COMMERCIAL FINANCING – Part 4: Security Instruments
by BPE Law Senior Attorney and Co-Manager, Keith Dunnagan
In the previous posts we have reviewed promissory notes and business loan agreements. The next step is securitization. Very few commercial lenders want unsecured loans. Nearly all commercial loans require some form of security if not multiple forms of security. It is important to understand what is secured, how it is secured, and what are the lender’s remedies to the collateral.
Commercial loans are significantly more complex than your everyday run of the mill residential mortgage loans. They place far more requirements and restrictions on a borrower and it is important to understand how these documents work and are enforced. The theme remains the same, the lenders have multiple attorneys working on their loans, you should have at least one competent lawyer working on your behalf.
Security takes many forms in the world of commercial lending. Such security includes collateralization in tangible personal property, it can include assignments of financial interests, hypothecation of business interests, pledge of real property and/or various guaranties (I will address guaranties in a separate article).
The most common form of security in my opinion is security in real property. It is a fixed asset, readily identifiable and has the most comprehensive and defined laws when execution on an asset under a security instrument is required. In California, Washington and other states west of the Mississippi River, the common method for securing and perfecting collateral in real property is through the execution and recordation of a Deed of Trust (“DOT”). The execution of the DOT secures the designated real property for the benefit of the lender while the recordation of the DOT acts to perfect the security and create a hierarchy of priority. In securing priority, California uses a race-notice system, which loosely means that the first to record is the first in right. There are several exceptions that play into this – but for purposes of this article we will stick to the first in time is the first in right.
In most commercial loans the lender makes a loan and it is secured against the primary real property collateral which is the subject of either construction lending, acquisition lending, refinancing or some other model. That is the borrower is using funds related to a particular piece of real property which serves as the collateral for that loan. However, sometimes a lender is not satisfied with the primary real property collateral. Maybe market forces are taking a down turn so there is a question about future valuation, maybe the lender is in a junior position and wants to assure collection or maybe the lender is just looking for additional security. In these situations the lender is looking to cross-collateralize the loan. That is, to have multiple properties to secure the loan. Sometimes the lender cross-collateralize against other properties owned by the borrower, in extreme cases the lender looks to secure property held by a guarantor. It is important to understand where that collateralization is coming from and what property is securing the loan.
Unlike a residential DOT, a commercial DOT is complex and can have several different and varying terms. There are also multiple forms of default and remedies that can be accounted for in a single DOT. Much like the promissory note, the DOT also includes an exhaustive list of covenants. Some of the basic covenants include obligations that require the borrower to maintain insurance, keep the property free of junior liens or encumbrances, paying property taxes as they come due or maintaining the property. Other covenants include due on sale or transfer obligations and insolvency prohibitions. In the commercial context, the due on transfer clause can create significant problems as the provision often times contains an anti-dilution clause. What this generally means, is that while the borrower is prevented from selling the property without paying off the full balance of the loan, it also prohibits the selling or transferring of corporate interests that exceed a certain percentage of the business interest, commonly 25%. What that means is that if you have a commercial loan and you bring a capital partner to the table at a later date, that capital partner cannot take more than 24% interest in the business without the risk of accelerating the loan. Any violation of these conditions is considered an event of default that would allow the lender to act adversely to the borrower’s interest.
But the security in real property under a DOT is generally not limited just to the real property. Most commercial DOTs also contain assignments of the financial interests in the property, namely any rents generated by the profits. While the rents are assigned to the lender for the lenders benefit, there should be limiting language included that limits the lenders ability to collect rents unless an event of default occurs.
Commercial loans are significantly more complex than your everyday run of the mill residential mortgage loans. They place far more requirements and restrictions on a borrower and it is important to understand how these documents work and are enforced. The theme remains the same, the lenders have multiple attorneys working on their loans, you should have at least one competent lawyer working on your behalf.
In the next installment we will look at lender remedies and enforcement of DOT in the event of default along with other forms of security instruments.
BPE Law Senior Attorney and Co-Manager, Keith Dunnagan, practices exclusively in the area of commercial transactions and finance. If you have any questions, you can reach him at 916-966-2260 or kbdunnagan@bpelaw.com.
For over 20 years, the attorneys of BPE Law Group, P.C. have been advising and representing business and property owners and investors in dealing with their legal needs. Check us out on the Web at: www.bpelaw.com. If you would like a consultation with us, please call our office at (916) 966-2260 or e-mail Keith Dunnagan at the above link.
This article is not intended to be legal advice, lending advice, or a specific recommendation of any particular lender or company, and should not be taken as such advice.
by BPE Law Senior Attorney and Co-Manager, Keith Dunnagan
In the previous posts we have reviewed promissory notes and business loan agreements. The next step is securitization. Very few commercial lenders want unsecured loans. Nearly all commercial loans require some form of security if not multiple forms of security. It is important to understand what is secured, how it is secured, and what are the lender’s remedies to the collateral.
Commercial loans are significantly more complex than your everyday run of the mill residential mortgage loans. They place far more requirements and restrictions on a borrower and it is important to understand how these documents work and are enforced. The theme remains the same, the lenders have multiple attorneys working on their loans, you should have at least one competent lawyer working on your behalf.
Security takes many forms in the world of commercial lending. Such security includes collateralization in tangible personal property, it can include assignments of financial interests, hypothecation of business interests, pledge of real property and/or various guaranties (I will address guaranties in a separate article).
The most common form of security in my opinion is security in real property. It is a fixed asset, readily identifiable and has the most comprehensive and defined laws when execution on an asset under a security instrument is required. In California, Washington and other states west of the Mississippi River, the common method for securing and perfecting collateral in real property is through the execution and recordation of a Deed of Trust (“DOT”). The execution of the DOT secures the designated real property for the benefit of the lender while the recordation of the DOT acts to perfect the security and create a hierarchy of priority. In securing priority, California uses a race-notice system, which loosely means that the first to record is the first in right. There are several exceptions that play into this – but for purposes of this article we will stick to the first in time is the first in right.
In most commercial loans the lender makes a loan and it is secured against the primary real property collateral which is the subject of either construction lending, acquisition lending, refinancing or some other model. That is the borrower is using funds related to a particular piece of real property which serves as the collateral for that loan. However, sometimes a lender is not satisfied with the primary real property collateral. Maybe market forces are taking a down turn so there is a question about future valuation, maybe the lender is in a junior position and wants to assure collection or maybe the lender is just looking for additional security. In these situations the lender is looking to cross-collateralize the loan. That is, to have multiple properties to secure the loan. Sometimes the lender cross-collateralize against other properties owned by the borrower, in extreme cases the lender looks to secure property held by a guarantor. It is important to understand where that collateralization is coming from and what property is securing the loan.
Unlike a residential DOT, a commercial DOT is complex and can have several different and varying terms. There are also multiple forms of default and remedies that can be accounted for in a single DOT. Much like the promissory note, the DOT also includes an exhaustive list of covenants. Some of the basic covenants include obligations that require the borrower to maintain insurance, keep the property free of junior liens or encumbrances, paying property taxes as they come due or maintaining the property. Other covenants include due on sale or transfer obligations and insolvency prohibitions. In the commercial context, the due on transfer clause can create significant problems as the provision often times contains an anti-dilution clause. What this generally means, is that while the borrower is prevented from selling the property without paying off the full balance of the loan, it also prohibits the selling or transferring of corporate interests that exceed a certain percentage of the business interest, commonly 25%. What that means is that if you have a commercial loan and you bring a capital partner to the table at a later date, that capital partner cannot take more than 24% interest in the business without the risk of accelerating the loan. Any violation of these conditions is considered an event of default that would allow the lender to act adversely to the borrower’s interest.
But the security in real property under a DOT is generally not limited just to the real property. Most commercial DOTs also contain assignments of the financial interests in the property, namely any rents generated by the profits. While the rents are assigned to the lender for the lenders benefit, there should be limiting language included that limits the lenders ability to collect rents unless an event of default occurs.
Commercial loans are significantly more complex than your everyday run of the mill residential mortgage loans. They place far more requirements and restrictions on a borrower and it is important to understand how these documents work and are enforced. The theme remains the same, the lenders have multiple attorneys working on their loans, you should have at least one competent lawyer working on your behalf.
In the next installment we will look at lender remedies and enforcement of DOT in the event of default along with other forms of security instruments.
BPE Law Senior Attorney and Co-Manager, Keith Dunnagan, practices exclusively in the area of commercial transactions and finance. If you have any questions, you can reach him at 916-966-2260 or kbdunnagan@bpelaw.com.
For over 20 years, the attorneys of BPE Law Group, P.C. have been advising and representing business and property owners and investors in dealing with their legal needs. Check us out on the Web at: www.bpelaw.com. If you would like a consultation with us, please call our office at (916) 966-2260 or e-mail Keith Dunnagan at the above link.
This article is not intended to be legal advice, lending advice, or a specific recommendation of any particular lender or company, and should not be taken as such advice.