As the financial crisis deepened in recent years and banks corrected past excesses by tightening underwriting requirements, Federal Housing Administration (FHA) programs became one of the only reliable sources of financing for multifamily housing in the United States. In fact, in federal fiscal year 2010 FHA originated approximately $11.3 billion in new multifamily mortgage loans, roughly 10 times the amount of loans originated in 2000. U.S. Dep’t of Hous. and Urban Dev., FY 10 Multifamily Initial Endorsements, Hud.gov, http://portal.hud.gov/hudportal/HUD?src=/program_offices/housing/mfh/mfdata/fy10mie (last visited Feb. 27, 2012). This increased volume meant that multifamily developers, who traditionally relied on financing from the private sector, have instead turned to the Department of Housing and Urban Development (HUD) for FHA-insured loans. The complications arising from these increased demands on FHA, including the need to meet ongoing program operations while processing new applications and managing increased assets, were compounded by the fact that the legal documents and accompanying guidance for insured multifamily transactions had not been updated in decades.
The purpose of this article is to provide a concise and accessible description of recent changes to the multifamily housing mortgage insurance program, with a particular emphasis on the legal documents used to close such loans. The paragraphs that follow highlight the important conceptual legal changes made to the multifamily closing documents as well as noteworthy modifications to the regulations and other major changes in agency guidance. The guidance documents mentioned below, in particular HUD Multifamily Rental Projects: Regulatory Revisions, 76 Fed. Reg. 24,507 (May 2, 2011) (to be codified at 24 C.F.R. pts. 200, 207), are the source for much of the information in this article; but the opinions expressed in this article are the personal views of the authors only and do not reflect the views of HUD or the U.S. government.
To meet the increasing demands facing FHA quickly, HUD’s new leadership, brought in as part of the Obama Administration, instituted an effort to modernize the multifamily programs on all fronts. HUD engaged in extensive outreach to affected parties beyond the standard Administrative Procedure Act notice and comment and Paperwork Reduction Act requirements, including a series of roundtables held across the United States. Carol Galante, the current acting FHA commissioner, noted at an FHA Multifamily Closing Documents Roundtable discussion on February 19, 2010, that this modernization effort necessitated changes in underwriting practices, asset management capabilities, and FHA’s monitoring of counterparties. There was an urgent need to deal with the issues other lenders currently faced in commercial real estate practice, such as the layering of public financing and proliferation of tax credit utilization. In discussing the document reform improvements at that 2010 roundtable, HUD General Counsel Helen Kanovsky stated that the goals for the closing document reform efforts, in particular, were to “provide greater flexibility, to accommodate new methods of property ownership, operation, and new methods of financing that were not even contemplated when the original documents were first drafted.” As General Counsel Kanovsky also noted, the documents should provide “greater transparency as well as increased risk mitigation and enforcement.”
In accordance with these modernization goals, revisions to the legal documents demonstrate the realization of several different goals outlined by HUD leadership. The updated documents were developed in recognition of modern legal developments, such as changes in the form of asset ownership. They were also designed to increase FHA risk mitigation measures and improve the efficient management of FHA programs by placing new obligations on lenders to complete more of the due diligence required for loan underwriting that was formerly performed by FHA. In addition, the new documents require borrowers to recognize their responsibility for managing project operations in a manner that prevents waste, fraud, and abuse. The reallocation of these tasks is designed to create balanced responsibilities among all parties involved in the production of multifamily housing while assuring that the federal government’s insurance funds remain financially sound.
Updating the multifamily closing documents has been discussed for many years but was first considered in earnest in 1999 because of concerns that changing legal trends called for widespread revisions to HUD documents. For example, as a general rule, FHA traditionally allowed individuals to own multifamily property and qualify as borrowers. Under the new documents, like most commercial real estate lenders in the United States, FHA requires the single asset form of ownership to lower the risk of bankruptcy claims against the property.
To facilitate these changes, FHA hosted a series of roundtables with affected industry participants and instituted processes meeting Administrative Procedure Act and Paperwork Reduction Act requirements. On May 2, 2011, HUD published the revised documents and an accompanying notice describing significant alterations in the documents. U.S. Dep’t of Hous. and Urban Dev., Multifamily Rental Project Closing Documents: Final Version of the Closing Documents, Hud.gov, http://portal.hud.gov/hudportal/HUD?src=/ program_offices/housing/mfh/ mfhclosingdocuments (last visited Feb. 27, 2012). Corresponding changes were made to HUD’s regulations supporting the revisions. HUD Multifamily Rental Projects: Regulatory Revisions, 76 Fed. Reg. 24,507 (May 2, 2011) (to be codified at 24 C.F.R. pts. 200, 207). The revised forms are available online. U.S. Dep’t of Hous. and Urban Dev., HUD Forms 90003 through 999, Hud.gov, http://portal. hud.gov/hudportal/HUD?src=/ program_offices/administration/ hudclips/forms/hud9 (last visited Feb. 27, 2012).
Given the policy changes reflected in the documents, revised regulations were published and posted as well. HUD Multifamily Rental Projects: Regulatory Revisions, 76 Fed. Reg. 24,363 (May 2, 2011). To give regular FHA-insured housing borrowers and lenders time to adjust to the changes, HUD did not require use of the revised closing documents under the revised regulations until the closing date of transactions that received a firm commitment for insurance from HUD on or after September 1, 2011. Id. at 24,364. In addition, HUD published state-specific riders to the closing documents, acknowledging differences in state and local law, and an FHA Multifamily Program Closing Guide to outline the procedures and protocols that HUD closing attorneys and counsel for lenders and borrowers will use to ensure that decisions on closing requirements and procedures are consistent across the nation in the over 30 HUD field offices where closings are performed. See http://portal.hud.gov/hudportal/ HUD?src=/program_offices/ administration/hudclips/forms/hud9/riders-addendums. To respond to industry queries about HUD’s legal and policy positions as reflected in the revised documents and administrative guidance, HUD also published “Frequently Asked Questions” (FAQs) on HUD’s website and updates these FAQs on a periodic basis as issues arise.
Finally, to promote the efficient preparation of HUD required applications by lenders, FHA published a new Multifamily Accelerated Processing underwriting guide (MAP Guide) for lenders seeking multifamily loan insurance. The MAP Guide, which became effective November 1, 2011, consolidates in one comprehensive document a number of FHA’s multifamily lending practices and policies previously expressed in the outdated MAP Guide, individual mortgagee letters, and FAQs that had been previously published. The new MAP Guide provides a useful, convenient tool for lenders and attorneys by gathering into one place information that had been developed by the agency over many years. Exemplary of these changes is an entirely new chapter in the MAP Guide describing underwriting requirements and the HUD review process for projects using tax credits such as federal Low Income Housing Tax Credits, 26 U.S.C. § 42, and the federal New Markets Tax Credit program, 26 U.S.C. § 45D. The MAP Guide also provides explanations of related issues, such as structuring equity bridge loans. The inclusion of this guidance for financing tax credit deals in the modern multifamily lending environment facilitates lender processing, standardizes and provides uniformity across financing options, and ultimately will, according to Acting FHA Commissioner Galante, minimize the department’s credit risks and promote securitization of FHA’s multifamily mortgages. See U.S. Dep’t of Hous. and Urban Dev., Multifamily Accelerated Processing (MAP) Guide (rev. Nov. 23, 2011), available at http://portal.hud.gov/hudportal/documents/huddoc?id=4430GHSGG.pdf. These publications represent the beginning of an ongoing effort to update the asset management and other handbooks and forms of HUD guidance accompanying the closing documents to make the program more effective.
The Closing Documents
The closing documents consist of a comprehensive set of 34 closing documents, ranging from recordable documents such as the security instrument to construction escrow agreements. One of the most critical, but often overlooked, changes to these documents—in contrast to the various documents and riders used before this reformation effort—is the establishment of common definitions that are used consistently in all 34 documents and across all jurisdictions. Two examples of this strategy are the inclusion of definitions for “program obligations” and “waste.” During the public comment periods on the proposed regulation and documents, commenters consistently expressed concern that FHA could effectively “renegotiate the terms of the deal” by adopting regulatory or administrative changes to the FHA programs and applying them to FHA borrowers even after they obtained commitments or signed the closing documents. The chief complaint was that post-closing changes could affect the economics of the project and substantially alter the borrower’s obligations to the department. Letter from John Courson, President and Chief Exec. Officer, Mortg. Bankers Ass’n, to Shaun Donovan, Sec’y of U.S. Dep’t of Hous. and Urban Dev. (Mar. 22, 2010).
To address this concern, since the 1970s the codified regulations governing FHAs multifamily programs have provided that amendments to the regulations shall not adversely affect the interests of a mortgagee or lender under the contract of insurance on any mortgage or loan already insured and shall not adversely affect the interests of a mortgagee or lender on any mortgage or loan to be insured on which the Commissioner has made a commitment to insure. 24 C.F.R. § 207.499. This clause provided lenders working with FHA programs with a unique reassurance that their contracts will not be changed, but no such language existed for the benefit of FHA borrowers.
To allow HUD to make necessary future programmatic changes without amending all relevant documents while reassuring borrowers that the overall business terms will not change, FHA now includes a definition of “program obligations” in the Security Agreement and the Regulatory Agreement (which is the document that contains the requirements for borrowers regulated by HUD) and references this term in many of the other documents.
The definition of “program obligations” states:
“Program Obligations” means (1) all applicable statutes and any regulations issued by the Secretary pursuant thereto that apply to the Project, including all amendments to such statutes and regulations, as they become effective, except that changes subject to notice and comment rulemaking shall become effective only upon completion of the rulemaking process, and (2) all current requirements in HUD handbooks and guides, notices, and mortgagee letters that apply to the Project, and all future updates, changes and amendments thereto, as they become effective, except that changes subject to notice and comment rulemaking shall become effective only upon completion of the rulemaking process, and provided that such future updates, changes and amendments shall be applicable to the Project only to the extent that they interpret, clarify and implement terms in this Security Instrument rather than add or delete provisions from such document.
Included in Multifamily Assignment of Leases and Rents and Security Agreement, HUD-94000M ¶ 1(dd); Regulatory Agreement, HUD-92466M ¶ 1(y).
This definition of “program obligations” recognizes that regulatory and administrative requirements must change in light of industry changes or programmatic problems, but it also provides borrowers with assurance that they, as program participants doing business with FHA, will not be subject to attempts to change contract terms administratively without input from the public.
This language incorporates current administrative law litigation standards and helps assure borrowers that any “program obligations” changes will not be issued via informal e-mail blast or on an inconsistent basis across jurisdictions. HUD Multifamily Rental Project Closing Documents: Notice Announcing Final Approved Documents and Assignment of OMB Control Number, 76 Fed. Reg. 24,507, 24,508 (May 2, 2011). In addition, the notice also provides that, “to the extent any administrative requirements in HUD handbooks, guidance, housing notices, or mortgagee letters are inconsistent with any provisions in the revised closing documents, the provisions in the closing documents will prevail.” Id. at 24,510.
Lawyers should note that the definition of ‘‘program obligations’’ also explicitly states that notice and comment rulemaking procedures must be followed for changes in significant substantive requirements. For example, HUD defines the term “Principals” in the Regulatory Agreement by a reference to the applicable federal regulation. HUD-92466M ¶ 1(w); see also 24 C.F.R. § 200.215. The detailed list of principals includes individuals as well as entities such as joint ventures, partnerships, sponsors, and other parties that serve as owners under the Regulatory Agreement. Thus, the Regulatory Agreement will initially be interpreted with reference to the definition of principal in the codified regulation applicable at the date the document was signed. Because these regulations can be changed only in accordance with the Administrative Procedure Act requirements for notice and public comment, program participants will be aware of proposed changes and will have the opportunity to identify any problems a proposal might create in relation to their existing obligations and requirements. This process assures that beneficiaries will have time to plan for any new requirements.
Another example of this effort to provide standardization at a national level is the inclusion in the documents of a definition of waste. Although state law definitions and state court interpretations of waste differ, FHA is required by statute to develop a national program. Inclusion of a common contractual definition of waste provides a national legal test and certainty for FHA and program participants as to what FHA means by waste in the Security Instrument and the Regulatory Agreement. The new five-part definition builds on standard legal dictionary definitions of waste while adding the highly recognizable HUD requirement that multifamily owners maintain properties in decent, safe, and sanitary condition and in good repair. HUD-94000M ¶ 1(jj); HUD-92466M ¶ 1(ll).
As General Counsel Kanovsky indicated at one of the first HUD roundtables, in addition to revising the documents to make them understandable to all participants, they were also redrafted to ensure that the roles and responsibilities of the participants—lenders, borrowers, and FHA—are clear. Specifically, the documents were revised to require the lenders and borrowers to undertake some of the work that was formerly performed by FHA while imposing reasonable review and oversight responsibilities on the department. In accordance with these expanded responsibilities, the parties, including lenders, borrowers, and their attorneys, are required to make representations in the documents that they have completed their assigned responsibilities. HUD states in the Notice that the liability structure developed in the documents establishes a balance between, for example, delegations of authority to the lender in underwriting and construction management and new flexibility empowering lenders to address the problems of managing troubled projects. 76 Fed. Reg. at 24,508. In addition, financial incentives and the roles of the parties in the transaction are more explicitly defined. Several of these types of changes are discussed in the following sections.
Guide for Opinion of Borrower’s Counsel
One of the most significant documents from an attorney’s point of view is the Guide for Opinion of Borrowers Counsel. HUD-91725M. FHA-approved lenders request opinions from the borrower’s counsel because they depend on the borrower and its counsel to provide them with information on local law in the relevant jurisdiction. This is particularly important for national lenders. The FHA form opinion also asks attorneys to opine on the borrower’s legal status and the borrower’s power and authority to enter into the relevant contracts.
In its May 2011 publication, HUD made several adjustments to its form opinion to streamline and shorten the opinion, remove non-essential requirements, and shift the obligation to opine on certain matters to other parties. For example, the revised opinion removes some language disclosing how the loan was funded. It also recognizes the incorporation and entity-creation requirements in different jurisdictions and the availability of certain types of documents in specific states regarding the status of the borrowing entity. For example, HUD updated requirements for a certificate of good standing for trusts to allow attorneys to provide alternative legal status documents that are appropriate for the jurisdiction and the entity. Some of the certifications on permits are shifted to the lender, which now must confirm that these are provided before final endorsement of the Note in the Lender’s Certificate. HUD-92434M ¶ 30.
Of particular interest to attorneys is a change in the opinion that revised the conflicts test for law firms. 76 Fed. Reg. at 24,509. The new test limits the conflicts to “attorneys who devote substantive attention to the transaction.” HUD notes that this change could allow large firms that represent borrowers in other legal arenas to also represent them in multifamily housing closings. For example, a large national law firm that represents a borrower in an area such as employment law may not have, before the changes, been able to make the representations required in the opinion despite the substantive distinctions in the legal work. Under the new conflicts test, the firm is more likely to be able to provide the required opinions and ultimately lower borrower costs. FHA’s interest in increasing participation in the multifamily housing industry is further demonstrated by another clause that significantly narrows the conflict requirements to limit the test to whether the participating attorney has knowledge of other firm attorneys’ financial interests and conflicts in the project, the property, or the borrower. HUD also changed its requirements for the permitted signatories of the opinion of borrower’s counsel to reflect a current practice in many firms that the opinion be signed on behalf of the firm issuing the opinion rather than by an individual lawyer.
The Lender’s Certificate includes the certifications made by the lender to HUD regarding the due diligence undertaken to achieve final underwriting of the project. HUD-92434M. For instance, the Lender’s Certificate includes the lender’s representations to FHA on such matters as loan underwriting and construction expenditures. As part of the expanded role for the lender in HUD-insured transactions, the agency included several new standards and legal tests in the Lender’s Certificate. As described in the Notice, lenders must now make “reasonable inquiry” in their due diligence efforts, but they are also permitted to certify their statements by limiting their representation “to the best of their knowledge.” 76 Fed. Reg. at 24,509. Further, rather than absolutely “certifying” that, for example, the borrower possesses the governmental permits, and other documents necessary to own and operate the mortgaged property, under paragraph 30 of the Lender’s Certificate, lenders confirm that the necessary permits have been obtained. Attorneys can highlight in their advice to lender clients using these revised documents that, while lenders and attorneys must complete their due diligence, these new legal tests change the legal standard to which lenders must attest.
In addition to increasing the lender’s due diligence requirements in the revised underwriting guidelines and the liability structure established in the documents, HUD is stepping back from its role in troubled projects and giving lenders greater ability to address property management problems that affect the financial viability of the project. These changes were made, according to FHA, based on the expectation that lenders will undertake increased due diligence to assure sound underwriting.
Under that authority, HUD has also required that the lender must provide prior written approval for all nonresidential leases, including telecommunication leases, as well as for the form of the actual lease agreement itself and all modifications, extensions, or amendments.
In response to these increased responsibilities, lenders may seek compensation such as a “fee” for processing a “Transfer of Physical Assets.”
Certifications by Borrower/Principals
FHA mortgage insurance programs offer long-term, nonrecourse financing for multifamily affordable apartments and cooperatives. But, in response to concerns that the financial and housing markets needed stronger regulation and that mortgage market participants needed to have more skin in the game, the revised Regulatory Agreement now clearly recognizes a controlling individual’s or controlling entity’s responsibility for any funds lost through waste, fraud, and abuse. It does so by requiring that principals sign the document and be personally responsible for paying damages for certain “bad boy” acts. The new Regulatory Agreement explicitly provides that acts of fraud and misconduct that put the FHA insurance fund at risk will be pursued through contract rights and other federal remedies. HUD believes that the “bad boy” provisions provide more certain legal mechanisms for enforcing HUD’s statutory, regulatory, and program requirements without overburdening owners. Principals that must accept personal liablity for the “bad boy” acts at closing will be identified expressly in the firm commitment.
Just as the lender makes representations in the Lender’s Certificate, the borrower makes representations to the FHA in the Agreement and Certification, the document comparable to the Borrower’s Affidavit in commercial lending transactions. HUD-93305M. Of note is a requirement that the borrower attest to pending litigation and claims for those entities most likely to be held responsible under the loan documents—the general partner, managing member, or similar person or entity. FHA tied principal requirements to a regulatory definition in 24 C.F.R. § 200.215. FHA recognized that, for example, requiring volunteer officers and trustees of nonprofit mortgagors, as well as individual investors in tax credit projects, to sign closing documents presented practical and legal issues. The parties responsible for signing are specified in more detail in the definition of “Principal” in the MAP Guide.
Also in light of developments in the mortgage markets that some have attributed to insufficient regulation, the new FHA documents explicitly provide that acts of fraud and misconduct that put the FHA insurance fund at risk will be pursued through contract rights and other federal remedies. HUD believes that the bad boy provisions provide more certain legal mechanisms for enforcing HUD’s statutory, regulatory, and program requirements without overburdening owners. Accordingly, FHA tied principal requirements to a regulatory definition in 24 C.F.R. § 200.215. FHA recognized that, for example, requiring volunteer officers and trustees of nonprofit mortgagors, as well as individual investors in tax credit projects to sign closing documents presented practical and legal issues. Principals that must accept personal liability for the bad boy acts at closing will be identified expressly in the firm commitment. In addition, attorneys should note that principals required to sign the documents are, in general, attesting only to the best of their knowledge and primarily to their own statements and representations.
Changes to the Regulatory Agreement Clarifying Capital Contributions
To protect the government’s interest and assure financially viable projects, FHA sets strict limits on the timing and amount of funds owners can withdraw from projects. As a practical matter, owners can make financial contributions for improvements on an ongoing basis. HUD therefore has included language in the new Regulatory Agreement that distinguishes funds related to the mortgaged property and funds that are separate and apart from the mortgaged property. HUD-92466M ¶ 12(a).
2011 Regulatory Changes
The FHA multifamily regulations include eligibility requirements, specifications concerning the type and features of property that can be insured, and contract rights and obligations. Changes to the regulatory requirements stemming from changes in the affordable housing documents were promulgated on May 2, 2011. These changes are found primarily in 24 C.F.R. part 207. The FHA regulations, like the corresponding changes to the documents, reflect an effort to update, modernize, and streamline the process of working with FHA.
Before adopting the 2011 regulatory revisions, natural persons, tenants in common, and single asset borrowers could be insured. Under the modified regulations, FHA envisions a program of borrowers that are primarily single asset entities, which has now become the standard form of ownership for commercial real estate. Under the regulations, single asset borrowers must have the powers necessary and incidental to operating the project. Id. § 200.5. Entities that are not single asset entities, primarily trusts, will be eligible under only certain terms and conditions. Essentially, HUD eliminated the category of natural persons, that is, individuals, as borrowers. In addition, as FHA narrowed its focus, it prohibited tenants-in-common from being borrowers. The revised regulations make several other changes necessary to match the regulations to modifications in the closing documents. Both the documents and the regulations now identify a monetary event of default, which occurs when the borrower fails to make a payment required by the note or security instrument. Id. § 207.255(a)(1)(i). A second new category, a covenant event of default, addresses material failures by the borrower to perform any obligation under the security instrument. Id. § 207.255(a)(1)(ii). The security instrument provides additional detail specifying the circumstances and specific actions that will constitute a covenant event of default.
FHA multifamily properties are securitized through Ginnie Mae, which guarantees investors the timely payment of principal and interest on mortgage backed securities that are made up of FHA federally insured mortgage loans. Several changes were made to the regulations to deal with problem projects and the resulting effects on Ginnie Mae investors. HUD has changed the grace period after which there will be a charge on late payments from 15 to 10 days to standardize the period and coordinate with Ginnie Mae issuer obligations to make payments to investors. Also affecting Ginnie Mae investors is a change in insurance claim requirements to provide that the mortgagee request a three-month extension of a 45-day deadline in 24 C.F.R. § 207.258 for a mortgage funded with the proceeds of state or local bonds, Ginnie Mae securities, or other bond obligations specified by HUD, any of which contains a lockout or penalty provision. Additional regulatory changes were adopted to coordinate with changes in the documents to allow cash flow generated during workouts to be used once a default is cured and a modification to insurance claim requirements to allow the lender to file an application for insurance benefits once HUD acknowledges the mortgagee’s election to assign.
Updating these documents and regulations was a challenging undertaking for FHA and the multifamily industry that participated in the notice and comment and consultation process. The extensive HUD legal team that worked on this project, including the authors and John Daly, Ellen Dole, Camille Acevedo, Millie Potts, Susan Campbell, Ventura Simmons, Jennifer Chu, Kelly Gil, Michael Montagne, and multifamily expert Chris Tawa, devoted many hours to making the documents and regulations reflect current legal practices. The implementation of these changes will be an equally challenging task. Many of the efforts described above, including the use of FAQs, will help ensure that the documents serve the purposes described in this article and allow FHA to serve its countercyclical role in multifamily lending in a manner that serves all parties to the transactions.