- Diana Liu by fsb96139


									              A Practical Guide for Owner’s Counsel whose Client is Faced with Default
                        or an Impending Default Under a Construction Loan

                                                By Diana C. Liu
                                   Wolf, Block, Schorr and Solis-Cohen LLP
                                          Philadelphia, Pennsylvania

                             For ABA Real Property, Probate and Trust Law Section
                                  “Construction Projects in Default” Program
                                    April 3-4, 2003, New York, New York

        “The online news service just reported that the parent company of my lead anchor tenant is
closing 100 stores across the country including the state where my shopping center is located and is
planning to lay off 1,500 workers. The CFO of the parent company left me a voicemail message late
Friday night saying he wished to speak with me about the anchor tenant’s lease. My lead anchor
tenant’s lease is a ground lease and it is in the process of building its own store. He had better not be
telling me that the company has decided not to roll out this store or that he wants to re-negotiate his

        The development of the shopping center is being funded by a $90 million construction loan.
When we broke ground, the newspapers reported that this center was the necessary impetus to turn
Placid Valley into a vibrant and thriving community. The design of the shopping center, which is
“environmentally correct,” has garnered praise and awards from community groups. Right now the
shopping center is 75% complete and I am ready to turn over stores to certain tenants. Some stores
and a few outparcels remain to be leased, but I am confident that my aggressive leasing team will
find the tenants. There are some cost overruns in my construction loan and my lender has been
making noises about the loan being “seriously” out of balance and certain loan covenants being
violated. It already sent me a “soft” default letter and is hinting at sending out a formal default letter,
but I believe that what we have here can be easily fixed with a reallocation of funds in the loan
budget. I need to call my attorney to set up a meeting with the lender.

        My lender has to understand that he and I have similar interests - if I make money, he gets
paid. So far we have been able to reallocate funds from various line items in the budget to pay the
cost overruns and my general contractor is also working with me. I need for my lender to continue
working with me. The building at one of the two entrances to the Shopping Center is to be occupied
by a supermarket and I am in the middle of negotiations with a supermarket operator. The
supermarket is a co-tenant for several of my other major tenants, including the lead anchor tenant. I
need for my lender to be flexible if the supermarket operator wants a few dollars more on the tenant
improvement allowance; this operator is going to take 50,000 square feet which is more than the
27,000 square feet that I had originally set aside for a high end grocer in that building.”

         The above scenario is familiar to attorneys who represented lenders and owners in the real
estate recession of the late eighties and early nineties, and the current economic downturn has many
owners and lenders thinking about whether they may be headed once again to the workout table,
foreclosure sale or bankruptcy court. This Article attempts to provide owner’s counsel with a
practical guide to counseling its client in the initial stages when faced with a situation similar to the

one described above, whether it involve a shopping center, an office building, a residential
condominium or an industrial complex.

Step One: The Initial Gathering.

         1.     Gather Your Documents - Owners and Counsel. Too often in the rush of closing and
the desire to put the shovel in the ground promptly after closing, the owner may not be so careful in
making sure that it has complete copies of the loan documents executed at closing. Owners are
typically known to leave the closing table with a copy of the Note, the Closing Statement and
sometimes the Construction Loan Agreement. Additionally, owner’s counsel may have placed the
completion of the owner’s closing binder on the back burner. “The Initial Gathering” means for
counsel to make sure that both the owner and its counsel have complete copies of all of the loan
documents including, but not limited to, any side letters and escrow agreements entered into at the
closing table and any amendments to the loan documents executed after closing. Counsel should also
review the loan file to determine whether the lender is holding certain security such as letters of
credit, escrowed funds and share certificates that may be seized by the lender following a default.

                Aside from the loan documents, do owner and counsel have complete copies of all
other project documents? The list below serves as a guide with respect to collateral or project
documents that counsel should confirm it and/or its client has in its files:

              (a)      With respect to leased projects, the files need to contain the leases and any
amendments and side letters. In this age of email transmissions, has the client kept email
correspondence from the lead anchor tenant who is in trouble? Is there a reciprocal easement
agreement/declaration of protective covenants that governs the shopping center or office

                (b)     With respect to for-sale projects, are the agreements of sale and list of
deposits readily available? If there is a condominium, does the owner have copies of all
condominium formation documents?

                (c)   For all projects, did the owner enter into development agreements or
easement agreements with the local municipality? If so, counsel should confirm that it has complete
copies of those documents.

         2.      Full Disclosure. It may seem unnecessary, but counsel needs to remind its client of
the importance of full, complete and timely disclosure to counsel of all communications between the
client and the lender and the client and the troubled anchor tenant. This includes requesting that the
client provide you with all documentation that you request (such as whether anyone is threatening to
lien the project, is there any possibility that real estate taxes will not be paid if not then being
escrowed with the lender, and are there informal modifications to the loan documents with the lender
or informal lease modifications with any of the major tenants) or drafts of term sheets for a workout
and/or drafts of a pre-workout agreement between lender and borrower submitted by the lender to the
borrower. This disclosure would further include conversations with a loan officer over a casual
lunch as to the status of the loan. Did the loan officer mention that the head of the workout group
said that this loan must be modified before year end or else the situation would turn very ugly for the
borrower? Counsel, not the client, should determine the relevance of the correspondence and other

DSC:910645.1/999999-999999                        -2-
         3.      Know Your Lender(s). Presumably the lender, even an out-of-state lender, has heard
of the financial woes of the lead anchor tenant. The owner and its counsel ought to consider the
following questions in formulating strategy to deal with the lender:

                (a)     Does the owner have a “friendly” loan officer and is that loan officer still
employed with the lender? Is this person someone that owner believes would try to persuade the
institution to work with the owner? Is this person smart and practical or is this loan officer afraid to
make any decision? Does this person have any power? Or, given that the loan is not in balance and
may need restructuring, is this lender the type that would use the information on the lead anchor
tenant to recommend that this loan be transferred to the loan workout group?

               (b)    Is the owner’s project a high profile project for this lender such that the lender
would not want any egg on its face that may result from a nasty, protracted court battle with the
borrower and would, in the face of community and other pressure, prefer to do what it takes to make
the project work?

                 (c)     Is there more than one lender involved in this loan? The playing field
changes drastically if there is more than one lender involved in the project (whether in the form of
participants or involving a second tier mezzanine lender). This can work to the detriment or to the
benefit of the borrower. On the downside, the borrower is faced with having to court many parties if
it desires a loan workout in addition to the inevitable delay in obtaining lender approvals and
consensus for the workout. On a practical level, each stage of delay in securing such approvals and
consensus may inadvertently assist in “tanking” a project. From the borrower’s viewpoint, the
upside of having multiple lenders involved is that the battle of the lenders with disparate agendas and
similar egos may unintentionally allow the borrower more time to plan its next moves in terms of
staying in or exiting the project and to play one group of lenders against the other to better the
borrower’s position.

        While it is prudent for an owner with a troubled project to be discrete with divulging any
information to its tenants, counsel should encourage their owner clients to maintain active and lively
dialogue with the representatives of the lender. Through this dialogue, owners can get a feeling from
the lender as to which way the lender is leaning, who will be making the decision with respect to the
loan and how difficult it may be and/or how long it may take if the parties decide to embark on a loan

        4.      How Friendly is your Contractor? Counsel and owner need to have a solid
understanding of whether the general contractor intends to weather the storm with the owner or
whether the contractor is preparing to stop work and file liens against the project. Exactly how bad
are the cost overruns and has the completion schedule been impacted?

        5.      Plan for the Worst. Owners would be well-advised to check their financial situation
to determine whether they have sufficient funds to create a war chest in the event after consultation
with counsel, they believe bankruptcy to be the best and most practical solution.

Step Two: Counsel’s Next Steps.

        6.      Know Your Client. Counsel should always be mindful of whom it represents. This is
axiomatic but not always heeded. While the owner is in all likelihood a single asset entity oftentimes
controlled or owned by a single entity or individual, the owner may be a joint venture of two serious

DSC:910645.1/999999-999999                        -3-
players including possibly an institutional investor or perhaps a group of sophisticated individual
investors. It is important to know with whom counsel is dealing at the owner level in deciding how
to react to the default situation, in finding out whether one’s client is willing to walk away from the
project and in strategizing with one’s client its next steps. If an institutional partner, member or
venturer is involved, the necessity for obtaining certain internal approvals at the institution may
affect counsel’s advice on whether to affect a more aggressive or more amenable posture in loan
workout negotiations, whether to agree to “friendly” foreclosure or offer a deed in lieu of foreclosure,
or whether to file for bankruptcy or assert lender liability claims. Internal approvals would also be
necessary if there is more than one individual partner or member in the owner entity. Counsel for the
owner entity should be aware if the other partners or members have in-house counsel or outside
counsel of their own. If such other counsel exists, counsel for the owner entity needs to bring such
other counsel into the loop as soon as possible and discuss with them the process and timing for
securing necessary internal approvals to proceed.

                  (a)      The Heart-to-Heart Talk. Sometimes owners direct the next steps of their
counsel with a clear, inflexibly fixed and determined mind; other times, even the owners with the
“devil may care” attitude and fiery temper to match, will after discussion with counsel concede that
they are prepared to give the lender a deed in lieu of foreclosure or offer the lender additional
collateral as an incentive to restructure the loan. It is incumbent upon counsel to know thoroughly its
client, its project, its documents and the law so as to be able to effectively assist the client in making
the best decision for the client.

                 (b)     Looking out for Your Client. Prudent workout counsel for the owner would
advise its client to examine its tax situation and consult with its accountants and tax counsel about the
consequences of certain loan workout arrangements. A deed in lieu of foreclosure may trigger
adverse tax consequences to the borrower that should not come as a surprise. Are there certain
states’ laws that could potentially shield a portion of your client’s assets if your client happens to be
an individual guarantor?

        7.      Know Your Project. In determining how to respond to the lender’s default letter
(including taking the proactive approach of requesting a restructuring of the loan), owners and their
counsel need to consider the nature of the project and all the relationships that the owner entered into
as a prerequisite to the development of the project.

                  (a)    Nature of the Project. Is this a phased project or a mixed-use project? What
is the status of construction? If there is a loan workout and the lender refuses to fund an additional
phase, how does that impact the overall development of the project? Or, if it is a mixed-use project,
is the success of one portion/use dependent on the existence of another portion/use? Will a restricted
development entitle certain tenants to cancel their leases? If the project is a residential or office
condominium, can the owner (if still the declarant) be in default under the terms of the condominium
documents if it does not complete portions of the project? Owners should be alert to whether a
prospective purchaser can terminate its agreement of sale if certain portions of, or amenities within,
the project are not completed or, in the case of a residential condominium, if certain home models
(including type and number) are not built. Once again, if the owner contemplates being able to have
the loan restructured and the condominium documents allow it flexibility with respect to alterations
in project design, it may be prudent for the owner to devise an alternate scheme for the portion of the
project that exists and that may be the subject of restricted development so as to retain some control
over both its project and what the owner believes will maximize its return once the altered project is

DSC:910645.1/999999-999999                         -4-
                 (b)     Are any Tenants Active Players ? If there is a reciprocal easement agreement,
is the troubled lead anchor tenant responsible for maintenance of the Common Areas surrounding its
own premises? If that is the case and the lead anchor tenant is gone (without a leasehold mortgagee
to step in), owner will have to assume that maintenance and try to pass on the costs for such
maintenance to the other tenants at the project. Do any of the other leases restrict the owner’s ability
to recalculate a tenant’s proportionate share of maintenance and operating expenses?

                 (c)      Are Government Benefits Involved? Are there municipal and/or tax
incentives associated with this project? Sometimes a project is located in a special empowerment
zone where the owner will be receiving real estate, municipal and other tax abatements or deferrals if
its project creates a certain number of new jobs in the empowerment zone. Owner and its counsel
should look into whether the tax incentives and other similar benefits could be adversely impacted if
the lead anchor tenant is gone and/or if the loan goes into default.

                (d)     Are there Obligations to the Government? Is the project the subject of
municipal agreements pertaining to capital improvements and escrow agreements for which the
owner is responsible? Are there any municipal improvements that are tied to the development of
other phases of the shopping center so that the owner can find a way to avoid having to construct
them if the lender refuses to fund the other phases of the Shopping Center? Are there project reserve
accounts? What is the status of any escrows held by the lender or municipality?

         8.      Know your Documents. Once counsel has determined that it has a full set of
documents pertaining to the project as discussed above in this Article, it needs to become fully versed
in the terms of those documents including any cross-default provisions in order to be able to
anticipate steps to be taken by the lender and/or major tenants and, accordingly, plan the owner’s
next moves.

                (a)      The Default Notice and Response to a Default Notice. Even a “soft” default
letter (for example, a letter stating that the loan is out of balance or that a material adverse change has
occurred in the financial condition of the borrower or a “Major Tenant” but lender is not at this time
calling a default under the loan and such letter does not constitute a waiver of lender’s right to call
such a default in the future) from the lender must be addressed promptly to keep the lines of
communication open between lender and borrower and to create a paper trail. This paper trail can be
used by the borrower to imply on the one hand, that the lender and borrower have been working
together over the course of time so that a subsequent “hard” default letter or aggressive stance by the
lender would appear as a “total shock” to the borrower, and on the other hand, the borrower may be
collecting evidence to later support a claim of lender liability. If a notice of default has been given,
counsel should determine whether it has been delivered properly in accordance with the requirements
of the loan documents, including any requirement that copies of such notice be sent to persons such
as the borrower’s counsel and the guarantors.

                (b)      Is there a Guaranty? Is this loan secured by a fully recourse payment
guaranty and a performance and completion guaranty? Is the loan non-recourse except for the
customary “bad boy/bad girl” carveouts, or is there only a partial or limited guaranty? Is the
guarantor a well-heeled institution/parent company or are there multiple individuals, chiefly made up
of the principals of the borrowing entity?

                 (c)      Know the Borrower’s Covenants in the Loan Documents. Counsel should
familiarize itself with the provisions in the loan documents setting forth the borrower’s covenants

DSC:910645.1/999999-999999                         -5-
and continuing representations and warranties (for example, financial, leasing, out of balance, debt
service coverage and material tenant financial condition) and events of default. If the owner is
interested in approaching the lender to restructure the loan, is there any wiggle room or cushion in
the loan budget so that in the event of a workout, the owner will agree to defer or reduce sums
previously budgeted for developer fees and/or administrative overhead? If the owner believes that
the lender will cooperate in a restructure, the owner may wish to formulate a new budget prior to
meeting with the lender and therefore attempt to have some say as to how any future income from the
project is allocated. If counsel and owner have an inkling that the lender may be looking for other
collateral as an inducement to a restructure, counsel should discuss with the owner whether there is
an owner affiliate whose property is providing positive cash flow and is available to offer lender a
collateral mortgage in connection with the restructure. Similarly, there may be an affiliated entity
that can pledge its partner or member interests to lender as additional collateral.

                (d)     Know the Owner’s/Landlord’s Obligations under the Leases. Keeping in
mind the fact pattern set forth at the beginning of this Article, owner’s counsel should consider the
following issues with respect to the leases:

                         (i)     How many leases for the project name the lead anchor tenant as a co-
tenant for an opening and/or operating co-tenancy? Counsel ought to consider whether the owner
needs to start re-negotiating certain major tenant leases to substitute another operator for the lead
anchor as a co-tenant, whether such substitution is feasible and whether it can be accomplished in a
timely manner in conjunction with a loan workout.

                        (ii)    Since the owner still needs to lease space to a supermarket to comply
with the co-tenancy requirements of the lead anchor, is there any way that the lead anchor can use
this requirement to re-negotiate its lease?

                             (iii)   What happens if the lead anchor tenant files for bankruptcy?

                       (iv)    Does the lease obligate the lead anchor tenant to open for business,
even for one day? If not, does the lease require the tenant to construct its building and provide for an
outside date by which construction must be completed?

                        (v)     Is the lead anchor tenant constructing its building with its own cash or
is there a leasehold mortgagee in the picture?

         9.        Know the Law.

               (a)      Governing Law(s). Counsel should check to see what state’s laws govern the
loan documents. Additionally, where appropriate, counsel should promptly consult with local
counsel (who in all likelihood will be the local counsel engaged in connection with the construction
loan closing).

                        If the mortgaged property is located in another state and the mortgage
provides that the laws of that state (instead of the state whose laws govern the other loan documents)
govern the mortgage, counsel should understand the state specific remedies contained in the loan
documents and their implication for any strategy of the owner/borrower in dealing with the lender.
For example, a Pennsylvania-based lender may provide in all of its loan documents excluding the
mortgage that Pennsylvania law governs the loan documents. In that connection, it has required, and

DSC:910645.1/999999-999999                            -6-
the borrower and guarantors have consented to, the inclusion of a confession of judgment in the note
and in the guaranty, respectively. However, the mortgaged property is located in California and,
accordingly, is the subject of a deed of trust which is governed by California law and which contains
a power of sale. In this example, counsel for the owner/borrower needs to understand the following:
(i) the procedural aspects of enforcing a confession of judgment in Pennsylvania and the right to
move to strike or open a judgment; (ii) the deficiency judgment rule in Pennsylvania; (iii) the
California power of sale and “one-action” rule, (iv) the procedure and timing for transferring and
executing on judgments, and (v) with the foregoing in mind, the likely strategy of the lender if
workout negotiations fail.

                (b)     Mechanics Liens Laws. While lender’s counsel should be more concerned
with understanding the mechanics liens laws that apply to the mortgaged property,
owner’s/borrower’s counsel should be knowledgeable as to these laws especially in cases where there
are cost overruns and it is foreseeable that the lender will stop funding.


         There is much scrambling that owner’s/borrower’s counsel must do when its client
telephones with the news that its lead anchor tenant may be filing for bankruptcy, the construction
loan budget has taken a wrong turn, the financial covenants in the loan agreement have been violated
and the construction lender has issued or is about to issue a default notice. Some situations carry all
the signs that the house of cards is about to crumble whereas others forecast a period of posturing
between borrower and lender ultimately followed by a loan modification or restructure. Anticipating
that the next venue for this stage play may be a battlefield, prudent counsel for the owner/borrower
will focus the initial steps of counseling its client on solid detective work into the players, the setting,
the conflict, the operative scripts, the props and the overriding law that is the director, as well as the
various scenarios that careful planning can produce.

DSC:910645.1/999999-999999                          -7-

To top