New Fannie Mae Loan Documents: 10 Issues for Multifamily Borrowers
The top 10 issues borrowers should focus on as they evaluate the new Fannie Mae loan documents.
By Christopher M. Iavarone and Pamela V. Rothenberg
Washington, D.C.—Fannie Mae introduced a new set of form multifamily loan documents in 2011. These new documents reflect a major overhaul of the previous Fannie Mae loan documents in both form and substance and they include several additional provisions that materially expand the risks of recourse exposure to borrowers and loan guarantors.
As many multifamily professions are probably aware, the most apparent change in the new loan documents is structural. Fannie Mae consolidated a number of the previously standard loan documents, including its Replacement Reserve and Security Agreement, Completion/Repair Agreement, and Certificate of Borrower, into one document: the Loan and Security Agreement. This “Loan Agreement,” along with the Security Instrument and the Environmental Indemnity Agreement, contain all most all of the substantive loan provisions. The Note and the Guaranty round out the list of core Fannie Mae loan documents.
While the structural changes to the Fannie Mae loan documents are noteworthy, there are a number of more important substantive changes that are worthy of consideration. The following is a list of the top 10 issues we believe borrowers should focus on as they evaluate the new Fannie Mae loan documents.
- Full personal liability for failure to comply with single-asset entity requirements. Under the Loan Agreement, the borrower and any guarantor is personally liable to the Lender for repayment of the entire indebtedness if the borrower fails to comply with the single asset requirements of the Loan. This is broader than the previous non-recourse carve out that was limited to loss or damage suffered by Fannie Mae, but is fairly customary for a non-recourse loan. What is unusual, however, is the lack of clarity about exactly what comprises these single asset entity requirements. The recourse provision does not reference a particular section of the Loan Agreement or any other loan document, so the borrower is left guessing about what failure might trigger this major liability. Also, there is no apparent notice or cure period before full personal liability is triggered, so the borrower is not even afforded the opportunity to fix a loan document violation it may not even clearly understand it has engaged in.
- Full personal liability for non-willful material misrepresentation. Under the Loan Agreement, the borrower and any guarantor are personally liable to the Lender for repayment of the entire indebtedness if the borrower, any guarantor, any key principal, or any officer, director, or owner of those parties commits fraud or material misrepresentation in connection with the original underwriting of the loan or in complying with the loan’s on-going reporting requirements. In the old Fannie Mae loan documents, the borrower and any guarantor were only liable for the loss or damage suffered by the lender due to fraud or material misrepresentation; these infractions did not trigger full personal liability for the indebtedness. Again, this new provision is broader than a traditional a non-recourse loan.
- Full personal liability if a mechanic’s lien is not removed due to insufficient funds. This is not a new concept, but it has always bothered us since it strikes at the heart of the types of risks associated with an operating deficit scenario for which a borrower should not face personal liability under a non-recourse loan. As in most non-recourse loans, an unauthorized transfer of the mortgaged property triggers full personal liability for the borrower and any guarantor. However, Fannie Mae defines the term transfer broadly enough that it includes mechanic’s liens. Therefore, the borrower and any guarantor is personally liable for the full amount of the indebtedness if the borrower fails to bond off or otherwise release a mechanic’s lien filed against the mortgaged property within 60 days. This is true even if the property is not generating sufficient income to pay vendors and debt service. So, in a circumstance where the borrower has no cash on hand to pay both its vendors and the debt service on the loan, the Fannie Mae loan documents drive the borrower to pay the vendors in lieu of the debt service if it wants to avoid full personal recourse liability for the entire outstanding balance of the loan.
- Representations and warranties regarding any “principal.” The Loan Agreement requires the borrower to make extensive representations about any person or entity owning at least a 25 percent direct or indirect interest in the borrower, guarantor or key principal, including, among other things, representations about litigation, bankruptcy, compliance with law and ERISA. This could present a problem for investment funds or other large borrowers, because the term “Principal” is defined broadly enough to include passive investors, shareholders of publicly-traded companies, and entities that are not under common control with the borrower. In certain circumstances, a breach of those representations could result in full personal liability for the borrower and the guarantor.
- Guaranty of environmental indemnity. In the previous Fannie Mae loan documents, the borrower was personally liable for the environmental indemnity granted in favor of the lender, but that personal liability did not extend to the guarantor. That has changed in the new loan documents. Now in the Environmental Indemnity Agreement, the guarantor is liable for the environmental indemnity and all other indemnities in the loan documents and liability under these indemnities is not limited to the value of the property or the amount of the loan. The indemnity is triggered once an environmental representation or covenant is breached without notice or any opportunity to cure. This dramatically increases the exposure of the guarantor under the new loan documents.
- Evergreen environmental representations. As in the old security instrument, the environmental representations made by the borrower in the new Environmental Indemnity Agreement are evergreen— that is, they are continuing representations and are deemed made and in effect until the loan has been paid in full. However, unlike the previous security instrument, any breach of an environmental representation is an automatic “Event of Default” under the loan documents. Therefore, even though the Environmental Indemnity Agreement appears to permit the borrower to remedy a breached representation or otherwise remediate a prohibited condition that occurs subsequent to the origination of the loan, the automatic nature of the Event of Default relating to a breach of an environmental representation appears to prevent the borrower from exercising that remediation right.
- Failure to complete life/safety repairs within completion period. Under the new Loan Agreement, it is now an automatic Event of Default if the borrower fails to make repairs associated with fire, life or safety issues within the completion period without apparent regard to force majeure delays other than weather. This is a policy change for Fannie Mae, so Fannie Mae is unlikely to change this provision. Further, Fannie Mae has refused our requests to grant any notice or cure period for a breach of its terms in the Loan Agreement. The completion periods specified in the loan documents are often short and, therefore, any delay can present a risk of default for a borrower. The borrower will have to put a greater emphasis on managing the completion timeline for the repairs and, in advance of signing the loan documents, raising with Fannie Mae any concerns that the borrower may have in completing the required repairs by the specified deadline.
- Supplemental insurance. The definition of “Mortgaged Property” in the Security Instrument includes all “insurance policies related to the Mortgaged Property” and all proceeds thereof. This is broad enough to include any supplemental insurance carried by the borrower, even if that insurance is not required by the lender. The borrower should consider excluding this supplemental insurance from the collateral for the loan.
- Notify lender of all covenant breaches. The new loan agreement requires a borrower to notify the lender of any breach (however immaterial) of any covenant set forth in the loan documents. This notification is required whether or not the borrower cures the breach. Under the previous loan, documents that did not contain this default notification requirement; a borrower could remedy a breach (whether material or immaterial) before it was discovered by the lender and avoid an Event of Default under the loan documents. With this new affirmative obligation, the borrower may be put in the position of notifying the lender of a breach of a covenant that constitutes an automatic Event of Default, even if the breach could otherwise be easily remedied by the Borrower. In some instances, such a breach could also trigger personal liability to the borrower and a guarantor under the non-recourse carve out provisions of the loan documents.
- Prohibition against mezzanine financing. The new security agreement prohibits secured or unsecured “mezzanine financing” by the borrower or any owner of the borrower (arguably including indirect owners), including the pledge of the ownership interests in borrower or the cash flows of the borrower. A prohibition against “mezzanine financing” is not unusual for loan documents. However, borrowers with complex ownership structures should pay particular attention to this provision and consider its impact on upstream financing that is not typically considered “mezzanine debt,” such as preferred equity or operating lines of credit.
While these key issues presented by the new Fannie Mae loan documents are important, borrowers should note that they are not the only substantive changes that appear in the new loan documents. Borrowers should familiarize themselves with all changes included in the new documents and carefully evaluate them before committing to a loan.
Christopher M. Iavarone, [email protected], is a real estate attorney in the London, U.K. office of Clyde & Co. LLP and also works as an outside contract attorney for the real estate practice group at Womble Carlyle Sandridge & Rice, LLP. Pamela V. Rothenberg, [email protected], is a real estate attorney in the Washington, DC office of Womble Carlyle Sandridge & Rice, LLP. She leads the firm’s multifamily real estate industry team and is a member of the firm’s real estate practice group.