Syndication continues to grow in popularity among lenders. Here, the authors explain the significant legal issues surrounding such transactions.
According to a recent study, lenders closed $244.2 billion of commercial/multifamily mortgage loans in 2012. The multifamily property category accounted for $103.2 billion of that total, leading all real estate loan originations in dollar volume.1 Due to the rapid growth in volume and the escalating size and complexity of mortgage loans and the projects securing such loans, lenders have been forced to further develop methods to adequately diversify their risk. While most mortgage loans are sold into the CMBS securitization market, mortgage loans held for syndication still represent a significant share of the loans made by many real estate lenders. The syndication market provides mortgage originators with an opportunity to create a customized lending product which extends beyond the standard requirements of the rating agencies. The syndication market has recently gained significant momentum for “value-added” lenders who are willing to incur above average risk by placing loans in higher leveraged loan positions in the capital stack or provide financing outside a conduit structure for construction projects, land acquisitions and/or lease-up projects.
The primary incentive for syndicating loans in today’s market is diversifying risk and, thus, increasing the granularity of a lender's loan portfolio. Other considerations for lenders who sell loan participations include leveraging income and reducing capital weight while building and maintaining relationships with clients. Access to the know-how and deal flow of established real estate lenders is an incentive for lenders who purchase loan participations to join a syndicate group. The majority of key players in real estate loan syndication in the United States include U.S. lenders and international lenders from such countries as Germany, France, Canada, and England, serving in roles of both agent lenders and participant lenders.
As these trends continue, it becomes increasingly important for real estate lawyers and their clients, whether they be agent banks or participants, to understand not only the driving forces behind syndication, but also the legal issues that arise in connection with these transactions, including issues often negotiated between members of the syndicate group. The respective interests among loan participants vary to the extent that pari-passu loan shares, subordinate loan shares, A/B loan structures, or mezzanine loan interests are involved in the capital stack.
Driving forces behind loan syndication
The major benefit of loan syndication is that it allows arranging lenders (who are often the loan originators) to diversify risk while maintaining close relationships with their customers. In order to minimize credit risk and to ensure acceptable levels of diversification, lenders monitor and impose limits on their exposure with regard to a particular project as well as the amount of loans made to a particular sponsor. As development projects become more complex and expensive, developers require larger loans, which may exceed a particular lender’s loan exposure limits or the maximum amount that a particular lender is willing to extend to a sponsor.
By creating a syndication group and, thus, dividing the obligations to lend the entire loan amount among several lenders, participating lenders are more likely to be able to stay within their credit exposure limits. The participating lenders also have the opportunity to access the expertise, business relationships, and deal-flow of arranging lenders, allowing the participants to extend their customer base without investing large amounts for marketing costs and administrative capabilities.
Lenders that arrange the syndication group or serve as the administrative agent for the participants (oftentimes the same lender) can enhance their own profitability by charging and collecting additional fees and other compensation for arranging and administering the loan without the need for committing capital for the entire loan amount. To a certain extent, agent lenders may also expect their participant banks to bring future syndication deals back to the agent lender. All of the lenders in the syndicate group benefit financially from their loan participation by collecting pro-rata interest and fees, particularly commitment fees.
Participation structures for real estate loans
In a loan involving direct participation, each participant lender acts as co-underwriter and becomes a party to the loan documents at the closing of the loan. Although each participant lender has its own contractual relationship with the borrower (and, thus, is called a co-lender), typically one of the lenders (in most cases the originator of the mortgage) will serve as the administrative agent for a group of participants. Such deals may be executed in a “club” format, in which several lenders partner to form a small lender group for transactions that exceed the risk appetite of each individual lender. The agent lender is responsible for administering the loan and maintaining the day-to-day relationship with the borrower. Each of the co-lenders owns its respective portion of the loan, which obligates such co-lender to fund to the borrower the amount to which it has committed to lend and entitles such co-lender to the benefits (i.e., interest and fees) arising out of its portion.
Each co-lender often acquires a promissory note in the amount of such co-lender’s share of the loan, made by the borrower payable to the order of such co-lender, as payee. However, the notes often provide that the payments made under the note be sent to the agent lender, who collects the payments and distributes to each co-lender its respective share of the funds.
In a loan involving regular participation, direct participants join as a participant lenders after the initial closing of the loan. An existing lender, often-times, the arranging lender who typically also serves as the administrative agent, sells a portion of the loan to the incoming participant lender (who is also called a co-lender), which sale is documented by an assignment and assumption agreement or assignment and acceptance agreement between the selling lender and the co-lender. The co-lender will acquire by assignment an undivided participation interest in the loan on a pro-rata basis, which means that it will accept the obligation to advance its portion of the loan and will receive a direct interest in the amount of their participation in the right to repayment of the loan and the collateral given to secure the loan. In most other respects, the rights and obligations of the lenders in a regular participation are similar to those in a direct participation.
If a loan is syndicated through indirect participation, the participant lenders are not and do not become parties to the loan documents. An indirect participant enters into an agreement with the selling lender to purchase interests and obligations under the loan and receives a participation certificate executed by the lead lender, and not a note executed by the borrower. The participant lender incurs only a guarantee-like funding obligation and must reimburse the selling lender for any loan expense in connection with the loan documents. As a result, the borrower may not have knowledge of an indirect participant’s existence. Certain lenders’ regulations or internal guidelines require a direct claim against the borrower and the collateral and therefore such lenders are prohibited from purchasing indirect participation interests in loans. Some loan structures involve a combination of direct and indirect participations and some structures may have varying levels of priority among participants in terms of rights to receipt of payments and ability to exercise remedies.
In a co-lending arrangement, the lead lender has certain duties to the other members of the loan group, known as the Servicing Standard. The Servicing Standard requires the lead lender to service the loan (or manage the property) in "a commercial reasonable manner" that benefits all co-lenders, and without regard to its relationships with or ownership of any other parties to the agreement.2 It is sometimes stated as the higher of these standards: (a) the standard by which the lead lender services its own loans, and (b) the customary standard for servicing in the industry.
Documenting syndication relationships
Because syndication involves multiple parties, it is very important that the primary and syndication loan documents clearly define the role of each party and set forth the relative rights, obligations, and priorities among the parties. Many provisions are standard, but some may be heavily negotiated or modified by side letter between the agent lender and a co-lender.
Although loan syndication enables lenders to increase diversification and engage in transactions they might otherwise be obligated to turn down, lenders within a syndicate group give up the flexibility to make decisions independently and take actions with respect to the loan. Although the agent lender is generally granted the power to make the day-to-day decisions alone, oftentimes, loan documents provide that the consent and/or approval from some or all of the participant lenders is required for certain decisions.
In some syndications, co-lenders execute the primary loan documents with the borrower at the closing of the loan. More commonly, in a secured mortgage loan, the loan agreement, the promissory note, the mortgage and the other ancillary documents executed in connection with the closing of the loan are executed by the main underwriter. The main underwriter, as agent, is the only lender at the closing and intends to sell portions of the loan in the secondary market. To facilitate the future sale interests in the loan the agent lender must consider market pricing, loan terms, and reasonable agent/co-lender provisions at loan closing. The co-lenders do not have a real-time opportunity to review or comment on the primary loan documents or participate in negotiations with the borrower even though many provisions regarding the agency/participant lender relationship are contained in the loan agreement.
In cases where multiple underwriters execute the loan agreement as direct co-lenders, participating in the primary closing with the borrower, these concerns do not arise. Co-lenders signing the primary loan documents at closing are granted co-underwriter privileges, such as primary market pricing, co-agent and co-underwriter titles related to the transaction and are able to negotiate loan provisions to some extent, especially the sections relating to the agent/co-lender relationship.
In the absence of clear documentation, disputes can emerge regarding the roles and authority of the group vis-à-vis its individual members. The New York Court of Appeals, in Beal Savings Bank v. Sommer, 8 N.Y.3d 318 (2007), established a presumption in one such dispute. The court found that one member of a lending group could not, in contravention of the syndicate's decision, take action against a guarantor of debt obligations following the default on that debt. As the court noted, "Had the parties intended that an individual have a right to proceed independently, the Credit Agreement ... should have expressly so provided."3
Several other considerations should be accounted for in the loan documents. For instance, they may require a party to disclose the existence of any intercreditor agreements to potential assignees.4 Loan documents should also clearly define the lead lender's authority to act as administrative agent for the syndicate and what levels of consent from co-lenders are required before administrative agent takes various actions. Exhibit A is an example of how many lenders decide what level of consent is required for different decisions a lead lender may be called upon to make from time to time during the term of a loan. These guidelines give all members of the lending group a voice in determining key factors, yet allow specific issues to be decided without "too many cooks" getting involved.5 In addition, a lending group must determine if it would be willing to offer seller financing for the sale of a property, and if so, on what terms and in respect of what legal and tax structuring considerations.6
Assignment and assumption agreement
When lenders sell participations in a loan, the sale is documented by an agreement sometimes called an assignment and assumption or assignment and acceptance agreement. This document describes the purchase and sale of the participation interest and assigns to the buying lender both the obligations under and interests in the portion of the loan purchased from the selling lender. The assignment agreements usually provide sufficiently detailed true-sale language to support favorable treatment under capital adequacy rules. The purchasing lender may appoint the agent lender and authorize the agent lender to act on its behalf in the agreement. This document, usually the agent lender’s standard form and possibly attached to the loan agreement, is not negotiated or revised heavily, because it often refers back to the rights and obligations set forth in the loan agreement. An agent lender is very unlikely to go back to the borrower to renegotiate and amend the primary loan documents. All this has made the loan assignment the preferred participation device in today’s real estate syndications market.
Information rights of co-lenders and notice provisions
Generally, the primary loan documents will require third parties and the borrower to give notices with respect to the loan to the agent lender rather than to each of the co-lenders directly. The primary and/or syndication loan documents typically address the types of information that the agent lender is obligated to provide to the co-lenders and the timeframes within which the obligations must be carried out. The co-lenders often negotiate for rights to as much information relating to the loan as possible such as notices of borrower default, recording information, copies of all loan documents. The agent, however, will prefer to keep the obligation to provide information to a minimum either by negotiating to exclude certain obligations to provide such information altogether or limit the obligation to provide certain information to only after a co-lender requests such information.
Liability and reliance on agent lenders
Agent lenders usually limit their liability to co-lenders under the primary and syndication loan documents to willful misconduct or gross negligence resulting in actual damages. The agent lender is usually held to the standard that it would use in its own transactions. The courts usually accept these provisions and do not read a fiduciary relationship into the agreements between agent lender and participants. Most primary and/or syndicated loan documents provide that agent lenders are only deemed to have knowledge of a borrower default when the agent lenders have actual knowledge of such default. Some very large agent lenders, with far-flung operations, are concerned about being deemed to have knowledge of which employees not directly involved in the subject loan have actual knowledge. Therefore, they seek to limit their liability of knowledge of defaults to those defaults of which they have received written notice from either the borrower or their co-lenders. Their prospective co-lenders respond that it is a most unusual borrowers that will give its lender notice of its own default and that the co-lender’s likelihood of obtaining knowledge of a default before the agent lender receives it is very remote. While a fair compromise for such large agent lenders may be to limit the universe of its employees obtaining actual knowledge of the subject borrower’s default to those working on the subject loan transaction, rarely do very large agent lenders agree to that compromise. Rarely do prospective co-lenders terminate negotiations over this point.
In order to avoid liability to co-lenders, agent lenders require that co-lenders perform their own due diligence and credit analysis with the information provided by the agent lender. To memorialize the lack of co-lender reliance on the agent lender’s analysis, the agent lender will typically require representations from each co-lender that such co-lender has not relied on the financial analysis of the agent lender and that the co-lender has done its own credit analysis and made its own decision with respect to joining the syndicate group. Therefore, the agent lender is usually protected when making day-to-day decisions with regard to a real estate loan. Liability issues do arise for an agent lender if a certain real estate loan requires specific skills and the agent lender explicitly commits to apply such skills in administering the loan as additional obligations under the primary and/or syndication loan documents.
The agent lender will want the maximum amount of freedom possible with respect to administering the loan, avoiding interference or delay due to co-lender involvement in the decision-making process. For example, the agent is usually granted the right to make protective advances without co-lender consent (i.e., taxes, insurance and ground lease payments) to maintain the value of the collateral in case of emergency. Co-lenders, on the other hand, will want some degree of control over certain key issues such as material amendments to the loan documents, including, but not limited to, changes in the interest rate applicable to the loan or the maturity date of the facility or increases in the facility amount. Co-lenders also want control over the management of the collateral, decisions regarding acceleration of the loan after an Event of Default, releases of any collateral and actions that affect the value of the collateral, and appointments of successor agent lenders. Co-lenders are not likely to request control over non-material issues, because they also have an interest in distancing themselves from the burdens of administering the loan. Therefore, negotiations over the granting of authority to the agent to act on behalf of the co-lenders and over the decisions that will require co-lender consent are likely to be limited to material decisions affecting the loan and the collateral.
The borrower will only want to deal with one lender for payments and other day-to-day loan administration. For more material decisions and approvals, however, loan syndication documents might require that all or a certain percentage of the participant lenders approve an action before the borrower may act, which can be a time-consuming process, causing the borrower unwanted delay. To minimize the likelihood of future issues arising within the syndicate group with respect to decision-making, it is imperative to select participant lenders with adequate risk tolerance and expertise for the subject real estate project.
Primary and syndication loan documents may distinguish between decisions requiring unanimous co-lender consent and those only requiring consent from a certain percentage of the syndicate group. Again, the agent lender will generally prefer a requirement of a lesser percentage of co-lender consent, while the co-lenders will want their votes to count on major decisions. Typically, all decisions regarding the extension of a maturity date, reduction in the interest rate and payment of debt service as well as the release of collateral require unanimous co-lender consent. Other major decisions, such as approval of changes in the controlling interest in the borrower, a borrower’s request for change orders in construction loans above certain thresholds or a borrower’s request to enter into all leases with respect to the mortgage property, as well as any transfers of subordinate loan interests to another lender can be tied to a qualified majority of the syndicate lenders. The calculation of the majority percentage is usually based on the individual distribution of participant lenders in the bank group and their respective money at risk, rather than on a headcount of lenders. The percentage of lenders required should be more than 51 percent of the syndicate group, but typically is set at 60 percent or 66.67 percent of the aggregated amounts of all lenders.
In loan structures involving both senior lenders and subordinate lenders, the lender relationship may be arranged such that only senior lenders have the right to be involved in decision-making. The documentation for such structures typically limits the subordinate lender’s right to cure existing borrower defaults and the right to buy out the senior lender in order to gain control of the mortgage collateral. The subordinate lender’s motivation and incentive to take control in default situations varies to the extent the current market value of the mortgage collateral still supports the subordinate lender’s subordinate position. A/B loan structures may allow for a shift in control of decision-making to the subordinate lender once a default with respect to the senior obligation is cured. In such cases, the shift of decision-making is only valid for a period of time during which the subordinate lender can pursue foreclosure of the real estate and pay off the senior lender.
When a borrower makes a request for a change or a response from the agent lender which requires the consent of co-lenders, the agent lender must process the request before submitting the issue to the syndicate group for approval. The co-lenders then consider the information provided along with any other documentation and due diligence items that may be involved before informing the agent lender of its decision. To limit the amount of time between a borrower’s request and the agent lender’s response when co-lender consent is involved, agent lenders will push to limit the amount of time that the co-lenders have to consider the request and related information. Oftentimes, the primary and/or syndication loan documents will include a provision giving a number of days after which, if no co-lender response is received by the agent lender, the consent is deemed given. Co-lenders will negotiate for as long a time period as possible so that they are comfortable that they will have adequate time to consider the issue.
With little existing law in this area, and with the agency provisions of the loan agreement and the participation and co-lending agreements rarely addressing issues in detail, solutions frequently depend on the judgment and consensus of the parties and their lawyers. The courts have typically deferred to the language in agreements among lenders, in particular the decision-making procedures they establish. When entering into these agreements, therefore, it is vital that all parties understand such agreements will likely form the main, if not the only, foundation for legal judgments in the case of later disputes. The decision-making processes should be considered and established carefully.7
Nevertheless, it is incumbent upon the lending group's decision-making party or parties to respect the implied covenant of good faith and fair dealing. The interests of other members of the lending group should be factored in, and the decision-making party should keep all members apprised of its actions or potential actions. By keeping the decision-making process transparent, and by building consensus where possible, a lending group can head off most potential conflicts. Often, a lending group will enlist a co-agent to review and make objective recommendations on certain substantive decisions. However, in cases where the decision-making authority acts contrary to the co-agent's recommendations, this may be used as damaging evidence in future conflict issues.8
Finally, the lending group should bear in mind that, once they become a property owner, it will have to make all of the decisions associated with real estate ownership—leasing, management, tenant terms and so forth, as well as the ownership structure.9
Some syndicated real estate loans involve senior and subordinate tranches within a facility that are secured by the same mortgage (A/B loan structures). Because the senior lenders and the subordinate lenders share the same collateral, the respective priorities and rights of each group of lenders must be set forth in an agreement between such parties. When various classes of lenders are involved in the capital stack, multiple intercreditor agreements may be required. Because the priority and control over the claim against the mortgage collateral is instrumental to each lender’s underwriting, the intercreditor agreement is often heavily negotiated.
Generally, the senior lenders will agree to provide notice to the subordinate lenders of a borrower default either contemporaneously with delivery of such notice to borrower or at the expiration of borrower’s cure period. How much time the senior lenders will afford the subordinate lenders to cure a default remaining uncured by borrower before the senior lenders accelerate the loan or otherwise exercise remedies is heavily negotiated. Once the senior lenders commence foreclosure proceedings, they will often allow the subordinate lenders the opportunity to acquire the senior loan. The purchase price will always be at least equal the sum of the principal balance at par plus accrued but unpaid interest. However, in portfolio loan documents, the senior lenders will often seek to include in that purchase price default interest, late fees, breakage charges, yield maintenance and the like. In securitized transactions, the convention seems to be that such additional items are foregone by the senior lenders.
If the borrower becomes involved in a bankruptcy proceeding, the senior lenders will generally allow the subordinate lenders to file a claim in that proceeding, but will rarely allow the subordinate lenders to vote on a plan of reorganization or otherwise act upon their claim.
While a default under the senior loan documents invariably constitutes a default under the subordinate loan documents, the reverse is almost never the case. When a default occurs under the subordinate loan documents, the senior lenders may allow the subordinate lenders to foreclose upon their collateral, but any third-party transferee at such foreclosure sale (or, if the subordinate lenders bid the collateral in or obtain a deed-in-lieu of foreclosure, any transferee thereof) must generally meet certain eligibility requirements negotiated into the intercreditor agreement.
By empowering senior lenders at the expense of subordinated lenders' ability to influence or oppose proposals, intercreditor agreements reduce decision-making costs in the event of default. However, it is possible for an investor to exploit this imbalance, increasing its own return by damaging other creditors. When considering intercreditor agreements that waive or assign bankruptcy rights, courts are forced to weigh the benefits to the agreement's signatories against the potential for harm to subordinated creditors and non-signatories.10
Second-lien lenders face a host of other considerations unique to their status. In particular, they may become a "silent second" by agreeing contractually to refrain from exercising some or all of their rights as secured creditors. As identified in one paper, the key elements usually included an intercreditor agreement which pertain to "silent second" terms are:
- "Prohibitions (or limitations) on the right of the second lien holders to take enforcement actions, with respect to their liens (possibly subject to time or other limitations)
- Agreements by the holders of second liens not to challenge enforcement or foreclosure actions taken by the holders of the first liens (possibly subject to time or other limitations)
- Prohibitions on the right of the second lien holders to challenge the validity or priority of the first liens
- Waivers of (or limitations on) other secured creditor rights by the holders of second liens"11
Defaults and payment priorities
The syndication documents typically specify both a pre-default and post-default waterfall. For A/B loan structures or senior/subordinate note structures, the senior group will be paid first. The subordinate group has taken on more risk by being subordinated to the senior group and will not be paid until after the senior group is fully repaid. Therefore, the subordinate group is usually entitled to collect a higher interest rate in exchange for taking on such risk. Losses of principal and interest due to a default can also be allocated among the senior and subordinate groups. In most cases, the losses will be allocated first to the subordinate group and then to the senior group.
Before an event of default, the agent lender will generally receive its administrative and servicing fees, as well as reimbursement for its legal or other out-of-pocket expenses before reimbursement for further payments, such as protective advances, interest and principal payments are distributed to lenders. Interest is paid before principal is repaid, because the primary interest of all of the lenders is to have the debt paid current. If there are tranches among the lenders, the senior lenders will negotiate to have their interest and principal paid before any payments are distributed to the subordinate lenders, because being paid first is consistent with their lower level of risk.
In some cases, the subordinate lender is able to negotiate for priority of its interest payments over the principal payments to the senior lender. Such concessions are justifiable in specific transactions as long as no event of default exists and in transactions in which the borrower does not agree to an accrued interest feature. Such accrued interest rate features shift the multiple interest payments during the term of the loan to a one-time interest payment at the maturity date. This is usually granted in exchange for the calculation of a substantially increased interest rate throughout the term of the loan.
After an event of default occurs, the senior lenders will be even more likely to insist that their interest and principal are paid before subordinate lenders can collect any payments. Administrative and servicing fees (including special servicing fees), collection, and other out-of-pocket expenses of the agent lender will be paid before default interest, late charges, regular interest and principal to the senior lenders. Subsequently, the interest and principal, all before costs and expenses, fees and principal of the subordinate group are paid.
Although the lead lender typically has wide latitude in addressing loan defaults, limitations still exist. Certain provisions of the loan documents may require a prescribed vote before the lead lender can take action. In other cases, remedies may need to be effected within a certain time period lest the lead lender be deemed to have, through inaction, waived enforcement rights or accepted a de facto loan modification. Participation and co-lending agreements may also restrict the lead lender's options after foreclosure occurs.12 During this period, several possible "outs" may allow the lead lender to cede its lead lender duties, including a purchase option or a buy-sell option.13 Each specific contract must be considered and interpreted to determine what, if any, approvals may be needed before action can be taken.
Examining relevant court cases, such as New Bank of New England, N.A. v. Toronto Dominion Bank, one paper argues that US case law preserves unaltered the contractual rights of the creditors among themselves during a debt restructuring process. A creditor's right to enforce its claim against the borrower is not affected by the problems such action may cause other lenders. Similarly, the rights of the lending group's majority are not impacted by an implicit obligation to a minority lender or its interests.14
When one co-lender fails to perform its obligation to fund its percentage of the loan to the borrower, it has breached its agreement with the borrower (if a direct or regular participant) or with the other lenders (if an indirect participant). In lending relationships with additional funding obligations, such as construction loans or lease-up loans, the mechanism for dealing with a defaulting lender must be clearly set forth in the primary and/or syndication loan documents. Some loans are structured to allow the non-defaulting lenders to advance the defaulting lender’s share in exchange for the benefits associated with that advance. In some cases, defaulting lenders must take a step-down in priority with respect to distribution of payments and fees received from the borrower. In addition, some primary and/or syndication loan documents state that a defaulting lender loses its right to have its vote counted in any decision requiring the consent of co-lenders.
As syndication continues to grow in popularity among lenders and as the number of syndicated loans continues to rise, lenders and their counsel must make themselves familiar with the legal issues surrounding such transactions. Particular attention should be given to the relationship between the lenders within the syndicate group, especially between the agent lender and the participant lenders.