February 08 2011
While the real estate and financial crisis of the last few years has meant that many real estate financing schemes have been extended as a result of the poor market situation, an increasing number of parties involved find themselves forced to give thought to issues such as the realisation of collateral or the identification of suitable exit strategies. In order to spread risk, many real estate loans granted during the period from 2005 to 2007 were syndicated loans and have since been sold; or third parties have acquired sub-participations in such syndicated loans. As a result, a multitude of lenders with partly diverging interests must be taken into consideration when formulating a suitable strategy to exit such financing transactions. Another reason why these issues are becoming increasingly topical is the growing number of cases in which the term of securitisation transactions finalised in the period from 2005 to 2007 will soon end.
In all of these financing schemes, real estate (typically commercial real estate) is acquired through a special purpose vehicle (SPV) and largely financed by borrowed capital. The loan interest and redemption payments are then made out of the rental income. While on paper the real estate is owned by the SPV, a parent company of the SPV actually controls the real estate in economic terms. In this update these parent companies are, in each case, referred to as being the owners of the real estate concerned. In many cases major groups consisting of a multitude of SPVs have been created by a German or foreign holding company, which are also responsible for ensuring appropriate cash pooling within the group. In most cases the investment funds that created such group structures hold only small shares in the equity capital of the SPVs.
The principal difficulty in backing out of such syndicated schemes or a securitisation lies in the fact that many parties with different financial interests are involved, making it difficult to make use of legal possibilities to engineer a financially adequate loan workout scheme (the so-called 'prisoner's dilemma'). Often, many of the parties involved have nothing more to lose. This is especially true for those banks which never held shares in syndicated loans or loan bonds, or have sold them and merely act as a trustee, holding or managing shares in syndicated loans or collateral security on behalf of the creditors (facility/security agent or (special) servicer). In addition, the requirement that all bond creditors agree to major decisions often renders it difficult to make use of available legal options. Furthermore, loan conditions often provide for a tail period during which the duration of a financing scheme cannot be modified or can be modified only at short notice.
The term of many of these securitisation schemes will expire within the next two or three years and, seen from the perspective of the bond creditors and (partly) syndicate banks, the repayment of these loans involves just as many uncertainties as the question of whether they can be refinanced under acceptable conditions. Against this background, this update discusses certain legal aspects of conceivable loan workout schemes. The large number and wide variety of legal issues arising in this connection, touching on real estate, financing, insolvency and even tax law, make it impossible to discuss more than just a small selection of the legal aspects that may be of relevance in this connection.
All of these workout strategies are based on covenant breaches (giving creditors the right to terminate their loan commitments prematurely) that occurred as a result of the financing crisis experienced by property holding companies.
Termination rights during financial crisis
The minimum requirement to be met before further consideration can be given to any workout strategy is that the borrower committed a covenant breach which entitled the creditor to terminate the loan prematurely. Such a covenant breach may consist of a delay in payment or an inability on the part of the borrower to pay its debts when they fall due, but may also consist of a breach of contractual obligations committed before payment problems actually occur.
(Imminent) inability to pay
In connection with a loan, 'inability to pay' means that a borrower is unable to make interest and redemption payments when these fall due. All loan agreements contain a clause allowing the lender to terminate the loan prematurely if such a situation arises. Under German law, the requirement for a 'valid cause' justifying the premature termination of a loan may be deemed to have been met even in cases where such an inability to pay is merely imminent.
Once a borrower has become unable to pay, this increases the difficulties involved in finding and implementing an acceptable workout strategy. If the borrower has the legal form of a limited liability company or of a limited partnership with a limited liability company as sole general partner, the directors of the limited liability company must file an insolvency petition within three weeks of the date on which the inability to pay first occurred. This period is rarely sufficient to hold the necessary negotiations with the owner or to prepare a confrontational course of action.
Therefore, in order to win time, it is usually necessary to make liquid funds available. However, the owner will rarely be able (let alone prepared) to make additional payments subsequently. Nor is it likely that the original lenders (and even less so, any new lenders) will be prepared to provide fresh funds. For one thing, syndicated financing structures and securitisation schemes lack the degree of flexibility that would be required for this. Moreover, seen from the perspective of lenders, the risk of being held liable is a sword of Damocles that hangs over all loans granted while the borrower is experiencing financial difficulties. Very often, obtaining a work-out opinion is the only way to reduce this risk, but once the borrower is unable to pay (or such inability is imminent), the amount of time and money available usually no longer suffices to obtain such an opinion.
Other covenant breaches
Apart from cases involving obvious covenant breaches (ie, where a borrower is in delay with its payments, or even entirely fails to make any payments), such breaches may also occur at the level of the tight network of loan conditions which allow creditors to monitor their borrowers that has evolved over the past 10 years. For instance, most real estate loan agreements nowadays provide for a 'loan to value' threshold and for a 'debt service cover' ratio or 'interest cover' ratio.
If these ratio requirements are not met or if a borrower fails to disclose the relevant information to the lender, this gives the latter the right to terminate the loan. However, at least in cases where German law applies, it is necessary to ensure that loans are not terminated at a time when this is considered inappropriate by the law or when a valid cause stands in the way of the termination, or where the termination may be seen as an improper exercise of a legal right.
On the other hand, the mere existence of circumstances which allow a loan to be terminated prematurely usually suffices to motivate property owners to engage in negotiations to avoid the termination. This then allows lenders to adjust the loan conditions rather than to terminate the loan.
Possible courses of action
When encumbered real estate is to be realised, creditors can choose between adopting a cooperative or confrontational approach. The choice largely depends on whether the owner is prepared (fully or in part) to give up its position as shareholder of the corporate entity that owns the property in legal terms.
Several possibilities of terminating a real estate financing without confrontation exist in cases where the property owner is prepared to give up its position as a shareholder of the property company. One such possibility is the sale of the property by private contract on the open market, without the involvement of judicial authorities. The principal advantages of this procedure are that there may be realistic hopes of obtaining an acceptable price that corresponds to the market value of the property, and at the same time it may be possible to avoid unnecessary publicity. The borrower will temporarily keep its shares in the corporate entity which is acting as legal owner of the property, but will at the same time try to find a purchaser for the property on the open market. When the property is then sold, the proceeds from such sale will be used to satisfy the creditors' claims. Alternatively, the borrower's shares in the corporate entity that is holding the property may be transferred to a trustee or third party of the creditors' choice, which can then see to it that the real estate is sold in an orderly manner.
Sale in the open market by the owner
In most cases a borrower selling financed real estate is required under the loan agreement to repay such part of the loan that served to finance the property sold, and not to use any of the sale proceeds for any other purpose before the repayment has been made. However, such clauses provide for no obligation to sell and, apart from a very few exceptions, even a covenant breach by the borrower does not suffice to give the lender any right to require the borrower to sell the property.
Therefore, if a lender wants a borrower to sell a mortgaged property, this must be agreed between the parties when such a situation arises. In most cases any willingness to negotiate on the part of borrowers in such cases is motivated by fears that the lender may otherwise terminate the loan because of a covenant breach. There is also the possibility of promising a share in reorganisation profits. However, the disadvantage of this is that claims arising from such a promise are difficult to enforce. If a borrower first agrees to sell a mortgaged property, but then refuses actually to do so, the lender often has no other option but to call in the loan and to realise the collateral.
However, even if the owner of mortgaged property is willing to cooperate, it is nonetheless important to be aware of certain legal intricacies that may gain practical relevance. For instance, a decision that real estate held by a property company (ie, all assets of that company) is to be sold may have the effect that the property company is regarded as being over-indebted (in legal terms). Financial difficulties may make it difficult to obtain a fair market price for the property. Capital gearing frequently has the effect that an SPV is over-indebted according to its balance sheet of over-indebtedness, which is a statement of assets and liabilities to be drawn up for insolvency law purposes on the basis of the commercial balance sheet. However, since November 2008, it is permissible to ignore such a balance sheet of over-indebtedness as long as the management may reasonably believe that the company will 'survive'. However, if the decision to sell the real estate held by the SPV has the effect that there are no longer sufficient grounds for such a favourable forecast, this may mean that the SPV is over-indebted and must file an insolvency petition before any such sale of its real estate may take place. After the filing of an insolvency petition, any sale of real estate of the SPV must be preceded by a declaration of subordination or a waiver of claims by the creditors (in return for which the SPV will be required to issue a debtor warrant or a profit participation certificate).
Shareholder loans may constitute another source of difficulty. In insolvency proceedings, loans granted to a company by its shareholders may be redeemed only after all other debts of the company have been paid. The permissibility of any payments made to redeem shareholder loans, and the validity of any collateral provided to secure claims for repayment of shareholder loans, are easily contestable. The fact is that the lenders are still not the legal owners of the SPV, even though they may be seen as such in financial terms (given the loss in value of the real estate). However, if they interfere too much with the management of the SPV, they may be considered to hold a position that is similar to that of shareholders, which would have the result that their loan claims become subordinate to any other claims and that their entitlement to realise collateral security may be put in question. Therefore, as regards their authority to exercise influence, lenders should content themselves with (reasonable) rights being provided for in the loan agreement and lenders should take no action that goes beyond the limits of the typical role of a lender. In some cases, what is known as the 'restructuring privilege' may have the effect that the provisions on the subordination of shareholder loans do not apply. An essential requirement for avoiding such a subordination is that the only motive of the lenders for taking control of the company is to rehabilitate it financially. Evidence of this can be provided in the form of a workout opinion.
Transfer of shares
It may be agreed that the shares in the SPV are to be transferred to an independent trustee or to the creditors. In both cases it is common practice to establish new SPVs, which serves to limit liability as well as to facilitate the sale of the real estate. In order to avoid real property transfer tax (RETT), it is common practice to split the shares in an SPV into two share packages of 94.9% and 5.1% (known as the 'RETT blocker structure'). However, such a transfer of shares in an SPV does not occur in lieu of realising a mortgage, but merely to facilitate such operation.
The procedure to be followed in such cases is that the shareholder transfers the shares to a trustee, who will hold the shares on trust on behalf of both the lenders and the shareholder. Consequently, these trust agreements are often trilateral agreements which stipulate that the shares shall be managed on trust on behalf of their owner, while at the same time they shall also be held in trust as collateral security on behalf of the lenders. Such trust agreements also set standards or provide for objectives regarding the amount of time it may take to sell a property or the amount of the expected realisation proceeds. If any of these standards or objectives are not met, or if the creditors are not consulted as stipulated in the trust agreement, the latter may terminate that agreement and may realise the collateral security. Such a situation at the same time constitutes an occurrence allowing the creditors to terminate the loan agreement.
Such a twofold trust structure with the trustee holding collateral security on behalf of one party and managing such collateral security on behalf of another seems particularly expedient and appropriate in cases where the realisation proceeds are likely to be higher than the outstanding claims of the creditors. If the realisation proceeds are likely to fall short of the claims to be satisfied, the owner is left with nothing but a certain nuisance value, with respect to which the owner will receive some valuable consideration when the shares are transferred without any resistance being put up against such transfer. It may well be that an owner agrees to transfer all or part of its shares directly to the creditors. If all shares are to be thus transferred, the shares are usually assigned to the creditors against payment of a symbolic purchase price of €1, unless some additional consideration is provided with regard to the owner's nuisance value. This procedure may also be the most appropriate if the owner is to stay tuned to the project, for example, where:
In some cases a debt-to-equity swap may be considered as an alternative to the above. The first step to be taken in such cases is to reduce the capital of the SPV, following which the claims of the creditors are transferred to the SPV in the form of a capital contribution, in return for which the creditors receive shares in the SPV. It is always difficult to value the claims of the creditors being worth less than their nominal amount. In such situations a suitable trustee or independent third party may have to be called in as well. This may have the advantage not only of not having to comply with capital replacement and of not being bound by consolidation requirements that are unwanted by creditors. Depending on the individual circumstances, thought may have to be given to merger control issues.
The reason why confrontational strategies should be considered, and their pros and cons should be determined, is not so much that such strategies should actually be implemented, but that they constitute a means of coercion. The effectiveness of threatening to adopt a confrontational attitude depends on the likelihood of any threats actually being carried out. Creditors of real property loans usually hold mortgages on the properties financed by them or pledges on the shares in the SPVs holding such properties. In general, no obstacles stand in the way of enforcing such mortgages or pledges.
Realisation of pledged shares
In principle, the realisation of pledged shares has the advantage that existing corporate structures in which the entities holding the real estate are embedded may be preserved. Especially in cases where such SPVs have the legal form of a limited liability company and are controlled by several holding companies (RETT blocker structure), it suffices simply to transfer the shares in the principal holding company, which also has the advantage that no real property transfer tax becomes payable. However, the enforcement of share pledges should always be seen as a first step in a more elaborate workout strategy. Such an enforcement serves to break any resistance that may be put up by a shareholder, but does not improve the operative business of the SPVs concerned.
However, these advantages must be assessed in light of the practical difficulties involved in the enforcement of share pledges. These difficulties are due to the fact that under German law (in contrast to that of other jurisdictions), a right of lien may be enforced only after the secured claim has actually fallen due. On the other hand, an SPV required to repay a loan prematurely will almost certainly be unable to do so – that is, it will be insolvent and its management will have to file an insolvency petition within a three-week deadline. Moreover, shares that are not traded on any exchange will, in practice, have to be sold by public auction. This means that any creditors attempting to enforce their claims by realising pledges that they hold on the shares of the SPV will have to complete that procedure before the statutory deadline for filing for insolvency expires – that is, the shares must be sold within 20 days and the management of the SPV must be persuaded to take no action until then. This 20-day deadline can be met only with the assistance of an experienced notary public.
The necessities arising in such a situation require close cooperation with the notary, the management of the SPV and, in cases involving banking syndicated or securitisation structures, with the trustees of the lenders and attorneys representing any other parties involved. The first obstacle to be overcome is that the management of the SPV must be convinced that the company can be put back on its feet within three weeks. Otherwise, the management of the SPV must file for insolvency immediately, without waiting until the end of the three-week period. Consequently, the management of the SPV must be satisfied that the shares can be sold in time and that the loan repayment claim will be deferred immediately after the shares have been transferred to their new holder. Given the shortness of the time available, the public auction procedure needs to be planned in great detail. All of the required documentation must be prepared in consultation with the parties involved. This includes, without limitation, the notifications to be issued to the debtors, the public announcements to be made and the instructions to be given to trustees representing the lenders (in each case as stipulated in the loan agreement). In most cases the facility agent and the security agent will be represented by a law firm and will insist that any liability issues be clarified in detail. This may make it necessary to agree to the trustees being exempted from liability. Moreover, the auction terms will have to be agreed with the notary (eg, as regards credit bidding).
Moreover, no matter how well prepared an auction may be, there is no guarantee that the owner of the property will not apply for an interim injunction, possibly even without any valid reason for doing so (ie, merely in order to delay the proceedings and with the ulterior motive of increasing its nuisance value). The enforcing creditors should be prepared for all of this. The required preparations may include filing a protection writ with the appropriate court.
Enforcement of mortgages
A right of lien on real estate, which will almost always exist in the form of a land charge, is enforceable by the secured creditors irrespective of whether insolvency proceedings are pending. Given that a land charge is enforceable only after the secured loan has been called in, and further given that the procedure of enforcing a land charge is quite time consuming, it is usually the case that insolvency proceedings are pending while the land charge is being enforced. It is therefore important to ensure that the real estate is not affected by the insolvency proceedings.
On the other hand, compulsory auction proceedings take between one and two years, which makes such proceedings rather unattractive. The length of compulsory auction proceedings depends not only on the court in charge of the matter, but also on whether any third parties submit bids in the auction and on the amount of these bids. The judicial officer in charge of the auction proceedings may limit his or her activities simply to complying with the statutory requirements. For instance, he or she is not obliged to point out any improvements increasing the value of the property to be sold or to organise a bidding process to ensure that the property fetches a price that corresponds to its market value. The creditors have practically no influence on how a forced sale is conducted. As a rule, auction proceeds paid out to the secured creditors are unreasonably low.
Nor does the possibility of the creditors themselves acquiring the property in a compulsory auction make this course of action more attractive. In many cases the only reason why creditors may themselves purchase a property encumbered for their benefit is to avoid the property being dumped in auction proceedings. If the property is purchased by the creditors themselves, or more commonly by an SPV established by the creditors for this purpose (which means that the individual creditors acquire only indirect ownership of the property), this does not reduce the additional delay of between one and two years caused by the auction procedure.
It is therefore beyond doubt that a private sale on the open market is the most efficient way to sell a land charge property. Except in the context of insolvency proceedings, the role of the seller will have to be assumed by the SPV holding the property. If insolvency proceedings are pending, such a private sale must be conducted by the insolvency administrator, who must agree to manage and sell the property on the open market, acting in a fiduciary capacity on behalf of and in accordance with the instructions of the secured creditors (so-called 'cold administration'). The contractual arrangements to be made between the insolvency administrator and the secured creditor should cover all relevant matters including:
Such contracts may also provide for improvements to the property, advertising and sales activities such as organising a bidding process. Possibly, the insolvency administrator may employ real estate service providers to ensure that the property is successfully managed and marketed. Generally speaking, the fee paid to an insolvency administrator is equal to or somewhat below the average fee paid to a sequestrator or auctioneer. The principal advantages of a private sale on the open market are that this sale is the fastest and most flexible alternative, while the cost involved is relatively moderate. However, any such cooperation with the insolvency administrator is possible only if the validity and effectiveness of the land charge can no longer be challenged.
In practice, the procedure of cold administration does not usually give rise to disputes, given that both the creditors and the insolvency administrator benefit from such arrangements. Nonetheless, it can happen that an insolvency administrator declines to enter into such arrangements or, more commonly, that no agreement can be reached on specific issues such as the administrator's fee. Such difficulties can be avoided only by clarifying any such points before the insolvency petition is filed.
In particular, Anglo-American investors analysing various strategies proposed to them often raise the question of whether what is known as a 'pre-pack' would be possible in Germany and could be considered as a further alternative. Such pre-packaged administration proceedings for the sale of corporate entities have become common in England in recent years. Officers Club, Tom Atkins, Whittard and USC are examples of companies that have undertaken this procedure, which consists of negotiating the sale of a business before administration proceedings are instituted. As soon as an agreement has been reached with the party financing the transaction, an individual already familiar with the matter will be appointed administrator. The only action to be taken by such individual in the capacity as administrator will be immediately to sell the business concern to an agreed purchaser. Depending on the circumstances of the individual case, part or all of the sale proceeds will be paid to the secured creditors, while the unsecured creditors may be left with an empty corporate shell. No resolutions need be passed by the creditors' meeting, which is often seen as being the principal advantage of this procedure, given that the business concern is sold with no substantial involvement of third parties and the continuity of the operations is therefore ensured. Nonetheless, certain misgivings regarding the permissibility of this course of action were raised in the past, based primarily on the lack of transparency of the procedure of selecting a purchaser, which was considered incompatible with the purpose of administration proceedings and the fiduciary duties of the administrator towards the creditors. These weaknesses of this procedure have been remediated by the Statement of Insolvency Practice on Pre-packaged Sales in Administration, which entered into effect on January 1 2009.
It has also been argued that it is not compatible with German law to appoint a person already involved in the matter as (preliminary) insolvency administrator. However, the relevant statutory texts merely stipulate that the candidate should be in no way dependent on either the creditors or the debtor. Many courts interpret this to mean that preparatory discussions or even just a recommendation of a specific individual for this position should have the effect that this individual should not be appointed as the (preliminary) insolvency administrator. On the other hand, other judges are inclined to accept such proposals. It is stipulated in the preliminary government draft (published in July 2010) of a law to be passed to facilitate the reorganisation of business enterprises that an individual's prior involvement in the matter should not be regarded as making such individual unsuitable for appointment as insolvency administrator.
Experience shows that the fact that pre-packs have the advantage of allowing an insolvent business to be sold quickly, – possibly even within days of the institution of the insolvency proceedings – this is not of major importance, at least not where poorly performing real estate portfolios are concerned. After all, it is rare that there is a purchaser at hand ready to buy existing portfolios in their entirety and without an appropriate due diligence review. Moreover, capital expenditure in existing real estate portfolios was in many cases reduced when the current crisis began and in many cases needs to be made now, before a property can be sold at a reasonable price. It should also be taken into consideration that the loss in value likely to be triggered by the institution of insolvency proceedings is negligible, especially where commercial properties are concerned.
There is one further reason why instituting insolvency proceedings in such a situation will not result in major delays: a preliminary insolvency administrator in charge of a 'normal' company is likely to use insolvency benefits to increase the insolvency estate because this allows him or her to save wage and salary payments. Such insolvency benefits are normally granted for up to three months as of the filing of the insolvency petition, which may be the reason why many preliminary insolvency proceedings take three months. However, given that SPVs have no staff other than their directors – who are often not even paid by the SPVs themselves – this three-month period is not of relevance when a typical real property company becomes insolvent. All property management and accounting tasks are attended to by specialised service providers. Therefore, the preliminary insolvency administrator does not usually take long to produce an initial report on the financial situation of the company, which will then be the basis of the insolvency court's decision to open insolvency proceedings.
Thus it can be seen that while a legal institution comparable to a pre-pack should indeed be introduced in Germany, this is irrelevant to the restructuring of poorly performing real estate portfolios. Provided that the creditors properly attend the necessary preparatory work and build up a sound basis for successful cooperation with the insolvency administrator, it is quite possible to obtain satisfactory results when it comes to enforcing claims that are secured by land charges on German real estate.
Irrespective of certain weaknesses that German restructuring and insolvency law may still have, creditors whose claims are secured by land charges can nevertheless choose between several feasible and financially viable possibilities of realising encumbered real estate. Compared to the laws of other jurisdictions – in particular, the United Kingdom – German law tends to be somewhat reluctant to allow creditors to grasp direct control of real estate. For this reason, the amendments to the Insolvency Code proposed by the Federal Ministry of Justice in a preliminary draft document should be welcomed.
Nonetheless, even in Germany it is possible to recover the keys – that is, to gain control of an SPV. Often, amicable arrangements are the best and safest way to terminate a real property loan commitment without financial loss. However, the term of many real property loan agreements will end in the course of the next few years and there will be cases in which it will be necessary to take restructuring measures or to terminate a loan commitment, even if this is contrary to the wishes of the owner. No matter which exit strategy may be considered the most appropriate in any specific case, it is always essential to be familiar with general legal requirements regarding the realisation of collateral security, to have experience in dealing with notaries and insolvency administrators, and to plan carefully all steps to be taken. A certain willingness to take risks is also needed; but if all of these requirements are met, it is quite possible for secured creditors to achieve highly satisfactory results.
For further information on this topic please contact Stefan Sax at Clifford Chance LLP by telephone (+49 69 7199 01) or email (email@example.com).
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