The emergence, proliferation, and escalating complexity of commercial mortgage-backed securities (CMBS) as essential options in real estate financing between the mid 1990s and 2007 is well documented, with the origination of CMBS loans reaching a peak of $230 billion in 2007. The securitization of commercial real estate loans was based on the established foundation of other classes of assets backed securitizations, which were developed earlier, with numerous adjustments in structure to accommodate the fundamental differences in the underlying assets and differences in the kinds of rights and remedies that would ensue from a borrower default or increasing intercreditor issues.
Until the onset of the Great Recession in 2008, default rates in CMBS loans were extremely low and the industry-wide experience borrowers had in working through defaulted loan situations were few. Over the last three years, with escalating loan default rates in CMBS, borrowers and their counsel have been faced with new challenges in working out loans under the constraints specific to securitized loans. This article will examine the differences between traditional mortgage loans and CMBS loans, the impact of those differences on the loan workout and restructuring process, the best strategies for borrowers and their counsel in approaching the workout of a CMBS loan and, finally, how special servicers realize upon the loan collateral if a consensual loan modification fails to materialize.
I. The Traditional Mortgage Loan vs. the CMBS Loan.
Loans made by traditional lenders, such as commercial or savings banks or life insurance companies, were the dominant form of commercial real estate finance until the mid-1990s when securitizations were introduced into the commercial real estate finance market. Traditional mortgage loans were based on a contract between a lender and a borrower. Though the lender may have had participants or co-lenders, the contract that governed the loan between the borrower and lender was one set of documents between two parties. If the loan went into default, the lender knew it had certain rights under the loan documents and at law, as well as the ability to negotiate terms to restructure the loan with the borrower with few constraints (other than those imposed under participation and co-lending agreements and federal or state regulations that governed the lender).
In simplistic terms, there were two parties to the loan transaction, and a workout or restructuring of the loan could be effectuated by an agreement between those two parties based on what they agreed was in their best interests under the overall circumstances. Many traditional lenders have adopted many of the bells and whistles in CMBS loans, such as non-recourse carve out guarantees, bankruptcy remote ownership structure requirements, or non-consolidation legal opinions, unless the lenders contributed these loans (which they often reserve the right to do) into a pool of mortgage loans for securitization. Yet, as long as the loan was retained on the traditional lender’s balance sheet, the dynamics of a workout scenario remained that of a direct two-party negotiation.
Compared to traditional mortgage loans, borrowers of securitized loans face many more obstacles in obtaining a loan modification that will stabilize the loan collateral due to applicable Real Estate Mortgage Investment Conduits (REMICs) rules and to the applicable provisions of the pooling and servicing agreements (PSAs) that govern the relationships of the various constituent investors in the loan and their servicers for the loans being pooled and securitized. Most commercial real estate mortgage loan securitizations are structured as REMICs, which are designed to pass income through the trust on a tax-free basis so that income is recognized not by the trust but directly by the bondholders of the trust.
REMIC rules limit the circumstances in which a servicer may make a significant modification of the loan to those where the loan is in default or a default is reasonably foreseeable. Given the importance of maintaining REMIC tax status, PSAs require servicers to service mortgage loans in a manner consistent with REMIC tax rules. PSAs, however, contain their own requirements that control the servicer’s authority to enter into loan modifications. REMIC rules are essential to real estate mortgage conduits due to the exemption from federal taxes at the entity level. Qualification as a REMIC requires that on the close of the third month after the startup date and at all times thereafter, “substantially all of its assets consist of qualified mortgages and permitted investments.”
Under previous REMIC rules, it was contemplated that a compliant trust would have no ability to vary the composition of its mortgage assets. Since a significant modification of a loan held in a REMIC was deemed to be an exchange of a new debt for the original debt, such a modification may have caused the trust to lose its REMIC status if the modification caused “less than substantially all of the entity’s assets to be qualified mortgages.”
II. Loan Transfer Event for Specially Serviced Loans.
Under most PSAs, in order for the servicer to have the authority to modify a loan, the loan must first be transferred to special servicing, which typically follows a “Transfer Event” under the PSA. The easing of REMIC rules expanding the situation and type of loan modifications that can be made under the revised REMIC rules does not alter the contractual provisions of the PSA governing Transfer Events or permitted loan modifications. Consequently, compliance with both REMIC rules and the provisions of the PSAs is essential to a successful loan modification that results in the stabilization of a distressed asset or defaulted loan. While most borrowers, and many borrowers’ counsel, are not familiar with REMIC rules and borrowers are not a party to the PSA and PSAs are often unavailable to borrowers and their counsel, a basic understanding of both REMIC rules and provisions typically in PSAs is essential to a successful borrower workout strategy.
Under a typical PSA, a servicer only has the authority to modify a loan after it has been transferred to special servicing, so making the case to the master servicer that a Transfer Event has occurred is essential. A Transfer Event, in addition to defaults under a loan in the trust and other similar events (i.e., bankruptcy, insolvency) includes a determination by the master servicer or special servicer, in its good faith and reasonable judgment in accordance with the servicing standard, that a payment default or a default of another obligation of borrower that is likely to have a material adverse effect on the value of the collateral for the loan, is likely to occur and remain unremedied for at least a stated period of time. Thus, the standard for a loan to be transferred into special servicing under the typical PSA is the occurrence of a default or the likelihood of a default, combined with compliance by the servicer with REMIC rules, as described above, and the servicing standard, which governs all actions of the servicer.
The servicing standard is composed of several factors and is set forth in the applicable PSA. First, the master and special servicer must each act in accordance with a standard of care that is the higher of (i) the standard of care it applies to loans held for its own account, and (ii) the standard of care it applies to loans held for third parties. Second, the master and special servicers are required to take into account the interests of all bondholders (and any holders of participation interests in the loan) collectively, as a whole. Third, the master and special servicer are required to service the loan with the objective of the timely collection of all principal and interest payments, or, if a loan is in default, maximizing recovery on the loan on a “net present value” basis.
Lastly, the master and special servicer are required to service the loans without regard to conflicts of interest, such as other business relationships it may have with the borrower, its ownership of any portions of the loan, or obligation to make advances on the loan. All actions by the master and special servicer are to be governed by the servicing standard, and the servicer that is found to have not observed and performed its obligations in compliance with such a standard may face claims by one or more of the bondholders or noteholders of the securitization for such failure. Servicers tend to be mindful of such potential claims by bondholders or noteholders, perhaps more than they are concerned about lender liability claims made against them by borrowers.
However, the servicing standard as described above is very broad and general, so that it is difficult to clearly determine when the standard has not been met. Surprisingly, there has been little guidance provided by legal decisions in cases regarding whether the servicers breached the servicing standard, other than decisions that denied bondholders the right to intervene in cases to contest certain actions taken by the special servicer (see, for example In re Innkeepers USA Trust, 448 B.R. 131 (Bkrtcy.S.D.N.Y. 2011); Bank of America, N.A. v. PCV ST Owner L.P., Case No. 10–1178 (S.D.N.Y.) [Summary Order Denying Motion to Intervene, Docket No. 89]), without making any determination of whether or not the special servicer had, in fact, complied with the servicing standard. As these are issues confined to rights and remedies between various classes of creditors and their servicers under the PSA, their impact on borrowers in the loan restructuring process is indirect, as only servicers are constrained by such matters and borrowers do not have the standing to assert the failure to comply with the servicing standard in a dispute with the special servicer.
III. The CMBS Loan Modification Process.
Once a loan has been transferred to special servicing, what kind of modification is a special servicer permitted to effect and what constraints apply? Generally, a standard PSA and applicable REMIC requirements permit a special servicer to modify a defaulted or defaulting loan by (i) modifying the rate of interest, (ii) extending the term (subject to certain constraints on when the securitization trust must be liquidated), (iii) permitting a reduction in the principal amount of the loan (which could include the so called “A/B note” structure), and (iv) accepting a discounted payoff of the loan. In each case, there must be sound economic justification for the modification and it must be designed to result in the highest return to the trust on a net present value basis.
It should be noted that although REMIC rules have been expanded to permit a loan to be modified where it is reasonably foreseeable that a loan will go into monetary default, it is another matter to establish that the modification of a loan many years in advance of maturity will be in the best interests of the collective whole of the bondholders and difficult to assess whether such a modification is likely to result in a better return to the trust on a net present value basis. Thus, compliance with the PSA that was written many years earlier may not permit the kind of modifications now permitted under the revised and more permissive REMIC rules.
Many PSAs have an additional requirement that for a loan modification that is deemed material: the special servicer has to obtain the prior approval of the “controlling holder.” Typically, the controlling holder is the holder(s) of a majority of bonds or notes of the most subordinate tranche of a securitization that has not suffered a loss (based on an appraisal) of more than 75 percent of the initial principal balance of the loans in that tranche of the pooled loans. Thus, if the value of a tranche of loans is less than 25 percent of the original balance based upon the most recent appraisal, then that class is no longer in the money, the majority of that class will no longer be the controlling holder, and the majority of the next senior class that meets the same appraisal test will be the controlling holder until there is another appraisal that changes the determination. Based on the fluidity of this determination, the volatility of the real estate market, and the protracted nature of workouts and the legal process, there is room for disputes between classes of bondholders or noteholders concerning who is the controlling holder at any time in the resolution process.
It is obvious from the foregoing analysis that the timing and process for the modification of a CMBS loan can be very challenging and complex. Add to this the additional complexities that arise where CMBS loans have one or multiple levels of subordinate mezzanine loans, each secured by an equity pledge of each special purpose entity (SPE) borrower up the ownership chain, and where intercreditor agreements govern the rights and remedies among the various levels of mezzanine loans and the senior mortgage loan (which is usually securitized and may have multiple tranches and/or component notes within the securitization pool). At best, successfully modifying a CMBS loan, after running all of the traps, is likely to take many months, as opposed to a traditional portfolio loan, which can take a very short time to effectuate. The restructuring process is not only protracted and complex, but often is influenced by issues outside the knowledge or control of the borrower.
IV. Borrower Strategies.
The many obstacles to a successful loan modification may underscore the critical need of a well thought-out strategy by a borrower and its counsel. First, the borrower seeking a modification must establish that a Transfer Event has occurred. Often, where a loan is not yet in default, borrowers write letters to the servicer to establish the existence of a Transfer Event, but the tone or character of a letter often includes veiled or unveiled threats as to the consequences that might ensue from a failure of the servicer to transfer the loan to special servicing to permit a modification of the loan. While threats, primarily of bankruptcy filings, may have been meaningful prior to the mid 1990s and the implementation of bankruptcy remote structures, SPE covenants and borrower principal guarantees making loans fully recourse upon certain bankruptcy events, many borrowers or their counsel still feel that other threats are helpful to stir the servicer to action. However, experience with special servicers has shown that the blustery threats of borrowers or their counsel are not likely to change the determination by the servicer of whether a Transfer Event has, in fact, occurred.
The obligation of the servicer to make this determination is to the bondholders and noteholders, not to the borrower, and the adherence to the standards of the PSA, the servicing standard, and REMIC rules by the servicer and special servicer will be the controlling factor. Most experienced counsel feel that the threats are unnecessary to trigger a Transfer Event and can be counterproductive to a successful negotiation process with the parties servicing the loan.
Second, the structure of CMBS loans was never designed to handle the flood of loan defaults that has followed the financial crisis and the Great Recession, and which continue unabated. Servicers and special servicers are overwhelmed and understaffed, so, in general, patience and a professional and cordial approach usually work best to remain in the servicers’ good graces.
Third, the special servicer, once the loan has been transferred to it, will seek specific information to evaluate any proposed loan modification. Unreasonable resistance or delay in providing the requested information is likely to be detrimental to a successful loan restructuring. Reasonable cooperation and being forthcoming are more likely to be productive in achieving the result.
Fourth, given the likely short attention span of a special servicer to any one loan modification, the borrower should take the initiative to make a fair and well thought-out proposal that will stabilize the property and make likely the full repayment of the loan at maturity with maximum return to the trust. A borrower should do all of its homework and have anticipated the special servicer’s questions and other issues that may arise before engaging with the special servicer. A borrower’s proposal may require additional equity from the borrower or a third party to invest proceeds in the property or to replenish depleted loan reserves or escrows. As time will be short once the special servicer is listening, the shortest and most direct route to a successful plan to stabilize the property through a restructuring of the loan is best, and the more complex and drawn-out the negotiation, the lower the likelihood of success.
Finally, the more a borrower and its counsel can do to simplify and expedite the negotiation process, the better. Getting bogged down in pre-negotiation letters, information requests, and the like is detrimental to a successful strategy. Showing diligence in trying to refinance the loan—even if it is not possible—raising additional capital, and thoughtful adjustments to the property’s business plan that will help maximize the realization of the loan should all be part of a successful borrower’s strategy. Approaching the special servicer with a clear and coherent plan is critical to any borrower’s success. That said, even if these strategies are followed, the many constraints on special servicers in modifying a loan and the volatility of the real estate and capital markets make the outcome of a defaulted loan situation challenging and uncertain.
V. Special Servicers’ Alternatives to Loan Modifications.
When borrowers recognize that their real estate mortgage loans are in or, inevitably, heading toward default, they usually seek to approach the lender in the hope that the lender will modify the loan to give the borrower the time and means to stabilize the property and return the loan, as modified, to performing status. Although the likelihood of a successful loan restructuring, from the borrower’s perspective, may vary tremendously when dealing with traditional, balance sheet lenders based on many factors and circumstances, the process and parameters of success are far more challenging when dealing with special servicers of defaulted CMBS loans. This article describes the particular obstacles and structural issues underlying a CMBS loan restructuring. While it is useful to understand the process and best practices for a successful loan restructuring, it should also be understood that special servicers have a number of options other than modifying the defaulted (or imminent defaulted) loan to achieve the highest return, on a net present value basis, to the bondholders, in accordance with the servicing standard. Those alternatives include: (i) proceeding to foreclosure sale or similar remedy to gain possession and control of the collateral, (ii) taking a deed in lieu of foreclosure to expedite taking ownership and control of the collateral, (iii) the appointment of a receiver, (iv) accepting a discounted payoff of the loan from the borrower or an affiliate of the borrower, or (v) a sale of the note to a third party.
Though the special servicer is required to act in accordance with the servicing standard and to maximize value to the bondholders when making such decisions, they generally view foreclosure and related actions to obtain ownership or control of the collateral as the option least likely to be challenged by the bondholders, since it is a clear and usual remedy. Accepting a discounted payoff from a borrower requires a special servicer to document and establish that the amount paid is at least as much, on a net present value basis, as would be obtained from another alternative, including the amount that would be received were the note marketed for sale. A discounted payoff would, consequently, entail the procurement of an appraisal by the special servicer to establish value. One interesting change in approach to a discounted payoff by lenders is that during the banking crisis and real estate recession of the 1990s, it was an exception for a lender to accept a discounted payoff from its borrower, especially where the loan was in default. Lenders seemed to prefer selling the note to a third party, even for less than the borrower would pay, giving the sense that they would not allow their borrower to pay off the loan for less than the full principal amount as a matter of business philosophy, principle or stubbornness. Today, that is no longer the case, though discounted payoffs are not, by any means, the preferred route to realize upon a non-performing loan.
The days of “extend and pretend,” prevalent at the onset of the financial crisis, appear to be over. The extend and pretend strategy, though mocked by hungry investors seeking to purchase loans in bulk at huge discounts as they did in the early 1990s to help “clear” the market, actually succeeded in preserving value and minimizing losses for bondholders, as a premature sell-off of loans in 2009 and 2010 at the bottom of the market would have inflicted severe losses on bondholders that were already suffering from their own financial problems and financial distress.
Extend and pretend gave special servicers time to understand the market, the assets they managed, and, more important, allowed the market to recover substantially from the sudden and severe losses in value caused by the financial crisis and the Great Recession. Today, while values may not have returned to levels underwritten when the loans were made, values have recovered significantly. However, in the view of many, the recent rise in commercial real estate values in most markets has leveled off. Given this time and movement in the real estate market, special servicers now appear to be more inclined to reach final resolution of defaulted loans quickly and no longer grant a reflexive one- or two-year extension or forbearance.
Instead, special servicers seem to be deciding which option will maximize realization of the bondholders’ investment and taking that path, in most instances, more decisively. The most common actions tend to be the commencement of the exercise of remedies under the loan documents or a sale of the note to a third party. While loan modifications are still a viable option in many cases, especially where the borrower has the means to demonstrate an effective plan for turning the situation around with a high likelihood of paying off the loan in full, note sales are becoming a more frequent choice given the ability to realize the full value of the property (with no meaningful discount for the note buyer for the time and money it is likely to take for it to exercise remedies or modify the loan) and to obtain the cash very quickly.
As CMBS loan defaults have increased dramatically over the last few years, borrowers have frequently sought to modify loans as their best strategy to stabilize the asset, preserve their equity investment and tax position, and retain some upside in the future. Understanding the obstacles in the loan modification process and employing a good strategy are essential to a successful outcome. That said, the trend is clearly for special servicers to exercise remedies or engage in note sales as a faster and more certain way to maximize the return of the investment of the bondholders they serve.
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