Example 1. Borrower’s loan documents provide that borrower may obtain the release of noteholder’s lien on a portion of the collateral (Parcel C) if: (1) borrower pays a $1.5 million release price to pay down part of the loan’s principal; AND (2) the remaining collateral meets specified financial conditions (LTV, DSCR) following the release.

Borrower does not meet the conditions necessary for the release of Parcel C. The servicer would, nonetheless, like to allow the release and pay down transaction to go forward believing the transaction will improve the loan’s credit profile. Can the servicer approve the release of Parcel C and related pay down despite the fact that the borrower cannot meet the required (LTV, DSCR) conditions?

Answer. Not likely, but for reasons other than what you might think. In order to undertake any action, the servicer must determine that the proposed action: (1) does not have negative REMIC tax consequences to the noteholder (or similar tax consequences for a grantor trust or CLO, as applicable); (2) makes sense from a credit perspective; AND (3) does not violate the terms of the Pooling and Servicing Agreement (the “PSA”) or other servicing requirements by which the servicer is bound.

(1) Securitization Issues. A partial pay down of a loan has no negative REMIC tax consequences and will never compromise a REMIC’s tax status. See Kilpatrick Townsend, Servicer Survival Guide 2019-2020 Edition, Tom Biafore “Prepayments and Payoffs—What You Can and Cannot Do” for a discussion of the technical reasons why a pay down of a loan presents no REMIC concerns.

In Example 1, however, the borrower’s partial pay down is associated with a release of the noteholder’s lien on Parcel C. The servicer must review the release aspect of the borrower’s request separately from the borrower’s partial loan prepayment. The release of the noteholder’s lien on part of the real property collateral (Parcel C in this example) will not cause any adverse REMIC tax consequences only if after the release of Parcel C, the borrower’s loan meets the “principally secured” by an “interest in real property” test. The “principally secured” test is met when the fair market value of the remaining real property collateral for the borrower’s loan equals at least 80% of the loan’s remaining balance. See Kilpatrick Townsend, Servicer Survival Guide 2019-2020 Edition, Tom Biafore “Modern Day Alchemy—Modifying Qualified Mortgages in REMICs” for an analysis of the “principally secured” test. Provided that the 80% valuation test is met in connection with the release of Parcel C, the noteholder’s release of Parcel C will not cause any adverse REMIC consequences.

Note that the “principally secured” test described above applies to REMICs only. If the noteholder is a grantor trust or CLO rather than a REMIC, the servicer and its counsel must similarly examine the impact of the release of Parcel C and the partial pay down on the noteholder under the applicable tax structures.

(2) Credit Concerns. Even if the release and partial pay down result in no adverse REMIC or other tax consequences, the servicer should not approve the transaction unless the transaction is acceptable from a credit standpoint. In this case, the servicer could, depending on the facts, determine that the release of Parcel C together with the partial pay down of the loan is a benefit to the credit for the loan in potentially reducing refinance risk and in otherwise deleveraging the loan.

(3) PSA Limitations. Just because a borrower’s request may be granted without causing adverse REMIC or other securitization-level tax consequences and without raising credit concerns does not mean that the servicer can approve the borrower’s request before confirming that the requirements in the PSA provisions can also be satisfied.

Most PSAs for fixed rate securitizations prohibit the servicer’s taking actions that change the amount or timing of the borrower’s loan payments. In this case, and despite the fact that the transaction may not cause any REMIC or other tax concerns and may also be regarded by the servicer as positive for the credit for the loan, the servicer must review the PSA and confirm that the release and pay down will not violate the terms of the PSA. In this case, by allowing the transaction to go forward, the servicer will be accelerating the prepayment of part of loan by the amount of the pay down of the release price which violates the standard provisions in most PSAs prohibiting the alteration of the timing of a borrower’s loan payments.

When examining these rules, it does not matter that the borrower’s loan documents contemplated that under some circumstances (which circumstances are not met in Example 1) the borrower could have paid down part of the loan prior to maturity. In Example 1, the borrower fails to meet the conditions for the release of Parcel C and the servicer’s waiving required loan document conditions for the release and pay down results in an impermissible alteration of the loan’s payment terms in violation of the PSA.

Conclusion. Despite the fact that that the release of Parcel C and the borrower’s associated partial pay down of the loan do not result in any adverse tax consequences to the securitization and might otherwise be regarded by the servicer as a positive development for the overall credit of the loan, the impact of the transaction on the borrower’s payment terms likely results in a violation of the PSA. As a result, the servicer would not be in a position to grant the borrower’s request.

Example 2. In Example 1 above, does the fact that Parcel C was attributed no value in the underwriting associated with the origination of the loan impact the servicer’s decision?

Answer: No. In situations like those outlined in Example 1, some servicers may be tempted to approve the transaction based on the belief that, because Parcel C was given no value in the origination appraisal that supported the loan’s underwriting, there is no harm in allowing the transaction to go forward. This approach is incorrect.

As a preliminary matter, when a borrower has gone through the trouble of including in its loan documents the conditions necessary for a future collateral release, it is not uncommon to exclude the value of the release parcel (Parcel C in Example 1) from the appraisal. (After all, the borrower is contemplating that the parcel may be released quickly, so ascribing Parcel C with a value at $0 makes sense.) Assigning $0 value to Parcel C at origination, however, has no impact on the servicer’s review of the issues associated with the borrower’s requested release and pay down as discussed above in Example 1.

Irrespective of the value assigned to Parcel C at origination, the servicer can only approve the transaction if the transaction does not violate the REMIC (or other applicable) rules, makes sound credit sense, and is permitted under the applicable PSA or other servicing agreements. The value attributable to Parcel C at origination has no bearing on the servicer’s analysis of these three issues. See Kilpatrick Townsend, Servicer Survival Guide 2019-2020 Edition, Tom Biafore  “REMIC Issues in CMBS 2.0/3.0/4.0 Things You Should Never Say (Or Do)" for more detailed discussion of these and similar issues