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Presenting a live 90-minute webinar with interactive Q&A Commercial Mortgage-Backed Securities 3.0: Structuring Commercial Mortgage Securitized Loans in an Evolving CMBS Market Navigating New Structures, SPE Covenants, Cash Management and

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Commercial Mortgage-Backed Securities 3.0: Structuring Commercial Mortgage Securitized Loans in an Evolving CMBS Market

Navigating New Structures, SPE Covenants, Cash Management and Other Loan Provisions

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THURSDAY, MARCH 19, 2015

Presenting a live 90-minute webinar with interactive Q&A Allen Dickey, Shareholder , Munsch Hardt Kopf & Harr, Dallas Dan Flanigan, Department Chair , Polsinelli, Kansas City, Mo.

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Commercial Mortgage-Backed Securities 3.0: Structuring Commercial Mortgage Securitized Loans In An Evolving CMBS Market

Presented by: Allen Dickey adickey@munsch.com Thursday, March 19, 2015 1:00 pm Central

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Presentation Outline

Introduction/Background
CMBS 1.0 to 2.0/3.0 and Back
Summary of Changes From CMBS 1.0 to 2.0
Original Goals of CMBS 2.0
CMBS 2.0 – How Were Loan Terms Different From CMBS 1.0
CMBS 1.0 Guarantees Withstood Court Challenges
CMBS 3.0
CMBS 3.0 Loan Structures
Pari Passu
A/B
Mezzanine Loan
Comparison of A/B to Mezzanine Loan

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Introduction

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Introduction

The total issuance of U.S. CMBS in 2007 was $230 billion.
Moody's says that new issuance will grow to $110 billion in 2015,

reflecting the strong loan origination pipeline, refinancing of 10 year loans, and a healthy property transaction market.

Investors are aggressively purchasing CMBS bonds as late payments on

commercial mortgages decline to record lows.

As of 2015, issuers have loosened underwriting standards as the

recovery in the commercial property markets has solidified. Moody's states that loan credit quality at the beginning of 2015 aligns with that from the first half of 2006 and that there is a danger of credit quality sliding quickly towards the 2007 level.

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CMBS 1.0 loans from the 2006-07 era are viewed as somewhat difficult

to refinance, however, as they often had full proceeds, little amortization, and will be maturing in 2016-17 as interest rate are projected to increase.

The recovery in the office and retail sectors, which account for more

than 50% of the collateral backing recent CMBS loans, will advance in

2015. Modest construction rates have allowed each of these sectors to

absorb vacancies / maintain rent increases.

In short, credit quality for 2015 loans is projected to be better than loans
riginated at the pre-crisis peak but weaker than loans made during

2014.

Introduction (Cont.)

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Conduit loan leverage is increasing at such a pace that it will exceed its

pre-crisis peak of 118% well before the 10th anniversary of the peak in the 3rd quarter of 2017. Interest only loans will comprise more than 70% of 2015 issuance. Interest only loans forego amortization that helps to offset the impact of a rate increase on maturity default risk.

With CMBS surging in popularity once again, this presentation will provide

a summary of the legal and structural changes from the prior era of CMBS ending in 2008 (CMBS 1.0) along with a discussion of current loan structures being utilized by CMBS loan originators.

Introduction (Cont.)

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CMBS are bonds created from pools of loans secured by commercial real

estate mortgages, and each pool of loans is aggregated into a single trust

The trust is then divided into multiple classes, each of which is assigned a

credit rating (based on overall loan / property characteristics & loss protection)

Various Parties to Commercial Real Estate Capital Stack
Trustee
Lender of Record of Mortgage Loan
Master Servicer
Services Loan Prior to “Specially Serviced’’ Designation
Handles Cash
Responsible for Advancing

Introduction (Cont.)

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Special Servicer
Takes Over Active Servicing of Loan Once it Becomes “Specially

Serviced’’

Controlling Holder
Has Consultation and Consent Rights Over Major Servicing

Actions

Has the Right to Replace the Special Servicer
Mezzanine Lender
Holds a Separate Loan With Separate Collateral
Party to Inter-Creditor Agreement With Mortgage Lender

Introduction (Cont.)

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CMBS 1.0 to 2.0/3.0 and back

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CMBS 2.0 refers to the resurgent capital markets commercial real

estate loan origination and securitization industry which restarted in 2010; there were:

Changes to loan structures (business underwriting) at the

borrower level

Changes to loan structures (legal) at the borrower level
Changes to securitization legal structures at the bond level
Changes to securitization / subordination levels and other

business terms

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Original Goals of CMBS 2.0:
Increased Transparency / Disclosure
Risk Alignment
Vastly more conservative underwriting
Lower leverage
Enhanced Representations / Warranties
More input from investors

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CMBS 2.0 securitizations were far smaller than 1.0, with fewer loans and

limited bond classes (senior AAA comprised the top 80%, rather than 70% under CMBS 1.0)

Deal sizes much smaller
Higher average loan size
Higher weighted average DSCR
Lower weighted average LTV
Much higher percentage of amortizing vs. interest only loans
Virtually no mezzanine debt and less allowance for future mezzanine debt
Below Investment Grade (B-Piece) now at 5% (as opposed to 3% or less

under CMBS 1.0)

CMBS 2.0 Deals in 2011-2012

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Vastly increased % of loans with hard lockbox provisions
Very few loans with no cash management whatsoever
Escrows for real estate taxes in excess of 80% of pool balance
CapEx reserves in excess of 70% of pool balance
Very few loans had a borrower principal that had recently filed for

bankruptcy

Most lenders began requiring that all loan documents be governed by

New York law (except for the creation / perfection / enforcement of liens, which are still governed by the state where the property is located)

CMBS 2.0 Deals in 2011-2012 (Cont.)

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CMBS 2.0 – how were the loan terms different from CMBS 1.0

Amortization expected / Interest only loans were rare;
Added Independent Directors / national service providers
Most deals required the borrower’s organizational documents to require

independent directors to consider only the interests of the borrower and its creditors prior to approving a bankruptcy filing (i.e. specifically excluding consideration of the corporate enterprise)

Very limited exceptions to the “no comingling” SPE covenant
Additional Recourse Guarantees;
Ongoing Financial Reporting and Financial Tests are more common,

including net worth and liquidity requirements

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CMBS 1.0 - Guarantees have withstood court challenges

CMBS 1.0 Guarantees have largely held up under court challenges
Upheld claim regarding misapplication of settlement proceeds
Rejected argument that a springing recourse guaranty constituted

an unenforceable liquidated damages provision

Upheld full liability after a voluntary bankruptcy filing
Upheld full liability after misapplication of rents and failure to

maintain SPE status

in some cases court decisions have been contrary to what might

be expected in non-recourse lending, e.g. liability for failure to remain solvent.

Cash Management / Lockboxes almost mandatory

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CMBS 3.0 (Second half of 2012 to Present)
The slow recovery in the CMBS market got a big boost in the second

half of 2012 thanks to more competitive financing rates. That momentum has carried over into 2013, 2014, and now 2015.

Originations may exceed $110 billion in 2015, which would be more

than any period except 2005 through 2007, when the market for real estate bonds surged before rising delinquencies caused demand to crash.

CMBS 3.0 trusts now have 70% Super/Senior AAA ratings (as opposed

to 80% under CMBS 2.0), with a corresponding increase in the Junior AAA rated levels (now approximately 10%).

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At the peak of CMBS 1.0 issuance, credit quality

corresponded with greater deal complexity and falling credit enhancement levels.

Most CMBS 3.0 loans are taking on the negative

aspects of CMBS 1.0 loans at its peak.

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CMBS 3.0 / Loan Structures

Pro forma underwriting is back / particularly for non-stabilized assets; this

is a pre-peak, CMBS 1.0 issuance practice that has begun to reappear.

Interest only loans are on the rise again, particularly for large, stand-alone

loans; Interest only loans now comprise 70% of the market.

Pari-passu loans are also back (can introduce complexities in a workout

scenario)

Cash-out loans – fairly common
Fully 30% of 2015 CMBS issuance is expected to be single-asset/single-

borrower transactions; 20% of issuance will be backed by multi-family loans originated by Freddie Mac, and the remaining 50% of issuance will be standard conduit loans backed largely by office / retail.

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Split Mortgage Loan - a “split” mortgage loan is a mortgage loan which either is evidenced by more

than one promissory note or which has been otherwise “split” into different lender interests

The most common types of split mortgage loans:
Pari passu loans (A/A structure) - the structure has become more popular due to the increased

risk perceived by investors of single asset CMBS transactions. The pari passu note structure is an effective method of decreasing large loan concentration in a CMBS transaction; the corresponding increased diversity is generally treated more favorably in rating agency models.

A “pari passu” loan structure is a mortgage loan structure where the mortgage loan is

evidenced by two (or more) separate promissory notes, each executed by the borrower and secured by the same collateral

Control over the servicing of the whole loan (all of the pari passu notes) typically resides in

the master servicer and special servicer for the first pari passu note securitization

Each pari passu A Note can be sold into a separate securitization
Evidenced by more than one promissory note

CMBS 3.0 / Loan Structures (Cont.)

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Cons of Pari-Passu Loan Structures:
Potential delays in loan workouts due to the necessity of collaboration

and coordination of multiple parties across CMBS trusts.

Control rights vary.
Advancing requirements vary.
Monitoring the loan’s performance becomes more complex.
Event risk of a single asset may negatively impact multiple transactions

CMBS 3.0 / Loan Structures (Cont.)

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A/B Loan Structure
An A/B loan is a mortgage loan evidenced by two separate promissory

notes, each executed by the borrower, and each secured by the same collateral

The A Note is generally senior to the B Note in rights to payment of

principal and interest

Variations of the A/B Loan Structure
A-1/A-2/B – pari passu senior notes and one or more subordinate

notes

A/B/C – multiple subordinate notes
A/B with mezzanine – one or more subordinate notes, with

additional structurally subordinate mezzanine loans made to the parent or parents of the mortgage borrower

CMBS 3.0 / Loan Structures (Cont.)

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Generally, the loan is administered by a servicer acting on behalf of the A Note - initially,

pursuant to an interim servicing agreement; post securitization, pursuant to the PSA.

The A and B Notes have a senior / subordinate payment structure; the A Note holder is

paid interest and principal first & the B Note holder is paid interest and principal second.

the B Note serves as “credit support” for the A Note - in light of the B Note’s

subordination and higher risk, the yield on the B Note is typically higher than the yield

n the A Note
Here are a few basic questions that will help you understand some of the most

important aspects of the A/B loan structure:

Are the two notes cross defaulted? If not, then what happens in the event the A

note defaults? or if the B note defaults?

Who services the B note?

CMBS 3.0 / Loan Structures (Cont.)

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Regardless of who services the B note, if note A goes to special servicing (in

a CMBS pool), is the special servicer required to work in the best interests of the A note holder AND the B note holder (combined)?

What is the payment priority? Does cash flow first go to interest, principal,

property taxes, insurance and other reserves for the A note before applying any remaining cash to the B note obligations? If the principal balance, interest rate or scheduled payments on the mortgage loan are reduced, or any other material modifications are made to the mortgage loan, will the full economic effect of the modifications be borne by the B Note holder (up to its then remaining principal balance?

Does the B note holder always have the right to purchase the A note – even

in the event of a default? How is the purchase price determined?

When an event of a default exists under the mortgage loan, what are workout

effects of payments to the A Note and B Note holders?

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Mezzanine loan
The mortgage lender has a mortgage and a first lien on the real estate
The mezzanine lender does not have a mortgage or a lien on the real

estate

The mezzanine lender does not lend to the mortgage borrower
The mezzanine lender has a pledge of equity
If the mortgage is foreclosed, the mezzanine lender’s equity pledge

will be worthless (because the mortgage borrower will own nothing)

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Comparison of A/B Loan Structure to Mezzanine Loan Structure
An A/B loan is a mortgage loan (composed, in part, of A Note and B Note) made

by the mortgage lender to the mortgage borrower, secured by a lien on real estate.

A mezzanine loan is a loan made by mezzanine lender to the mezzanine

borrower (parent of the mortgage borrower), secured by a pledge of the equity interests in the mortgage borrower.

The B Note is serviced by the master and special servicer of the A Note, subject

to certain consent and consultation rights held by the B Note holder or an “operating advisor” acting on behalf of the B Note holder

The mezzanine lender services its own loan, independently of the servicing of

the mortgage loan

___________________

***See U.C.C. § 9-307 cmt. 5 (2009).

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Control Rights
The B Note holder has little or no control over its investment,

with the exception of certain specific consent and consultation rights over specific servicing matters, including

foreclosure
modification of a mortgage loan resulting in a discounted

payoff

modification of a monetary term of the mortgage loan
approving any bankruptcy plan of the borrower
waiver of a due on sale or due on encumbrance

provision

right to appoint the special servicer

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Mezzanine lender has sole control over its mezzanine loan servicing, subject to

specified restrictions set forth in the mezzanine intercreditor agreement

Cure Rights / Purchase Options
B-Note lenders share some of same rights as mezzanine lenders; upon

default, two fundamental rights: (i) Right to cure loan and (ii) Right to purchase loan

Remedies
B Note holder assigns its right to foreclose upon the mortgage to the A Note

holder, which exercises remedies on behalf of both the A Note and B Note holders – property foreclosure can take 3-18 months / state dependent

The mezzanine lender, however, can perform a UCC foreclosure upon the

equity pledge (subject to certain conditions and restrictions) – usually takes 60-90 days.

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Unlike an A Note, which is always cross-defaulted with the B Note (i.e., a

default under the B Note constitutes a default under the A Note and vice- versa), a mortgage loan is typically not cross-defaulted with the mezzanine loan (i.e., a default under the mezzanine loan does not, in and

f itself, constitute a default under the mortgage loan); the mezzanine

loan, however, is cross-defaulted with the mortgage loan (i.e., a default under the mortgage loan automatically constitutes a default under the mezzanine loan)

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Commercial Mortgage-Backed Securities 3.0:

Structuring Commercial Mortgage Securitized Loans In An Evolving CMBS Market

Dan Flanigan, Chair, Real Estate and Financial Services dflanigan@polsinelli.com SELECTED NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE ISSUES: THE WALL OF CMBS MATURITIES 2015-2017 SUBORDINATE DEBT (A-B, Mezzanine, Preferred Equity) DELAWARE STATUTORY TRUSTS (THE NEW TICs)

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Commercial Mortgage-Backed Securities 3.0: Structuring Commercial Mortgage Securitized Loans In An Evolving CMBS Market

Dan Flanigan, Chair, Real Estate and Financial Services New York: Direct: 212-644-2090 Fax: 212-684-0197 E-Mail:dflanigan@polsinelli.com 900 Third Avenue, 21st Floor New York, NY 10022 Kansas City: Direct:816-360-4260 Fax:816-753-1536 E-Mail:dflanigan@polsinelli.com 900 West 48th Place, Suite 900 Kansas City, MO 64112

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“LIFE IS JUST A BOWL OF (SOUR) CHERRIES” FROM CHERRYLAND NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE

(Thanks to my POLSINELLI colleague Aaron Jackson for his help with the research for this Section.)

NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE

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As illustrated by the list of cases attached, Borrowers and Guarantors have fared

very poorly in carveout and springing recourse cases, and even worse for them, Lenders have even managed to obtain, in the Cherryland and Gratiot cases, windfall benefits that the drafters of the loan documents never intended.

The “document means what it says (or what we say it says), however irrational”

approach of the Cherryland and Gratiot courts has provoked well-represented Borrowers and Guarantors to carefully analyze every nuance and implication of the language of the carveout, exculpation, and springing recourse provisions.

NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE

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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE

Accordingly, in CMBS 2.0 and 3.0, counsel for Borrowers and Guarantors have

sought to clarify such ambiguous words and phrases as “solvency,” “failing to pay liabilities as they come due,” “failure to maintain SPE status,” and to insist more than before that Lenders suffer true negative consequences before they are allowed to take advantage of “foot faults” to obtain deficiency judgments when their Borrowers and Guarantors may be “insolvent boys” or even “stupid boys” but not “bad” ones.

But none of this is easy, and different Lenders, and different counsel for Lenders,

have different approaches and different tolerance levels for changes in their documents and it can be very hard to tie up and tie off all the trip wires.

But even CMBS lenders themselves should not want their “product” to be seen as
ne festooned with booby traps that make a mockery of the premise of

nonrecourse financing.

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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE

The following are some selected important issues in loan documentation that

have surfaced in light of the Cherryland and Gratiot cases. This summary is meant to be suggestive only and not by any means a comprehensive identification of all the problems. Moreover, the curative language offered may not actually solve the problems, or, being language, may just not be able to get us all the way there. In short, this discussion is to provoke thought, not offer ironclad solutions.

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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE

– Limit number of items that cause full recourse to as few as possible (when, in fact, the springing recourse items have proliferated over the years). – Some particularly problematic examples: solvency, violation of reporting provisions, violation of any SPE covenant (“You did not have separate stationery.” Really?), lockbox/cash management breaches, nonmaterial breaches of transfer restrictions, etc. – Waste: Intentional, physical waste only. No requirement to maintain property if cash not available. One of many possible variations on protective language: "provided, however, that Borrower or Guarantor shall be liable for waste only to the extent of physical waste and then only to the extent that [during the preceding twelve (12) months] the Property generated sufficient Gross Revenue to pay the Operating Expenses, Taxes, Insurance Premiums, Debt Service, and costs of maintenance and repair, but Borrower failed to apply the Gross Revenue to such purposes;"

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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE

– Solvency etc.: At mercy of value decline? One of many possible variations

n protective language: "No provision of this [Schedule, Loan Agreement,

Guaranty, etc. where SPE provisions appear] shall be construed to require Borrower or any member of Borrower to contribute additional funds or capital to Borrower or the property, and no member of Borrower or other person guaranteeing to Lender the performance of Borrower shall be required to pay

r provide any funds (other than Borrower’s own funds) to cause Borrower to

remain solvent or to pay Borrower’s debts or liabilities or otherwise maintain adequate capital." – Definitions of “trade payables”: realistic thresholds, ability to cure a default after notice, indemnification only, NOT springing recourse.

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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE

– “No harm, no foul” for breach of separateness covenants: “Borrower breaches Section and a court of competent jurisdiction renders a final nonappealable decision that such breach is a substantial contributing factor to the substantive consolidation of the Borrower with __________________.” – Why should Guarantor ever incur full springing recourse for a violation that does not result in actual substantive consolidation? And the truth is that even actual substantive consolidation is not likely to cause any damage to the Lender because its lien will almost surely be preserved and its position no worse than if consolidation does not occur, just one example of the incredibly fuzzy and unsophisticated thinking that has made substantive consolidation a modern day Boogey Man that otherwise intelligent, sophisticated CMBS players will do anything to avoid, including, incredibly, forego an actual guaranty of payment in fear that it might create some remote risk of substantive consolidation. (But good luck with that. Think Galileo.)

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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE

– Bankruptcy: Springing recourse if Guarantor does not have control of Borrower decision to file? Takeover by Mezzanine Lender followed by filing? Guarantor partners remove Guarantor and file? – Conflict of Guarantor who has springing recourse upon bankruptcy filing but possible fiduciary duty to partners or LLC members. Obtain exculpation from partner and members in governing documents.

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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE

– LLC Provisions

Limitation of Liability of Other Member. Notwithstanding any other

provision of this Agreement, if a Member or any of the Member’s members, managers, agents, attorneys, accountants, representatives, employees, officers, Affiliates or consultants (collectively, the “Related Parties”) performs any services for or on behalf of the Company, neither the Member nor any of the Related Parties of such Member acting on behalf of such Member shall be subject to any liability therefor except in the case (and only to the extent) of Misconduct. To the fullest extent

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– LLC Provisions (continued) permitted by law, including Section 18-1101 of the Act, and notwithstanding any other provision of this Agreement, any other agreement contemplated hereby or related hereto, or applicable provisions of law or equity or

therwise, the Members hereby (i) agree that no Member or Managing

Member shall have any fiduciary duty to any other Member, the Company, any Managing Member, or any other party to this Agreement, and (ii) allow each Member and Managing Member to act solely in the interests of such Member or Managing Member (and their respective affiliates) with respect to any act, election or omission that could result in any liability of such Member or Managing Member under any guaranty or similar document including ______________; provided, however, the foregoing shall not eliminate the implied contractual covenant of good faith and fair dealing, to the extent such covenants are not waivable under the Act.

NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE

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– LLC Provisions (continued)

Loan . . . [Developer/Sponsor] shall be obligated to provide Lenders

with any guaranty, non-recourse carve-out guaranty, environmental indemnity, or other guaranty or indemnity or credit enhancement required in connection with the Loans, and [JV Partner] shall not be obligated to provide Lenders with or be obligated to Lenders under any guaranty or indemnity except with respect to certain bankruptcy actions taken by the Company at [JV Partner’s] direction or with its collusion or approval (provided that, pursuant to the Indemnity Agreement, [JV Partner] shall indemnify [Developer/Sponsor] for certain liabilities that may arise under the non-recourse carve-out guaranty to be provided by [Developer/Sponsor] for the benefit of the First Mortgage Lender, subject to the terms of the Indemnity Agreement).

NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE

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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE

– Materiality and Material Adverse Effect. Both are important. “Materiality” refers to the quality of the breach itself, “Material Adverse Effect” refers to the consequences of the breach. – General indemnity of Lender in Loan Agreement by Borrower as carveout

item. Exposure potentially huge and beyond Guarantor or even Borrower

control. – Springing recourse for “resistance” to enforcement efforts. Is it beyond Guarantor’s control? Good faith self-defense vs. bad faith hostage-taking. – Lender’s enforcement costs even where there is no resistance.

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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE

– Should a Guarantor be able to terminate its liability if Borrower offers to tender deed in lieu (subject to clean title and clean environmental). – Anticipate Transfer and Assumption: Will new Guarantor be required to be liable for violations prior to transfer? Will initial Guarantor be let off the hook for future acts and omissions? Negotiation power is entirely different (and can approach non-existence) at assumption compared to origination. Servicer will be resistant to changes in carveout language because Servicer cannot justify since there is often no demonstrable benefit to Lender.

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BORROWER RESPONSE TO LENDER DRAFT

Here is an example of Borrower’s first round of comments to what was, on the whole, a relatively speaking not unreasonable first draft from the Lender:

Exculpation. Subject to the qualifications below, Lender shall not

enforce the liability and obligation of Borrower to perform and observe the

bligations contained in the Loan Documents by any action or proceeding

wherein a money judgment shall be sought against Borrower, except that Lender may bring a foreclosure action, an action for specific performance or any other appropriate action or proceeding to enable Lender to enforce and realize upon its interest and rights under the Loan Documents, or in the Property, the Rents or any other collateral given to Lender pursuant to the Loan Documents; provided, however, that, except as specifically provided herein, any judgment in any such action or proceeding shall be enforceable against Borrower only to the extent of Borrower’s interest in the Property, in the Rents and in any other collateral given to Lender, and Lender shall not sue for, seek or demand any deficiency judgment against Borrower in any such action or proceeding under or by reason of or under or in connection with any Loan Document. The provisions

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f this Section 10.1 shall not, however, (i) constitute a waiver, release or

impairment of any obligation evidenced or secured by any Loan Document; (ii) impair the right of Lender to name Borrower as a party defendant in any action or suit for foreclosure and sale under the Mortgage; (iii) affect the validity or enforceability of any of the Loan Documents or any guaranty made in connection with the Loan or any of the rights and remedies of Lender thereunder; (iv) impair the right of Lender to obtain the appointment of a receiver; (v) impair the enforcement of the Assignment of Leases and Rents; (vi) constitute a prohibition against Lender to commence any other appropriate action or proceeding in order for Lender to fully realize the security granted by the Mortgage or to exercise its remedies against the Property; or (vii) constitute a waiver of the right of Lender to enforce the liability and obligation of Borrower, by money judgment or otherwise, to the extent of any actual out of pocket loss, damage, cost, expense, liability, claim

r other obligation incurred by Lender (including attorneys’ fees and costs

reasonably incurred) arising out of or in connection with the following (all such liability and obligation of Borrower for any or all of the following being referred to herein as “Borrower’s Recourse Liabilities”):

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(a) fraud, willful misconduct or intentional misrepresentation by or on behalf of Borrower, Sole Member, Guarantor, or any Person owning an interest (directly or indirectly) in Borrower, Sole Member or Guarantor, or any of their respective agents or representatives in connection with the Loan, including by reason of any claim under the Racketeer Influenced and Corrupt Organizations Act (RICO); (b) the forfeiture by Borrower of the Property, or any portion thereof, because of the conduct or purported conduct of criminal activity by Borrower or Guarantor or any of their respective agents or representatives in connection therewith; (c) intentional physical waste of the Property or any portion thereof, resulting from the acts or omission of Borrower, provided, however, no liability shall arise under this subsection if sufficient revenues are not available to Borrower from the Property, which, after payment of other bona fide expenses including the items required to be paid pursuant to this Section 10.1, to prevent such waste, or after an Event of Default the removal or disposal of any portion of the Property outside the

rdinary course of operating the Property;

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(d) any Proceeds paid by reason of any Insured Casualty or any Award received in connection with a Condemnation or other sums or payments attributable to the Property not applied in accordance with the provisions of the Loan Documents (except to the extent that Borrower did not have the legal right, because

f a bankruptcy, receivership or similar judicial proceeding, to direct disbursement of

such sums or payments); (e) all Rents of the Property received or collected by or on behalf of the Borrower after an Event of Default and not applied to payment of Principal and interest due under the Note, andor to the payment of actual and reasonable

perating expenses of the Property, as they become due or payable (except to the

extent that such application of such funds is prevented by bankruptcy, receivership,

r similar judicial proceeding in which Borrower is legally prevented from directing

the disbursement of such sums);

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(f) misappropriation or conversion by or on behalf of Borrower (including failure to turn over to Lender on demand following an Event of Default) of any gross revenues (including Rents, security deposits, advance deposits, any other deposits, rents collected in advance, funds held by Borrower for the benefit of another party and Lease Termination Payments); (g) the failure to pay Taxes and Insurance Premiums to the extent that the revenue from the Property, after payment of other bona fide expenses including items required to be paid pursuant to this Section 10.1, is sufficient to pay such amounts, and provided Borrowerthat no liability shall not be liablearise under this subsection to the extent funds to pay such amounts are available in the Tax and Insurance Subaccount and Lender failed to pay same or provided the _ Tenant is obligated to pay same pursuant to the Lease; (h) the failure to pay Common Charges [not defined] to the extent that the revenue from the Property, after payment of other bona fide expenses including the items required to be paid pursuant to this Section 10.1, is sufficient to pay such amounts or the failure to comply with the requirements of Section 5.33(b), (d) and (e) hereof;

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(i) the breach of any representation, warranty, covenant or indemnification in any Loan Document concerning Environmental Laws or Hazardous Substances, including Section 4.21 hereof and Section 5.8 hereof, and clauses (viii) through (xi) of Section 5.30 hereof; or (j) Borrower’s setting forth a defense, seeking judicial intervention or injunctive or other equitable relief of any kind or asserting in a pleading filed in connection with a duly exercised and prosecuted judicial proceeding any defense against Lender or any right in connection with any security for the Loan which the court in such action or proceeding determines does not on its face state a defense (and therefore is dismissible with prejudice as a matter of law or subject to being stricken) or is frivolous or in bad faith following an Event of Default and the acceleration of the Debt; (k) the breach of Borrower’s obligations under Section 3.7(b) hereof with respect to any letter of credit issued in lieu of a Security Deposit; and/or (l) Borrower’s indemnification of Lender set forth in Section 9.2 hereof.

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Notwithstanding anything to the contrary in this Agreement or any of the Loan Documents, (A) Lender shall not be deemed to have waived any right which Lender may have under Section 506(a), 506(b), 1111(b) or any other provisions of the U.S. Bankruptcy Code to file a claim for the full amount of the Debt or to require that all collateral shall continue to secure all of the Debt in accordance with the Loan Documents, and (B) Lender’s agreement not to pursue personal liability of Borrower as set forth above SHALL BECOME NULL AND VOID and shall be of no further force and effect, and the Debt shall be fully recourse to Borrower in the event that

ne or more of the following occurs (each, a “Springing Recourse

Event”): (i) an Event of Default described in Section 8.1(f) hereof shall have occurred;

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(ii) a material breach of any of the representations set forth in the “Recycled SPE Certificate” delivered to Lender in connection with the Loan or a breach of the representation set forth in Section 4.1(b) hereof or a breach in the covenants set forth in Section 5.13 (exclusive of clause [(I)(x) and (I)(xviii) and (II)(vi)]24 and (II)(xiii)]21of the definition of “Special Purpose Bankruptcy Remote Entity” in Schedule 5 annexed hereto) and, as a result of such breach or breaches

f covenant, a court of competent jurisdiction determines in a final nonappealable
rder that such breach or breaches are the basis for the substantive consolidation
f the assets and liabilities of Borrower with those of any other Person pursuant to

the Bankruptcy Code and Lender has diligently and in good faith contested such determination and Lender suffers a material adverse effect as a result of such substantive consolidation; (iii) Borrower is substantively consolidated with any other Person; unless such consolidation was involuntary and not consented to by Borrower or, Guarantor, or Lender; and/or

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(iv) (A) Borrower, and/or Sole Member files a voluntary petition under the Bankruptcy Code or any other Insolvency Law; (B) the filing of an involuntary petition against Borrower, and/or Sole Member under the Bankruptcy Code or any

ther Insolvency Law by any Person in which Borrower, and/or Sole Member, any

Key Principal, any Guarantor or any Affiliate of the foregoing colludes with or

therwise materially and affirmatively assists such Person, and/or Borrower, Sole

Member, any Key Principal, any Guarantor and/or any Affiliate of the foregoing solicits or causes to be solicited petitioning creditors for any involuntary petition against Borrower, Sole Member by any Person; (C) Borrower, and/or Sole Member files an answer consenting to, or otherwise materially and affirmatively acquiescing in, or joining in, any involuntary petition filed against any of them by any other Person under the Bankruptcy Code or any other Insolvency Law; (D) other than at Lender’s request or initiation, Borrower, Sole Member, or any Affiliate consents to, or materially and affirmatively acquiesces in, or joins in, an application for the appointment of a custodian, receiver, trustee or examiner for Borrower or any portion

f the Property; (E) Borrower, Sole Member makes an assignment for the benefit of

creditors.

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TRENCH WARFARE

– The black is the Lender’s original draft. – The red are the Borrower’s initial proposed revisions. – The blue and the cross-outs are the Lender’s response to the Borrower’s proposed revisions.

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TRENCH WARFARE

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TRENCH WARFARE

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TRENCH WARFARE

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TRENCH WARFARE

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TRENCH WARFARE

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TRENCH WARFARE

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NONRECOURSE CARVEOUTS AND SPRINGING RECOURSE

In conclusion, it is well to remember that the liberalization of language that is

being achieved now will not change the thousands of loan documents out there with the old language in them and that the curative legislation passed in Michigan reversing the Cherryland decision controls nothing beyond Michigan’s borders. There are many state and federal courts in many jurisdictions before which these issues may surface, especially in the next three years when the Wall of Maturities discussed below inevitably results in many unrefinanceable loans and ensuing litigation.

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NONRECOURSE CARVEOUT AND SPRINGING RECOURSE CASES

Federal Deposit Insurance Corporation v. Prince George Corporation, 58 F.3d

1041 (4th Cir. 1995): Court held partner of Borrower who filed involuntary bankruptcy petition against Borrower was liable for deficiency judgment.

First Nationwide Bank v. Brookhaven Realty Associates et al., 223 A.D.2d 618

(N.Y. App. Div. 1996): Borrower’s bankruptcy case was ultimately dismissed but after the 90 day window provided for in the carveout provision. Borrower and partners held liable for deficiency judgment.

Heller Financial , Inc. v. Harry F. Lee and L. Joe VanWhy, 2002 WL 1888591

(N.D. Ill. Aug. 16, 2002): Individuals held liable for deficiency judgment for all remaining debt post-foreclosure due to violation of "no additional liens" covenant.

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NONRECOURSE CARVEOUT AND SPRINGING RECOURSE CASES

LaSalle Bank N.A. v. Mobile Hotel Properties, LLC, et al., 367 F.Supp.2d 1022

(E.D. La. 2004): Borrower amendment of articles of incorporation to eliminate single purpose entity status triggered full recourse provision.

Blue Hills Office Park LLC v. J.P. Morgan Chase Bank, 477 F.Supp.2d 366 (D.
Mass. 2007): Failure of developers to pay over $2 million in proceeds to which

Lender was entitled caused guarantys to "spring," resulting in judgment against them for $17 million.

Princeton Park Corporate Center, LLC v. SB Rental I, LLC, 980 A.2d 1 (N.J.
Super. Ct. App. Div. 2009): Violation of a covenant not to encumber resulted in

springing recourse and judgment for deficiency against Borrower and Guarantors.

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NONRECOURSE CARVEOUT AND SPRINGING RECOURSE CASES

111 Debt Acquisition LLC v. Six Ventures Ltd., 2009 WL 414181 (S.D. Ohio Feb.

18, 2009): Filing of voluntary bankruptcy by Borrower resulted in full recourse liability against Guarantors.

Monroe Center II Urban Renewal Co. LLC v. Strategic Performance

Fund-II, 2010 WL 5343317 (N.J. Super. Ct. App. Div. Dec. 29, 2010): Individual Guarantors held liable for full amount of debt due to Borrower’s bankruptcy filing.

Bank of America, NA, et al. v. Lightstone Holdings LLC and David Lichtenstein,

Index No. 601853/2009, Supreme Court, New York County, New York, July 14, 2011: In a case arising out of the Extended Stay bankruptcy, summary judgment entered in favor of Lender against Guarantor for $100 million (that is not a typo) due to voluntary bankruptcy of Borrower.

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NONRECOURSE CARVEOUT AND SPRINGING RECOURSE CASES

U.S. Bank v. Kobernick, 454 Fed. Appx. 307 (5th Cir. 2011): Affirming summary

judgment on behalf of Lender when Borrower attached the collateral to a voluntary bankruptcy triggering a full recourse liability provision.

51382 Gratiot Avenue Holdings, LLC v. Chesterfield Development Company,

LLC, 835 F.Supp.2d 384 (E.D. Mich. 2011): Summary judgment entered in favor

f Lender imposing full recourse liability clause when Borrower violated covenant

to remain solvent and pay liabilities as they become due merely by defaulting on the loan.

Gratiot was appealed to the 6th Circuit. Before any action by the Court, the case

was settled and, upon stipulation of the parties, the judgment was set aside.

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NONRECOURSE CARVEOUT AND SPRINGING RECOURSE CASES

Wells Fargo Bank, NA v. Cherryland Mall Limited Partnership, 812 N.W.2d 799, 295
Mich. App. 99 (Mich. Ct. App. 2011): Affirming entry of money judgment against

Borrower where mortgage provision stated that loan would be full recourse to Borrower if Borrower failed to maintain its status as single purpose entity by remaining solvent and Borrower, in fact, failed to remain solvent.

Cherryland was appealed to the Michigan Supreme Court, which remanded the case

back to the Court of Appeals for reconsideration in view of the passage of the Michigan Nonrecourse Mortgage Loan Act, which attempted to reverse the Cherryland and Gratiot decisions or any similar future decision. Wells Fargo Bank, N.A. v. Cherryland Mall Ltd. P’ship, 812 N.W.2d 779 (Mich. Ct. App. 2011); Cherryland, 820 N.W.2d 901 (Mich. 2012). The constitutionality of the Act had been questioned. On remand the Court of Appeals decided, among other things, that the Act did not violate the U.S. Constitution’s contracts clause or the due process protections of the Fifth and Fourteenth Amendments. Wells Fargo Bank, NA v. Cherryland Mall Ltd. P’ship (On Remand), 835 N.W.2d 593 (Mich. Ct. App. 2013). The decision was not appealed to the Michigan Supreme Court.

In February 2015 the U.S. Sixth Circuit Court of Appeals issued a similar decision

upholding the Michigan Act in Borman, LLC v. 18718 Borman, LLC, No. 14-1419, 2015 WL 424548 (6th Cir. Feb. 3, 2015).

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NONRECOURSE CARVEOUT AND SPRINGING RECOURSE CASES

Wells Fargo Bank, N.A. as successor by consolidation to Wells Fargo Bank MN,

N.A. as Trustee for the registered holders of Banc of America Commercial Mortgage Inc., Commercial Mortgage Pass-Through Certificates, Series 2003-2, by and through its Special Servicer, ORIX Capital v. Mitchell's Park, LLC et al., 2012 WL 4899888 (N.D. Ga.): The applicable document imposed personal liability if the Borrower failed to maintain the specified SPE requirements including the following: “be solvent and pay its liabilities from its assets ... as the same shall become due,” to be “a legal entity separate and distinct from any other entity ... uti-liz[ing] a separate telephone number and separate stationery, invoices, and checks,” to “establish and maintain an office through which its business shall be conducted separate and apart from those of any of its affiliates,” to “file its own tax returns,” and to “maintain adequate capital for the normal obligations reasonably foreseeable in a business of its size and character.” Defendant did not contradict Lender’s summary judgment allegations that each of these had been violated. Citing Gratiot and Cherryland among others, the Court ruled in favor of Lender, imposing personal liability for a deficiency in excess of $4

million. [Note “separate stationery” breach]

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NONRECOURSE CARVEOUT AND SPRINGING RECOURSE CASES

Appeal of Ga. case docketed No. 14-14130 (11th Cir. Sept 12, 2014). And these two unusual cases with pro-Borrower outcomes:

GECCMC 2005-C1 Plummer Street Office Limited Partnership v. NRFC NNN

Holdings, LLC, 204 Cal. App. 4th 998, 140 Cal. Rptr. 3d 251 (2012) (Lender was unable to show an actual breach).

ING Real Estate Finance (USA) LLC v. Park Avenue Hotel Acquisition LLC, 907

N.Y.S.2d 437 (N.Y. Sup. Ct. 2010) (Court held, resolving ambiguous language in favor of Guarantor as required by New York law, that Borrower cured the violation (failure to pay a tax when due) before springing recourse “sprung.”)

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The Wall of CMBS Maturities 2015-2017

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The Wall of CMBS Maturities 2015-2017

CMBS issuance volumes were higher than ever in 2005, 2006, and 2007 with a

peak volume of about $230 billion in 2007.

The great majority of this issuance was made up of ten year balloon loans,

creating a wall of maturities from 2015 to 2017.

Over the next three years, more than $300 billion in Conduit CMBS loan balance

will mature, which is more than 2.5 times the amount that matured from 2012 to 2014.1

1 The above statistics are from Trepp’s Research Report, “The Wall of Maturities:

Something’s Gotta Give,” November 13, 2014.

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The Wall of CMBS Maturities 2015-2017

When originally recognized several years ago, this situation was expected to

produce yet another financing crisis, or more accurately, it was assumed that a limping recovery from the 2008 debacle would be crushed by the wall (or “drowned,” because the metaphor back then was not a “wall” but a “tsunami”) of hopelessly undervalued loans.

Nobody then (and that was not so long ago) believed that either the CRE market
r the CMBS market would recover nearly as strongly as they have.
Assuming no new crisis erupts due to exogenous macro events, CMBS 3.0

should greatly help mitigate any crisis caused by the wall of maturities.

However, as the Trepp Report cited above shows, many of the legacy 2005-2007

collateral properties cannot meet certain important current underwriting standards, especially the current DSCR and LTV requirements.

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The Wall of CMBS Maturities 2015-2017

But this, again subject to exogenous macro events, does not create a general

crisis; it creates opportunities.

It especially creates opportunities for lawyers and their capital provider clients as

well as real estate entrepreneurs.

The next 3 years looks like one of the best of all worlds, where both the DOWN

escalator (defaults, workouts, and some loan enforcement litigation due to the maturities of loans that cannot be easily refinanced) and the UP escalator (numerous refinancing and restructuring transactions) ARE BOTH FULL!

There will be much room for interesting and creative deal-making for all kinds of

debt and equity providers, providing good work for the lawyers on both sides of the transactions.

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SUBORDINATE DEBT (A-B, Mezzanine, Preferred Equity)

“The report of my death was an exaggeration.” Mark Twain

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SUBORDINATE DEBT (A-B, Mezzanine, Preferred Equity)

For the basic features of A-B and Mezzanine loan structures see the Slides

presented by my co-presenter Allen Dickey.* I will not belabor those here but will focus on some special issues of each structure.

After suffering horribly and ending up pretty much written off for dead in the wake
f the Crash, subordinated debt in CMBS deals, as Allen Dickey points out in his

materials, has made a powerful comeback. It is likely to play an increasingly prominent role as we begin swimming in the waters of the CMBS Maturity Flood (you can only work so much with the “Wall” metaphor).

*For in-depth analysis of Mezzanine, see the Polsinelli Guide To Real Estate

Mezzanine Finance (Peppercorn Press, 2008) and Dan Flanigan and Michael Hickman, “Subordinate Finance in Real Estate Transactions,” Business Workouts Manual (Thomson Reuters, November 2013).

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The yield tends to move upward from A-B to Mezz to Preferred Equity.
A-B is a lien on the real estate.
Mezz is a lien on the ownership interests in the entity that owns the real estate.
Preferred Equity is an ownership interest in the entity that owns the real estate or

an upper tier parent of the ownership entity, sometimes also secured by a security interest in some or all of the other ownership interests.

It is perceived, and the perception is at least roughly accurate, that one gains

more control as one moves from A-B to Mezz to Preferred Equity.

COMPARATIVE ADVANTAGES AND DISADVANTAGES

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COMPARATIVE ADVANTAGES AND DISADVANTAGES

After being fairly popular in CMBS 1.0, A-B notes are not so popular these days

due, among other things, to a hunt for higher yield and a perception that the B Note holder has less control over its destiny than Mezz. Although some of this ground might be made up by negotiating new provisions more friendly to B Note holders in new deals (that is, if Rating Agencies be willing), it will be hard to

vercome the fact that, despite its security in the real estate, it is just a tail on the

A dog. The thought would be that it is better to be the Mezz Omega dog than no dog at all.

The senior-sub relationship in the A-B context is documented through a Co-

Lender Agreement, in the Mezz context by an Intercreditor Agreement, and in Preferred Equity by a Recognition Agreement.

Another disadvantage to the B Note holder vs. the Mezz holder is that the Co-

Lender agreement in the A-B context provides for the possibility that the small amount of control that the B may initially possess can be eliminated through “appraisal reductions” if the property deteriorates in value so that the B position’s value deteriorates below a certain percentage of its original principal amount (usually 25%).

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Another disadvantage to the structure, this time to the A Note, is that the

bankruptcy court will treat the A-B as one note for purpose of fixing the debt and valuing the collateral, thus increasing the likelihood that the A position, as well as the B, will be deemed to be undersecured in the bankruptcy case and thus not entitled to postpetition interest or attorneys’ fees.

Real estate foreclosure vs. UCC sale of ownership interests vs. contractual

removal or subordination of Manager by Preferred Equity.

COMPARATIVE ADVANTAGES AND DISADVANTAGES

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SENIOR-SUB ISSUES

Litigation against a common Guarantor.
Do Mezz Nonrecourse Carveouts interfere with Senior Lender remedies? E.g.

springing recourse under Mezz upon a voluntary transfer (deed in lieu) to senior lender, a bankruptcy, or a collusive receiver appointment, eliminating any incentive Borrower and Guarantor may have to an efficient and prompt resolution with the Senior Lender.

Qualified Transferee Issues:

– Changing fortunes. – What must transferee prove and to whom? – UCC Sale Commercial Reasonableness Issue. – What restrictions should there be on transfer of Senior?

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Do Mezz Lender approval rights conflict with Senior Lender interests?

– Property Modifications – Property/Ownership Transfers – Lease Modifications/New Leases – Property Manager – Annual Budget – Refinancing of Senior Loan

Stuy Town Resolution
New Guarantor Issues Upon Exercise of Mezz Remedies

– Old “CMSA” Form: Only if Guarantor removed – Automatic guaranty liability? – Must deliver Gty now? – Condition Precedent to Foreclosure?

Senior Loan Extension Options

SENIOR-SUB ISSUES

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MEZZ REMEDIES

Note: a UCC sale of mezzanine collateral is an acquisition of ownership interests
f an enterprise with no reps and warranties, no indemnifications, and no due

diligence.

UCC Commercial Reasonableness Issues
Mezz “Deed In Lieu”/Strict Foreclosure
Control Provisions
Receiver Appointment
Taking Advantage Of Certain Helpful UCC Provisions

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

(Thanks to my POLSINELLI colleague Brandon Bartee who did most of the research and analysis for this Section.)

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

Even TIC Borrowers, perhaps the most disfavored of all non-felonious Borrowers

in CMBS 2.0, are making a limited comeback in CMBS 3.0. And their better bred cousins, Delaware Statutory Trusts (“DSTs), are mingling with the other guests at the party.

Moreover, the huge number of problematic loans comprising the bricks of the

impending Maturity Wall discussed above will include a very large number of loans with TIC Borrowers made in 2005-2007 before TICS became pariahs. And DST’s are thought to be a possible rescue vehicle for troubled TICs. While the Parachute LLC discussed below is one rescue approach, the TIC investors lose their 1031 eligibility on a future sale while 1031 eligibility is maintained in a conversion to a DST.

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

The problems with TICs included--

– The unwieldiness of dealing with up to 35 individual Borrowers on one loan, each of whom might file a partition lawsuit or an individual bankruptcy proceeding imposing an automatic stay of Lender action and potentially exposing the Lender to a large number of separate bankruptcy reorganization plans restructuring various slivers of TIC debt in perhaps impossibly inconsistent and irrational ways. – The cost of post-default enforcement actions against a number of TIC Borrowers for one loan. – Complexity of servicing administration, e.g., processing transfers of TIC interests. – Cumbersome governance including severe limitations on the ability and willingness of TIC owners to contribute additional capital for necessary improvements or rescue.

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

DST’s do not eliminate all but do eliminate some of the major problems with

TICs— – Title to the property is held by a single entity, not up to 35 individuals. – The Lender makes one loan to one Borrower. – The DST is bankruptcy remote. The Lender need be no more concerned about the bankruptcies of individual beneficiaries than of LLC members or corporate shareholders.

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

DSTs Generally

– A DST is a trust created under Delaware law that is regarded as a legal entity separate from its owners or beneficiaries. DSTs may have an unlimited number of beneficiaries (as opposed to the 35 co-owner limit imposed by TIC regulations), though securities laws generally limit the number to 500. The trustee (or “signatory trustee” as it is commonly known) is responsible for the management of trust assets and distribution of profits to the beneficiaries.

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

Revenue Ruling 2004-86 and Section 1031 Eligibility

– In Rev. Rul. 2004-86, the IRS explained the circumstances under which a DST would be treated as a “fixed investment trust” (rather than a business entity) for tax purposes and whether the beneficial interests in such a trust were Section 1031 eligible. The IRS found it critical that the powers of the trustee were limited so that the trust acted as a mere conduit between profits generated by the property and the beneficiaries, rather than an entity that managed and operated the real property for business purposes. These limitations have long been regarded as the “seven deadly sins” and are the cornerstones of the DST/1031 exchange eligibility analysis:

After the initial offering has closed, there can be no future contributions to

the DST by current or additional beneficiaries.

The trustee cannot renegotiate the terms of the existing mortgage loan or

borrow any additional funds. *This also raises the issue of whether a DST is a non-business trust and thus not eligible to be a Debtor under the Bankruptcy Code

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

The trustee cannot sell the property and reinvest the proceeds into the

DST (DSTs cannot be “recycled” borrowing entities).

The trustee is limited to making minor repairs or structural improvements

to the property (unless required by law).

The trustee may establish reserves and hold cash between distribution

dates to the beneficiaries, but may only invest such funds in short-term debt obligations. All cash (excluding reserves) must be distributed to the beneficiaries on a current basis.

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

The trustee cannot enter into new leases (unless the tenant files

bankruptcy or becomes insolvent).

The trustee cannot renegotiate existing leases (unless the tenant files

bankruptcy or becomes insolvent).

So long as the trustee does not run afoul of the foregoing, ownership of beneficial

interests in the trust will be deemed to be direct ownership in the real estate

wned by the trust for income tax purposes, and thus, acceptable property for

Section 1031 exchange purposes.

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

DST Structures in Lending Transactions.

The following sections describe the key players in a typical DST structure and

ther unique characteristics of DST loan transactions.

– DST Borrower A bankruptcy remote, special purpose entity (SPE). The trust agreement should contain standard separateness covenants and restrictions against activities that could trigger one of the “seven deadly sins.” Lender’s consent required for any amendment to the trust agreement.

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

– Signatory Trustee The signatory trustee is often a single-member LLC owned by the sponsor/Guarantor. It is preferable that the signatory trustee be an SPE and limited to acting as the trustee of the DST Borrower. In certain instances (i.e., where the property is leased to a single credit tenant pursuant to a triple-net lease), the signatory trustee may act as the property manager, provided it has assigned all of its obligations to a third-party property manager pursuant to a sub-management arrangement. The signatory trustee is entitled to receive compensation for its role in administrating the trust. The signatory trustee should own at least a 0.5% of the beneficial interests in the DST after the

ffering has closed.

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

– Delaware Trustee DSTs are required to maintain at least one trustee located in the State of Delaware for service of process. The Delaware trustee need not have an active role in the management of trust assets. Most major corporate service companies offer Delaware trustee services. – Depositor In most instances, the property has been pre-acquired by an affiliate of the sponsor known as the depositor. Simultaneously with the closing of the mortgage loan transaction, the depositor will contribute money to the trust in exchange for 100% of the beneficial interests in the DST. The depositor recoups this contribution from the proceeds of the sale of the interests to the investors/beneficiaries of the trust pursuant to a private offering.

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

– Guarantor/Sponsor The Guarantor is an entity/individual selected by the Lender (usually owned and controlled by the sponsor) to serve as the non-recourse carveout Guarantor and to indemnify the Lender from losses resulting from environmental conditions related to the property. – Beneficiaries The beneficiaries of the trust are strictly passive investors. They have no ability to control the actions of the trustee or the property. Because of this limitation, they cannot commit “bad boy” acts and will not be required to execute a non-recourse carveout guaranty. In fact, a full payment guarantee by a beneficiary of the loan can be viewed as an obligation to make an additional capital contribution to the DST, and thus prohibited by Rev. Rul. 2004-86.

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

– “Parachute” LLC If the property were to be in jeopardy or if there was a default under the mortgage loan, the trustee is prevented from taking any action to remedy the situation pursuant to Rev. Rul. 2004-86. Under these circumstances, the trustee is authorized (pursuant to the terms of the trust agreement) to convert the DST to a limited liability company (a “Parachute LLC”). The trustee becomes the managing member of the Parachute LLC and the beneficiaries its members. The Parachute LLC must be an SPE whose operating agreement is pre-approved by the Lender and is typically attached as an exhibit to the trust agreement. The conversion provides the trustee/managing member with an opportunity to address any issues related to the property. The initial 1031 property exchange is not adversely affected by the conversion but the members lose the 1031 exchange status with respect to their membership interests. It is always possible for the Parachute LLC to later convert to a DST.

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

Use of a Master Lease

– One of the disadvantages of a DST structure is the limitation imposed on the trustee with respect to the management and operation of property. Unless the existing tenant has filed bankruptcy or is declared insolvent, the trustee cannot renegotiate existing leases or enter into new leases. If the property is leased by a single-credit tenant pursuant to a triple-net lease for a term extending beyond maturity of the mortgage loan, this risk is diminished. However, for loans secured by multi-family apartment complexes, office buildings, or retail shopping centers, the Lender must require the DST to master-lease the property to an SPE affiliate. The master tenant may then sublease the property to the ground tenants and function as a traditional

landlord. The master lease must be subordinate to the mortgage loan and

the master tenant assigns its interest in the leases and rents to the Lender.

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

Multi-Property DST Transactions

– Multi-property DST offerings are possible through the use of a master DST

structure. It is preferred that a separate DST hold title to each individual

property, but it is possible for multiple properties to be contributed to a single DST-Borrower. In either case, the depositor transfers up to 99.5% of its interest in the Borrower DST to an “offering DST” who then sells its own beneficial interests to investors pursuant to a private placement

memorandum. Through this structure it is possible for the investors to own

an indirect interest in multiple properties and, provided the requirements of

Rev. Rul. 2004-84 are satisfied by all DSTs in the structure, the interests in

the offering DST will be Section 1031-eligible. The transfer of the Borrower- DST’s interest to the offering DST should be a pre-approved transfer in the loan documents.

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

Benefits and Risks

– When compared to traditional TIC transactions, DST structures offer the following benefits:

The Lender need only underwrite the DST, signatory trustee, sponsor,

and any related parties (i.e., master tenant and Guarantor). Only beneficiaries owning in excess of 20% of the trust must be underwritten.

Title to the property is held by a single entity. The Lender makes one

loan to one Borrower, reducing complexity and transactional costs.

The beneficiaries have no role in governance of the DST and its property,

thus allowing for true centralized and presumably professional management of the DST’s affairs without interference pesky owners.

The DST is bankruptcy remote. The property is not subject to claims of

beneficiaries’ creditors. Unlike TICs, individual bankruptcy filings or partition actions by beneficiaries are not of concern to the Lender.

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DELAWARE STATUTORY TRUSTS (THE NEW TICs)

DSTs structures do introduce special risks into a loan transaction, many of

which can be mitigated by creative use of the Master Lease structure: – The trustee’s lack of control over the property or the underlying lease. – The inability of the trustee to restructure the DST’s debt or otherwise work with the Lender if a default should occur. This risk is mitigated by the Parachute LLC provisions; however, the Lender is still reliant on the trustee to complete the conversion. – The inability of the trustee to refinance the mortgage loan creates a refinance

risk. In most cases the trustee will seek to liquidate the property as an exit

strategy. – The beneficiaries may not make additional capital contributions to rescue the property.

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Drafting Considerations and Other Requirements

– DST structures necessitate revisions to the structural aspects of a CMBS loan as well as to standard CMBS loan documents. The following list is not intended to be exhaustive but indicates the kind of special consideration that DST loans require—

The DST, Master Tenant, and preferably the signatory trustee, must be

SPEs subject to standard separateness covenants.

Signatory trustee should maintain a minimum interest in the DST

(typically no less than 0.5%).

Beneficiaries may not be liable for the obligations of the DST and cannot

act as Guarantors of nonrecourse or springing recourse carveouts.

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The sponsor and its affiliates may only guarantee nonrecourse or

springing recourse carveouts but cannot provide an unconditional guarantee of the loan (something that is in any event not usually present in CMBS loans due to substantive consolidation risk concerns).

Permitted transfer provisions in the loan documents should be tailored to

permit (a) the transfer of interests in the trust to third party investors (up to 20% to any one individual without Lender consent) and between the depositor and an offering DST, and (b) the transfer of the property (or conversion of the Borrower-DST) to a Parachute LLC.

Non-recourse carveouts should be considered to mitigate various special

risks including for unauthorized amendments to the DST’s organizational documents, or failure to convert to a Parachute LLC when required.

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If the property tenant is not a single-credit tenant under a triple-net lease,

the DST must incorporate a master-lease structure as described above. While early DST deals were generally limited to single tenant properties, CMBS Lenders have since closed and securitized loans secured by multi- family apartment complexes, office buildings, and shopping centers using a master lease. The master lease term must extend beyond the loan term and be subordinate to the Lender’s interest in the property. Special nonrecourse carveouts and springing recourse need to be considered for such things as filing of bankruptcy by the Master Tenant or rejection of the Lease in the Master Tenants’ bankruptcy. The Lender must be aware of the complications introduced by the Master Lease structure, such as the fact that the Master Tenant is the owner and thus must be the assignee of the tenant leases (actually subtenant leases) that will furnish the underlying income supporting debt payments. The Master Tenant will also be the owner of, and thus must be the grantor of security interests in, any related personal property that is acquired during the Master Lease term.

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Reserves for taxes, insurance premiums, replacements and rollover costs

are especially important given the limitations on additional owner equity contributions.

The loan documents should be revised generally to ensure the

Borrower’s compliance with Rev. Rul. 2004-86. The signatory trustee and offering DST (if applicable) should be considered “Borrower parties” under the loan documents. It is recommended that the signatory trustee and offering DST execute a joinder agreement to the loan agreement acknowledging and agreeing to comply with its terms.

Failure to comply with the Parachute LLC provisions should be springing

recourse events.

Consider what special opinions of counsel should be required.