Structuring Default Provisions g in Commercial Loans Maximizing - - PowerPoint PPT Presentation

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Structuring Default Provisions g in Commercial Loans

Maximizing Borrower Protection and Lender Remedies Through Effective Event of Default Clauses

T d ’ f l f

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific TUES DAY, JUNE 7, 2011

Today’s faculty features: Zachary G. Newman, Partner, Hahn & Hessen, New Y

• rk

Aric T . S tienessen, Attorney, Hinshaw & Culbertson, Minneapolis

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Structuring Default Provisions in Commercial Loans in Commercial Loans

5

ZACHAR Y G. NEWMAN LITIGATION & DIS PUTE RES OLUTION P ARTNER HAHN & HES S EN LLP , NEW YORK CITY , 212.478.7435 znewman@ hahnhessen.com ARIC T . S TIENES S EN CORPORATE LAWYER HINS HAW & CULBERTS ON, LLP , MINNEAPOLIS 612.334.2504 astienessen@ hinshawlaw.com

6

D f lt P i i A Th K t T P ti Default Provisions Are The Keystone To Prosecuting And Defending Lender-Borrower Claims

 One of the consequences of a depressed economic climate

is a rise in borrower-lender disputes.

 Disputes over the lending relationship, and, especially, the

existence of defaults become the centerpiece of litigation. Wh th t d f lt ill b h ld ill l l d d

 Whether or not a default will be upheld will largely depend

• n the very specific language of the credit facility

 Care must be given when drafting amending and enforcing  Care must be given when drafting, amending, and enforcing

these provisions as they are the key to a successful litigation.

7

NEGOTIATING DEF AULT PROVIS IONS

TERMINATION OF FUNDING PROVIS IONS

 TERMINATION OF FUNDING PROVIS

IONS

 ADDRES

S ING FORES EEABLE EVENTS AND CONDITIONS

 CROS

S

• DEF

AULT PROVIS IONS

 INS

OL VENCY-RELATED EVENTS AND MAC CLAUS ES S O C S C C US S

 CHANGE OF CONTROL PROVIS

IONS OTHER DEF AULT PROVIS IONS AND RELATED IS S UES

 OTHER DEF

AULT PROVIS IONS AND RELATED IS S UES

8

Termination of Funding Termination of Funding

 We have seen an influx of cases surrounding the issue of

whether the lender is obligated to continue funding proj ects, or whether the lender is permitted to t i t f di terminate funding.

 The right to terminate funding will depend on the terms

• f the credit facility, as well as whether the borrower is
• f the credit facility, as well as whether the borrower is

alleged to have defaulted under the terms thereof.

 Courts have seen a rise in these types of cases as

lenders have lost confidence in their borrowers, or because borrowers claim the lender had no right to terminate or reduce funding.

9

Destiny US A Holdings, LLC v. Citigroup Global Markets Realty Corp (N Y App Div 4th Dep’ t 2009) Realty Corp. (N.Y . App. Div., 4th Dep t 2009)



Citigroup agreed to lend Destiny US A Holdings, LLC (“ Destiny” ) $155 million in construction financing for the addition of a “ green” mall.



Citigroup also acted as agent for all of the proj ect’s lenders and was responsible for approving all advances from the various other sources of funding.



The loan documents contained a standard “ balancing” provision that required the borrower to deposit any deficiency with the lender if pending advances were insufficient to complete improvements or pay related costs.



Allegedly, Citigroup honored disbursement requests despite deficiencies on a number of occasions and deducted interest payments from these advances.



When construction was close to finished in June 2009, there existed a $15 ll d f d l d d h million deficiency in part due to tenant improvement costs included in the deficiency and Citigroup declared a default and refused to continue its scheduled disbursements. D ti d f ifi f i j ti j i i g Citig f



Destiny sued for specific performance or an inj unction enj oining Citigroup from refusing to continue disbursing funds.

10

The Destiny-Citigroup Court Battle



In July 2009, Destiny was granted a preliminary inj unction and Citigroup was required to continue funding the proj ect.



The trial court found that the not ices of deficiency and default were erroneous since tenant improvement costs should not have contributed to the deficiency under the balancing provision. The court concluded that Citigroup breached the loan agreement and its fiduciary duty as Destiny’s agent.



In November 2009, the appeals court upheld the order granting the preliminary inj unction, finding that Destiny was likely to succeed on the merits since the source of the deficiency should not have been included in the calculation of the deficiency under the clear terms of the agreement The court found the deficiency under the clear terms of the agreement. The court found irreparable inj ury if the inj unction was lifted since the proj ect was near completion, and, due to the economic climate, alternative financing was unavailable.



However, the appeals court vacated the trial court’s determination of the ultimate rights of the parties and held that these issues should be determined at a full hearing on the merits.



The final outcome is yet to be determined.

11

T k Takeaways

If li h l d

 If counseling the lender:

 Draft specific provisions that provide escape clauses,

default provisions, and funding limitations.

 Avoid provisions that obligate the lender, without the

lender explicitly agreeing to a firm lending commitment.

If li h b

 If counseling the borrower:

 Ensure provisions that will permit the borrower access to

the funds necessary to accomplish its business obj ectives

 Ensure that the reporting provisions and financial

covenants are achievable, and, most importantly, understood by the borrower.

12

ADDRES S ING FORES EEABLE ADDRES S ING FORES EEABLE EVENTS AND CONDITIONS :

When Default s Are Met Wit h The Defense of Commercial Impract icabilit y Defense of Commercial Impract icabilit y

13

Bank of America, N.A. v. S helbourne Development Group Inc (N D Ill March 3 2011) Group, Inc. (N.D. Ill. March 3, 2011)

 Bank of America (BOA) and S

helbourne entered into a loan agreement

• n December 11, 2006 in which BOA provided defendants with a $3

illi l i li f dit t i t i th d l t f Chi million revolving line of credit to assist in the development of a Chicago property.

 On June 5, 2008, the parties agreed to an amendment to accommodate

d f d ’ f i f i b i bi di defendant’s request for an extension of time to obtain a binding irrevocable construction loan commitment.

 This amendment

contained a non-monetary covenant that required S helbourne to provide additional collateral in the event they were unable to obtain the construction loan.

 Due to the credit crunch resulting from the financial crisis, S

helbourne was unable to obtain the construction loan and BOA informed them they were required to provide additional collateral.

 S

helbourne did not meet this demand and BOA declared the loans to be in default and accelerated the outstanding balance.

14

Who Wins The Court Battle?

 BOA commenced an action and defendants asserted the affirmative

defense of commercial impracticability concerning their non-monetary d f lt ll i th t th fi i l i i d bt i i h l default, alleging that the financial crisis made obtaining such loan commercially impracticable. This is becoming a popular defense.

 BOA moved to strike the affirmative defense.  In its August 18, 2010, the court held that the viability of this defense

cannot be determined on a motion to strike with respect to the non- monetary default, which turned on whether the financial downturn was foreseeable. This was especially so where BOA publicly acknowledged that the 2008 financial crisis was unprecedented and not reasonably foreseeable.

 However,

• n

BOA ’s motion to strike S helbourne’s commercial impracticability defense as it related to the monetary defaults, the Court held that this defense was unavailable since the doctrine can never j ustify failure to make a payment. j y p y

 “ Financial distress differs from impossibility.”

15

Takeaways Takeaways

 Many disputes addressing commercial impracticability or

frustration can be addressed back in the drafting phase by ensuring the terms addressing performance and defaults are clear and comprehensive.

 It is important to discuss with your client (especially on

the borrower side) to address downturns, seasonal h i h b i d h l f h changes in the business, and other external factors that could impact the management of the credit facility.

 The drafting responsibilities do not end at closing rather  The drafting responsibilities do not end at closing – rather,

they need to be addressed and reassessed at each amendment, extension and forbearance agreement t it

• pportunity.

16

Cross-Default Provisions Provisions

• Complicated financings typically involve cross-default

provisions. p g yp y p But, even the simplest financings can involve or should involve cross- default provisions.

• These provisions place the borrower in default

if the borrower p p defaults

• n

another

• bligation

contained in a corresponding agreement.

• These provisions can be quite important as they can result in a

p q p y widespread default, and result in a “ bet the company” type of litigation if a dispute arises.

17

C D f lt ( ti d) Cross-Default (continued)

D f lt P i i

 Default Provision:

 Any default in any debt to lender or other creditor  Carve-outs (ex. unsecured trade debt, default in loans of a

d f f d b f d certain size, uncured for a specified number of days)

 S

ignificance: Allow the lender to pursue its enforcement remedies as timely as other lenders enforcement remedies as timely as other lenders and minimize cherry-picking by borrower regarding which loan gets paid (minimizing exposure)

 Challenge is learning when other defaults have

• ccurred – rely on borrower’s obligation to disclose?

 Consider intercreditor issues.

18

Roswell Capital Partners LLC v. Alt ti C t ti T h l i (S D N Y 2009) Alternative Construction Technologies (S .D.N.Y . 2009)

 Roswell Capital Partners LLC (“ Roswell” ) provided funding to Alternative

Construction Technologies (“ ACT” ) a manufacturer of “ green” panels Construction Technologies (“ ACT” ), a manufacturer of “ green” panels used in construction, and entered into a security agreement in connection therewith (the “ 2007 Funding” ).

 Roswell then provided an additional round of funding in 2008

which was

 Roswell then provided an additional round of funding in 2008, which was

documented by the execution of a line of credit with Bridgepoint and CAMOFI (with Roswell acting as collateral agent) in 2008 (the “ 2008 Funding” ).

 The 2007 Funding and 2008 Funding were linked by a cross-default

provision that provided that a default by ACT on any indebtedness under the 2007 Funding also constituted a default under the 2008 Funding.

 ACT failed to repay its obligation under

the 2007 Funding. Roswell informed ACT that they would not provide additional funding under the 2008 agreement until ACT caught up with its obligations under the 2007 Funding, and applied funding from the 2008 Funding to pay down

• bligations under the 2007 Funding.

19

The Dispute The Dispute

 ACT focused significant resources on trying to establish that the default

called under the 2008 Funding was not supportable called under the 2008 Funding was not supportable

 But, the court held that ACT’s failure to meet its obligations under the

2007 Funding caused a cross default under the terms of the notes that i t d th 2008 F di impacted the 2008 Funding.

 ACT’s efforts to defend against the cross-default by attacking their default

under the 2008 Funding were futile since even a successful defense with respect to the 2008 Funding would not preclude the cross-default.

 The Court found that Plaintiffs simply exercised “ their contractual rights

achieved through a bargain conducted at arms’ length ” ACT’s affirmative achieved through a bargain conducted at arms length. ACT s affirmative defenses of frustration of performance and unclean hands failed because they did not show that plaintiffs took “ unconscionable” action

• r

prevented ACT from executing their obligations; they simply exercised h l h their contractual rights.

20

Change of Control Provisions Change of Control Provisions

 Default Provision:  Change in %

• wnership of all equity

Change in %

• wnership of all equity

 Change in %

• wnership of voting equity

 Equity becomes encumbered by a security interest  Change in maj ority of directors

Change in maj ority of directors

 S

ignificance: lender underwrote loan based upon the

• wnership, leadership, or both from a competency or

philosophy perspective or from a creditworthiness perspective philosophy perspective or from a creditworthiness perspective (guarantors)

 Carve-outs:  Approved estate or succession plan for closely held  Approved estate or succession plan for closely-held

companies

 Restructurings  Public offerings

Public offerings

21

Change of Control Provisions Change of Control Provisions (continued)

 Loan agreements typically require change of control

provisions.

 These provisions are designed to provide a level of

comfort and consistency that the borrower’s ownership ll b d structure will be maintained.

 The provisions can, however, become the focal point of

litig ti h ld th b d t t f litigation should the borrower proceed to transfer

• wnership without the lender’s consent OR if the lender

will not reasonably consent

22

In re Y

• ung Broadcasting Inc.

In re Y

• ung Broadcasting Inc.

(S .D.N.Y . April 19, 2010)

Y B d ti I (YBI) th b d 2005 C dit

 Y

• ung Broadcasting Inc (YBI) was the borrower under a 2005 Credit

Agreement secured by several lenders’ (the “ Lenders” ) first priority security interest in substantially all of its assets.

 YBI filed for chapter 11 bankruptcy protection and the board of

directors sought confirmation

• f

the Unsecured Creditor’s Committee’s proposed plan (the “ Committee Plan” ).

 The Committee Plan was premised upon the reinstatement of the

debt under the Credit Agreement, but the Lenders argued that the Committee Plan could not be confirmed because its proposed allocation of voting rights would trigger an immediate change of control default under the Credit Agreement.

23

The Dispute

U d th C dit A t' h f t l i i th C dit

 Under the Credit Agreement's change of control provision, the Credit

Agreement required that Mr. Y

• ung, his immediate family members

and certain other controlled individuals (the “ Y

• ung Group” ) were

required to have more than 40%

• f the Voting S

tock by number of q g y votes.

 Further, it required that if any person or group owned more than 30%

• f the total outstanding Voting S

tock then the Y

• ung Group must
• f the total outstanding Voting S

tock, then the Y

• ung Group must
• wn more than 30%

, or, alternatively, the Y

• ung group must have the

right or ability to elect or designate for election a maj ority of the board of directors.

24

How the Default was Triggered



The Committee plan manipulated the votes allocated to voting stock and



The Committee plan manipulated the votes allocated to voting stock and created two classes of directors in an attempt to circumvent the Credit Agreement’s change of control provisions.



The plan provided for only one Class B director for which the Y

• ung



The plan provided for only one Class B director, for which the Y

• ung

Group was allocated all of the voting stock, and six Class A directors, the election of which the Y

• ung Group was allocated only a nominal amount
• f votes.



Due to the inflated number of votes given to the Y

• ung Group for the

election of the one Class B director, Y

• ung was allocated more than 40%
• f the “ votes” for all directors and the Unsecured Creditor’s Committee

argued that the plan did not run afoul of the Credit Agreement ’s change argued that the plan did not run afoul of the Credit Agreement s change

• f control provision.



Although allocated greater than 40%

• f the total votes, the Y
• ung Group,

however, could control the election of only one of seven directors. , y

25

The Resolution

 The lenders argued that these provisions would result in a  The lenders argued that these provisions would result in a

change of control that constitutes a default under the terms

• f the Credit Agreement, which precluded reinstatement of

the loans.

 The court held that voting power must involve the power to

influence the composition of the board of directors, and the provision requiring the Y

• ung Group to own 40%of the voting

stock meant that this group must have the power to influence stock meant that this group must have the power to influence 40%of the composition of the entire board.

 The Court

looked to the intent

• f the change of control

provision ensuring that no one person or group would have provision – ensuring that no one person or group would have more control than the Y

• ung Group – and held that

the Committee Plan undermined the intent of these provisions.

26

Drafting for Insolvency-Related Events

 Default Provision:  Voluntary (no cure period) or involuntary (cure period)

party to a case:

 under bankruptcy laws, or

ki i f i di

 seeking appointment of a receiver or custodian  Be unable to pay its debts when due  Applied to: borrower, its subsidiaries, guarantors,

guarantors’ subsidiaries (market trend away from guarantors subsidiaries (market trend away from unrestricted subsidiaries)

 S

ignificance: i il t d f lt i i i

 similar to cross-default, minimize exposure  Borrower is about to become subj ect to someone else’s

control with the authority to restructure debt

 Ipso Facto Clause – bankruptcy law may make

such provisions unenforceable

27

Material Adverse Change Clauses (a/ k/ a Material Adverse Effect)

D f l P i i

 Default Provision:  Material change in assets, liabilities, revenue,

expenses, business, operations, condition, expenses, business, operations, condition, prospects, etc.

 Qualitative vs. Quantitative test  S

ignificance: lender’s risk has materially changed from when the loan was underwritten but no particular default covenant (other than the MAC/ MAE) is triggered

 Can be difficult to prove

28

Ch i B i Change in Business

D f lt P i i Ch i th t f

 Default Provision: Change in the nature of

the borrower’s business f h b

 S

ignificance: change in business since underwritten resulting in a change in the risk risk

 Integration risk  Competency risk (borrower and lender)

p y ( )

 Carve-outs: natural extension of borrower’s

existing line of business existing line of business

29

Enforcement of Material Adverse Change Provisions

 Many agreements contain MAC clauses the material adverse  Many agreements contain MAC clauses, the material adverse

change clause.

 This clause takes many shapes and forms.

y p

 They are sometimes (or perhaps deliberately) written too

simply.

 Just what is a material adverse change:

 A 25%

decline in business?

 A 50%

decline in business?

 A 75%

decline in business?

 S

hould the clause be defined and the conditions set forth in the agreement? the agreement?

30

Examples of MAC Examples of MAC Clauses & Their Impact

 The commitment letter included a "material adverse changes"

clause:

It i diti f thi [L tt ] th t i t th d f

 It is a condition of this [Letter] that prior to the advance of any or

all moneys hereunder, there be no material adverse change in the conditions, financial

• r
• therwise,
• f

the Borrower

• r

the Guarantors from the conditions as set forth in support for this loan. pp

 There is no language in this clause that indicates that the

clause obligated S terling to refrain from advancing money upon i l d h I d h l a material adverse change. Instead, the clause empowers S terling to deny an advance after a material adverse change. Hunter v S terling Bank 750 F S upp 2d 530 534 (E D Pa 2010) Hunter v. S terling Bank, 750 F . S

• upp. 2d 530, 534 (E.D. Pa. 2010)

31

Capitol Justice LLC v. Wachovia Bank, N.A. Capitol Justice LLC v. Wachovia Bank, N.A. (D. D.C. December 8, 2009)

T bt i fi i t h ffi b ildi th A i

 To obtain financing to purchase an office building, the American

Association for Justice (AAJ) solicited financing from Wachovia, which offered AAJ a ten-year, interest only loan for $89.5 million.

 Wachovia intended to sell

into a commercial mortgage backed security (CMBS ).

 Under the Term S

heet for the loan AAJ could not seek financing

 Under the Term S

heet for the loan, AAJ could not seek financing from another lender, and the MAC clause provided that Wachovia could terminate the loan if there was a "material adverse change

in the capital, banking and financial market conditions that could

impair the sale of the loan by Lender as contemplated in the term sheet.“

32

What Went Wrong?

I M 2007 th ti i d th L C it t

 In

May, 2007, the parties signed the Loan Commitment Agreement (LCA) that contained the MAC provision, despite AAJ's fears that such cause would permit Wachovia to arbitrarily renege on its obligations arbitrarily renege on its obligations.

 Meanwhile, trade publications and investor reports expressed

concerns over the CMBS market, and following the execution , g

• f the LCA, CMBS continued to decline.

Wachovia contacted AAJ to discuss restructuring the LCA on August 6, 2007, but AAJ refused to reprice the loan.

 On October 22, 2007, Wachovia invoked the MAC clause to

terminate the LCA citing “ a material and adverse change in the fixed income sector of the capital markets ” the fixed income sector of the capital markets.

33

The Lawsuit

AAJ b ht ti ll i b h f th LCA d

 AAJ

brought an action alleging breach

• f

the LCA and Wachovia responded with a motion for summary j udgment.

 The court held that the fact-finder could determine that the

MAC clause applies only to unforeseeable events, and denied Wachovia summary j udgment.

 The court found there is a genuine issue of material fact as to

whether events after the execution

• f

the LCA were f bl unforeseeable.

 Resolution of this matter is still pending.

34

Oth D f lt P i i Other Default Provisions

L d I l D f lt P i i (C t M k t)

 Lender Insolvency Default Provisions (Current Market)  Lender fails to fund or becomes insolvent  S

imilar to borrower provisions, fails to fund other loans or affiliates become insolvent

 Provisions  “ Y

ank-A-Bank” – force a lender to sell its interest Y ank A Bank force a lender to sell its interest (challenge is finding a buyer)

 Pay-off the defaulting bank (without prepayment fee)  Loss of voting rights (ex amendments)  Loss of voting rights (ex. amendments)  Liquidated damages

35

Oth D f lt P i i Other Default Provisions

P D f l ( i d i b f

 Payment Defaults (any grace period – time before

it becomes a default, or cure period – time to cure a default before enforcement )

 Financial Covenants (interval vs. continuing)  Affirmative Covenants (e.g., maintain bankruptcy

remoteness)

 Negative Covenants (e.g., transfer assets)  Representations and Warranties

36

Oth D f lt P i i Other Default Provisions

 General Trends Applicable to Defaults (Current  General Trends Applicable to Defaults (Current

Market)

 Fewer carve-outs (ex. negative covenant on

incurring debt and no carve out for refinancing incurring debt and no carve-out for refinancing, intercompany, acquisition)

 No unrestricted subsidiaries  Equity Cures (cash contribution to cure financial

covenant breaches; ex. applied to EBITDA or prepay debt) – reducing the number of permissible cures

 Junior liens more permissible  Express provision for credit bidding at collateral

sale sale

37

Oth C id ti Other Considerations

 General Negotiating Points

g g

 Grace Periods (before default or before

remedies)

 Notice  Opportunities to Cure (time, bonds, cash

contributions pursue defense or cure) contributions, pursue defense or cure)

 Carve-outs (exceptions, such as permitted debt,

affiliated/ consolidated group transactions,

• rdinary course of business)

 Be mindful of interrelationships (overlaps and

gaps) among default provisions gaps) among default provisions

38

Don’ t Forget The Importance of Drafting Clear and Comprehensive Post Default Remedies: Comprehensive Post- Default Remedies:

F AMM S t eel Inc. v. S

• vereign Bank (1st Cir. 2009)

 F

AMM, a steel fabricating company, entered into a credit facility with Fleet National Bank, predecessor in interest to S

• vereign,

which loaned F AMM $6.1 million between 1998 and 2002.

 After F

AMM began experiencing financial difficulties in late 2001, S

• vereign had F

AMM hire an outside consultant and comptroller of their choosing

• ver

F AMM’s

• bj ections.

The consultant and comptroller failed to reconcile F AMM’s general ledger accounts and monthly bank statements, grossly overstated j ob revenues for work in progress, and presented F AMM with inaccurate financial data that showed the company was turning a profit when it was actually losing p y g p y g money.

 S

• vereign ultimately terminated F

AMM’s line of credit, selling its loans to a third party After the sale F AMM’s facility was shut down loans to a third party. After the sale, F AMM s facility was shut down and its assets liquidated.

39

The Lawsuit



FMM brought suit in December 2006, alleging that S

• vereign breached the implied

covenant of good faith and fair dealing. F AMM also alleged that Sovereign breached its fiduciary duties to F AMM, caused F AMM t o make business decisions under duress, and caused F AMM to become the bank’s instrumentality. and caused F AMM to become the bank s instrumentality.



The district court in June 2008 granted summary j udgment to S

• vereign on each of

F AMM’s claims. The First Circuit affirmed in June 2009. F AMM had not produced sufficient evidence that S

• vereign had promised to take certain actions such as issue

sufficient evidence that S

• vereign had promised to take certain actions such as issue

a forbearance agreement or extend the credit line. Even though S

• vereign had

required F AMM to hire the consultants, there was no evidence that such consultants were acting under S

• vereign’s direction.



S

• vereign was not able to control F

AMM’s day-to-day affairs, a requirement for a finding that a fiduciary relationship existed. F AMM could not allege duress as a tort

• n which F

AMM could recover damages since it is an affirmative defense rather than a cause of action S

• vereign did not tortiously interfere with F

AMM’s business a cause of action. S

• vereign did not tortiously interfere with F

AMM s business relations by preventing F AMM from obtaining refinancing or preventing F AMM from pursuing third party contracts by refusing to grant forbearance or extension after F AMM paid down part of its debt.



S

• vereign was merely exercising its contract rights and attempting to protect its

financial position.

40

Takeaways

L d itt d t “ d i h d b i ” d b

 Lenders are permitted to “ drive a hard bargain” and borrowers can

simply walk away. This simple concept is not lost before the courts regardless of how complicated or large the facility may be.

 Default provisions need to be carefully drafted, ensuring to account for

all foreseeable events and conditions.

 Default provisions need not be lumped into one category, and different

defaults can result in different consequences. Ensuring consistency though is paramount.

 Each extension, modification, and forbearance provides both

sides to re-evaluate the provisions.

41