structuringg default provisions in commercial...
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Presenting a live 90‐minute webinar with interactive Q&A
Structuring Default Provisions gin Commercial LoansMaximizing Borrower Protection and Lender Remedies Through Effective Event of Default Clauses
T d ’ f l f
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
TUESDAY, JUNE 7, 2011
Today’s faculty features:
Zachary G. Newman, Partner, Hahn & Hessen, New York
Aric T. Stienessen, Attorney, Hinshaw & Culbertson, Minneapolis
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Structuring Default Provisions in Commercial Loans in Commercial Loans
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ZACHARY G. NEWMAN
LITIGATION & DISPUTE RESOLUTION PARTNER
HAHN & HESSEN LLP, NEW YORK CITY,
212.478.7435
ARIC T. STIENESSEN
CORPORATE LAWYER
HINSHAW & CULBERTSON, LLP, MINNEAPOLIS
612.334.2504
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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 on 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.
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NEGOTIATING DEFAULT PROVISIONS
TERMINATION OF FUNDING PROVISIONS TERMINATION OF FUNDING PROVISIONS
ADDRESSING FORESEEABLE EVENTS AND CONDITIONS
CROSS-DEFAULT PROVISIONS
INSOLVENCY-RELATED EVENTS AND MAC CLAUSESSO C S C C US S
CHANGE OF CONTROL PROVISIONS
OTHER DEFAULT PROVISIONS AND RELATED ISSUES OTHER DEFAULT PROVISIONS AND RELATED ISSUES
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Termination of FundingTermination of Funding
We have seen an influx of cases surrounding the issue of whether the lender is obligated to continue funding projects, or whether the lender is permitted to t i t f diterminate funding.
The right to terminate funding will depend on the terms of the credit facility, as well as whether the borrower is of 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.
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Destiny USA 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 USA Holdings, LLC (“Destiny”) $155 million in construction financing for the addition of a “green” mall.
Citigroup also acted as agent for all of the project’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 injunction enjoining Citigroup from refusing to continue disbursing funds.
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The Destiny-Citigroup Court Battle
In July 2009, Destiny was granted a preliminary injunction and Citigroup wasrequired to continue funding the project.
The trial court found that the notices of deficiency and default were erroneoussince tenant improvement costs should not have contributed to the deficiencyunder the balancing provision. The court concluded that Citigroup breachedthe loan agreement and its fiduciary duty as Destiny’s agent.
In November 2009, the appeals court upheld the order granting the preliminaryinjunction, finding that Destiny was likely to succeed on the merits since thesource of the deficiency should not have been included in the calculation ofthe deficiency under the clear terms of the agreement The court foundthe deficiency under the clear terms of the agreement. The court foundirreparable injury if the injunction was lifted since the project was nearcompletion, and, due to the economic climate, alternative financing wasunavailable.
However, the appeals court vacated the trial court’s determination of theultimate rights of the parties and held that these issues should be determinedat a full hearing on the merits.
The final outcome is yet to be determined.11
T kTakeaways
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 objectives Ensure that the reporting provisions and financial
covenants are achievable, and, most importantly, understood by the borrower.
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ADDRESSING FORESEEABLE ADDRESSING FORESEEABLE EVENTS AND CONDITIONS:
When Defaults Are Met With The Defense of Commercial ImpracticabilityDefense of Commercial Impracticability
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Bank of America, N.A. v. Shelbourne Development Group Inc (N D Ill March 3 2011)Group, Inc. (N.D. Ill. March 3, 2011)
Bank of America (BOA) and Shelbourne entered into a loan agreementon 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 Chimillion revolving line of credit to assist in the development of a Chicagoproperty.
On June 5, 2008, the parties agreed to an amendment to accommodated f d ’ f i f i b i bi didefendant’s request for an extension of time to obtain a bindingirrevocable construction loan commitment.
This amendment contained a non-monetary covenant that requiredShelbourne to provide additional collateral in the event they wereunable to obtain the construction loan.
Due to the credit crunch resulting from the financial crisis, Shelbournewas unable to obtain the construction loan and BOA informed them theywere required to provide additional collateral.
Shelbourne did not meet this demand and BOA declared the loans to bein default and accelerated the outstanding balance.
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Who Wins The Court Battle?
BOA commenced an action and defendants asserted the affirmativedefense of commercial impracticability concerning their non-monetaryd f lt ll i th t th fi i l i i d bt i i h ldefault, alleging that the financial crisis made obtaining such loancommercially 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 defensecannot be determined on a motion to strike with respect to the non-monetary default, which turned on whether the financial downturn wasforeseeable. This was especially so where BOA publicly acknowledgedthat the 2008 financial crisis was unprecedented and not reasonablyforeseeable.
However, on BOA’s motion to strike Shelbourne’s commercialimpracticability defense as it related to the monetary defaults, theCourt held that this defense was unavailable since the doctrine cannever justify failure to make a payment.j y p y
“Financial distress differs from impossibility.” 15
TakeawaysTakeaways
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 itopportunity.16
Cross-Default ProvisionsProvisions
Complicated financings typically involve cross-default provisions.p g yp y pBut, even the simplest financings can involve or should involve cross-default provisions.
These provisions place the borrower in default if the borrowerp pdefaults on another obligation contained in a correspondingagreement.
These provisions can be quite important as they can result in ap q p ywidespread default, and result in a “bet the company” type oflitigation if a dispute arises.
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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 dcertain size, uncured for a specified number of days)
Significance: 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 occurred – 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 AlternativeConstruction Technologies (“ACT”) a manufacturer of “green” panelsConstruction Technologies (“ACT”), a manufacturer of “green” panelsused in construction, and entered into a security agreement in connectiontherewith (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 wasdocumented by the execution of a line of credit with Bridgepoint andCAMOFI (with Roswell acting as collateral agent) in 2008 (the “2008Funding”).
The 2007 Funding and 2008 Funding were linked by a cross-defaultprovision that provided that a default by ACT on any indebtedness underthe 2007 Funding also constituted a default under the 2008 Funding.
ACT failed to repay its obligation under the 2007 Funding. Roswellinformed ACT that they would not provide additional funding under the2008 agreement until ACT caught up with its obligations under the 2007Funding, and applied funding from the 2008 Funding to pay downobligations under the 2007 Funding. 19
The DisputeThe Dispute
ACT focused significant resources on trying to establish that the defaultcalled under the 2008 Funding was not supportablecalled under the 2008 Funding was not supportable
But, the court held that ACT’s failure to meet its obligations under the2007 Funding caused a cross default under the terms of the notes thati t d th 2008 F diimpacted the 2008 Funding.
ACT’s efforts to defend against the cross-default by attacking their defaultunder the 2008 Funding were futile since even a successful defense withrespect to the 2008 Funding would not preclude the cross-default.
The Court found that Plaintiffs simply exercised “their contractual rightsachieved through a bargain conducted at arms’ length ” ACT’s affirmativeachieved through a bargain conducted at arms length. ACT s affirmativedefenses of frustration of performance and unclean hands failed becausethey did not show that plaintiffs took “unconscionable” action orprevented ACT from executing their obligations; they simply exercisedh l htheir contractual rights.
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Change of Control ProvisionsChange of Control Provisions Default Provision: Change in % ownership of all equityChange in % ownership of all equity Change in % ownership of voting equity Equity becomes encumbered by a security interest Change in majority of directorsChange in majority of directors
Significance: lender underwrote loan based upon the ownership, 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 offeringsPublic 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 dstructure 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 ownership without the lender’s consent OR if the lender will not reasonably consent
22
In re Young Broadcasting Inc.In re Young Broadcasting Inc.(S.D.N.Y. April 19, 2010)
Y B d ti I (YBI) th b d 2005 C dit Young Broadcasting Inc (YBI) was the borrower under a 2005 CreditAgreement secured by several lenders’ (the “Lenders”) first prioritysecurity interest in substantially all of its assets.
YBI filed for chapter 11 bankruptcy protection and the board ofdirectors sought confirmation of the Unsecured Creditor’sCommittee’s proposed plan (the “Committee Plan”).
The Committee Plan was premised upon the reinstatement of thedebt under the Credit Agreement, but the Lenders argued that theCommittee Plan could not be confirmed because its proposedallocation of voting rights would trigger an immediate change ofcontrol default under the Credit Agreement.
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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. Young, his immediate family members and certain other controlled individuals (the “Young Group”) were required to have more than 40% of the Voting Stock by number of q g yvotes.
Further, it required that if any person or group owned more than 30% of the total outstanding Voting Stock then the Young Group must of the total outstanding Voting Stock, then the Young Group must own more than 30%, or, alternatively, the Young group must have the right or ability to elect or designate for election a majority of the board of directors.
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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 Young The plan provided for only one Class B director, for which the Young Group was allocated all of the voting stock, and six Class A directors, the election of which the Young Group was allocated only a nominal amount of votes.
Due to the inflated number of votes given to the Young Group for the election of the one Class B director, Young was allocated more than 40% of 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 of control provision.
Although allocated greater than 40% of the total votes, the Young 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 achange of control that constitutes a default under the termsof the Credit Agreement, which precluded reinstatement ofthe loans.
The court held that voting power must involve the power toinfluence the composition of the board of directors, and theprovision requiring the Young Group to own 40% of the votingstock meant that this group must have the power to influencestock meant that this group must have the power to influence40% of the composition of the entire board.
The Court looked to the intent of the change of controlprovision ensuring that no one person or group would haveprovision – ensuring that no one person or group would havemore control than the Young Group – and held that theCommittee Plan undermined the intent of these provisions.
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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)
Significance: i il t d f lt i i i similar to cross-default, minimize exposure
Borrower is about to become subject 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
Significance: 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 prove28
Ch i B iChange 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 Significance: change in business since underwritten resulting in a change in the riskrisk Integration risk Competency risk (borrower and lender)p y ( )
Carve-outs: natural extension of borrower’s existing line of businessexisting line of business
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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?
Should 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 orall moneys hereunder, there be no material adverse change in theconditions, financial or otherwise, of the Borrower or theGuarantors from the conditions as set forth in support for this loan.pp
There is no language in this clause that indicates that theclause obligated Sterling to refrain from advancing money upon
i l d h I d h la material adverse change. Instead, the clause empowersSterling to deny an advance after a material adverse change.
Hunter v Sterling Bank 750 F Supp 2d 530 534 (E D Pa 2010)Hunter v. Sterling Bank, 750 F. Supp. 2d 530, 534 (E.D. Pa. 2010)
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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 AmericanAssociation 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 backedsecurity (CMBS).
Under the Term Sheet for the loan AAJ could not seek financing Under the Term Sheet for the loan, AAJ could not seek financingfrom another lender, and the MAC clause provided that Wachoviacould terminate the loan if there was a "material adverse changein the capital, banking and financial market conditions that couldimpair the sale of the loan by Lender as contemplated in the termsheet.“
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What Went Wrong?
I M 2007 th ti i d th L C it t In May, 2007, the parties signed the Loan CommitmentAgreement (LCA) that contained the MAC provision, despiteAAJ's fears that such cause would permit Wachovia toarbitrarily renege on its obligationsarbitrarily renege on its obligations.
Meanwhile, trade publications and investor reports expressedconcerns over the CMBS market, and following the execution, gof the LCA, CMBS continued to decline. Wachovia contactedAAJ to discuss restructuring the LCA on August 6, 2007, butAAJ refused to reprice the loan.
On October 22, 2007, Wachovia invoked the MAC clause toterminate the LCA citing “a material and adverse change inthe fixed income sector of the capital markets ”the fixed income sector of the capital markets.
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The Lawsuit
AAJ b ht ti ll i b h f th LCA d AAJ brought an action alleging breach of the LCA andWachovia responded with a motion for summary judgment.
The court held that the fact-finder could determine that theMAC clause applies only to unforeseeable events, and deniedWachovia summary judgment.
The court found there is a genuine issue of material fact as towhether events after the execution of the LCA were
f blunforeseeable.
Resolution of this matter is still pending.
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Oth D f lt P i iOther 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 Similar to borrower provisions, fails to fund other loans or
affiliates become insolvent Provisions “Yank-A-Bank” – force a lender to sell its interest Yank 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
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Oth D f lt P i iOther 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
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Oth D f lt P i iOther 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
salesale
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Oth C id tiOther Considerations General Negotiating Pointsg 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, ordinary course of business)
Be mindful of interrelationships (overlaps and gaps) among default provisionsgaps) among default provisions
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Don’t Forget The Importance of Drafting Clear and Comprehensive Post Default Remedies:Comprehensive Post- Default Remedies:
FAMM Steel Inc. v. Sovereign Bank (1st Cir. 2009)
FAMM, a steel fabricating company, entered into a credit facilitywith Fleet National Bank, predecessor in interest to Sovereign,which loaned FAMM $6.1 million between 1998 and 2002.
After FAMM began experiencing financial difficulties in late 2001,Sovereign had FAMM hire an outside consultant and comptroller oftheir choosing over FAMM’s objections. The consultant andcomptroller failed to reconcile FAMM’s general ledger accounts andmonthly bank statements, grossly overstated job revenues for workin progress, and presented FAMM with inaccurate financial data thatshowed the company was turning a profit when it was actually losingp y g p y gmoney.
Sovereign ultimately terminated FAMM’s line of credit, selling itsloans to a third party After the sale FAMM’s facility was shut downloans to a third party. After the sale, FAMM s facility was shut downand its assets liquidated.
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The Lawsuit
FMM brought suit in December 2006, alleging that Sovereign breached the impliedcovenant of good faith and fair dealing. FAMM also alleged that Sovereign breachedits fiduciary duties to FAMM, caused FAMM to make business decisions under duress,and caused FAMM to become the bank’s instrumentality.and caused FAMM to become the bank s instrumentality.
The district court in June 2008 granted summary judgment to Sovereign on each of FAMM’s claims. The First Circuit affirmed in June 2009. FAMM had not produced sufficient evidence that Sovereign had promised to take certain actions such as issue sufficient evidence that Sovereign had promised to take certain actions such as issue a forbearance agreement or extend the credit line. Even though Sovereign had required FAMM to hire the consultants, there was no evidence that such consultants were acting under Sovereign’s direction.
Sovereign was not able to control FAMM’s day-to-day affairs, a requirement for a finding that a fiduciary relationship existed. FAMM could not allege duress as a tort on which FAMM could recover damages since it is an affirmative defense rather than a cause of action Sovereign did not tortiously interfere with FAMM’s business a cause of action. Sovereign did not tortiously interfere with FAMM s business relations by preventing FAMM from obtaining refinancing or preventing FAMM from pursuing third party contracts by refusing to grant forbearance or extension after FAMM paid down part of its debt.
Sovereign 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.
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