Cash Management Structures: Issues for Consideration C Kevin Sullivan John Lloyd Challenges and Problems with Cash Management ash management structures have been a commonly required feature in loans structured for commercial mortgage-backed securities (CMBS) execution since the inception of the industry. While the protective device is not always required on smaller loans, its use has become almost universal on larger loans and on more heavily structured transactions. As the focus on conservative structuring principles becomes more pronounced in 2008, the use of a cash management feature will likely become even more common. While the use of a cash management structure may be inevitable on many transactions, the industry should be sensitive to problems and issues frequently encountered, such as: • The terminology used across the industry varies from bank to bank and from lender to lender thereby leading to much confusion and misunderstanding. For example, the terms “lock box account,” “deposit account,” “springing,” “cash trap,” and similar common phrases have inconsistent meaning throughout the industry. The key objective to the arrangement is to provide the mortgage lender with some degree of control over property revenues. While all cash management arrangements share this common objective of control, the details and particulars of the structure vary significantly from originator to originator. Particular aspects of cash management structures are added or subtracted based on the degree of control required by the originating lender, which desired degree of control is, in turn, typically, governed by the nature of the property, risk factors, size of the loan, presence of mezzanine debt, or other more elaborate structuring, etc. The point of this article is to identify and discuss the various issues for consideration in establishing a cash management structure which will satisfy the lender’s objective of effective control while still allowing a workable arrangement for the borrower and for property operation. • The term “lock box” is properly used to mean a post office box where tenants mail their rent checks. There is a common perception that a lock box is required on all cash managed transactions when in fact a lock box is only one of several methods typically used to manage receipts and is generally inapplicable to multifamily, hotels and mobile home park projects (even when cash management is otherwise in place). It is for that reason that the phrase “cash management” is used in this article to include both arrangements with a lock box and those without. • Borrower resistance exists due to (1) cost and expense of lock box arrangements particularly in small transactions, (2) general concerns about the servicer/lender controlling property cash flow, (3) 10 Cash Management Structures: Issues for Consideration (cont.) Figure 1. 1. Basic Basic Cash Cash Management Management Figure unfamiliarity with the process, and/or (4) previous bad experiences with cash management structures. Cash Collateral Account • Frequently the borrower is given responsibility to open a lock box or clearing account which can result in an inadvertently incorrect setup and a delay in the timeline for closing. Property Revenue Periodic Sweeps • Depository banks holding the clearing account are frequently inflexible in the use of their deposit account control agreements so there can exist a disconnect between that document and the originating lender’s form cash management documents. Clearing Account • A property’s operation may not match the loan document timeline (i.e., the mandated collection period may not work well with the borrower’s monthly cyclical need for operating funds). Waterfall Distribution Monthly Debt Service Property Operating Expenses and Borrower Residual arrangement is more common with retail, office or industrial properties but does require the tenants’ cooperation in this direct payment arrangement. In this approach, the loan documents require the borrower to provide “tenant direction letters” to existing and future tenants. Basic Cash Management While more complex structures are discussed below, in order to achieve an understandable terminology for this article, a very basic cash management structure is indicated in Figure 1. 2. The borrower or, more commonly, borrower’s property manager, collects rental from the tenants as would normally be the case but then deposits such rentals into the Clearing Account within a very finite time frame (one or two business days). This structure is more common with multifamily and hotel properties. This basic structure indicates that property revenues are deposited into a “Clearing Account” frequently at a bank designated by the borrower which monies are swept periodically into a “Cash Collateral Account” solely controlled by the lender’s servicer and frequently maintained at a different financial institution. From the Cash Collateral Account, monies are distributed through the waterfall provision first, to assure adequate payment for Borrower’s monthly debt service obligations with the remainder being available for property expenses and to serve as a borrower residual. While we have elected to use the phrase “Clearing Account” and “Cash Collateral Account” to describe these two basic accounts, it should again be noted that originators, servicers and depository banks will frequently use different terminology to describe these same two identical accounts. Hybrid arrangements also exist. With respect to retail or office properties with a handful of very large tenants and many other very small tenants, cash management arrangements are sometimes structured so as to require only the very large tenants to make direct deposits through a lockbox while the smaller tenants will continue to pay rental directly to the property manager (for subsequent distribution to the Clearing Account). Particularly with respect to single tenant properties, a direct tenantpay arrangement into the Cash Collateral Account will sometimes be facilitated thereby negating the need for a Clearing Account altogether. With this very basic structure in mind, below is a discussion of issues for consideration in creating a cash management system. “Springing” Cash Management Features How Does the Rent Get Deposited into the Clearing Account? Frequently an arrangement is struck with the borrower whereby cash management is not wholly effective unless a “trigger” event occurs (e.g., an event of default, hyperam period, failure of major tenant to renew, etc.). This feature requires documentation which describes the trigger event and establishes a procedure whereby The two most common arrangements are: 1. Rents are directly deposited by tenants by way of a “lock box” arrangement through the bank administering the Clearing Account. This 11 CMBS World Summer 2008 Cash Management Structures: Issues for Consideration (cont.) Figure 2. Springing Cash Management (Changing Sweep Destination) Property Revenue Clearing Account Periodic Sweeps if Cash Management NOT then effective the destination of the day-to-day sweeps). This arrangement is illustrated in Figure 2. Frequently depository banks refer to this arrangement as “soft” cash management or as a “dual account” system. Borrower Operating Account Periodic Sweeps if Cash Management IS then effective •T he Clearing Account is initially set up as a nonblocked borrower operating account, but the bank holding the Clearing Account acknowledges that the mortgage lender shall be entitled to require, upon the occurrence of a springing event, that the Clearing Account be blocked and that sweeps thereafter occur on a periodic basis to the Cash Collateral Account. This arrangement is sometimes referred to as a “single account” system and is indicated in Figure 3. This approach has proven to be more problematic than the “soft” or “dual” account system described above due to procedural difficulties in changing control over the single account and frequent inadequate documentation with the depository bank for that single account. Cash Collateral Account Waterfall Distribution Monthly Debt Service Property Operating Expenses and Borrower Residual cash management controls will be implemented or enhanced upon the occurrence of the trigger. This arrangement can be undertaken in various ways but a few common methodologies are described below: • Mortgage lenders have occasionally agreed to an informal sort of springing arrangement whereby the borrower essentially covenants to establish cash management upon the occurrence of a triggering event. The benefit from the borrower’s perspective to this technique is obvious—no documented agreement with the bank holding the Clearing Account is necessary at the loan closing. The value and practical enforceability of this sort of springing arrangement from the perspective of the mortgage lender, however, is very dubious. Particularly in the context of an event of default triggered spring, it is doubtful that the lender will get much practical benefit from the borrower covenant to then establish cash management procedures for the first time. Particularly with respect to single tenant properties, a direct tenant-pay arrangement into the Cash Collateral Account will sometimes be facilitated thereby negating the need for a Clearing Account altogether. • A Clearing Account is established at closing and blocked from borrower access throughout the duration of the loan. At the inception of the loan and prior to the “spring” occurring, the Clearing Account bank is authorized to sweep the funds in the Clearing Account on a day-to-day basis to an operating account established by and under the control of borrower. Upon the occurrence of the triggering or springing event, the lender is to provide the bank holding the Clearing Account with an appropriate notice whereby such bank is required to thereafter redirect the sweep to the lendercontrolled Cash Collateral Account. The advantage of this approach is that it provides the heightened degree of control to the lender but also provides for a fairly simplistic spring methodology to be used by the bank holding the Clearing Account (i.e., that bank simply needs to acknowledge that the mortgage lender and its servicer are solely entitled to require that such Clearing Account Bank redirect In establishing a springing cash management structure it is important to the mortgage lender that the bank holding the Clearing Account not be entitled to use any discretion in evaluating the mortgage lender’s assertion that a triggering event has occurred and that cash management procedures are to be implemented. The cash management documents should simply provide that the Clearing Account bank be both entitled and required upon receipt of the appropriate notice from the mortgage lender to immediately undertake cash management procedures without any inquiry into the merits of whether or not a triggering event has actually occurred. 12 Cash Management Structures: Issues for Consideration (cont.) Figure 3. Springing Cash Management (Clearing Account Control Changes) Property Revenue Clearing Account becomes blocked to Borrower and subject to sweeps upon springing of cash management Clearing Account Withdrawals available by Borrower at will pending springing of cash management Borrower flow following the payment of monthly debt service to be disbursed into a borrower-controlled operating account (at least absent an event of default). In this scenario the borrower is entitled to handle all operating expense payments as well as retaining such residual amounts as may be available from month to month. Cash Collateral Account • In certain instances lenders require a more controlling arrangement with respect to borrower’s operating expenses. In certain circumstances, operating expenses are sometimes petitioned for disbursement from a lender-controlled account on a periodic basis based on invoices for amounts incurred. More frequently, the borrower is entitled to a monthly stipend for operating expenses based upon a pre-approved operating expense budget. Using this approach, there is often some sort of periodic reconciliation between the actual expenses incurred and budgeted expenses that can require the borrower to redeposit unused monies from the monthly stipend. This monitored cash expense approach is frequently used if the mortgage loan is structured so as to include deposits into a particular reserve based on monthly available net cash flow or other circumstances where the expense side of operations is of heightened concern. A monitored cash expense approach is also commonly used when mezzanine debt exists such that available net cash flow after operating expenses can be deposited into the mezzanine lender’s clearing account and its own secondary cash management waterfall hierarchy. Waterfall Distribution Monthly Debt Service Property Operating Expenses and Borrower Residual Inasmuch as springing cash management features usually arise in circumstances where a borrower is adverse to cash management being in effect throughout the loan term, it is not surprising that borrowers and their counsel frequently also try to allow a springing cash management arrangement to expire to noncash management status as soon as the offending circumstance has been resolved. Cash management structures have frequently been documented so as to allow the cash management procedures to toggle on and off to address changing circumstances but care should be taken that any such on-and-off toggle is not susceptible to being used excessively. A cash management arrangement which starts and stops every couple of months is a difficult if not unworkable arrangement from the perspective of servicers, tenants and banks alike. In certain instances lenders require a more controlling arrangement with respect to borrower’s operating expenses. Care should also be taken in describing the triggering event which initiates any period of time when cash management is effective. If possible, the triggering event should be described in a manner which is clear, simple and straightforward so as to minimize any possible point of contention which can arise from this provision. • Of course the hybrid arrangement also exists whereby the cash management documents are flexible enough to change from a borrower-controlled expense arrangement as described in the first point above to a lender-controlled expense arrangement as described in the second point above, and vice versa. The most common use of this technique is upon the occurrence of an event of default whereby a borrower who was previously entitled to control all expense disbursements is immediately placed in a more controlled environment. Another example is the use of a reserve which requires no deposits at the inception of the loan but does require a monthly “sweep” deposit of all available net cash Handling Operating Expenses While control over property revenues is the defining feature of cash management arrangements, the mortgage lender’s ability to monitor or control the borrower’s operating expenses varies considerably. • Frequently the waterfall provisions in the cash management documents allow all excess cash 13 CMBS World Summer 2008 Cash Management Structures: Issues for Consideration (cont.) flow month to month at some future date or in some future circumstance (e.g., failure of lease to renew). In that instance, a lender-controlled expense disbursement mechanism will frequently commence simultaneously with the requirement for net cash flow deposits into the reserve. includes both the borrower and the mortgage lender and is frequently undertaken with a bank historically used by the borrower or its affiliates. The account documentation with respect to the Cash Collateral Account is directly undertaken by the mortgage lender/servicer with a bank of their choosing which is typically a financial institution handling numerous similar Cash Collateral Accounts with various borrowers. The documentation with respect to the Clearing Account is very straightforward inasmuch as the bank holding the Clearing Account does not need to have any involvement with respect to the waterfall provisions or other complexities relevant to the Cash Collateral Account. A meeting of the minds between the lender and the borrower should be sought as early as possible on the topics of rent deposit techniques, operating Use of Depository Bank as Agent expense procedures and, if applicable, This variation is frequently used with some of the larger institutional depository institutions. It should be noted that in certain instances the depository bank for the Cash Collateral Account is designated as an “agent” for purposes of handling the direct disbursement of funds from the Cash Collateral Account. The advantages of this structure can be one consistent contact for customer service for the borrower and the same account remaining in effect at the same bank during the full cycle of the loan assuring that cash flows remain uninterrupted despite servicer transfers or securitization of the mortgage loan. The disadvantages of this structure can be the costs involved, the necessity that the servicer rely on a third party for disbursement of funds and the possibility that time zone differences may delay disbursement requests. springing features. Efficient Documentation of Cash Management Structures The documentation for cash management structures typically consists of two parallel basic arrangements: 1. The documentation between the mortgage lender and the borrower including detailed terms of the arrangement, the waterfall provisions and a description of any applicable triggering events. This document may consist of a separate “Cash Management Agreement,” may be included in the mortgage lender’s loan agreement or may be a combination of both. This document is typically not executed by the bank holding the Clearing Account and is typically negotiated as a part of the borrowerlender loan document negotiation process. 2. A deposit account control agreement among the borrower, lender and the bank holding the Clearing Account. While some originating mortgage lenders prefer to use their own form for this document, it is more frequently the form mandated by the bank holding the Clearing Account which serves as the basis for this arrangement. Luckily, over the last couple of years, there has been a great increase in uniformity with respect to the use of this document due in no small part to the good work by an American Bar Association task force on this subject. As CMBS origination climbs out of the doldrums in 2008, cash management structures will again be a frequent requirement. A meeting of the minds between the lender and the borrower should be sought as early as possible on the topics of rent deposit techniques, operating expense procedures and, if applicable, springing features. Cash management is a tool that a lender can use to reduce its risk by controlling the collateral property’s revenues. The degree of the originating lender’s need or desire for control over property revenue will govern the cash management features which need to be included in any particular loan. A clear understanding by all parties as to these issues as well as the use of a common terminology will greatly expedite the memorialization of the overall cash management process into appropriate documentation. A distinction should be drawn between the documentation with the bank holding the Clearing Account and with that holding the Cash Collateral Account. The arrangement with the bank holding the Clearing Account Kevin A. Sullivan is the Chairman of the Real Estate Structured Finance practice at Dallasbased Winstead P.C. John Lloyd is the Director of Primary Servicing at Centerline Capital Group. 14