Is the Borrower's Gun Empty?

By: Richard O. Kopf
Real Estate in the Changing World: Confronting the Crisis
October 2009

During a recent call with a client following his receipt of a default notice from his lender, it struck me how different the options are today from the last real estate crash in the late '80s. The client, a long time real estate investor, started rattling off a litany of options as he remembered the '80s; and I had to just say "STOP, it is not the '80s any more and many of the rules have changed." How have they changed?

1. Springing Guaranties. The key change in virtually every commercial real estate loan is the inclusion of a springing recourse provision in the "carveout" or "bad boy" guaranty. That is a provision that says that despite the loan being a non-recourse loan, the loan becomes fully recourse to the carveout guarantor in the event that the borrower files bankruptcy or takes any other action intended to impede or hinder the lender from exercising its rights and remedies following an event of default. This provision alone takes away the biggest bullet in the borrower's gun: the ability to fight back without exposing the guarantors to significant personal liability (unless, of course, the guarantor is also facing bankruptcy due to other circumstances).
2. "Bad Boy Carveouts." The so called "bad boy" carveouts became commonplace following lender's experiences arising out of the savings and loan crisis. The most significant bad boy carveout creates liability for misappropriation of rents and other income. In prior downturns, borrowers customarily utilized the rents and other income as their “war chest” to fight the lender either in litigation or bankruptcy. Disputes typically centered around whether the assignment of rents was an absolute or conditional assignment of rents. Today, that is pretty much a moot question as assignment of rents provisions in loan documents are correctly drafted and borrowers have little, if any, incentive to take the rentals and expose the guarantor to a personal claim under the non-recourse carveouts. In addition to misappropriation, the bad boy carveouts have been expanded significantly over the years, so one of the first things that any borrower must do when facing a default situation is carefully review those carveouts. For example, it is common for lenders to include failure to pay ad valorem taxes, waste (beauty is in the eyes of the beholder), enforcement costs, failure to maintain insurance, failure to turn over security deposits, and more. Such expansive careveouts can have a very significant impact on the options that are realistically available to the borrower.
3. Bankruptcy Remote/Independent Directors. Especially in commercial mortgage-backed securities (CMBS) transactions, lenders have required the inclusion of an "independent director" within the organizational documents of the borrowing entity and required approval from that director for any bankruptcy filing. While the General Growth bankruptcy case has created real questions about the impact of those provisions in certain cases,1 the existence of an independent director will clearly add complexity to the decision-making process.
4. Anti-Deficiency Statute. In response to widespread objections following the savings and loan crisis and Texas' streamlined foreclosure process, the Texas legislature adopted an anti-deficiency statute in the '90s. Historically, while lenders typically bid a specified percentage of fair market value in order to mitigate fraudulent conveyance risk, Texas law imposed no requirement on the lender to bid a minimum amount at a foreclosure sale. The absence of such restrictions allowed lenders to bid less than the property value and pursue the borrower or guarantor for the difference in a deficiency lawsuit. The anti-deficiency statute was intended to allow the borrower or guarantors to receive the benefit of the value of the property in a deficiency lawsuit. To avoid that benefit, lenders started customarily including specific waivers of the anti-deficiency statute in their loan documents. A number of lawsuits have been filed challenging the enforceability of those waivers on public policy grounds; but so far, the Texas courts have come down on the side of the lenders and upheld the waivers.
5. Litigation Strategy. While each of the changes described above impacts the decision to fight the foreclosure, once that decision is made, there have also been a number of changes in just how the "game" is played both from a legal and practical standpoint. For example, during the savings and loan crisis, it was common for the borrower to adopt a two step approach. First, the day before the foreclosure (or maybe the morning of the foreclosure), the borrower would go to state court and ask the court to issue a temporary restraining order stopping the foreclosure sale because of an alleged impropriety in the lender's actions. The Temporary Restraining Order (TRO) would typically be issued that day and a hearing would be scheduled in the following week or so to decide whether or not the lender was entitled to pursue the foreclosure. Those claims often turned on some particular nuance of the loan documents or the lender's demand (i.e., notice was sent to the wrong address and the borrower didn't have appropriate notice of the foreclosure sale). If the borrower was either unsuccessful in obtaining the TRO or the court refused to grant a permanent injunction at the subsequent hearing (subject to appeal rights), the borrower's next step would be to file for bankruptcy which would automatically "stay" the pending foreclosure. While this two step approach is still possible, borrowers should realize that there have been significant changes that both speed up the process and limit the defenses that borrowers can raise, thereby limiting the likelihood of success. Certain of those changes are listed below:
   1. The most material change was the adoption of the Bankruptcy Reform Act of 2005. Under the Act, the likelihood of single asset bankruptcies being successful is significantly reduced because the borrower is now required, within 90 days of the filing of the bankruptcy case, to either begin making interest payments on the loan or file a plan of reorganization that has a reasonable likelihood of being confirmed. In addition, the process is significantly accelerated since the debtor is now required to confirm a plan within 180 days with only one extension as opposed to having multiple extensions available prior to the Act. Thus, it can be used as a delaying tactic but it is rarely successfully utilized to affect the adoption of a plan of reorganization.
   2. The Texas legislature has focused on many of the "errors" that borrowers often claimed their lenders made in pursuing acceleration and foreclosure and tightened up the statutes so as to make it more difficult for the borrower to find an error that would justify the issuance of a TRO and ultimately a permanent injunction. Those changes include (i) specifically authorizing a servicer to act with respect to the loan on behalf of the lender (especially important in the CMBS context), (ii) confirming that the day the notice is sent is included for purposes of determining whether at least 21 days’ notice is given prior to the sale, (iii) restrictions on borrower's ability to change its address prior to the sale (if the borrower timely sent a change of address notice to the lender, the posting notices could easily pass in the mail and make it impossible for the lender to provide appropriate notice), and (iv) requirements for filing notices of sale with the county clerk and procedures for retaining copies of the notices that have been filed (certain nefarious borrowers were accused of tearing down the notices at the courthouse and then claiming that the lenders never actually posted the notices of sale).
   3. Despite perceptions to the contrary (primarily with respect to residential loans), policies and procedures at the typical bank or other financial institution have improved significantly from the days of the savings and loan crisis. It was not uncommon in those days for a bank or savings and loan association to be taken over and for the Federal Deposit Insurance Corporation (FDIC) or Federal Savings and Loan Insurance Corporation (FSLIC) to discover that the loan files did not include promissory notes, copies of the loan agreements, guaranties, etc. If nothing else, the computer age has made it easier for banks to maintain files and copies of important documents. It still remains to be seen whether the fast and furious growth of the CMBS industry has resulted in the same issues. However, it is likely that the focus will be on the authority of the applicable lender or special servicer rather than on the existence of the loan documents themselves.

While each situation is unique, the rules of engagement have clearly evolved since the savings and loan crisis. Therefore, a fresh approach is often necessary. Most of the changes inure to the benefit of the lenders; but, as indicated above with respect to General Growth, changes in the financing industry in general (i.e., CMBS) will continue to present opportunities for borrowers to gain leverage when working with their lenders.

The borrower’s gun isn't empty, but the ammunition has changed.

1Despite feverous objection from the creditors, the court ruled that the original independent directors could be replaced by the borrower and the new independent directors authorized the bankruptcy filing.