What is a cognovit clause? What are some of the main things that a borrower should be aware of in a loan document for a commercial property? Adam Lustig, head of the Real Estate Group at Bilzin Sumberg shares his knowledge.
Tell us a little bit about you.
I'm the head of the Real Estate Group at Bilzin Sumberg, a 110+ attorney law firm based in Miami, Florida. I've been practicing commercial real estate law for 24 years which consists primarily of representing real estate developers and real estate investment companies in connection with acquisitions, sales, leasing, financing, and development of all property types.
What is a cognovit clause? How can that affect an investor if it is in a loan document?
A cognovit clause is a clause in an agreement that authorizes the entry of a judgment against the defaulting party in the event of a default. It's commonly referred to as a confession of judgment. If the loan documents contain a cognovit clause, it allows for the lender to file suit against the borrower in the event of a default, and to immediately obtain a judgment without any prior notice to the borrower. Obviously, that's potentially a major problem for a borrower because they don't receive notice of default, they don't receive an opportunity to cure, and they don't have the right to raise any defenses or effectively to have their day in court.
Why would a bank want to put that clause in the documents? It sounds a bit counterintuitive, because banks typically don't want to hold or take property back.
Because it gives the bank leverage upon a default rather than having to give notice and an opportunity to cure, or if the borrower does default, the banks can avoid a long-drawn-out foreclosure process that in some states can take six months to a year, maybe even longer, particularly if the borrower wants to fight, and raise all sorts of defenses. It really allows the lender to very quickly run to the court and get the entry of a judgment against the borrower without going through a long process in the courts.
Is that always negotiable when we get the loan documents, as a borrower?
It's definitely negotiable. In my experience, it's only available in a handful of states. I've only seen it in Pennsylvania, where it is quite common and difficult to negotiate it out but can be negotiated. In most states, it's not allowed.
What are some of the main things that a borrower for a commercial property should be aware of with regards to loan documents?
Most commercial real estate loans are non-recourse loans, which means that in the event that the borrower defaults, the lender’s recourse is to foreclose on the property. If the value of the property isn't the amount of the judgment, the lender does not have the right to go after the borrower personally, for the deficiency. However, lenders under non-recourse loans typically require what are referred to as bad boy guarantees, or non-recourse carve out guarantees. Principals who are signing those guarantees need to be aware of the circumstances under which they could have personal liability. Early in my career, bad boy guarantees were limited to truly bad acts like fraud and material misrepresentation, misappropriating funds, bankruptcy and similar bad acts. Today, bad boy guarantees have grown in length but many of those things do not necessarily result from a bad act of the borrower, they could be change in economic circumstances or more macro-economic things that could trigger liability. You have to be careful in negotiating the bad boy guarantee and those bad acts, because they trigger personal liability to the principals who are signing them.
Can you give us a few more examples of what a bad boy act could be?
They became much more extensive: failure to pay real estate taxes, failure to pay insurance are examples. While on its face, that doesn't sound so unreasonable, the lender would want to make sure that real estate taxes and insurance are paid. It really goes back to what was the nature of the loan, and the loan is intended to be non-recourse. If the property doesn't generate sufficient rents to pay the real estate taxes and the insurance, should that require the principals, which is the investors, to come out of pocket and pay for that shortfall. With a non-recourse loan, the answer to that should be, no. That's one of the things that I do negotiate with lenders, and I'm often successful getting them to agree that to the extent the cash flow from the property is sufficient to pay those taxes and insurance, then they have to be paid and the guarantors would be guaranteeing them, but if the cash flow from the property is not sufficient, then they would not be on the hook for them.
When you started your career, how long were these documents and how long are they now?
The length varies because there's so much boilerplate in those documents, that it's really the length of the list of bad boys that are most important. That list early in my career would fit on one page, and today it could go on for 2, 3, 4 pages, or more.
Can you share some horror stories with regards to lending documents that someone may not have passed by an attorney and then gotten into trouble later, or something they should have negotiated and they did not.
I don't have a horror story of someone who didn't use an attorney to review loan documents but I have had a number of clients over the years come to me who used attorneys without sufficient expertise in negotiating the loan documents. When they run into trouble, and the loan is in default, or it's about to go into default, they asked for advice on what to do. That's obviously a little bit late at that point and I do the best I can to help them work through the issues with the lender, but they often have significant exposure and little to no leverage. That conversation typically ends with the client saying "I'm going to just hire you the next time."
How long does the back and forth with regards to negotiating the loan document take?
In most cases, loan documents can be negotiated in less than 30 days. In a typical acquisition, you have a 30-day due diligence period, and then a 30-day period after that to close the transaction. It's quite common that the loan document negotiation doesn't start until after the due diligence period. It's certainly something that can be done within 2, 3, 4 weeks.
Do you recommend investors applying with at least two different lenders? The reason I asked this is because it has happened to me and many other people that I know that the lender had sent a term sheet, got everything approved and when the week of closing arrived, they said that they added a new clause there or a new requirement out of the blue.
It's important to talk to more than one lender, to get term sheets from more than one lender and oftentimes to work with a mortgage broker who has contacts with a number of lenders, someone that can go to the market with your potential loan transaction, and come up with a list of the potential sources for the financing. There's a lot of value in using good mortgage brokers and having them help you go to the market, particularly on a complex transaction. But regardless, there's a benefit to talking to multiple lenders to get multiple bids so that you can get a feel for the market and make sure that you get the best possible terms. Some lenders, in their commitment letters or term sheets, do require exclusivity. In that case, there could be penalties if you decide to go with another lender. That's something to be aware of when you're negotiating a term sheet or an application or a commitment letter, which might tie your hands in being able to deal with multiple lenders. But on the front end, it makes sense to do so, and until you have a commitment from that lender, it makes sense to keep your options open so that if the lender walks away or re-trades you, you have a plan B.
I have seen lenders re-trade at the last minute, this is a relationship business, and relationships are important. To the extent that you're dealing with a reputable lender, someone that you have a relationship with, or a mortgage broker or other professionals have a relationship with, that can help minimize some of that risk of getting re-traded at the end by someone that you've never dealt with before. Keeping your options open is important, particularly when you're dealing with a transaction that might have a deadline or if you're under contract to purchase a property, you might have a non-refundable deposit that's up and hard closing date. The timing can be tight, the dates are really important and the implications of not being able to close by the closing date are usually forfeiting that deposit.
Do you recommend us negotiating on the commitment letter that they're not going to change or require absolutely anything else after the commitment letter is signed to avoid this problem?
I recommend that clients get the attorneys involved at the term sheet or commitment letter stage, that's really important. A lot of clients don't think to do that, they don't necessarily want to incur legal fees before they know whether they have a deal with the lender. It's going to cost a little bit more, but it can save you a lot of heartache down the road. Once the client has agreed to something in a commitment letter or term sheet, it's much harder to negotiate it weeks down the road when you get the first draft of the loan documents, then you have a hard closing date and only a couple of weeks to get the deal done. Have these attorneys help you at the beginning, it's only a couple of hours’ worth of time to negotiate the term sheet or commitment letter and advise you of some of those risks and traps on the front end. It's going to be quite difficult to get the lender to agree that they're not going to make any changes because usually, at the term sheet or commitment or application stage, they haven't gone through all their underwriting, they don't have an appraisal yet, there's a whole list of requirements that have to be satisfied. At the end of the day, if the lender doesn't want to make the loan, they will find a way not to make the loan. As a borrower, you don't have much recourse there.
Besides having an attorney at that commitment letter stage, how do we avoid this problem of them putting extra requirements at the end?
It goes back to relationships. Having professionals involved, including mortgage brokers, that help feed business to those lenders helps, they keep them honest, and walking a straight line. Most of the lenders that I've seen that come back with additional requirements at the end are not doing it to re-trade the deal, they're doing it because their underwriting and due diligence has uncovered issues that have to be addressed. When there's a change in the terms it's when a lender completes their underwriting, "We reviewed the leases, and there's this issue, this tenant has the right to terminate early, so we can't really count it as a 10-year lease if they can terminate after three years, so we have to underwrite it a little differently", or the appraisal came back with something, or we had a property condition report done and it turns out that the roof needs to be replaced and that has to go into a reserve. That's more typically what I see, not just a blatant re-trade at the end, because the lenders think they can do it because they have leverage. There are some unscrupulous ones out there, but it goes back to know who you're doing business with, and having appropriate relationships and introductions to good people.
Is there anything else that you think is important for our audience to know with regards to these loan documents that they really should be mindful of?
There's a whole lot of provisions in loan documents, sometimes these loan agreements can be 100 pages, 200 pages so, it's important that you have a qualified attorney helping you in reviewing those documents that can point out the issues that you really need to be concerned about. Another thing is, I've seen term sheets or commitment letters, where the lender is requiring not just a mortgage on the property as their collateral, but also a pledge of all of the ownership interest in the borrower. Clients have agreed to that, they signed it before engaging counsel, probably not really understanding what it means. Once they've agreed to it, it's really hard when you get to the loan documents to try to undo it but that is one of those traps for the unwary. This means that with a foreclosure, in most states, you have to go through the courts, that process can take six to 12 months, potentially even longer. With a pledge of equity, the lender can do what's called a UCC Article 9 foreclosure, which only requires 10 days’ notice to the borrower before a public or private sale of the property is held. And they don't have to go through the courts at all. It's along the lines of a cognitive clause which is a method for a lender to very quickly foreclose on the collateral, and if they have a pledge of all of your equity, then if they foreclose on that pledge, they now own 100% of the borrower, so they now own the property indirectly. That's just one of the things to be careful of when you're negotiating loan documents. If you see it in the term sheet, or commitment letter, that's the best time to push back on it. The lender might have a reason why they need it, or why they have to have it, but it's important to understand what it means and to negotiate it away on the front end.