By Nancy R. Little and Russell T. Aaronson III
The aggressive appetites of real estate investment trusts and other investors with capital available for real estate have created a trend toward the consolidation of real estate ownership in the United States. This trend has also increased multi-property, multi-state portfolio acquisitions. Multi-property financing transactions have also proliferated in the form of pooled loan sales, loan originations and corporate finance transactions. This article focuses on the special problems associated with multi-property portfolio acquisitions and financings and includes practice tips to help buyers, borrowers, lenders and their counsel manage the process.
Managing Counsel's Role in Organizing the Team
One of the most difficult roles in a portfolio transaction is that of managing counsel to the buyer or borrower. Managing counsel must determine how to staff and organize the team and the deal. Managing counsel can avoid delays in closing by establishing a division of labor early in the process so that problems can be identified and solved.
In these transactions, most clients want a due diligence review by outside counsel. In addition, the client may have experienced in-house counsel or staff whom the client wants to involve in the due diligence process. A due diligence review involves obtaining the maximum amount of information as quickly as possible. In an asset sale or financing transaction, the seller's counsel frequently organizes the due diligence materials to reduce the disruption of its client's business and to facilitate a fast and efficient review of the materials. Buyers and lenders may provide checklists in advance to facilitate file organization. Even though the seller may make copies of documents and furnish them to the buyer and its lender, counsel
to the buyer and the lender should schedule an on-site review of the seller's files early in the process to avoid overlooking crucial data. This on-site review provides the basis for
a checklist of critical path issues to help prepare the teams of lawyers who are structuring and documenting the transaction.
Managing the details of due diligence review and allocating responsibility among team members, client contacts and local counsel are the essence of managing counsel's role. Throughout the due diligence process, managing counsel should seek comment from the client and keep an eye on the client's objectives. Issues that seem critical to the due diligence team may be immaterial to the client. In addition, managing counsel must recognize global issues affecting the transaction, such as antitrust considerations and the effect of Hart-Scott-Rodino requirements on the business aspects of the deal.
The Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, 15 U.S.C. § 18a (HSR), requires scrutiny of the details of certain transactions for their effect on competition in the marketplace. Portfolio acquisitions and dispositions may trigger review under HSR because of their effects on commerce, the size of the parties or the magnitude of the transaction. Managing counsel must consider the effect of the HSR reporting requirements and the ensuing review period on the contemplated transactions. After this initial review of submitted materials, the Federal Trade Commission and the Department of Justice often require supplementation. Although HSR contains several exemptions from the filing and notification requirements that apply to many real estate transactions, the legal team should include lawyers with a working knowledge of HSR and its ramifications.
Due Diligence and Review Forms
Management of multi-state transactions is most effective with a comprehensive checklist that includes clients' comments. The best way to start is to request information from
the seller for use in preparing a checklist of critical path items. Managing counsel often prepares a due diligence questionnaire for the seller that re-quests, among other things, information about the condition and operation of the properties.
Counsel should pay particular attention to property-related documents, including the review of leases. Because lawyers and legal assistants unfamiliar with the transaction often are responsible for reviewing these documents, managing counsel should include instructions designed to identify all issues in a concise manner to facilitate subsequent negotiation by the documentation team. A lease review form can provide uniformity, especially if the leases are being reviewed by more than one person. The form should include information such as the term, rent, rights to assign and sublease, landlord's recapture rights, use restrictions and operating covenants.
Document review forms or summaries should also be prepared for organizational documents of the seller, loan documents affecting the properties, consents to assignment of leases and management agreements, declarations of easements, covenants and restrictions and other material agreements. If possible, all of this information should be incorporated into shared databases, accessible by all members of both the due diligence and documentation teams.
Outside consultants are usually engaged for title commitments, surveys, environmental reports and appraisals. Outside counsel to the buyer or borrower normally manages the selection process. One of the first considerations in a large portfolio transaction is whether to use national consultants or individual firms located in each jurisdiction in which properties are located. Rarely is it efficient to use individual firms because national pricing and coordination are essential to the timely closing of the transaction. National consultants provide uniformity in their reports and a single point of contact, which speed up the transaction and reduce its cost.
Some title companies now affiliate with national survey, environmental companies or both to provide "one-stop shopping." Managing counsel should furnish each consulting firm with applicable guidelines and requirements of the buyer and its lenders before the bidding process to avoid misunderstandings, delays and additional costs.
National environmental companies sometimes subcontract with individual local firms because of the timing of the transaction or the number of properties involved. In addition to furnishing guidelines to the environmental consultants for the Phase I environmental reports, managing counsel should carefully review the contracts between the buyer or borrower and the consultants. An environmental consultant often tries to cap its liability for its actions or omissions at the amount of its fee. Given the amount of risk and potential cost of assuming possible environmental liabilities, such a cap is normally disproportionately low. It is usually possible to negotiate for a substantial increase in the liability cap. An environmental consultant may also charge an additional fee to permit third parties to rely on its reports. This additional fee is also subject to negotiation.
If time permits, managing counsel should request drafts of the reports to determine if any matters need clarification before delivery to the lender. That clarification requires significant lead time if it involves communicating with field personnel, checking environmental databases or initiating Phase II or other investigative studies. The studies themselves and the subsequent lab work are time-consuming and often involve an additional fee if conducted on an expedited basis. The environmental consultants need access to the property early in the process. The parties may need to exercise caution in allowing that access if the transaction has not been disclosed to the public, the seller's employees or the property managers.
The lead time for appraisals is usually a minimum of eight weeks. Typically, the lender controls this process, although sometimes the buyer or borrower coordinates the appraisals through a national appraiser. As with the reports of other consultants, the key is to provide the appraiser with the lender's requirements. Appraisal methods depend on whether the final product is for a traditional financing, a lease financing or a securitization. Managing counsel should consult early with the appraisal firm and the lender to ensure that the appraiser understands the requirements and has experience with the required methodology. If the appraiser is subcontracting with local firms, each local firm should receive the parties' requirements.
Only a few national survey com-panies are currently in the market. Unlike national environmental and appraisal firms, these companies typically do not use their own personnel to survey each property. Instead, they bid the work with local survey firms and coordinate the survey process. A number of advantages result from using a national surveyor, including ease of coordination and a standardized format for all surveys, which save time and money. Managing counsel should provide the lenders' survey requirements and the form of surveyor's certificate to the survey com-pany early in the process. Because surveyors often want to negotiate the form of surveyor's certificate, the form of certification should be made a part of the bidding process, along with the borrower's and the lenders' survey requirements.
One of the most time-consuming aspects of the due diligence process is title review. Closing a multi-state portfolio transaction efficiently is almost impossible without the services of the national division of a major title insurance company. National coordination and standardization are invaluable. Frequently, managing counsel solicits bids for the title insurance from the major title insurance companies. National pricing is particularly important in multi-state transactions. In some states, title companies are limited to "filed" or regulated rates that are not negotiable. A national title company usually offers a "blended" rate by reducing the rate in states with negotiable rates to compensate for the higher pricing in states with filed rates. It also is possible to negotiate for minimal or no cancellation fees. In addition, lenders and buyers in most portfolio transactions require a "New York-style" closing through a national title insurer to avoid the delays associated with updating title and verifying recordation before funding. National title insurers also help negotiate coverages and endorsements on a portfolio basis.
The use of a national title insurer does not guarantee uniform policies in all states because policy forms, endorsements and affirmative coverages vary from state to state. Some states have "filed" policy forms. Some endorsements and coverages are available only in certain states or at filed rates or negotiated premiums. In large, multi-state transactions, most lenders require the primary title company to reinsure with other major title companies. The lenders often specify the title companies that are approved as reinsurers as well as the limits of retention that can be held by each company. Lenders normally want to approve the form of reinsurance agreement. The buyer or borrower may not have much leverage on this issue, and the requirement for reinsurance usually increases the cost of title insurance.
Frequently, the parties do not devote adequate attention at the front end of the transaction to lien searches. Although the title company should produce copies of fixture filings, a comprehensive search of UCC filings is necessary for personal property that may be included in the transaction. Blanket liens and security interests may encumber property that is being sold as well as property that the seller will retain. Counsel should contact lienholders early to avoid delays in obtaining releases. In addition, lenders may require searches for judgments and bankruptcy filings.
The Buyer's Perspective:
Choice of Entity
The choice of the buyer or borrower entity is integral to structuring the transaction. If the buyer uses a limited liability company (LLC), managing counsel should determine whether the states in which the properties are located afford LLCs the desired tax treatment and permit single member LLCs, if applicable.
In certain types of portfolio transactions, such as sale-leasebacks, the buyer is often a bankruptcy remote entity, such as a trust. This structure raises additional questions, such as whether the trust must register or qualify to do business in the states where the properties are located. Even if the trust itself does not have to qualify or register, state qualification statutes may require qualification by the trustee bank or trust company. Qualification is expensive if it results in the imposition of franchise or other taxes or fees related to doing business.
Some states have no statutory procedure available for qualifying either the trust or the trustee. In the states that do, the statutes are sometimes unclear on whether qualification is required or even possible. The tax treatment of the trust can also be a factor. Normally, the buyer wants a "pass-through" trust with no entity level tax. Managing counsel should consult experienced tax counsel in each state to avoid an additional tax burden.
Options After Due Diligence Review
After the buyer and the lenders complete their due diligence, managing counsel must decide how to proceed. In the rare event that no problems exist after the due diligence review, the parties proceed to closing. More likely, problem areas will be discovered that require attention before the buyer purchases and lenders finance the portfolio of properties. A savvy buyer negotiates for the seller to correct the problems at the seller's expense. The buyer often prefers that the seller correct a problem rather than exclude deficient properties from the transaction. Exclusion may not be a viable option if the parties' intent is for the buyer to purchase the seller's entire busi-ness or portfolio. If a particular property is regarded as a valuable location, the buyer may want to keep it out of the hands of a competitor.
Conversely, the seller wants to avoid paying to correct problems, particularly if it has operated a property for a long time without having addressed the issue. The seller, therefore, often negotiates for a provision that limits the buyer's remedies to termination if there are defects. That provision concerns a buyer because it has invested considerable time and money in the due diligence process and does not want to walk away empty-handed. The issue of correcting problems is generally resolved by compromise because the seller rarely wants the buyer to walk away from the deal. The parties may agree that the correction of defects costing less than a specified amount will be paid for by the seller. In the alternative, the parties may agree
that the seller pays for correcting defects only if the cost exceeds a certain threshold.
Due Diligence Costs
Normally the buyer is responsible for all due diligence costs. If the seller expects to use a bidding process to sell the properties, it sometimes obtains, at its expense, title reports, surveys and environmental studies before marketing the properties. By doing this, the seller hopes to obtain better pricing and a quicker sale. Doing this work in advance also permits the seller to correct any deficiencies ahead of time and gives the seller more control over the process.
The parties often negotiate the use of the due diligence materials if the transaction does not close. The seller usually asks that the buyer return all copies of third party reports and other documents obtained from the seller. The seller may also ask the buyer to keep that information, particularly sensitive environmental matters, con-fidential. The buyer should avoid a blanket confidentiality agreement because of possible mandatory reporting requirements on environmental matters. The buyer should also exempt its right to discuss the details with its lenders and their respective lawyers, accountants and consultants.
If the transaction does not close, the seller also may want to retain copies of all title reports, surveys, environmental reports and other diligence materials, whether obtained by the buyer or produced by the seller from its records. With this information, the seller may market the properties more easily. The buyer may resist giving away the due diligence materials it has paid for, even though the buyer will have no use for the reports and studies. The buyer may fear that the seller is using it as a "stalking horse" to attract other buyers. Several obvious compromises exist, such as splitting the costs that the buyer incurs in obtaining the due diligence materials.
The buyer typically expects the seller to deliver the properties free of any liens that the buyer does not expressly assume. Therefore, the seller pays for all costs associated with the release of any liens. Transfer taxes vary widely among the states and can significantly increase the cost of a portfolio transaction. The parties often agree to split transfer taxes, but to do so can be detrimental to the buyer if local custom puts the tax burden on the seller. Buyer's counsel should investigate the local practice in each jurisdiction and the applicable recording tax rates to determine the significance of the tax burden before negotiating this provision. Title companies can provide transfer, mortgage and other recording tax information in each jurisdiction as well as information about which party customarily pays the transfer and recording taxes and fees.
The parties often spend considerable time negotiating the form of conveyance documents in a portfolio transaction. Local custom in some jurisdictions may necessitate a general warranty deed, but an asset purchase agreement commonly requires only a grant or special warranty deed by which the seller covenants as to its own actions but not those of its predecessors in title. For the purposes of the buyer's and lenders' title policies, title insurance companies rarely differentiate between a special warranty deed and a general warranty deed. In a few jurisdictions, the seller customarily provides a quitclaim deed. Before accepting a quitclaim deed, the buyer should make sure that its lenders are willing to accept a quitclaim deed and that the buyer's title company is willing to insure a quitclaim deed without exception. In addition, to avoid a problem with a later sale, the buyer should ask local counsel whether a quitclaim deed is the custom in the applicable jurisdiction and whether other major title companies generally insure title to the same extent as for a special or general warranty deed.
The asset purchase agreement should spell out which party will be responsible for completing and filing any local recording forms. These forms may include affidavits of consideration, environmental disclosure forms and purchase price allocation affidavits, among others. If local law requires the seller to execute these forms, the agreement should require the seller to cooperate. The buyer should ask the title insurance company to provide copies of these forms and affidavits early in the transaction. Some forms, such as environmental disclosure affidavits, may require lead time for seller investigations.
Consents, Estoppels and SNDAs
If the seller is the tenant under leases that the buyer will assume, the seller may need to obtain the landlord's consent to the assignment. At the inception of the deal, the seller should identify any leases that may require consent, either through its own due diligence or through the buyer's lease reviews. The parties may debate the form of the consent. The buyer typically wants a landlord's consent to the lease assignment, a landlord's estoppel as to the rent and other key items under the lease and a landlord's certification as to the absence of any defaults by the seller as tenant under the lease. The seller frequently wants the landlord to release the seller from liability under the lease following the assignment. Most buyers will resist a release of the seller because the process of obtaining release normally delays the consent, makes it very difficult to obtain or both. Instead, the buyer will prefer that the seller defer its request for a release until the transaction has closed.
If the buyer is assuming any mortgages, the parties must obtain consents and estoppels from the mortgagees. In addition, if any of the properties are subject to leases (i.e., the seller is the landlord), the buyer and lender will want comprehensive estoppel certifications as well as subordination, nondisturbance and attornment agreements. These documents can take consider-able time to negotiate and are likely to trigger requests for opinions, additional title work and reimbursement of costs. Similarly, the buyer or the lender may require estoppel certificates for declarations or operating agreements that affect the properties. Again, managing counsel should identify these issues early in the process because they usually involve third parties that do not have the same incentive to respond as do the parties to the deal.
A buyer will want the seller's covenants, representations and warranties, particularly for environmental matters, to survive closing for an extended period. The seller will want little or no survival. Although the buyer may have undertaken substantial due diligence, it is virtually impossible to uncover every property-related issue. The ability of the buyer to pursue post-closing recourse against the seller may be invaluable. Survival also may affect the price the seller is willing to accept for the portfolio. The buyer may have to balance its desire for favorable pricing against its need for the representations and warranties to survive.
What happens if there is a breach of the representations and warranties that do survive? The buyer will want a post-closing purchase price adjustment. Often the agreements call for a post-closing "true-up" between buyer and seller. This adjustment, however, is usually intended to address rents, taxes, accounts receivable and similar items that usually become manifest within 30-60 days after closing. This time period is too short to be meaningful for a purchase price adjustment for an environmental problem, which may take years to discover.
The purchase agreement may require the seller to indemnify the buyer for a breach of the representations or warranties. The seller often attempts to cap its indemnity obligations, but a cap may not fully protect the buyer against liabilities such as environmental problems. The buyer can negotiate for an escrow or letter of credit to ensure that money will be available to pay a purchase price adjustment or a claim for indemnity. The seller will resist both because it wants to receive the purchase price in full at closing and will not want to escrow any of the sales proceeds or pay a letter of credit fee.
Allocation of Purchase Price
Another source of contention between a buyer and seller is the allocation of the purchase price between the personalty and the realty and the allocation among each of the properties. The latter allocation has significant recording tax consequences because the tax rates are higher in some states than in others. Although appraisals are helpful in this area, the parties often do not use them to determine the purchase price as between the buyer and the seller. The seller may want to receive at least its book value for each property, which may or may not be the same as the appraised value. The buyer and seller will need to agree. The buyer will need the allocations of value for recording tax and title insurance purposes.
The Lender's Perspective
In addition to sharing the concerns of the buyer or borrower, lenders are concerned about loan and mortgage enforcement issues. Some additional lender concerns are described below.
* Choice of law. Lenders typically request a single note cross-collateralized by liens on all of the properties. They also want local counsel's advice on whether the choice of law selected for the note and loan agreement will be recognized in the states in which the properties are located. Notwithstanding the choice of law for the note and loan agreement, the real estate security documents generally select the law of the state in which the property is located, at least to the extent that local law is required to apply. Lenders may ask local counsel to address the enforceability of the choice of law in their legal opinions.
* Document forms. Lenders prefer to record the same form of mortgage in each jurisdiction, if pos-sible. The parties will use the form of security instrument that is customary where the property is located, which may be a mortgage, deed of trust or deed to secure debt. Managing counsel should ask local counsel or the title company to advise on the usual form of security instrument and the remedies that are customary for lenders in the states in which the properties are located. Some states permit either judicial or nonjudicial foreclosure. Although a proceeding to foreclose nonjudicially under a deed of trust is usually preferable, some states may not have sufficiently developed a body of law for this type of proceeding.
* Enforcement impediments. Lenders usually want to know whether the jurisdictions in which the properties are located have "borrower friendly" regulations that dictate how a lender can realize on its collateral. Lenders, for example, want to identify any legal requirements for marshaling of assets, requirements for merger of the debt into a judgment to prevent successive foreclosures, any antideficiency statutes that preclude lenders from pursuing a borrower for a deficiency after foreclosure and any requirements for lenders to pursue a borrower before pursuing guarantors. Lenders are also concerned about any "one-action" rule that permits lenders either to sue the borrower or to foreclose on the property, but not both. Lenders want to know that taking action, such as foreclosure, in one state will not preclude taking a different action, such as suing the borrower, in another state. Local counsel typically assists managing counsel and lenders' counsel in these areas.
* Mortgage taxes. Many states have recording taxes that apply to the recordation of mortgages, deeds of trust or deeds to secure debt. Although lenders usually want cross-collateralization of all properties to secure the entire debt, most lenders will work with the borrower to minimize recording taxes and avoid paying mortgage taxes on the entire debt multiple times in various jurisdictions. Sometimes this result can be accomplished by an allocation of values among the properties located in each state. Additional specialized considerations can arise in lease financings in states in which taxes are payable on the recordation of leases as well as mortgages. In many lease financings, the lease is treated as a lease or a loan arrangement. The borrower/lessee in these transactions should pay one tax or the other, but not both. Local counsel and the title insurer can assist by suggesting ways to work within the particular recording tax statutes.
* Title insurance. Lenders' concerns about title insurance over-lap with those of the buyer or borrower. Lenders, however, may also be interested in obtaining additional endorsements, such as tie-in, variable rate and usury endorsements. These endorsements are not available in all states or are available only on payment of an extra-hazard premium.
Closing the Deal
Technology has made all deals mobile. Although a transaction can be closed almost anywhere, closing in the offices of the seller's counsel often makes sense because the seller's records are available if questions arise. Most portfolio transactions are closed in a New York-style closing so that all of the deeds and mortgage documents will not have to be recorded before funding. Such a closing can avoid the nightmare of trying to fund through multiple time zones in jurisdictions with prescribed recording times. A New York-style closing involves a gap indemnity, in which one or more parties agree to indemnify the title company for liens and encumbrances that are recorded after the last title update but before the date of recording. As with many other pre-closing items, he title company should produce its form of gap indemnity early in the process for each indemnitor to approve. Because record title is in the seller's name at the time of disbursement of the sales proceeds, the seller usually provides the indemnity. The seller wants to limit its exposure by providing a set time frame for the title company to record, after which the indemnity is no longer effective. The parties may want to schedule a title update shortly before closing to minimize the gap period. In a multi-jurisdictional transaction, this update can take considerable time and coordination.
Portfolio transactions present a myriad of legal and management issues. The primary advice for counsel handling these transactions is to plan ahead and organize well. Frequently, the battle is won simply by identifying problems early in the transaction and managing the transaction accordingly.
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