As a great songwriter once wrote, “the times they are a-changin’…” For the first time since its inception in the early 1990’s, the United States Commercial Mortgage- Backed Securities (“CMBS”) market and CMBS servicer capabilities are being tested by the very economic stress that was the impetus for the creation of the CMBS market. The servicing of distressed real estate loans is presenting many problems for borrowers as their loans become troubled due to the continued downward spiral of the market. One of the major challenges for borrowers are the various restrictions on CMBS loans that severely limit the flexibility of loan servicers (who take the place of lenders in the CMBS framework) when working out distressed loans. This limited flexibility means that many loans that may have been worked out in the past (for example, properties that are fundamentally sound but that are facing short-term economic distress resulting from an excessive vacancy or unexpected one-time expense) cannot be worked out due to the fact the loan has been securitized.
CMBS Structure: An Overview. Unlike traditional nonsecuritized commercial real estate loans, the structure of CMBS is complex and there is a complicated interplay of parties with differing and conflicting interests, documentation, structures and rigid tax rules. In a CMBS transaction, a loan originator makes a loan secured by a mortgage on commercial real estate. The loan originator holds the loan until it accumulates a pool of loans of varying size, property type, location and risk classification for securitization. The loan originator then sells the pool of loans to a depositor, whereupon the depositor transfers the pool of loans to a trust which, if properly structured and maintained, acts as a pass-through entity exempt from federal income taxation. Typically, in order to assure such favorable tax treatment, this trust will be a real estate mortgage investment conduit (“REMIC”), authorized by the Tax Reform Act of 1986, amending the Internal Revenue Code (the “Code”). A REMIC is an investment vehicle that holds various mortgages in trust and issues securities representing a specified undivided interest in such mortgages. The REMIC assembles mortgages into pools and then issues a series of bonds with various risk and maturity classes (or “tranches”). The bonds are then sold to investors who wish to purchase interests in the secondary mortgage market. The CMBS transaction is structured and priced based on the assumption that it will not be subject to double taxation (i.e., the REMIC itself will not be taxed on its income). As such, compliance with REMIC status is crucial and any deviation from the tax rules set up for REMICs may result in taxation of the REMIC entity as well as the bondholder.
Servicing the Loan: The Pooling and Servicing Agreement. Upon securitization, the loans are serviced in accordance with the applicable loan documents and the pooling and servicing agreement (the “PSA”). The PSA (i) dictates the allocation and distribution of any loan proceeds and losses to the various bondholders; (ii) establishes the management structure for the pool of loans; (iii) sets forth the responsibilities and duties of the servicers handling the pool of loans; and (iv) provides guidance to ensure that the trust complies with REMIC rules to insure that the trust will maintain favorable tax treatment. The parties to the PSA typically include the Master Servicer, Special Servicer and Trustee.
Master Servicer. Customarily, the Master Servicer is selected by the depositor at the time of securitization to service the pool of performing loans through their respective maturity dates and is charged with processing any borrower requests. The Master Servicer acts as an advancing agent and serves as a fiduciary to the trust. As advancing agent, it is responsible for arranging for the collection of payments from borrowers, calculating the amounts due to bond holders, and remitting such amount as required by the PSA. It is responsible for insuring that the servicing of the loans will be performed in accordance with the trust requirements. Additionally, the Master Servicer responds to borrower requests for items requiring approval under the loan documents, such as loan assumptions, lease approvals or withdrawing from reserve or impound accounts. The Master Servicer must be creditworthy as it is required to advance principal and interest payments to the bondholders, even if the borrowers do not make such payments, until such time as it determines that such payments are not likely to be recovered from the disposition of the property.
Special Servicer. In the event the borrower fails to make a payment of principal and interest, which payment is not cured within 60 days of a due date, the servicing of the loan is transferred to the Special Servicer (who also has the authority to oversee actions such as loan modifications). The Special Servicer is usually the holder of the lowest level tranche – commonly referred to as the “first-loss” or “B-piece” of the CMBS pool, which has the most risk of loss of value. The Special Servicer handles the workout or foreclosure process and otherwise services the loans that go into default. If a defaulted loan is cured, the Special Servicer is obligated to return the servicing of the loan to the Master Servicer. Typically, the Special Servicer and a majority of the subordinate bondholders have the option to purchase a defaulted loan at a price equal to the lesser of (i) unpaid principal, accrued interest and advances or (ii) “fair value”. Unless this purchase option is exercised, the Special Servicer is required to proceed with resolution strategies, including foreclosure. Additionally, the Special Servicer may have the right to “put” the defaulted loan back to the loan originator in the event of a document defect or breach of a representation or warranty by the borrower which materially and adversely affects the value of the loan. The Special Servicer is obligated to seek recovery of all scheduled payments due, but is not obligated to recover prepayment penalties or yield maintenance. This may lead to a conflict of interest with senior tranche holders if the Special Servicer approves a full payoff and waives prepayment penalties. Senior tranche holders may believe that the Special Servicer is favoring the interests of the subordinate class for which a full payoff is beneficial, while depriving the senior tranche holders of their entitled penalties. Given the prospect of second-guessing and the subjective nature of its duties, the Special Servicer is typically exculpated in the PSA for its actions or omissions taken in good faith, excluding any willful misfeasance, bad faith or negligence in the performance of its obligations or duties.
Trustee. The Trustee holds the loan documents and distributes payments received from the Master Servicer to the bondholders. Although the Trustee generally has broad authority under the PSA with respect to managing the loans, it typically delegates its authority to the Special Servicer or the Master Servicer. Because the Trustee is the holder of the loan documents, the Trustee is the one who will be named in enforcement actions (i.e., lawsuits or non-judicial foreclosures).
REMIC Rules. In order to preserve its preferential tax treatment and avoid penalty taxes, the trust must comply with REMIC tax rules, which govern the CMBS transaction and are comprised of Code provisions and related Treasury regulations. These rules include: (a) substantially all of the assets must be “qualified mortgages” or certain permitted investments – with debt secured by real property having a market value of at least 80% of the amount of the loan constituting a qualified mortgage; (b) no new loans may be contributed to the REMIC more than three (3) months after its formation; (c) no loans may be substituted for any loan in the REMIC more than three (3) months after its formation (as discussed below, a modification or workout of an existing loan may be considered a substitution of a new loan); (d) no material changes in the yield or the timing of payments of loans in the REMIC; (e) limitations on substitution, addition or deletion of obligors of loans in the REMIC; (f) limitations on changes to security or credit enhancements of loans in the REMIC; and (g) no changes in the priority of debt instruments of loans in the REMIC.
Servicing Standard. In addition to the REMIC rules, the Master Servicer and Special Servicer are required to comply with certain standards set forth in the PSA (the “Servicing Standard”) for servicing the loan. The Servicing Standard requires that the Master Servicer and Special Servicer treat the loans with the same care, skill, prudence and diligence as they would for their own similar loans or those held for other institutional investors, whichever standard is higher. The Servicing Standard is intended to maximize the recovery of scheduled payments of principal and interest and must serve the best interest of the bondholders. Even if the borrower is a major client of the servicer, that relationship will not permit the servicer to offer any concessions to the borrower.
Loan Workouts. Invariably, any loan workout will involve some modification of the loan. Before the Master Servicer will agree to any modification of a loan it is likely to consult with the rating agencies which rated the bonds at the time of issuance, since the rating agencies have the power to lower the ratings in the event of any changes to the terms of the loan. To avoid the negative consequences of any such downgrade, the Master Servicer will typically require the borrower to deliver a “no downgrade letter” from the rating agency to confirm that the modification will not result in a lower rating. Additionally, the Master Servicer will customarily require the borrower to deliver a legal opinion from qualified counsel (the “REMIC Opinion”). The REMIC Opinion would confirm that the proposed modification will not violate the REMIC rules and cause the REMIC to lose the benefit of being a pass-through entity exempt from federal income taxation. If the borrower is unable to deliver both the “no downgrade letter” and the REMIC Opinion, the Master Servicer will not agree to the modification.
Unlike in a portfolio loan, where the lender contemplating a modification or workout has originated and serviced the loan, the Special Servicer (by definition) has not participated in any loan administration until an event has occurred which has caused the Master Servicer to transfer servicing of the loan to the Special Servicer. The result is that the Special Servicer may have little knowledge of the history of the loan and may have difficulty in performing its due diligence. This may frustrate the Special Servicer’s decision-making ability. In addition, the REMIC rules place certain limits on the Special Servicer’s ability to utilize many of the tools frequently available to lenders in restructuring troubled loans. For example, the Special Servicer may not accept additional collateral from the borrower or convert a partial or limited guaranty into a full guaranty. In a traditional non-securitized loan transaction, these credit enhancements would be beneficial to a lender and could be sought in exchange for other concessions, but these changes would violate the REMIC rules. In addition, the Special Servicer will not be permitted to lend additional money, capitalize past due interest or divide the debt into more than one obligation.
Notwithstanding the general REMIC rules, in the event that a loan is in default or at risk of being in default, the Special Servicer has greater flexibility in making modifications to the loan, subject to the Servicing Standard and other applicable requirements of the PSA. The regulations issued pursuant to the Code permit a loan modification “occasioned by default or a reasonably foreseeable default” of the borrower. In those circumstances (and provided the PSA so permits), the Special Servicer may agree to modifications of the loan such as reduction in interest rate, deferral of principal payments or maturity date, forgiveness of principal, accrued interest or prepayment penalties, or forbearance from any enforcement action. In addition to limitations placed on the Special Servicer as a result of the REMIC rules, accounting rules require that the PSA limit the discretion of the Special Servicer in the decisions regarding disposition of assets. Since the Special Servicer is considered an agent of the REMIC, in order to insulate the REMIC from bankruptcy issues that may affect the depositor, it is necessary that the transfer from the depositor to the REMIC be considered a “true sale” (meaning that the transfer is complete and that no rights remain as in a financing, for example). The transfer will not qualify as a “true sale” if the Special Servicer has broad discretion in the sale of REMIC assets. Therefore, the PSA will restrict these rights and make it more difficult to sell assets as part of a workout strategy.
Conclusion. In a workout of a securitized loan, the Special Servicer is constrained by the REMIC rules and the PSA. Due to the nature of the various relationships, the Special Servicer may not be familiar with the loan history. Notwithstanding the limitations imposed on the Special Servicer, a loan may be successfully modified if care is taken to abide by the applicable requirements.