CLIENT ALERT: CMBS Restructurings: Issues with Special Servicers
Under the typical commercial mortgage-backed securities (“CMBS”) loan structure, a group of commercial loans are pooled into a real estate mortgage investment conduit (“REMIC”) trust and interests in the REMIC are sold to investors. Once a borrower’s loan is placed into a CMBS pool, the borrower becomes subject to a borrower-lender relationship that is often materially different than the traditional commercial loan structure. As billions of dollars CMBS loans that were originated during the last credit bubble are at or near maturity, modifying or restructuring loans on underwater properties are becoming more commonplace. In this Client Alert, we explore five frequently asked questions posed by borrowers and investors regarding restructuring CMBS loans.
1. My loan is in need of a modification or restructuring. Who can I talk to?
One of the first questions borrowers of stressed or distressed CMBS loans often have is: “who do I speak to about my loan”? While this question appears simple on the surface, for many borrowers whose CMBS loans have been pooled, the answer is not so simple. Under the typical CMBS structure, once a loan is transferred into a CMBS pool, a “Master Servicer” is charged with administering the loan. While the Master Servicer administers a performing loan, generally it is not permitted to enter into a loan modification or restructuring agreement. The only “lender” party to a CMBS loan that can engage in restructuring discussions on an individual loan in a CMBS pool is the “Special Servicer”. The roles and duties of the respective servicers under a CMBS loan are specified in the governing Pooling and Service Agreement (“PSA”).
For a loan to be transferred from a Master Servicer to the Special Servicer, the loan must generally either be in default or at risk of imminent default. In many cases, while a CMBS borrower believes its loan may be in imminent default, the loan is not transferred to the Special Servicer giving rise to the very real practical problem of not having anyone to talk to about a loan that is or may become in default. If the Master Servicer is doing its job properly, it will communicate with the borrower and transfer the loan in default or imminent default to the Special Servicer.
2. My loan is in Special Servicing. What are the duties and obligations and duties of the Special Servicer?
Once a loan is transferred into Special Servicing, under the PSA, the Special Servicer is charged with handling the loan. While the borrower is not a party the PSA, it is typically a publicly available document (go to www.sec.gov) and borrowers should obtain a copy of their PSA to understand its terms and conditions and the duties that the PSA imposes on the Special Servicer.
While the PSA is often several hundred pages long, in essence, the Special Servicer is required to act according to a defined “Servicing Standard.” This standard generally requires the Special Servicer to act in a reasonable, prudent manner for the benefit of the holders of interests in the CMBS pool as a whole, and not just one class (junior or senior), with a view toward timely payment of principal and interest and the maximization of the value of the property for all holders. The Servicing Standard also recognizes that the Special Servicer must act in a disinterested manner, without regard to the relationship the Special Servicer may have with the borrower or any of the investors in the CMBS pool.
3. Who appoints and controls the Special Servicer?
CMBS pools are “securitized”, meaning they are placed into the REMIC trust, and “tranched” or divided into different classes of interests (i.e., certificates or bonds) and sold to investors. Typically, multiple investors invest in the different “slices” of the loan, ranging from investment grade “AAA rated” certificates (which are at the top of the capital stack and with the smallest risk of default) to below investment grade, and even unrated certificates that are at the bottom of the “stack” and at most risk of default. The most junior class of bondholders, in the “first loss position”, is often called the “Controlling Class” of certificate holders.
The Controlling Class has many significant rights under the PSA, but arguably none is more powerful than appointing or replacing the Special Servicer, the entity charged with administering, or agreeing (or not agreeing) to a loan modification or restructuring transaction.
This is one of the most significant differences between a CMBS loan and non-securitized commercial loan: unlike in a non-CMBS loan relationship, where the most senior secured party is in “control”, a CMBS loan works in reverse: the most junior class that will bear the estimated first loss in the portfolio is the control party.
The Controlling Class Holder has the right to make other important decisions that are outside the scope of this Client Alert, yet which materially impact the borrower and investors in the pool.
Frequently, Special Servicers, or affiliates, seek to buy or control the required amount of the Controlling Class bonds, directly or indirectly, so that they can be appointed (or retain their position as) the Special Servicer, with the fees and other benefits that come to such position.
4. So the Special Servicer can become a Controlling Class holder?
Yes. A borrower that discovers that its Special Servicer purchased the Controlling Class position should understand this and what might be motivating the servicer to act or not act in certain ways.
5. Doesn’t this mean that the Special Servicer might have a conflict of interest?
While Special Servicers often properly adhere to the Servicing Standard, many borrowers and investors have experienced situations where Special Servicers may not be guided by their duties to all certificate holders, or to maximize the value of a loan asset, but by possible self-interest. Borrowers might have a legitimate concern when they discover that, for example, their Special Servicer is an affiliate of a large real estate owner or company, such that their role as Special Servicer gives it a “first look” at distressed buying opportunities. Investors might likewise be concerned that the Special Servicer may become a Controlling Class holder to ensure it retains its position as Special Servicer. When the Special Servicer is affiliated with the Controlling Class, it is important to recognize the conflicts or prejudices that a Special Servicer might have. Understanding these conflicts or prejudices are often important if one is seeking to negotiate a successful restructuring.
In our next Client Alert on CMBS loans, we will explore additional issues CMBS borrowers and investors may be interested in.
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For more information regarding CMBS loan restructurings, please contact the Olshan attorney with whom you regularly work or the attorney listed below.