William Murray
of Orrick, Herrington & Sutcliffe LLP

A. BORROWER

B. COLLATERAL

C. GUARANTIES

D. NON-RECOURSE CARVEOUTS

E. CASH MANAGEMENT ISSUES

As the real estate market continues its expansion we are beginning to see a significant increase in the volume of new constructions loans. While construction lending legal issues have not changed significantly from the issues involved in construction lending in the 70’s and 80’s, many of the people now involved in construction loans today were simply not around in the 70’s and the 80’s. This discussion reviews some of the basic issues involved in making a construction loan today.

II. TERM SHEET/LETTER OF INTENT                                                                                        Return to Top

The first issue that faces a construction lender is how to use a term sheet/letter of intent to begin to get the discussion going regarding the principle terms and conditions of a loan. It is quite common for the lender to use term sheets/letters of intent to outline the principle terms and conditions of the deal but there are several questions raised by this practice. First, which terms and conditions should be specified in the term sheet/letter of intent and which ones can safely be left to later documentation. Second, to what extent should the lender’s lawyer be involved in drafting and negotiating a term sheet/letter of intent. Finally, the most important issue in the use of the term sheet/letter of intent is whether it is intended by the parties to be a contractually binding agreement. Obviously, it is a document on which both the lender and the borrower will spend a lot of time and one on which they will in proceeding forward with certain additional actions, but is it something on which a lawsuit can be based. This is a very difficult question and the answer may be that there are parts of the term sheet/letter of intent that are intended to be binding on the parties and some that are not. It is often hard to draw this distinction.

A. BORROWER
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It may seem like a mundane issue to ask who is the borrower but in transactions where the borrowing entity actually involves multiple layers of entities and the real credit in the deal may be provided at one level (usually the parent) but the actual development activity and ownership of the collateral may occur at a subsidiary level that is one or two levels removed, this is a very important issue. This is a particularly common issue when loaning to REITs or other publicly held real estate companies or to any real estate entity that involves pension fund investors. The answer to this question may have significant bankruptcy and enforcement consequences. You may also want to consider the use of single purpose, bankruptcy remote entities as a borrower.

B. COLLATERAL
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A companion issue with "who is the borrower" is where and what is the collateral. Typically we would think that the collateral is the project being constructed and that will certainly be true. But in instances where a complicated borrowing structure is involved it may also be necessary to take pledges in accounts at various levels, pledges in stock or membership interests, letters of credit or other forms of cash collateral to make sure that you are getting the whole package. The goal of the construction lender is that if you ever have to go after the project, you will have a collateral package that enables you to take control as quickly and efficiently as possible of all aspects of the project that are necessary to put the project back on a stable tract. As part of thinking about what will be your collateral package you also need to think about the impact of the California one-action and anti-deficiency rules and how they will impact on your ability to reach the collateral.

C. GUARANTIES
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You may also want to take a guaranty from entities related to the borrower, the principles of the borrower or other affiliates. Such guaranties may cover (i) completion of the project, (ii) payment of interest and/or principal on the loan, (iii) responsibility for non-recourse carveouts in the case of nonrecourse loans, or (iv) environmental matters. When taking guaranties you need to consider the financial ability of the guarantor to respond to any call on the guaranty, any statutory limitations (such as the anti-deficiency rules) on the ability to call on the guaranty and the effect of calling on the guaranty on the balance of the collateral.

D. NONRECOURSE CARVEOUTS
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Many borrowers today are looking for nonrecourse loans. While a nonrecourse construction loan is somewhat unusual by using creative nonrecourse carveouts, a completion guaranty and other structuring devices you may be able to give the borrower a nonrecourse loan without significantly impairing the bank’s collateral or remedies.

E. CASH MANAGEMENT ISSUES

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One of the significant changes in lending in the last ten years is the use of lock boxes, soft lock boxes, clearing accounts and other cash management devices to keep tighter control of the cash flow of a project. These devices can be particularly effective if the project gets in trouble and may significantly shorten the time that will be required to take a project back after a default.

YADDA, YADDA, YADDA

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