Given the influx of new money into commercial real estate in certain locations and sectors, opportunistic investors need to examine more complex propositions to differentiate themselves from their competitors. One such proposition is to invest in CMBS containing distressed or near-distressed assets with a view to influence the asset level restructuring or enforcement strategy. While, in respect of a CMBS investment, investors may have the appetite and balance sheet (and where there are sufficient willing sellers) to acquire controlling positions in all note classes throughout the debt stack, other investors will look to target the relevant class of notes (or acquire the subordinated piece in a tranched loan) that has the right to control the appointment of the special servicer. The theory behind this strategy is that control of the special servicer will give the investor control in any asset level restructuring or enforcement process. However, investors who are looking to pursue this strategy need to be aware of the risks involved. These risks have been highlighted most recently in the Titan Europe 2007-1 (NHP) CMBS case where the court refused a presumptive controlling party the ability to replace the incumbent special servicer with its nominee.
LOAN SERVICING AND SPECIAL SERVICING
Both the servicer and special servicer of a CMBS deal are appointed at the time that the CMBS is constituted. They are appointed by the Issuer, the relevant loan level security trustee and often, where the relevant loans have been tranched, the relevant subordinated lender (collectively, the “Secured Parties”). The servicer and special servicer act as the Secured Parties’ agents and are empowered to exercise all of the Secured Parties’ rights and powers in relation to all of the loans in the CMBS. The servicer undertakes the primary administrative and decision making function in respect of each loan when that loan is not in distress. When a loan becomes distressed it is transferred to the special servicer. When a loan is in special servicing the special servicer will evaluate whether to enforce the security granted in respect of the loan or to undertake some other action such as a restructuring. In all cases the servicer and the special servicer are required to act in accordance with the “servicing standard”.
While the details of the servicing standard vary from programme to programme, the fundamental obligation in a servicing arrangement is for the servicer and the special servicer to act in accordance with:
- all applicable laws and regulations;
- the relevant loan level finance documents and intercreditor agreement (if relevant); and
- the higher of either:
- the same manner and with the same care, skill and diligence it applies in servicing similar loans for other third parties; and
- the standard of care, skill and diligence which it applies in servicing commercial mortgage loans in its own portfolio.
In each case the servicer and the special servicer are both required to act as a reasonably prudent commercial mortgage servicer would act when servicing commercial mortgage loans which are similar to the relevant loans in the CMBS. The servicer and the special servicer are also required to manage the loans with a view to the timely collection of all scheduled payments of principal, interest and other amounts due in respect of each relevant loan. If a loan is distressed and no satisfactory arrangement can be made with the relevant borrower, the special servicer is required to maximise the recoveries on that loan. For tranched loans, the relevant subordinated lender is required to acknowledge the subordinated nature of such subordinated lender’s interest and that the subordinated lender may suffer a loss or be otherwise adversely affected in circumstances where no such adverse loss, or a smaller loss, is suffered by the Issuer.
The requirement of the special servicer to adhere to the servicing standard constrains the special servicer to act wholly in accordance with the interests of only one investor but the servicing standard is sufficiently vague to allow the special servicer to follow one of a number of potential strategies in its discretion. Therefore, the theory is that the special servicer should have the power to formulate an enforcement or restructuring strategy and to execute this strategy unilaterally, subject to the servicing standard.
THE CONTROLLING PARTY
In most CMBS deals, the controlling party has the right to effect a replacement of the special servicer of a loan with its own nominee. In such deals a single class of creditor will be conferred the position of “controlling party”. As a general rule, the controlling party is the most junior secured creditor in the debt stack – either being the subordinated lender where a loan has been tranched or the most junior class of noteholder, provided that where the value of the underlying real estate drops by a certain level or losses in the CMBS vehicle crystallise by a certain level such that the most junior creditor no longer has any recoverable interest, the identity of the controlling party moves up one place to the next most junior ranking secured creditor.
To replace the special servicer the controlling party must satisfy a number of requirements. The requirements are established on a deal by deal basis but will invariably include the following:
- the replacement special servicer is bound by the same terms that bind the current special servicer;
- the replacement special servicer will be required to be experienced in undertaking the function of special servicer; and
- the rating agencies issue rating agency confirmations (RACs) that the then applicable ratings of the notes will not be downgraded, withdrawn or qualified as a result of the replacement of the special servicer (see article on “Rating agency refusal to give no downgrade letters – a cause for uncertainty”).
POTENTIAL CHALLENGES TO AN INVESTOR WISHING TO CONTROL THE APPOINTMENT OF THE SPECIAL SERVICER TO CONTROL THE MANAGEMENT OF AN UNDERLYING LOAN
There are a number of challenges to an investor wishing to influence the management of a CMBS loan by becoming the controlling party. The main challenges are set out below.
- Is the investment being made at the correct level? The investor will need to be confident that the investment it is making is at the correct part of the capital stack. In order to be so confident, the investor will need a clear view of the rules governing the identity of the controlling party. Unfortunately the documentation in certain CMBS deals can be very poorly drafted with numerous ambiguities together with inconsistencies between the disclosure prospectus and the underlying securitisation contracts (as is the case with Titan NHP). This is important because the investor is likely to rely on the disclosure document rather than the underlying contracts (to which it is less likely to have ready access). It is therefore important, if at all possible, to full and carefully review these underlying contracts before the investment is made. Moreover, owing to the dynamic nature of the controlling party status, the investor will need to be aware of the value of the real estate or whether losses have crystallised in respect of the loan and real estate issuance.
- Where the controlling party is a class of notes, does the investor have the ability to acquire sufficient amounts of such notes to ensure that it is able to control the rights afforded to the controlling party? The investor needs to understand the percentage of the relevant class to control these rights. The percentage is usually 50% or 75%.
- What are the rules governing the termination and appointment of the special servicer? The investor will need to have a clear view as to the requirements that it needs to satisfy to effect the replacement special servicer. The Titan NHP case highlighted two issues which should be on interest in this regard. First (and as mentioned above) there can be inconsistencies between the disclosure prospectus and the underlying securitisation contracts. Second, some of the requirements (such as obtaining RACs from all ratings agencies) has become impossible owing to Fitch taking the policy decision to not provide RACs in any circumstances for CMBS deals (see below).
- Will replacing the special servicer guarantee full control of a restructuring or enforcement strategy? As mentioned above the special servicer (whether the original special servicer or its replacement) is required to perform its duties in accordance with the servicing standard meaning that it cannot act in a way which favours only one creditor. Additionally, problems in the drafting of certain of the servicing standard clause in certain CMBS deals has led to uncertainty as to the approach that the special servicer has to take in certain circumstances. Finally, it should be noted that in some tranched deals, even where the subordinated lender is no longer the controlling party (owing to a reduction in value of the underlying real estate) it may still have certain rights embedded in the intercreditor agreement which inhibit the ability of the special servicer to control its own enforcement or restructuring strategy unilaterally. Therefore a careful review of all relevant documentation should be reviewed if at all possible before any investment is made.