Crisis Averted? Close Calls and Lessons for CRE Lenders After Recent Bank Shutdowns

March 17, 2023

This series of articles from Dechert’s Global Finance Group reviews various aspects of loan documents and market practices relating to commercial real estate lending in light of the takeover of several banks earlier this month.  Topics range from breaking up with your DACA bank to reviewing default provisions - with a focus on practical analysis and suggestions for navigating loan documents in a post-shutdown world.

Part V - Not It!

In the wake of the FDIC bank shutdown actions taken last month, we have written about cash management arrangements, account naming conventions, financial covenants and rating requirements in typical commercial real estate loans with 20/20 hindsight.  Our prior analyses often required connecting the dots across multiple defined terms, various provisions and more than one loan document to try to fully understand the implications of a bank closure.  In this article, we’ve delved into a much more direct topic: what do customary commercial real estate loan documents say about liability with respect to funds in various deal-required bank accounts?  Here’s a hint – probably less than you think!

We reviewed a wide sampling of commercial real estate loan agreements – from balance sheet loans, to SASB deals to conduit paper – and here is what we found:

  • Many loan agreements are completely silent regarding who is liable with respect to amounts on deposit in the various accounts set up under a loan (which we will call, generically, “Reserve Funds” for purposes of this article).
  • Some loan agreements, however, do contain indemnity language similar to these two examples:

Ex. 1 - Borrower shall indemnify Lender and hold Lender harmless from and against any and all Losses arising from or in any way connected with the Accounts, the sums deposited therein or the performance of the obligations for which the Accounts were established.

Ex. 2 - Borrower shall indemnify and hold Lender harmless from and against any and all actions, suits, claims, demands, liabilities, losses, damages, obligations and costs and expenses (including attorneys’ fees and expenses) arising from or in any way connected with the Reserve Funds Account and/or the Reserve Funds Lockbox Agreement (unless arising from the gross negligence or willful misconduct of Lender) or the performance of the obligations for which the Reserve Funds Account was established.

An indemnity from the borrower – that’s good, right?  Lenders are covered, right?  Well, an indemnification obligation from borrower to lender doesn’t directly get at the issue of who is liable in a situation where there is a bank shutdown and FDIC insurance is insufficient to cover the full amount of Reserve Funds.  If the Reserve Funds are the property of the borrower, and it is the borrower who suffers the “loss”, then query what it means for a borrower to indemnify the lender from losses…?

In the second example, above, note the carveout for gross negligence of the lender.  This is fairly typical language.

  • Some loan agreements contain clear language that the lender is not liable for certain kinds of losses:

Ex. 1 - Lender shall not be liable for any loss sustained on the investment of any funds constituting the Reserve Funds.

Ex. 2 - Lender shall not be liable for any loss sustained on the investment of any funds constituting the Reserve Funds so long as such investment was not expressly prohibited by this Agreement or the Reserve Funds Agreement.

While these and similar provisions protect lenders from claims relating to losses sustained by the investment of Reserve Funds, they still do not address a situation where there is insufficient FDIC insurance.

  • The best provisions we found were better at limiting a lender’s liability for risk of loss relating to Reserve Funds more generally, although they were still not completely on point.  Below are two of these more protective examples:

Ex. 1 - In no event shall Lender be liable either directly or indirectly for losses or delays relating to the Reserve Funds resulting from any event which may be the basis of computer malfunctions, interruption of communication facilities, labor difficulties or other causes beyond Lender’s reasonable control or for special, consequential, treble or punitive damages except to the extent of Lender’s gross negligence, willful misconduct, fraud or illegal acts.

Ex. 2 - Except as otherwise provided in this Agreement or as required by applicable law, Lender will have no duty as to any Reserve Funds, as to ascertaining or taking action with respect to calls, conversions, exchanges, maturities, tenders or other matters relative to any Reserve Funds, whether or not Lender has or is deemed to have knowledge of such matters, or as to the taking of any necessary steps to preserve rights against any parties or any other right pertaining to any Reserve Funds.

Given the banking industry events of last month, and the potential losses that depositors were facing due to the cap on FDIC insurance proceeds, loan documents should be clear as to the allocation of liability when Reserve Funds are at risk.  (From a lender’s perspective, the answer to who’s on the hook is, of course, “not it”!)

  • In our prior three articles, we discussed the potential impact of the recent bank shutdowns on cash management arrangements and guarantor financial covenants in commercial real estate lending. The issues we identified could make it appear that loan documents have no protection in the event a lockbox bank or cash management bank suffers distress. But, that is not the case. Loan documents generally contain a requirement that accounts be “Eligible Accounts” and that the accounts be held at “Eligible Institutions”. These definitions are meant to be the primary protection for both lenders and borrowers that all funds flowing through the cash management system are held in a safe manner.

    Let’s look at sample definitions of “Eligible Account” and “Eligible Institution”.

    Eligible Account” shall mean a separate and identifiable account from all other funds held by the holding institution that is either (x) an account or accounts maintained with a federal or state-chartered depository institution or trust company which complies with the definition of Eligible Institution, or (y) a segregated trust account or accounts maintained with a federal or state chartered depository institution or trust company acting in its fiduciary capacity that has a rating of at least “[XX]” and which, in the case of a state chartered depository institution or trust company, is subject to regulations substantially similar to 12 C.F.R. §9.10(b), and having in either case a combined capital and surplus of at least $[XX]. An Eligible Account will not be evidenced by a certificate of deposit, passbook or other instrument.

    Eligible Institution” shall mean (a) a depository institution or trust company insured by the Federal Deposit Insurance Corporation (i) the short term unsecured debt obligations or commercial paper of which are rated at least “[XX]” (or its equivalent) from each of the Rating Agencies (in the case of accounts in which funds are held for thirty (30) days or less) and (ii) the long term unsecured debt obligations of which are rated at least “[XX]” (or its equivalent) from each of the Rating Agencies (in the case of accounts in which funds are held for more than thirty (30) days) or (b) such other depository institution otherwise approved by Lender from time-to-time.
    The key qualifying criteria for both definitions are the minimum ratings required for the institution holding the relevant account.

    So, how do those ratings work?

    Ratings are issued by nationally recognized statistical ratings organizations (NRSROs) such as Fitch, Inc., Moody’s Investors Service, Inc., S&P Global Ratings, and others. NRSROs communicate their ratings to the general public through announcements, which are distributed to major financial newswires, and by publication on NRSRO websites. Many NRSROs also issue periodic ratings reports. Banks often include these ratings on their own websites.

    An NRSRO can update or withdraw its ratings at any time. A material a negative (or positive) credit event is likely to trigger a ratings reassessment. In advance of such a credit event, an NRSRO may issue an anticipatory statement, such as a downgrade (e.g., from “stable” to “negative”) or an upgrade, or place a rated entity “on watch”. These predictive actions put parties on notice that something may happen.

    As we know from recent experience, however, credit events can be sudden, with little or no advance warning. And, no NRSRO can predict the certainty of a credit event occurring. Consequently, many updates to ratings are reactive, and not proactive. Hence, a lag. Recently closed banks had high ratings at the time of shutdown, and the ratings for each were not updated until after the FDIC had intervened. In those cases, the update was that the ratings for each were withdrawn.

    Did the ratings requirement in the customary Eligible Account / Eligible Institution definitions provide the protection as intended in this instance? No, and it is not clear that they could have. NRSRO ratings are not always able to serve as a canary in the coal mine. So, what is a lender to do? While this may be an issue without a definitive fix, here are some things to consider:

    • Should the financial criteria used in “Eligible Account” definitions be adjusted?

    • Should the ratings used for assessing “Eligible Institutions” be modified?

    • Should additional criteria be added to “Eligible Institution”, such as requiring that no receivership or insolvency proceedings exist?

    • Should a lender have the right to take action based on a negative credit event, such as a downgrade, even if a bank’s minimum rating requirements remain satisfied?

    • Some loan documents pre-approve specifically named banks. Should a specifically named bank still be subject to minimum ratings and/or not under receivership criteria?

    Lots to think about here, and likely no right answers – but definitely some wrong answers, and maybe some better answers. In sum, ratings serve a variety of watchdog purposes in financing transactions, but they do come with the risk of a lag. And, when the monetary lifeblood of a commercial real estate deal is at stake, the lag really can be a drag.

  • While our other articles have focused on the nuts and bolts (and bumps and grinds) of lockbox accounts and cash management arrangements in the wake of the recent bank shutdowns, there is more of concern for lenders than the logistics of claiming insurance proceeds and the location of cash management accounts. Let’s talk about loan guarantees.

    Almost every commercial real estate loan has at least one guaranty as part of its collateral package. Depending on the type of loan, multiple guarantees may be required to cover various aspects of the transaction (i.e., recourse guarantees, completion guarantees, carry guarantees, replenishment guarantees, etc.). Lenders take great care to negotiate financial covenants with respect to the creditworthiness of the party providing the guaranty. The most common covenants are net worth and liquidity requirements. Not every loan has both covenants, so they are addressed individually below.

    Net Worth Covenants
     -- Here is a typical net worth covenant:

    At all times until the Loan has been indefeasibly paid in full, Guarantor shall maintain Net Worth in the aggregate of not less than $XX (excluding any equity or value attributable to the Property securing the Loan).

    “Net Worth” shall mean, as of any given date, (i) Guarantor’s total assets as of such date less (ii) Guarantor’s total liabilities (taking into account contingent liabilities) as of such date.

    Some loan documents will contain additional details and restrictions on the calculation of Net Worth, such as excluding non-US assets or intangible assets or adding in a concept of lender discretion.

    Liquidity Covenants -- Here is a typical liquidity covenant:

    At all times until the Loan has been indefeasibly paid in full, Guarantor shall maintain Liquid Assets in the aggregate of not less than $XX.

    “Liquid Assets” shall mean cash and cash equivalents, but only to the extent owned freely, free of security interests, liens, pledges or any other encumbrance; provided that Liquid Assets shall not include any asset that is part of the collateral for the Loan.

    Again, some loan documents will be more detailed and may specifically define “cash and cash equivalents” in a manner similar to this:

    Cash and Cash Equivalents” shall mean: (i) United States dollars and (ii) any of the following which may be liquidated without restrictions within five (5) Business Days or less: (a) securities issued or directly and fully guaranteed or insured by the United States government or any agency or instrumentality thereof having maturities of not more than six (6) months from the date of acquisition; (b) certificates of deposit and Eurodollar time deposits with maturities of six (6) months or less from the date of acquisition, bankers’ acceptances with maturities not exceeding six months and overnight bank deposits, in each case, with any domestic commercial bank having capital and surplus in excess of $500 million and an S&P Certificate of Deposit Rating (short term) of A-1 or better or the equivalent by Moody’s; (c) repurchase obligations with a term of not more than seven (7) days for underlying securities of the types described in clauses (ii)(a) and (b) above entered into with any financial institution meeting the qualifications specified in clause (ii) (b) above; (d) commercial paper having the highest rating obtainable from Moody’s or S&P, and in each case maturing within six months after the date of acquisition; and (e) money market funds substantially all the assets of which are comprised of securities and other obligations of the types described in clauses (i) and (ii)(a) through (d) above.

    What’s The Impact of the Bank Shutdowns on Guarantees?

    What is common across these covenants is that there is nothing which would expressly pick up an FDIC takeover of a bank. As a reminder, absent the extraordinary steps taken last week with respect to Signature Bank and SVB, depositors are only insured up to the first $250,000 of funds in each account meeting the FDIC’s recognized ownership categories. As an example, a guarantor with a $2,000,000 cash deposit account at a bank that gets taken over is insured for $250,000, but will only have a receivership certificate for the $1,750,000 balance. What might that mean in terms of compliance with the Net Worth and Liquid Asset covenants described above? As drafted, things might be better for the guarantor than for the lender…

    • If a Net Worth definition includes a concept of lender discretion, perhaps the lender has an argument to discount the value of the $1,750,000 receivership certificate.

    • If a Liquid Asset covenant doesn’t have a specific definition for “cash and cash equivalents”, a guarantor is likely to insist that the receivership certificate counts as a full cash equivalent.

    • If there is a detailed definition of cash and cash equivalents, a lender may be in a better position to exclude the receivership certificate – however, if the guarantor’s original asset was a certificate of deposit (rather than cash), and the bridge bank assumed the CD obligation, a lender may still face a fight with its borrower as to whether the CD counts towards the liquidity requirements.

    Clear language, rather than an argument with a borrower, is always preferred. Lenders should review their existing financial covenants (and related definitions) and consider whether changes to those provisions going forward could prevent a situation where a lender may have to live with the pretense that a guarantor is wearing clothes.

    And, lenders, beware -- your own closet may have some invisible garments in it. The same kind of financial covenants often appear in repurchase, warehouse and note-on-note facilities that lenders use to leverage their assets.

    Stay tuned for additional articles in this series analyzing the impact of the recent bank shutdowns on the CRE industry’s loan documents. Check out this post from Crunched Credit with Rick Jones’ commentary on market opportunities in a time of broken banks.

  • In the immediate wake of the Signature Bank takeover, commercial real estate lenders undertook swift inventory of their loan files to identify where they may have had exposure due to funds on deposit with Signature Bank. This meant identifying each deposit account control agreement (commonly called a lockbox agreement, or clearing account agreement, or deposit account agreement, and referred to in this article as a “DACA”) and each cash management agreement with Signature Bank as a counterparty.

    Further, most lenders have been evaluating whether there should be changes to their lockbox and cash management arrangements, and many borrowers have been contacting their lenders and insisting that their funds be transferred to accounts at banks other than Signature Bank.

    How does a lender break up with a DACA or cash management bank in financial distress? This article will walk through some relevant considerations, whether for this breakup or a future one.

    Let’s start with what the relevant documents say:

    Loan Agreement –

    • The loan agreement will usually contain eligibility requirements that must be satisfied in order for a bank to be used for cash management accounts and lockbox accounts (also sometimes called clearing accounts or deposit accounts). Often, the concept of an “Eligible Institution” is specifically detailed, with eligibility tied to a bank’s ratings.
    • The loan agreement often provides for the right of a lender to select the cash management account bank (including the unilateral ability to replace such bank from time to time).
    • However, loan agreements often are silent on the ability of a lender to select, or to cause the borrower to replace, a lockbox bank, unless such bank no longer meets the Eligible Institution criteria.
    • Even if the loan agreement provides for Eligible Institution criteria, and allows for the replacement of a bank, it generally is not so granular as to detail the specific replacement process should a bank no longer satisfy the relevant criteria (such as borrower cooperation, costs and expenses, etc.).

    DACA –

    • Typically, DACAs provide for unilateral termination by a lender upon 30 days’ notice to the lockbox bank and borrower.
    • Most DACAs do not address, either expressly or implicitly, what happens if the lockbox bank is taken into receivership or shut down (or downgraded or placed on any sort of watch list, for that matter).
    • However, simply because a DACA may require 30 days’ notice for termination to be effective, that does not mean that funds must continue to be deposited with the lockbox bank during the interim period. Although it will require the cooperation of both borrower and lender, tenants and other relevant parties can be directed to make their payments into a different account while the notice period for termination is running.

    Cash Management Agreement –

    • A cash management agreement is similar to a DACA, in that it provides for lender control over a specific bank account. Like with a DACA, generally a lender will have the unilateral right to terminate a cash management agreement upon notice to both borrower and cash management bank, usually 30 days.
    • As with the interim period after sending a termination notice on a DACA, a lender can prevent funds from going into the cash management account by sending a redirection notice to the lockbox bank, instructing it to send daily sweeps to a different account.

    Practically then, what is a lender to do? The documents described above provide a number of provisions that – even when taken as a whole – do not fully contemplate a sudden distress event, such as the shutting down of a lockbox bank or cash management bank, or the transfer of accounts to a successor bridge bank as part of receivership.

    What we are seeing right now, in light of current banking concerns, is a combination of the following:

    • Many lenders and/or their servicers preemptively moved funds out of Signature Bank, with or without following the technical provisions of relevant loan documents.
    • Some lenders have delivered redirection letters to their lockbox banks, instructing them to cease daily sweeps into cash management accounts at Signature Bank/Signature Bridge Bank.
    • Some lenders are working with their borrowers to divert funds from going into Signature Bank/Signature Bridge Bank lockbox accounts.
    • Many lenders are setting forth action plans with their borrowers to implement new lockbox and/or cash management regimes at banks other than Signature Bank/Signature Bridge Bank.

    All of the above actions rely, to a certain degree, on borrower cooperation and/or after the fact loan modifications.
    What could make this process easier, or at least more clear, for a lender should there be a next time?

    1) Consider using a definition for “Eligible Institution” in the loan agreement and any other relevant document, such as the servicing agreement, that specifically details as additional criteria that a bank taken under control of the FDIC or other relevant authority is no longer an Eligible Institution.

    2) In each of the loan agreement and DACA, consider whether a lender should have an express unilateral right to direct borrower to terminate and/or replace a lockbox bank relationship upon such bank no longer being an Eligible Institution. Note here that any such termination should not be automatic – rather at lender’s option so that cushion time (e.g., 30 days) can be utilized to identify and implement a replacement DACA. To have a DACA automatically terminate may not be enforceable (and/or raise ipso facto issues) and, from a practical perspective, could leave cash management matters in an even more abrupt state of limbo where funds could be rejected.

    3) In connection with any termination or replacement of a lockbox bank or a cash management bank, thought should be given to including a covenant (most practically in the loan agreement) requiring borrower to cooperate with the process and detailing related action steps.

    4) In each of the DACA and the cash management agreement, a lender may want to eliminate provisions that require the bank being terminated to affirmatively acknowledge receipt of the termination notice as a condition to the effectiveness in the case of a termination triggered by bank distress. A shut down bank or a bank in distress may not have the administrative processes in place to handle such acknowledgement.

    5) Similarly, lockbox banks often require written notice, then written acknowledgement back from the bank, and then the passing of a few business days before implementing any change in its daily or weekly sweep protocol to a new cash management bank. Given the importance of expediency in a shut down or receivership situation, lenders may seek an exception to that process allowing for a shorter timeframe and electronic delivery methods if the bank to which the funds are being swept is under FDIC control.

    Breaking up may be hard to do, but at least with a clearer path, it might be just a little bit easier.

    For thoughts about opportunities for new lockbox banks to ease the transition for rollover DACAs from Signature Bank, be on the lookout for our upcoming Crunched Credit blog post next week.

    Stay tuned for more thoughts and suggestions for commercial real estate lenders navigating their documents post-Signature Bank.

  • Shakespeare may have thought that a rose by any other name was still a rose…but would an FDIC regulator see things the same way? Don’t bet on it.

    This past weekend while the FDIC was taking over Signature Bank, many lenders (and their lawyers) were busy trying to understand the impact of the shutdown on the multitude of reserve accounts, cash management accounts and lockbox accounts set up at Signature Bank relating to hundreds of commercial real estate loans. It turns out – names matter.

    Before the FDIC announced late on Sunday, March 12, 2023, that all depositors at Signature Bank would be made whole, many lenders were grappling with the FDIC regulations regarding deposit insurance coverage. As many recent articles have already described in great detail, the FDIC insures the balance of a depositor’s account up to $250,000. However coverage amounts depend on how accounts are owned, including the application of certain distinct ownership categories recognized by the FDIC (e.g., individual accounts, joint accounts, trust accounts, retirement accounts, etc.). It came as a surprise, even to some highly sophisticated parties, that the maximum $250,000 of insurance is aggregated across all accounts in each ownership category at a failed bank that are owned by the same party.

    It is common practice for commercial real estate loan documents to require deposits of property revenues directly into a lockbox account, which then sweeps on a daily basis into a cash management account. In addition, reserve accounts (for taxes, insurance, FF&E, etc…) are a customary feature. These accounts -- lockbox, cash management and reserve -- are usually required to be “lender controlled” accounts, or accounts “in the name of a lender” or “for the benefit of the lender”. While that nomenclature may have been designed to describe a lender’s security interest in and control over the accounts, that wording could have unintended consequences when dealing with a bank receivership. The FDIC rules focus on the owner of the deposits and regulators start with the presumption that ownership is determined by the deposit account records of the failed bank (12 C.F.R. § 330.5). If an account is entitled in the name of the lender or f/b/o the lender, and the FDIC were to consider such lender to be the owner of the account, then the deposit insurance would be payable to that lender. So, what’s the problem with that outcome? Well, it turns out that lenders were often using Signature Bank for accounts on multiple loans at the same time. Under the aggregation rules, the FDIC would only allow a single $250,000 insurance claim across all of a lender’s accounts at Signature Bank, notwithstanding that the accounts related to completely different loans and unrelated borrowers.

    So, what’s a lender to do? Most complex commercial real estate loan documents require lender-controlled accounts, and some even contain boilerplate language stating that such lender-controlled accounts are not the property of borrower and should be excluded from the estate of any borrower who files for bankruptcy. But then, many loan agreements may also contain statements requiring borrower to report any interest earned on an account as borrower income, suggesting that the accounts are owned by borrower. It’s clear that for purposes of the FDIC insurance regulations, both lender and borrower benefit from making sure that borrower is considered the owner of the accounts and related deposits and gets the benefit of the FDIC insurance in the event of a bank failure. With that in mind, it would be prudent for commercial real estate lenders to:

    (i) include in the loan agreement an express statement regarding the ownership of any required accounts, including specifically for purposes of 12 C.F.R. § 330.5 (Recognition of deposit ownership and fiduciary relationships);
    (ii) require that borrower’s name also appear in the title of every account established in connection with a loan that is lender-controlled or f/b/o lender;
    (iii) require that any accounts maintained by a servicer (or custodian) clearly indicate that such account is being held in a servicing or custodial capacity only (See 12 C.F.R. § 330.7 – Accounts held by an agent, nominee, guardian, custodian or conservator);
    (iv) use the borrower’s tax ID number when establishing each required account; and
    (v) ensure that the account records at the bank consistently reflect that the account is owned by borrower.

    The FDIC’s late night decision on March 12th to provide insurance above the $250,000 cap saved lenders with cash management accounts at Signature Bank from having to wade through the details of how their accounts were named and owned (and avoided the need to explain these complex arrangements to regulators). However, a future bank takeover might turn out differently. So, lenders take heed and remember that a rose smells sweetest when you simply call it a rose.

    Stay tuned for further analysis of issues raised for commercial real estate lenders by the Signature Bank closure.