Don't Let Your Clients Sign That Loan Commitment!
By Sidney G. Saltz
Any number of issues may come into play in connection with the loan application or commitment, which, of course, is drafted on the lender's form. First and foremost is the issue of recourse; is the borrower to have personal liability for the loan and if so, to what extent? If the lender's recourse for the payment of the debt is limited to its security (i.e. the foreclosure of the mortgage and the exercise of its rights under the assignment of leases and rents or the security agreement), what exclusions (generally referred to as "carve-outs") are there to be from the non-recourse nature of the loan? What are the matters for which the borrower or guarantor is to have personal liability? Another issue is that of a lock-in, i.e., a period of time during which the loan may not be prepaid. The application or commitment may also provide for a substantial prepayment penalty, or a "due on sale or transfer" clause, which requires prepayment if the property is transferred (sometimes with the prepayment penalty being due at that time). The death of one of the principals of the borrower may trigger such an event. All these and possibly other important business terms must be dealt with at the commitment or application stage, or the borrower will be bound by terms it may not even have considered or evaluated. Once the application or commitment is signed, there is very little a lawyer can do to negotiate those provisions when the loan documents are being reviewed.
There is one particular issue which I always consider, even if the subject is not dealt with in the commitment or application. I want to assure that, if there is a fire or other casualty, the insurance proceeds will be made available by the lender to restore the property. Why is that important?
Most mortgages provide that if there is a fire or other casualty, the insurance proceeds are to be paid to the lender. The lender may either apply the proceeds to the loan or make them available to the borrower to restore the property. Assume that there is a fire and part of the building is damaged or destroyed. If in that situation, the proceeds are applied to the loan balance, the amount of the debt will be reduced but, as a rule, the debt service payments will not. For example, if the loan was $1 million and the monthly payments were $10,000, and the insurance proceeds were $600,000, the loan balance would be reduced to $400,000, but the monthly payments would remain at $10,000. Further, if the borrower does not get the proceeds, it will not be in a position to rebuild and may lose its tenants, who provide the wherewithal to pay the debt service. The borrower may not even have the right to prepay the balance of the loan and refinance, which will essentially ruin him or her. That is why having the lender be obligated to make the proceeds available (with appropriate protections for the lender) is so critical.
I had a situation once where the client owned an office complex of five buildings. He was financing one of them, and I tried to negotiate to have the commitment provide that the proceeds would be made available to rebuild. The lender refused. If that building had burned down, leaving the other four, and if it were not rebuilt because the insurance proceeds were not made available, the remaining buildings would not have been leaseable. Since the lender was adamant, the client had to find a different lender. If I had not negotiated that issue at the commitment stage, the client would either have been stuck with a bad loan, or would have had to breach the agreement contained in the commitment, with the loss of its commitment fee, and possibly a lawsuit.
The importance of legal input and negotiations at the commitment stage cannot be overestimated.
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Entity:
The ABA Real Property, Trust and Estate Law Section
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