‘Bad Boy’ Guarantees Provided to Brookfield DTLA Property Lenders Are Difficult to Effectuate Without Degradation of Property Value; Lenders’ Pursuit of Receivership Limits Guarantee Rights

Relevant Documents:
Brookfield DTLA Loan and Guaranty Agreements
10-K

Amid ongoing defaults and near-term maturities for Brookfield DTLA’s mortgage loans, lenders will need to decide whether to negotiate amendments or extensions to their loans or exercise the remedies available to them under the loan documents and sell or foreclose on the properties. As lenders seek to maximize recoveries under their loans, guarantees provided by Brookfield DTLA’s holding company parent and manager, Brookfield DTLA Holdings LLC, could offer an additional source of value. However, the guarantees are designed as “bad boy guarantees” to be triggered only by certain Brookfield DTLA actions, not solely inadequate cash flows, making it difficult for lenders to render the debts recourse to the property borrowers and precipitate the guarantees. Lenders to the Gas Company Tower and EY Plaza have already sought court-appointed receiverships to try to preserve property values, even though taking these actions could preclude realizing on the guarantees.

Current Defaults and Receiverships

Multiple properties are already in default. The 777 Tower first triggered an event of default when the interest rate cap required by the loan agreement was not obtained in November 2022. These loans matured in December, and interest payments were not made in March. Lenders Wells Fargo and Mesa West Capital do not appear to have taken any actions at this time.

The Gas Company Tower is also in default, as a loan extension option was not exercised when the loans matured on Feb. 19. Lenders Citi and Morgan Stanley transferred their interests in the $350 million first mortgage loan to a commercial mortgage-backed securitization which issued pass-through certificates, GCT Commercial Mortgage Trust 2021-GCT, Commercial Mortgage Pass Through Certificates, Series 2021-GCT, according to filings. Holders of these certificates brought on Situs Holdings as special servicer and sought through the Superior Court of California the appointment of a receiver, Gregg Williams, in April. The appointment was approved, and the court granted Williams the authority to “take possession of the property”; “operate, manage, maintain and preserve the property”; and “market, advertise, promote and negotiate the sale of the property.”

The EY Plaza lenders, Morgan Stanley and Wells Fargo, also sold their $275 million of loans through a securitization, and Wilmington Trust, as trustee for the certificateholders of BFLD Trust 2020-EYP, Commercial Mortgage Pass-Through Certificates, Series 2020-EYP, initiated a similar receivership process in the Los Angeles Superior Court in May. Gregg Williams was appointed receiver on May 24 and was conveyed similar powers granted in the Gas Company Tower case.

A court-appointed commercial real estate receivership is a faster, cheaper way to avoid a costly foreclosure proceeding while benefiting from the receiver’s commercial real estate expertise to effectively market the property. The receiver takes control of accounts and manages operations while simultaneously listing the property, speaking with local brokers and acquiring appraisals. Once an offer is secured that is acceptable to lenders, the court can approve the sale, and the proceeds can be used to repay the lenders.

Holders of the loans backing the 777 Tower as well as the Wells Fargo Center North Tower, a property for which “the amount of cash the property currently generates from its operations is not sufficient to cover the upcoming debt obligations, leasing costs and capital expenditures” according to the 10-K, may take similar actions in the near future to protect their interests in the properties. The declarations in support of the Gas Company Tower and EY Plaza receivership motions raised concerns as to Brookfield DTLA’s ability to effectively manage and maintain these properties. The declarant, a director in special servicing at Situs, stated with respect to both properties that she has “been contacted directly by tenants at the Subject property about urgent property and leasing issues, but without the immediate and ex parte appointment of receiver to address all tenant building and leasing concerns, these cannot be addressed.”

She also disclosed for both the Gas Company Tower and EY Plaza that the “collateral is in jeopardy” and that a receiver is “desperately needed to address the multiple leasing deficiency, as well as to handle urgent tenant property and leasing issues.” At this property “a recent rent roll indicates gross rents are approximately $2.3 million per month, however of the 160 units at the Gas Tower, at least 60 units of the Subject Property are vacant, substantially decreasing the amount of gross rents.” The $2.3 million per month is consistent with the disclosure in the annual report that annualized rent is $27.7 million, suggesting there has not been a massive deterioration in year-to-date leasing. For EY Plaza, “a recent rent roll indicates gross rents can be substantial, approximately $2.7 million per month; however, there are leasing issues and vacancies, substantially decreasing the amount of gross rents.” The $2.7 million figure is higher than the implied rent disclosed in Brookfield DTLA’s annual report indicating that annualized rent was $21.6 million, which would equate to $1.8 million per month, and disclosed rent abatements are not large enough to account for this difference.

In a letter filed as an exhibit to the declaration in support of the EY Plaza receivership, counsel to the certificateholders’ servicer raised concerns about Brookfield DTLA damaging relations with tenants. The letter described a disagreement between Brookfield DTLA and one of its tenants, law firm Jackson Lewis. Jackson Lewis alleged that Brookfield DTLA failed to “honor certain construction allowance obligations owed to Tenant under the Lease for purposes of paying tenant improvements made at the Property, [...] honor draw requests submitted by Tenant to Borrower pursuant to terms of the lease, and [...] return to Tenant certain inadvertently prepaid rent pursuant to the terms of the Lease.” This issue was brought to the attention of the lenders by Jackson Lewis in late February, and although the lenders tried to engage with Brookfield DTLA regarding these breaches, Brookfield DTLA “has to date refused to discuss the situation with Lender in any meaningful manner.”

According to the letter, Jackson Lewis intends to commence litigation for these lease breaches. Relationships with suppliers are also being compromised, as mechanic’s liens and preliminary notices have been filed against EY Plaza. Losing tenants and suppliers could irreparably damage the property’s long-term viability, and thus certificateholders may feel compelled to step in to halt further value destruction.

In addition to concerns about mismanagement of the properties, certificateholders have also already been forced to inject cash to preserve their interests in the facilities. The EY Plaza certificateholders advanced $2.4 million to pay real property taxes and $2 million to prevent property insurance from lapsing after the borrower failed to pay these amounts. Similarly, the Gas Company certificateholders provided $3.6 million in funding to avoid property taxes becoming delinquent. Brookfield DTLA’s inability to pay these obligations as they come due is threatening the viability of these properties, pushing lenders to take these actions to stabilize the situation and prevent further deterioration in property performance and value. This is important, as the actions the lenders have been forced to take will likely preclude them from collecting on the guarantees provided by Brookfield DTLA’s holding company parent, Brookfield DTLA Holdings LLC.

Brookfield DTLA Holdings Guarantee Structure

While the loans are not cross-collateralized and the direct impact of a foreclosure on Brookfield DTLA Fund Office Trust Investor Inc or the remaining properties might be isolated, the interplay of guarantees could be problematic, as a foreclosure has the potential to threaten DTLA Holdings’ compliance with financial covenants and its liquidity. All of these properties were granted guarantees from Brookfield DTLA Office Fund Trust’s parent holding company, Brookfield DTLA Holdings LLC. The 10-K says the following with respect to these guarantees:
 
A big unknown in this process is whether the lenders to these properties will be able to collect on the guarantees provided by Brookfield DTLA Holdings LLC. Brookfield DTLA Holdings LLC is an indirect partially owned subsidiary of Brookfield Property Partners LP, the flagship commercial property entity wholly owned by Brookfield Corp., and it is the “manager” together with its affiliates excluding Brookfield DTLA Fund Office Trust Investor (and its subsidiaries). No financials are publicly available for this entity to indicate what (if any) assets it holds. That being said, the guarantee agreements require this holding company to comply with financial covenants, and this could suggest that meaningful value sits at the box. The net worth covenants define “Net Worth” as:
 
The net worth covenants exist in the EY Plaza, Gas Company Tower, Wells Fargo Center - North Tower, and BOA Plaza guarantee agreements, and they range in amount from just $50 million for EY Plaza to $750 million for Wells Fargo Center - North Tower. The size of the guarantee does not appear related to when the loans were entered into or the perceived risk. Interestingly, the most restrictive $750 million net worth covenant was for the North Tower loan made in 2019, while only $50 million was required for the EY Plaza loan agreement signed in September 2020. Three of the loans also include unencumbered liquid assets covenants. Compliance with these covenants is typically determined by lenders, and a requirement for “reasonable discretion” is not applied for the net worth covenants.

An overview of the guarantees is provided below:
 
As previously outlined, the guarantor is Brookfield DTLA Holdings LLC. This entity owns 50.07% of Brookfield DTLA Fund Properties II LLC, which indirectly holds all of the properties, and holds the Series B preferred interests at the Brookfield DTLA Fund Properties II LLC entity, with a redemption value of $189.6 million as of Dec. 31, 2022. With the book value of the properties carried at $2.22 billion against $2.28 billion of debt, it is not obvious how enough value flows up from the Brookfield DTLA properties to comply with the $750 million net worth covenant, and thus it is likely other Brookfield assets are held at this entity and are available to support the guarantees. This entity has also been funding Brookfield DTLA Fund Properties II LLC through the Series B preferred interests, and there was $88.6 million remaining of capital contribution commitments DTLA Holdings made available as of year-end, though $8.1 million was contributed during the first quarter.

These are guarantees of payment, not collection, and consequently if one of these properties were to file for bankruptcy or otherwise have a recourse obligation against the borrower, the lenders to this property could immediately seek recovery under their guarantee. It seems unlikely that Brookfield DTLA Holdings would have the liquidity to perform under the guarantees, potentially triggering a violation of the net worth covenant and/or rendering the entity insolvent. There could even be a financial covenant breach absent a property filing for bankruptcy, as DTLA Holdings must provide financials to lenders within 90 days of quarter-end, and lenders have inspection rights of DTLA Holdings’ books and records, and given declining asset values, the lenders could determine that net worth is lower than covenant values. Such a breach is an event of default under the loan documents, and after a five-day cure period lenders would be permitted to accelerate their debt. Unfortunately for lenders, the guarantees Brookfield DTLA Holdings provided are structured such that if the lenders attempt to foreclose on or otherwise take control of their collateral, they could lose access to the guarantee.

“Bad Boy” Guarantees

While these guarantees could provide an additional source of recovery for lenders to the Brookfield DTLA properties, the lenders’ ability to realize on these guarantees is limited because they are structured as guarantees of recourse obligations or nonrecourse carve-out guarantees, which are colloquially known in the industry as “bad boy” guarantees. These guarantees are common in U.S. real estate loan documents, and they typically provide for personal liability against the borrower or its affiliates and/or principals in the event of certain specified “bad acts.” While most of “bad acts” enumerated are breaches of duties, fraud and malfeasance, the occurrence of a “Bankruptcy Event” is also typically included. Only loan obligations that are directly recourse to the borrower benefit from these guarantees, but outside of these “bad acts,” the mortgage loan obligations also become directly recourse to the borrower in the event of a “Bankruptcy Event” or transfers of the property in violation of the loan agreement.

The definition of “Bankruptcy Event” is significant, because while it customarily includes both cases under the Bankruptcy Code as well as actions “seeking appointment of a receiver, trustee, custodian, conservator or other similar official,” such proceedings must be initiated or acquiesced to by the borrower. There are explicit provisions that the appointment of a receiver for example must be “other than with the written consent or at the written direction of Lender,” and if there is an involuntary bankruptcy filing it qualifies as a Bankruptcy Event only if there is collusion with the borrower or its affiliates. These exculpation provisions emphasize this with the following language typically included:
 
This is consistent with the logic of the guarantees, as the intention is to prevent “bad acts,” not to punish the guarantor for insufficient cash flows. Nevertheless, it leads to perverse incentives that create tension with Brookfield’s fiduciary duties, as the company may seek to avoid filing for bankruptcy out of a desire to avoid triggering these guarantees.

An interesting example of this conflict occurred in 2009 when David Lichtenstein triggered a $100 million personal liability due to a bad boy guarantee he provided to his Extended Stay hotel chain’s lenders. Lichtenstein sued Willkie Farr & Gallagher for legal malpractice and $104 million, arguing that the lawyers advised him that he had a fiduciary duty to file the company for bankruptcy protection even though he could have avoided the $100 million personal liability if he had refused to file the company for bankruptcy and forced the lenders to file an involuntary bankruptcy or foreclose on the assets. Lichtenstein claimed if he had not filed the company for bankruptcy, he could have faced a breach of fiduciary duty lawsuit, but given the bankruptcy remote structure of the loans and his $50 million insurance policy to cover settlement costs for a breach of fiduciary duty claim (but not a bad boy guarantee), it would not have been as damaging.

Lenders’ Options to Maximize Value

Given the limited applicability of the guarantees, lenders may be willing to forgo immediately foreclosing on their collateral, anticipating that liquidity constraints will eventually necessitate a bankruptcy filing.This is a risky strategy for a variety of reasons. The first is that on an EBITDA-capex basis, these properties appear to be cash flow positive, so absent significant near-term capital needs, Brookfield may have sufficient cash to continue to operate them in the ordinary course. Second, in order to preserve cash and recognizing that Brookfield probably does not anticipate realizing equity value from these properties, Brookfield could focus on minimizing spending, potentially to the detriment of long-term value for the assets. As previously discussed, the motions seeking the appointment of a receiver indicate that this concern could be materializing, as Brookfield has stopped paying property taxes, insurance and suppliers at certain properties and has not been satisfactorily serving some of the tenants.

Lenders to the properties will have to weigh the value of taking actions such as installing a receiver now, before significant damage can be inflicted, against the hope of collecting on the guarantee. Interestingly, both of the properties that have already appointed receivers, the Gas Company Tower and the EY Plaza, have their guarantees capped at 20% in the event of a bankruptcy trigger, so they may have less to give up by assuming control now. The 777 Tower, on the other hand, has a full guarantee, and despite the loan maturing last December, no legal action has been taken.

As previously mentioned, it is unclear what, if any, value will be available at the DTLA Holdings entity to support these guarantees. If most of the value was expected to come from these properties and the market deterioration is such that most of these properties will be foreclosed upon or sold short with no value available to flow to DTLA Holdings, then lenders would give up little if they chose to exercise their remedies under the loans now. If DTLA Holdings has meaningful value apart from its interests in Brookfield DTLA Fund Properties II, lenders may be reluctant to initiate proceedings, as they do not want to preclude access to the guarantees.

–Meredith Dixon