Bring On Q4 – September 2021 – Limited Recourse Funding Series, Part 3: Safety Package and Considerations | Cadwalader, Wickersham & Taft LLP
In this part 3 of the Limited Recourse Funding Series, we discuss some common questions and considerations regarding the security package in a typical limited recourse structure.
For a typical SPV structure (see diagram below):
The customary English law guarantee package would include all asset guarantees to be given by all debtors. The Debtors would include the Borrower SPV and, if the real estate is held by subsidiary PropCos, the shares of those PropCos as well as all the assets of those PropCos. This will include:
- Real estate mortgage on properties.
- Security on all bank accounts held by debtors. (This will also include the agreed control mechanisms. It is not uncommon for some bank accounts to come under lender control, requiring co-signing authorization / approval prior to any withdrawal.)
- Security on insurance with regard to properties.
- Assignment of key contracts (if not all), including leases.
- Collateral on the subordinated debt of the shareholders in the structure.
In addition to security documents, the following documents are generally required:
- As long as there is a property manager managing the property, a due diligence agreement between the lender, property manager and borrower.
- As long as there is an asset manager, a due diligence agreement between the lender, the asset manager and the borrower.
- Shareholder debt subordination agreement.
- To the extent that there are other key contracts that would affect the value of income and / or the value of the property, additional documents that would provide the lender with intervention rights (for example, if the property is a hotel and subject a franchise or hotel management contract with a hotel chain, a non-disruption agreement).
When considering the security package, the ultimate question for a lender is how the security package should be structured to aid its exit strategy. Obviously, the cleanest, and perhaps the easiest, approach to a collection strategy for lenders is to sell the property in a compulsory execution. Therefore, the approach taken in non-recourse / limited recourse real estate finance would often require a guarantee on all of the assets of the borrowing SPV, and on each intermediary holding company (if any) on the underlying asset, as well as on the every asset that helps generate cash flow for the property. To ensure that the lender can sell the whole set with relative ease, an action charge is often levied at the level of the holding company (on the shares of the borrower SPV and each of the entities holding a real estate interest) to enable a business sale.
To ensure that the security package would not violate the unrestricted recourse structure, the security afforded by the holding company / promoter (i.e., the charge of action and the guarantee on shareholders’ debt, if any appropriate) must include limited-use language. The wording would provide that the lender’s recourse is limited only to the property subject to the guarantee (that is to say, said shares and / or shareholder debts), and beyond these assets, there is no further recourse against the limited partner. Although the documentation seeks to obtain null recourse / liability against the promoter by limiting the lender’s recourse to only the assets, the promoter could, despite the provisions of the security documentation, still be liable. This is the case in the event of a misrepresentation or breach of commitment on the part of the sponsor concerned, as the lender may seek general contractual remedies against the sponsor for breach of contract and seek damages from the sponsor. However, this is separate from collections for the underlying debt owed by the SPV borrower.
In addition to taking collateral on all affected assets and cash-generating contracts, lenders would ensure that anything that gives rise to liability is addressed. The types of liabilities can be broadly divided into two categories:
- debts essential for the continued day-to-day management of the asset, and
- liabilities that were sunk costs in the vehicle / SPV structure and which, if removed, would not affect future cash flows generated by the property.
The liabilities of the first category would include the head lease (if the property is a lease), routine maintenance / property management contracts and, in the case of hotels, the franchise contract – all of which are essential, and loss of these contracts and the related obligations would be detrimental to the value of the property.
The liabilities of the second category would include shareholder loans and other subordinated debt, and depending on the nature of the asset management contract and the services provided, if it is determined that these services do not contribute to the value and / or to the cash flows generated by the property, the commitments under these contracts. This is often the approach of ensuring that liabilities classified in category two can be eliminated on execution so that the asset is presented in as attractive a light as possible to potential buyers.
In Part 4 next month, we’ll discuss some of the common pitfalls of limited recourse funding structures.
 It is often the preferred approach of lenders to take collateral on subordinated debt as it provides estate interest on the debt, which facilitates release in an execution scenario. However, in certain circumstances where collateral cannot be provided on the subordinated debt, it is possible to agree specific powers to write off the subordinated debt in the subordination agreement. With this approach, the lenders will rely on its contractual rights under the subordination agreement.