Below are summaries of the noteworthy decisions, laws and requirements impacting the commercial lending industry which occurred or took effect in 2018. Please feel free to contact us for additional information or details on any of the items listed below and/or to discuss whether updates to your loan documents may be needed to address the same.
1. New, Improved Rules for High Volatility Real Estate Loans
On May 24, 2018, President Donald Trump signed into law the Economic Growth, Regulatory Relief and Consumer Protection Act, which reformed the widely unpopular rules relating to high volatility commercial real estate, or HVCRE, loans. Under the new rules, only capital equal to 15 percent of the real property’s appraised, as completed value, tested at closing, is required to remain in the project, and this is only until the loan has been reclassified as a non-HVCRE ADC loan. A loan can be reclassified by a lender as a non-HVCRE ADC loan once the project has been substantially completed and has stabilized such that the cash flow generated by the project satisfies the minimum debt service requirements, in each case, using the lender’s underwriting criteria for permanent financing. In addition, in order to satisfy the borrower’s minimum capital contribution requirement, lenders can count the appraised value of the real property toward the borrower’s satisfaction of the borrower’s minimum capital contribution requirement. Moreover, any loan made prior to January 1, 2015, is excluded from the definition of an HVCRE ADC loan and lenders do not have to assign a heightened risk weight to the same. Similarly, loans for the acquisition, or refinancing of existing income-producing real property “where the cash flow being generated by the real property is sufficient to support the debt service and expenses of the real property, in accordance with the institution’s applicable loan underwriting criteria for permanent financings” are expressly excepted from the definition of an HVCRE ADC loan. The prior alert, including a detailed analysis, can be found here.
2. Delaware Limited Liability Company Act Division Statutes
Effective August 1, 2018, the Delaware Limited Liability Company Act was amended, among other things, to permit any Delaware limited liability company (LLC), to divide into two or more LLCs with the dividing LLC either surviving or ceasing to exist, pursuant to a plan of division. Upon the division becoming effective in accordance with the requirements set forth in the statute, all assets, debts, liabilities and duties, without any further action, are allocated to and vested in the division companies as specified in the plan of division, and shall not be deemed, as a result of the division, to have been assigned or transferred to such division company. In addition, unless specified in the plan of division, the dividing company is not required to wind up or will not be deemed dissolved by reason of the division. The question becomes whether representations, warranties and covenants restricting fundamental changes in existing loan documents adequately protect lenders from assets leaking outside the loan party structure when under a division, assets are not “transferred” or “assigned” and there is no consolidation, winding up or dissolution of the original entity. The statute provides some protection with respect to any LLC formed prior to August 1, 2018, that is party to any agreement entered into prior to August 1, 2018, which by its terms restricts, conditions or prohibits a merger, consolidation or transfer of assets of such LLC. In this regard, such restriction, condition or prohibition shall be deemed to apply to a division. In addition, the new law allows for an LLC’s operating agreement to provide that the LLC does not have the power to divide under such statue. As such, in addition to ensuring that appropriate restrictive language is included loan documentation entered into or amended after August 1, 2018, lenders and their counsel should require prohibitive language in an LLC’s operating agreement.
3. Compliance Required with Updated Customer Due Diligence Requirements
The Treasury Department’s Financial Crimes Enforcement Network (FinCEN) issued the Customer Due Diligence Requirements for Financial Institutions (CDD Rule) under the Bank Secrecy Act, which became effective July 11, 2016 with required compliance by May 11, 2018. FinCEN proffers that the CDD Rule is intended to clarify and strengthen customer due diligence requirements for certain financial institutions, including, among others, banks. The CDD rule includes four core elements: (i) “customer” identification and verification, (ii) beneficial ownership identification and verification ( i.e., any individual who owns 25% or more of, or controls, a legal entity customer at the time a new “account” is opened), (iii) understanding the nature and purpose of customer relationships to develop customer risk profiles, and (iv) ongoing monitoring to identify and report suspicious transactions and, on a risk basis, to maintain and update customer information. The conditions precedent, representations and warranties and covenants sections of any loan agreement should be revised to reflect the CDD Rule requirements (e.g., delivery of the appropriate certification, the accuracy of the information provided therein and the covenant regarding any change to such information).
4. Default Interest Rate Provision Held Unenforceable by California Bankruptcy Court
In July of 2018 the U.S. Bankruptcy Court of the Central District of California in In re: Altadena Crossing LLC, 2018 (Case No: 2:17-bk-14276-BB), found that a default interest provision in a loan agreement of 5.0% above the existing nondefault interest rate, which was the market default rate at the time, constitutes an unenforceable penalty. The Court concluded that default interest provisions are akin to liquidated damages under a contract and therefore must have a reasonable relationship to the anticipated actual damages foreseeable at the time of contract formation between the parties. The Court looked to Section 1671(b) of the California Civil Code to guide its analysis of the reasonableness of the relationship between the default interest provisions and the actual damages anticipated by the lender at the time of the agreement. Here, the default interest provision was found to be unenforceable because it did not have a reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach at the time the contracts were made, but rather were intended to serve as a penalty to incentivize avoidance of events of default. Although the precedential significance of the Altadena decisions remains to be seen, in the meantime, lenders should attempt to incorporate prophylactic language in their loan agreement which, among other things, acknowledges the reasonable of the default interest rate provisions.
5. Challenges to Collateral Descriptions in UCC-1 Financing Statements
In 2018, two decisions challenged the sufficiency of collateral descriptions in UCC-1 financing statements. The District Court of Puerto Rico in Fin. Oversight & Mgmt Bd. v. Altair Global Credit Opportunities Fund (A), LLC, 2018 U.S. LEXIS 140206 (D.P.R. August 17, 2018) held that a UCC-1 financing statement is ineffective to perfect a security interest if the public document to which its collateral description referred is not available at the local clerk’s office where UCC records are maintained. Here, the UCC-1 financing statement included a collateral description describing the collateral as “The pledged property described in the Security Agreement attached as Exhibit A hereto and by this reference made part hereof.” The filed financing statement attached the security agreement but did not attach the Pension Funding Bond Resolution which was incorporated by reference into the security agreement for purposes of the description of the pledged property (which was not otherwise described in the security agreement itself). The referenced Resolution was posted on several websites but was not available for review at the local clerk’s office that maintains UCC records. As such, the Court held that any search, which must extend beyond the local clerk’s office, is ipso facto too burdensome for Article 9 purposes. The prior article published in Law360, which includes a detailed analysis can be found here.
Similarly, the U.S. Bankruptcy Court for the Central District of Illinois in In re I80 Equipment, LLC, No.17-81749, 2018 WL 4006294 (Bankr. C.D. Ill. Aug. 20, 2018) held that a financing statement which contained no description of collateral within the statement itself, but instead referenced the definition of “collateral” in an underlying security agreement without attaching the security agreement to the financing statement, was insufficient to “reasonably identify” the collateral subject to the security interest pursuant to the Article 9 requirements. Accordingly, the secured party failed to protect its security interest. These decisions suggest that financing statements may be insufficient to perfect if not all applicable defined terms are specifically included on the financing statement itself or on an exhibit annexed to the financing statement.
6. Second Lien Lenders Prevail in Intercreditor Dispute
Late in the year, in In re MPM Silicones, LLC, No. 15-CV-2280 (NSR), 2018 WL 6324842(S.D.N.Y. Nov. 30, 2018), of which the opinion was amended on January 4, 2019 at 2019 WL 121003, the U.S. District Court in the Southern District of New York found in favor of second lien noteholders (collectively, the “Seconds”) in affirming the U.S. Bankruptcy Court’s dismissal of the senior lien noteholders, which includes the senior lien noteholders (collectively, the “Seniors”), claims in bankruptcy related to the Seconds’ alleged breach of the governing intercreditor agreement (“ICA”) by, among other things, (i) voting in favor of the troubled debtor’s reorganization plan that Seniors opposed, (ii) Seconds’ receipt of equity pursuant to the reorganization plan in exchange for release of claims to certain shared collateral and (iii) Seconds’ receipt of and failure to turn over certain professional fees prior to repayment in full of the senior debt. The Seniors and the Seconds held liens in shared collateral (“Common Collateral”), the priority of which was set forth in the ICA. Seniors claimed that the Seconds’ actions violated the ICA agreement provision which prohibited Seconds from taking “any action that would hinder any exercise of remedies undertaken by the [Seniors] with respect to the Common Collateral” further that each Second “waives any and all rights it … may have as a junior lien creditor or otherwise to object to the manner in which the [Seniors] seek to enforce or collect the Senior Lender Claims or the Liens granted in any of the Senior Lender Collateral.” In addition, until Seniors are repaid in full, pursuant to the ICA, the Seconds expressly agreed to not take or receive any Common Collateral or proceeds thereof in its capacity as secured creditor. In finding in favor of the Seconds with respect to the interference claim, the Courts focused on the ICA provision which provided that “notwithstanding anything to the contrary” in the ICA, the Seconds, were entitled to exercise their rights and remedies as “unsecured creditors” against the debtor. Applying principles of statutory construction, the Courts found this provision trumped any other provision of the ICA. As such, “the Seconds, when acting as unsecured creditors, have unfettered reign to act against” the debtor. In addition, with respect to the turnover claims regarding receipt of common stock and certain fees by Seconds in connection with the restructuring, the Courts found as a matter of law that such common stock did not constitute “proceeds” of the Common Collateral and that the fees were received by Seconds in their capacities as unsecured creditors. Accordingly, the ICA was not breached.
7. California Commercial Financing Disclosures: SB 1235
The California Financial Code was amended by SB 1235, which was signed into law on September 30, 2018 and became the first law to impose standardized disclosure requirements on providers of certain commercial financing transactions (including factoring, asset based and cash flow loans, open ended credit-plans and lease financing transactions) similar to those associated with consumer financing transactions such as the federal Truth in Lending Act. The new law is limited in scope and intends to target the small business owner/borrower ostensibly to protect potentially less sophisticated borrowers by requiring standardized disclosures relating to the loan. In this regard, the disclosure requirements do not apply to banks, but do extend to any bank sponsorship arrangements through an online lending platform administered by nonbank lenders. Commercial financing transactions secured by real estate are also excluded from the new law as well as loans greater than $500,000. Required disclosures include: the total amount of funds provided; the total dollar cost of the financing; the term or estimated term; the method, frequency and amount of payments; a description of prepayment policies and until January 1, 2024, the total cost of the loan expressed as an annualized rate.
8. Affirmation of Seminal Material Adverse Effect Decision
In October of 2018, the Delaware Court of Chancery upheld, for arguably the first time under Delaware law, the buyer’s termination of a merger agreement because a material adverse effect (MAE) had occurred in Akorn, Inc. v. Fresenius Kabi AG , C.A. No. 2018-0300-JTL. On December 7, 2018, the Delaware Supreme Court affirmed the Court of Chancery’s decision in respect of its MAE findings. More specifically, the Supreme Court affirmed the Court of Chancery’s decision properly applied established Delaware MAE jurisprudence and further that the factual record supported the Chancery Court’s decision with respect to (i) the sudden and sustained deterioration in the seller’s business performance constituted an MAE under the merger agreement and (ii) the seller’s false regulatory-compliance representations were reasonably expected to result in an MAE, in each case, failing to satisfy conditions to buyer’s obligations to close. Accordingly, the buyer properly terminated the merger agreement.
9. Updated GAAP Lease Accounting Standards Are Now Effective
In 2016, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) which amended the generally accepted account principles (GAAP) reporting requirements of lessees in certain leasing transactions. In short, lessees must recognize the assets and liabilities for the rights and obligations created by leases with lease terms in excess of 12 months on their balance sheets, i.e., including operating leases which were previously off balance sheet activities. The new guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, for (i) public companies, (ii) not-for-profit entities that have issued securities that are listed on an exchange or an over-the-counter market, and (iii) employee benefit plans that file financial statements with the U.S. Securities and Exchange Commission. For all other entities, the new guidance is effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. The FASB response to concerns that the additional lease liabilities will cause borrowers to foot fault debt service financial covenants in loan agreements is likely to be insignificant in part because the ASU characterizes operating lease liabilities as operating liabilities rather than debt.