From the frontline - Some points often overlooked in CREF termsheets Van Doorne's Commercial Real Estate Finance Team – Dutch CREF Blog
With the usual focus on getting to documentation phase and getting the deal done, financiers may overlook or occasionally perhaps avoid discussing certain loan terms with borrowers in more detail at termsheet phase. Experience shows though that paying more attention to these particular loan conditions, so that parties are already on the same page as to what exactly is required at termsheet phase, tends to ultimately save time on extensive negotiations during documentation phase and manage borrowers’ expectations. In this blog we will highlight a number of items which we often see overlooked at tersmheet phase, highlighting the importance of paying particular attention to the items sooner rather than later. At least a number of these may seem obvious, but are nevertheless often not dealt with. On that basis, we have listed our top seven (in random order) below.
We would be interested in learning from your experience as well, so your feedback and additions are most welcome.
1. The deal does not close – who is on the hook for costs and fees?
A point often overlooked in the rush to proceed to documentation phase and close is which entity will be signing the termsheet (possibly in addition to the borrower), to ensure that a financially sufficiently robust party can be called on to pay the lender’s costs and fees if the deal does not close. This is an important point for financiers to consider also keeping in mind that, especially when financing new acquisitions or a development from scratch, the borrower will often be a yet to be incorporated special purpose vehicle, propco or devco, with no assets to speak of if the deal does not close. Even when dealing with a refinancing, a lender may not wish to be stuck with having to collect an unsecured claim for costs and fees. Financiers should be careful to ensure that the termsheet is duly signed by a (sponsor) entity in the group that indeed has sufficient assets to pay the costs and fees if the deal does not close. Alternatively, a lender may consider asking the borrower for a deposit. However, from our experience this still seems to be less usual for continental European deals.
Considering the non-binding nature of termsheets, care should also be taken to ensure that the provision dealing with costs and fees creates a legally binding and surviving undertaking on the part of the (sponsor) entity signing the termsheet on behalf of the borrower. This should be explicitly stated in the termsheet.
2. KYC and DAC 6
Know your customer requirements are often only briefly dealt with at termsheet phase resulting in extensive discussions during documentation phase especially in the context of a change of control provision for cross-border deals or where fund entities are involved. Financiers would do well to specify requirements at termsheet phase to prevent these extensive discussions and possible delays.
Similarly, and being relatively new, the requirements of the EU rules enacted under the Directive on Administrative Cooperation (DAC 6) also require attention at termsheet phase in the context of confidentiality provisions. If the financing envisaged by the termsheet forms part of a reportable cross-border arrangement, for the purpose of DAC 6, a financier may be considered an intermediary. This could especially be the case in the context of a real estate financing where a financier often receives detailed information from its borrower regarding its tax structuring and as such may also have reporting obligations thereon pursuant to DAC 6. Care should be taken to allow for any disclosure relating to a tax advantage as may be required pursuant to DAC 6.
3. Waterfall
Diverting from the standard position under LMA where only net rental income is required to be paid into the rent account, in Dutch real estate financings the norm is that all rental income is required to be paid into the rent account and that a borrower will be allowed to continue to control the rent account for as long as no event of default shall have occurred and be continuing. On this point, three points should be kept in mind. The first is that both LMA and the Dutch approach seek to avoid that the lender has to (co-) approve opex or pre-agreed capex payments at least as long as the loan is performing. Secondly, it should be kept in mind that as opposed to English law, Dutch law does not recognise trusts, so that it becomes more important that gross rent is directly received from tenants and other debtors into a borrower’s account that is pledged to the lender. Thirdly, as opposed to what is the case under English law, there is no floating charge concept and the fact that the borrower continues to be in control of the relevant account does not entail (at least not from a strictly legal point of view, there is of course more security to be found in having factual control) that the pledge which the lender would obtain over the account is not as strong. The above means that an account waterfall for a Dutch deal will look a bit different from what parties are used to seeing under a standard LMA style document. Financiers should be mindful of this.
In any case, it will be useful to specify items which will be allowed to rank ahead of debt service in and outside of a default (as long as there is no active enforcement scenario) in the waterfall. Items ranking ahead of debt service will usually include expenses required to be paid for the operation and maintenance of a property, fees payable to any manager and amounts due under any groundlease, insurance premia, taxes, as well as any other public duties due by the borrower with respect to a property. These payments may be subject to a cap being a certain percentage of the net rental income or, at the more senior end of the loan spectrum, left alone as long as the borrower complies with its financial covenants.
One item that requires particular attention is the payment of management or other advisory fees to affiliates of the borrower. Considering that it is also in the interest of a financier that there is effective property management, in the case of a third-party property manager, it is usual for financiers to agree that such fees can always be paid subject to the property being well managed. However, where such management fees are payable to an affiliate of the borrower, a lender may wish to divert from this principle, at least where the borrower is in default and to the extent that such fees would otherwise be payable before debt service. Where management or advisory fees to affiliates other than strictly for property management are concerned it is usual for a lender to provide that these should (at least in a default or cash trap scenario) not become payable as long as the lender has not been discharged. Basically, those fees would commonly be given the same treatment as dividends on this point.
Ensuring that the borrower departs from the same assumptions as to which payments will be permitted when, is also relevant to ensure that the borrower takes into account the same assumptions as the financier in the context of calculating its debt/interest service cover or debt yield covenant, so that items permitted to be paid from the rent account before debt service are not taken into account for the purpose of calculating these covenants, as a result of which parties may have to redo their calculations at documentation phase.
4. Net rental income assumptions
It is also good to take some time to discuss what assumptions will apply with respect to net rental income in the context of calculating projected debt/interest service cover or debt yield covenants.
From the perspective of the financier it would be usual to exclude payments received from lease guarantors, payments from tenants that are in arrears for more than a certain period (typically one or two months), tenants that are affiliates of the borrower or its investors, as well as rent increases. Turnover based rent is also usually excluded, however, consider that this should be permitted in the case of retail or hotel financings.
As for projected net rental income, financiers should specify that rental income will not be taken into account if the tenant has the right to invoke a break option or a lease can otherwise be expected to end during the terns of the relevant forward testing period, unless it is clear that the relevant property can be re-let within a very short period of time (as may apply to residential property in the Netherlands).
5. Where does the cash go?
In recent years Dutch banks have become increasingly resistant to providing consent to borrowers to pledge accounts held with them in favour of financiers and currently have as their policy that they do, as a firm main rule, not accept the creation of a security interest in favour of a third-party financier on accounts held with them, unless, possibly where the borrower in question is a strong borrower with which the account bank also has a wider client relationship. Opening an account may these days also easily take up up-to three months in the Netherlands. In order to prevent delays at documentation phase, this should be checked with borrower early on so as to ensure that the account bank concerned can consent with the creation of a security interest over the accounts held with it in favour of the financier.
If no third-party account bank will agree to such right of pledge, a timely alert will also provide more time to reach agreement on alternative arrangements. Such alternative arrangements could include that the bank accounts (or at least the accounts which the financier requires to be in its control from day one, such as the rent account) are opened with the financier itself if possible or, alternatively, to work through a foreign bank account that can be made subject to the required security interest or (if rental income is received) apply a cash sweep from a Dutch bank rent account towards such a foreign account on a regular basis, leaving some cash behind to pay for opex and agreed capex.
6. Cancellation and prepayment fees
It is advisable to clearly provide under which circumstances and as from what point in time cancellation fees and prepayment fees become due. “On the (first) utilisation date” may very well not cover it if a lender wishes to charge cancellation fees also if the loan is not drawn and may not cover the lenders costs from the (earlier) date on which the lender must fund its loan and fix its interest.
It is not uncommon to see that no prepayment fee will be due in the event of illegality, increased costs or taxes, market disruption or in the case of a defaulting lender. Less usual but still sometimes encountered are exceptions to the effect that a borrower will not be required to pay prepayment fee in the case of prepayments following from warranty and insurance claims and, occasionally, even in the event that a borrower is making a prepayment to cure a breach of financial covenant.
As a general rule, make wholes are still less usual in the Netherlands. Therefore in case of cancellation or prepayment of fixed rate or higher risk loans where this is the intention, it should preferably be made clear if the intention is that the financier will require the borrower to pay a make whole compensation and how this will be calculated. It should also preferably be stated explicitly in the termsheet if a financier expects to receive an exit fee in addition to any prepayment or cancellation fees, Dutch borrowers sometimes tend to assume that one can be held to absorb the other.
7. Break funding costs
In respect of break funding costs, financiers should these days also consider how to deal with negative interest on amounts that are prepaid or deposited. If a financier wishes to divert from the standard position under LMA which effectively includes a zero-floor provision as a result of which any such negative interest cannot be added to the bill a lender can send the borrower for its break costs, this should be dealt with at termsheet phase so that is it is clear to the borrower that the lender would, as part of calculating break costs not just deduct positive interest it can receive by putting amounts prepaid on deposit but also add negative interest that it may be required to pay when doing so.
Conclusion
In this blog we have highlighted those items which from our experience results in saving time in the long run if already sufficiently addressed at termsheet phase. Using the above as a checklist when negotiating termsheets can be a useful tool for financiers to hopefully prevent further extended negotiations during documentation phase on these particular items.
