower, the prior written consent of the senior lender must be obtained. In this market the senior lender is usually pleased with “new money” coming into the project although senior lenders will be very careful not to allow its real estate collateral to be encumbered by the mezzanine lender. The mezzanine lender and senior lender will typically enter into an intercreditor agreement which provides for the senior lender’s consent and gives the mezzanine lender the right to cure the senior loan and perhaps purchase the senior loan upon a default after taking control of the borrower entity. Private equity firms, venture funds and other opportunistic lenders are good sources for mezzanine loans. Borrowers should expect to pay hefty origination fees, interest rates and other costs and significant restrictions on voting rights for these “high risk” loans.
Mezzanine lenders commonly require a junior lien on the real property as “additional collateral” for the mezzanine loan. Whether this collateral is available, will be almost entirely up to the senior lender. Under this structure, the mezzanine lender would have two basic remedies upon a default: a foreclosure on the equity interests of the principals and a foreclosure on the real property (subject to the lien of the senior lender).
Since mezzanine loans are secured by each principal’s respective equity interest in the ownership entity, the proper documentation of the formation and ownership of the entity is crucial. The mezzanine lender will fully scrutinize the entity formation documents to make certain that the equity interests were properly issued and currently owned by the principals. Each principal will be required to provide representations and warranties concerning ownership of their respective interests. Any deficiencies in the entity formation documents should be remedied before presentation of such documents to the prospective mezzanine lender. Mezzanine lenders may also require some level of repayment guaranty (depending on the equity in the project).
Second or Junior Loan
The third option is a second loan secured by a second or junior lien on the property. In the distressed situation, this option may not be possible without additional collateral for the junior lender. Such “additional collateral” could include a letter of credit, liens on other properties owned by the principals or other liquid assets of the principals. If such additional collateral is available, a junior loan may be the fastest and least expensive option from a legal perspective.
More often than not, a lender providing a junior loan would require a full personal guarantee by each of the principals of the borrower entity (or at least the majority principals). The financial strength of the guarantor will be a primary factor in the underwriting of the junior loan given the thin equity in the property. Under most bank guarantees, the lender is not required to first exhaust its remedies with respect to the collateral, but rather the lender may pursue its remedies immediately against the guarantor. If the guarantee or junior loan is joint and several, the parties should properly document their respective liabilities to one another.
The senior lender will certainly be involved in any junior lien situation. Almost all mortgages expressly prohibit junior liens without the express prior consent of the lender. Under most non-recourse guarantees of securitized loans, the violation of this covenant can trigger full personal liability for the guarantor. Under current market conditions, a senior lender may be more than willing to consent to a junior loan given its alternative of foreclosing on the property. The risk of not obtaining the senior lender’s consent is too great to ignore.
There are certainly combinations and derivations of the foregoing alternatives that should be explored to achieve the goals of the property owner, the principals and lenders. All these options require the parties to be flexible and to cooperate in a good faith with full disclosure.
 Originally published by the Colorado Real Estate Journal. Reprinted with permission.
 Securities Act of 1933, 15 U.S.C. § 77a et seq. (2006).
 Investment Company Act of 1940, 15 U.S.C.A. § 80a-1 et seq. (2006).