July 01, 2002

Organizational Due Diligence in Real Estate Secured Loan Transactions (2002, 16:04)

Organizational Due Diligence in Real Estate Secured Loan Transactions—The Role of Lender’s Counsel

Probate and Property, July/August 2002, Volume 16, Number 4

By Josias N. Dewey

Lending transactions today involve many types of entities, such as corporations, limited partnerships, limited liability companies, and even business and land trusts—just to name a few.  

Lending transactions today involve many types of entities, such as corporations, limited partnerships, limited liability companies, and even business and land trusts—just to name a few. The laws and principles governing business organization, existence, and authority vary among each of these different entities. Even within one particular form of organization various permutations exist, such as differences in governance between a manager-managed limited liability company and a member-managed limited liability company. In addition to the restrictions and requirements imposed by state law, the proliferation of securitized lending, subject to review by rating agencies such as Fitch, Moody’s, and Standard & Poor’s, has led to an increase in the amount of “self-imposed” restrictions and limitations placed in borrowers’ organizational documents. As a result, the role of lender’s counsel in reviewing organizational documents does not always consist merely of reviewing a simple set of bylaws and articles of incorporation and a one-page corporate resolution and incumbency certificate.

Lender’s counsel should not downplay its role in reviewing organizational documents and should not rely on a legal opinion from borrower’s counsel as to the due organization of the borrower and the proper authorization of the loan transaction, because there is no guarantee that borrower’s counsel has been diligent in rendering the opinion. A lawsuit against the borrower’s counsel for negligently rendering an opinion may provide little comfort to a lender client and may result in a malpractice suit against lender’s counsel for failing to ensure that the loan was duly authorized.

This article addresses the role of a lender’s-counsel in reviewing and analyzing organizational and authorization documents (for the purposes of this article referred to collectively as “organizational documents”) in a real-estate-secured loan transaction, the items that lender’s counsel should request and review, and areas of particular concern that lender’s counsel should be aware in reviewing organizational documents.

Defining Counsel’s Role

As with all aspects of client representation, lender’s counsel should first define with its lender client what counsel’s role and responsibilities will be in reviewing organizational documents. At a minimum, lender’s counsel’s role in reviewing organizational documents will typically include ensuring that the borrower (1) is duly organized and in good standing, (2) has the power under its organizational documents to enter into the contemplated loan transaction, (3) has taken all steps necessary to properly authorize the loan transaction, and (4) has authorized the individual signing the loan documents to do so on behalf of the borrower. Lender’s counsel’s role may also include confirming that certain equity contributions are in place as well as determining in whom ownership and control of the borrower is vested. A lender may desire to prohibit certain individuals involved with the borrower from having a controlling interest in the borrower or holding a corporate office, if, for instance, an individual principal has credit problems that may be a cause for concern. By contrast, a lender may require that a particular individual, such as an experienced developer, maintain a controlling interest in the borrower throughout the term of the loan.

Due Diligence Materials

The first step in determining what items of due diligence must be reviewed is determining the relevant parties to the transaction. Lender’s counsel should always review organizational documents for the borrower, its general partner or managing member, the general partner or managing member’s general partner or managing member, and so on, until an authorized individual signatory is identified. Lender’s counsel should also review organizational documents for any non-individual guarantors. In addition to the borrower and any guarantors, the lender may desire to confirm that other parties to the transaction are duly organized and have properly authorized that component of the transaction to which they are parties. As a practical matter, however, there are times when the additional certainty of proper authorization is outweighed by the increased transactional cost of reviewing organizational documents for a particular entity involved in the transaction, such as a general contractor that may be required to sign a consent to a collateral assignment of a construction contract.

After the relevant parties are identified, lender’s counsel can prepare a checklist of due diligence materials that must be reviewed. Although this list may vary from state to state, typically the core organizational documents will remain the same. At a minimum, lender’s counsel should review

• a current certificate of good standing or active status issued by the secretary of state for the state in which the borrower is organized;

• a certificate of limited partnership (for a partnership), articles of incorporation (for a corporation), or articles of organization or formation (for a limited liability company), each of which should be issued by the secretary of state for the state in which the borrower is organized;

a partnership agreement (for a partnership), operating agreement (for a limited liability company), or bylaws (for a corporation); and

• if the borrower is an out-of-state entity, a certificate of qualification to do business issued by the secretary of state of the state where the transactional property is located.

In addition to obtaining and reviewing the above items, lender’s counsel should obtain a certificate at closing executed by an officer of the borrower that attests to the completeness and correctness of copies of the above items that are attached to the certificate.

Good Standing and Foreign Registration

Lender’s counsel should review a current good standing certificate to determine whether the entity is in good standing in the state of its incorporation or organization and that it has filed all necessary annual reports and paid any required fees or taxes owing the state. If the entity is organized under the laws of a state other than the state where the project being financed is located, counsel should ensure that the entity (and possibly its general partner or managing member, if required under applicable law) is registered to do business as a foreign organization. Typically, this can be confirmed with the secretary of state, who will issue a certificate confirming such registration.

Due Organization

Lender’s counsel should confirm that the borrower has been duly organized. If the borrower has not been duly organized, then the borrower may not be a legal entity capable of borrowing money, owning property, or granting mortgages and security interests. The requirements for the organization of an entity may vary slightly from state to state and will depend on the type of entity involved.

In addition to the filing of articles of incorporation with the state, the due organization of a corporation generally requires that the corporation adopt bylaws and elect directors. This analysis can be very factual and may require that the minute books of the corporation be reviewed to ensure that the corporation has in fact adopted bylaws and elected directors. In lieu of reviewing the corporate minute books, lender’s counsel might rely on factual certifications from an appropriate officer of the corporation together with an opinion letter from borrower’s counsel opining on the due organization of the corporation.

The due organization of a limited partnership will generally require (1) a written partnership agreement, (2) the filing of a certificate of limited partnership with the state (that the state has accepted), and (3) that the limited partnership consist of at least one limited partner and one general partner. Lender’s counsel should verify that the partnership agreement has been signed by all of the partners of the partnership and that there is at least one limited partner and one general partner to the partnership agreement. Again, the exact requirements may vary slightly from state to state. Accordingly, lender’s counsel should review the applicable limited partnership statute to determine the exact elements necessary for the organization of a limited partnership.

The due organization of a limited liability company will generally require (1) a written operating agreement or a set of company regulations (although this is not a requirement under some states’ laws) and (2) the filing of articles of organization or a certificate of formation with the state (that the state has accepted). In addition, although almost all states now permit the existence of a single-member limited liability company, at least Massachusetts still requires that the limited liability company maintain at least two members. Lender’s counsel should verify that the operating agreement has been signed by all of the members of the limited liability company. Again, the exact requirements may vary from state to state. Accordingly, lender’s counsel should review the applicable limited liability company statute to determine the exact elements for the organization of a limited liability company.

Power

Lender’s counsel must review the borrower’s organizational documents to determine whether they give the borrowing entity the power to enter into the transaction and perform its obligations under the transaction documents. Generally, under state law, unless the organizational documents provide otherwise, an entity has all the powers that an individual has under state law. Organizational documents are not always drafted to be broad enough to cover most loan transactions. For instance, an entity may have previously obtained financing through a lender that required the borrowing entity to incorporate specific purpose entity (SPE) and bankruptcy remote restrictions and prohibitions into the borrower’s organizational documents. If this has been done, the organizational documents will typically prohibit the borrower from obtaining any financing other than the original loan. Lender’s counsel should require the borrower to amend its organizational documents to remove any restrictions or prohibitions against incurring the new debt or that are otherwise inconsistent with the contemplated loan transaction.

Authority

Lender’s counsel must identify who has the power to authorize the transaction and act on behalf of the borrower. If the borrower is a partnership, typically the power to enter into the loan will be vested in the general partner. If the borrower is a limited liability company, typically the power will be vested in the managing member or a manager appointed by the members. Occasionally, however, the consent of the limited partners or nonmanaging members, as the case may be, will be required. If this is the case, lender’s counsel should request written evidence of such consent and approval. When dealing with a corporation, the board of directors generally has the authority to govern the corporation. It is not uncommon, however, for the organizational documents to require that some percentage of the corporation’s shareholders approve the transaction. If shareholder approval is required, lender’s counsel must obtain written evidence of such approval.

Once lender’s counsel determines the entity or entities that have the authority to approve the loan transaction, counsel must identify the individuals authorized to sign the transactional documents on behalf of such entity or entities.

In the case of a corporate borrower or corporate general partner, counsel should obtain a certificate, often called an incumbency certificate or secretary’s certificate, that sets forth the names of the officers and directors of the corporation. The certificate should be signed by an officer of the entity, preferably the secretary or such other officer charged by the bylaws with maintaining the entity’s organization records. Counsel should ensure that the corporate resolution identifies the officers of the corporation authorized to sign the transaction documents. Counsel should review the resolution and the incumbency certificate together to determine which individuals are authorized to execute the loan documents. Although this is an easy task to accomplish, if overlooked, counsel could close a loan transaction without ever having any of the transactional documents properly executed.

In the case of a limited liability company, authority may be vested in the manager or managing member. If the manager or managing member is a corporation, then lender’s counsel would examine a secretary’s certificate as discussed above in the case of a corporate borrower or general partner. But ultimate authority may be vested in an individual or group of individuals in their capacity either as managers or as managing members. If this is the case, lender’s counsel must ensure that these individuals either all sign the loan transaction documents or, alternatively, that one such person signs the loan transaction documents and that a unanimous consent signed by all such individuals approving the loan transaction is delivered to the lender, unless the organizational documents permit each such individual to unilaterally approve the transaction.

Proper Authorization

Corporate authorization will generally be evidenced by either a unanimous written consent of the board of directors in lieu of a called meeting of the board or a corporate secretary’s certification that the resolutions approving the transaction were in fact passed pursuant to a properly conducted meeting of the board of directors. If lender’s counsel relies on a written unanimous consent of the board of directors, counsel should verify that the corporation is permitted to act without a formal meeting of the board of directors. Generally, state law provides that, unless the corporation’s organizational documents provide otherwise, the board of directors may conduct business without the need for a formal meeting if all the directors approve a transaction in writing. In that case, lender’s counsel should review the articles of incorporation and the bylaws for the borrower to ensure that the borrower has not prohibited this method of approval.

Lender’s counsel should examine the corporate resolution, whether in the form of a unanimous written consent or a corporate secretary’s certified set of resolutions, to ensure that the document adequately approves the loan transaction. Counsel should confirm that the transaction is properly described, i.e., the loan amount is correct, the name of the lender is correct, and the mortgaged property and applicable loan documents are correctly identified. The resolution should approve not only the acceptance of the loan and the incurring of the debt, but also the granting of a mortgage and a security interest in the collateral. The resolution should identify who is authorized to examine and execute the loan documents, such as the president, vice president, or any corporate officer. The resolution should provide sufficient discretion to the authorized officer to agree to such changes in the loan documents that the officer deems to be in the best interest of the corporation. The resolution should also provide that they will remain in effect until such time as revoked by action of the board. The resolutions should require that to be effective evidence of any such revocation be delivered to the lender.

Rating Agency Concerns and Requirements

If a loan is or may become part of a securitization of assets (such as a commercial mortgage-backed securities offering), the loan originator may require that the loan documents and the organizational documents of the borrowing entity comply with certain requirements generally imposed by the rating agencies. This will require lender’s counsel to determine whether the borrower’s, and most often its general partner’s or managing member’s, organizational documents contain restrictions (1) limiting the purpose of the borrower to the ownership and operation of the financed project, (2) prohibiting the borrowing entity from incurring any indebtedness other than the lender’s loan and unsecured trade debt incurred in the ordinary course of operation of the financed project, and (3) prohibiting the borrowing entity from merging, consolidating, dissolving, liquidating, or filing a petition for bankruptcy. In addition, the lender may require that certain “separateness” covenants be incorporated into the borrower’s organizational documents. These covenants are generally aimed at preventing the borrower from being consolidated with another entity (primarily the principals of the borrower) in a bankruptcy proceeding. In larger transactions, the rating agency may require that at least one member of the borrower’s board of directors be an “independent” director.

In addition to conduit lenders and other originators of loans destined to become a part of a securitized pool of assets, other nonconduit lenders, such as life insurance companies, have begun requiring that SPE and bankruptcy remote provisions be incorporated into the borrower’s organizational documents. Counsel should confirm with its lender client if any of these requirements are applicable. A detailed discussion of these requirements is beyond the scope of this article. A more specific set of guidelines and a detailed discussion of the restrictions and limitations typically required by rating agencies may be found in the various agencies’ legal criteria guidelines, such as Standard & Poor’s Legal Criteria for Structured Finance Transactions manual, available at this link , and Standard and Poor’s Legal and Structured Finance Issues in Commercial Mortgage Securities manual, available at this link.

Conclusion

The role of lender’s counsel in reviewing the borrower’s organization documents is an important one. Once the steps outlined in this article have been completed, lender’s counsel will know that the borrower is properly organized and in good standing, that it has the power to enter into the transaction, that the transaction has been authorized, and that a person with authority has signed or will sign the documents.

Josias N. Dewey is an associate at Holland & Knight LLP in Miami, Florida.