Many commercial mortgage-backed securities (CMBS) loans continue to go into default either because of maturity defaults or because the property is not generating enough income to pay the debt service. Although many articles discuss the technicalities of loan modifications when a loan has been securitized, this article will provide a practical guide for borrowers on how to deal with special servicers—the service companies that step in when a loan fails to perform as expected.
In the current market, a commercial borrower faces a number of obstacles to obtaining the type of loan modification that will enable the borrower that is unable or unwilling to pay its securitized loan to avoid the loss of the property. Because of IRS limitations on real estate mortgage investment conduits (REMICs) and the provisions of most pooling and servicing agreements, master servicers that generally oversee the administration of the loan possess only very limited authority to approve loan modifications. Thus, borrowers will have to deal instead with special servicers.
Although the master servicer may be willing to deal with interpretation questions, it cannot make a loan modification involving a payment change. Generally, the master servicer can deal only with nonmonetary terms such as lease renewal issues or a change related to a hard lockbox, but even these types of modifications may require the involvement of a special servicer. Therefore, the first step for a borrower seeking a loan modification is to call the master servicer and see if it is willing to address the types of issues of particular concern to the borrower. If not, the borrower will need the master servicer to transfer the loan to a special servicer. Before a default event, such a transfer is likely to occur only if the borrower is able to convince the master servicer that a default is “imminent.” If a default is imminent, the master servicer generally has the discretion to transfer the loan before the actual occurrence of the default event. For various reasons, some borrowers prefer not to default on their CMBS loans, even though they desire to modify the loan or obtain a discounted loan payoff.
Written requests to the master servicer for a transfer of an undefaulted loan typically take one of two forms. The first form might be best characterized as a plea: the borrower sends a letter explaining to the master servicer that a default is imminent, the borrower has a “fix,” but that, given the master servicer’s limited discretion to modify the loan, it is in everyone’s best interest for the master servicer to transfer the loan to special servicing. The second form of letter might be best characterized as a threat: the borrower demands a transfer to special servicing lest the borrower be compelled to force the issue by letting the loan go into default—thereby forcing a transfer to special servicing but at the potential cost of making a workable modification more difficult to achieve.
The recent case of Wells Fargo Bank NA v. Cherryland Mall Ltd. Partnership, 812 N.W.2d 799 (Mich. Ct. App. 2011), indicates that drafters must carefully word such letters to avoid triggering the nonrecourse provisions of the loan. In Wells Fargo the court held that the borrower’s insolvency and resulting failure to pay its debts as they became due violated the special purpose entity provisions, thereby triggering application of the nonrecourse provisions of the loans. See also 51382 Gratiot Ave. Holdings, LLC v. Chesterfield Dev. Co., LLC, 835 F. Supp. 2d 384 (E.D. Mich. 2011). The Wells Fargo opinion was opposed by the Mortgage Bankers Association and legislatively reversed when the governor of Michigan signed the Nonrecourse Mortgage Loan Act into law on March 29, 2012. Mich. Comp. Laws § 445.1591−445.1595.
Of course, a large percentage of borrowers that desire a modification of their CMBS loans do default on their loans, and those loans are transferred to a special servicer without further action by the borrower. The transfer to special servicing is only the first step for a borrower seeking a modification of a CMBS loan. Although special servicers have more discretion to make modifications and accommodations for borrowers, CMBS loan modifications are relatively rare. According to an informal survey of special servicers taken for purposes of this article, loan modifications are granted in less than 20% of defaulted commercial real estate loans valued at over $10 million and in less than 10% of defaulted commercial real estate loans valued at under $10 million.
Moreover, any successful modification of a CMBS loan (whether pre- or post-default) typically will require that the borrower inject new money into the project—in the form of either a principal pay down, increased equity in the borrower entity, or the establishment of new reserves (or an increase in existing reserves) for interest payments, tenant improvements, and the like. In addition, in some cases when new equity is added, the amount of the original debt owed may be split into A and B pieces.
The first tactic of a borrower that is short on available funds for upcoming debt service payments is to ask to use funds held in existing reserves as a short-term rescue. Because such funds are usually held for designated purposes and released only at the lender’s or servicer’s discretion, any use of the funds for debt service payments would require the special servicer’s consent and would constitute, in some form or fashion, a loan modification. Though a borrower might not view a request to use reserves as a loan modification, the master servicer undoubtedly will. Even in this circumstance, the borrower’s first challenge will be to get the loan moved to special servicing if a loan default has not yet occurred.
The special servicer, however, will not necessarily approve reserve releases, particularly if they are to be used to fund loan payments. A borrower’s best hope of obtaining a reserve release for a nondesignated purpose is when it relates to a defined, fixed expense (for example, a tax or assessment payment, tenant improvements for a new lease, and the like). A requested disbursement to be used to make a payment on the loan is much less likely to be approved. From the special servicer’s perspective, one can understand the reticence to use reserves (really just another type of collateral) to fund loan payments. Only if the borrower can demonstrate to the special servicer that the disbursement of reserve funds for a loan payment is necessary because of a temporary financial constraint highly likely to be alleviated in the near term might the special servicer consider such a disbursement. A borrower is unlikely to meet this difficult and unlikely standard. If the borrower’s cash flow is insufficient to meet its debt obligations now, how will circumstances differ once the reserve funds run out? If there is no reason to believe that the borrower’s financial issues will resolve themselves in short order, authorizing a release of reserve funds to pay a portion of the debt service for an interim period results in nothing more than a waste of additional collateral by the special servicer and a delay of the inevitable.
Contractual and Legal Limitations
The limitations placed on special servicers to modify loans in a securitized loan pool before and after a default are well chronicled. See, e.g., Patrick E. Mears & Mark R. Owens, Representing Special Servicers in “Cleaning Up” Defaulted CMBS Loans: A Herculean But Not Impossible Task, Prob. & Prop., May/June 2011, at 20. After a default, however, both the federal REMIC rules and the terms of most pooling and servicing agreements give special servicers flexibility to modify and dispose of loans. The scope of this discretion is limited less by the REMIC rules than by the terms of the pooling and servicing agreement. For example, while the pooling and servicing agreement may specifically permit loan modifications and foreclosure, it may be silent regarding the special servicer’s right to sell defaulted loans. Similarly, even when a right to sell the loan is provided, certain parties holding other tranches of the debt can possess rights of first refusal or first offer that the special servicer must honor. (It does not appear that these rights are being exercised in the current economic environment.) Generally, the special servicer and its counsel should carefully review the pooling and servicing agreement before taking any action on a defaulted loan.
Generally, the first action of a special servicer when a loan is transferred to it is to inspect the property and order an appraisal and an environmental review, which are paid for as protective advances by the master servicer. The special servicer gives limited weight to information or appraisals provided by the borrower. Many special servicers will start foreclosure actions immediately, on the theory that the threat of foreclosure pressures the borrower to promptly negotiate an acceptable loan modification. Further, if a foreclosure commences immediately, valuable time will not be lost if the parties cannot agree on a loan modification. The special servicer will send the borrower a standard pre-negotiation letter, which at a minimum will waive any defenses by the borrower against the lender, provide that there is no loan modification unless it is in writing, and require confidentiality as a condition precedent to any negotiations. Some special servicers will delay initiation of the foreclosure action if the borrower signs the pre-negotiation letter, negotiates in good faith, and remits all net cash flow to the special servicer.
In some cases, the special servicer will sell the note rather than foreclose, often to the borrower’s surprise. There are a variety of reasons why a servicer may pursue a note sale rather than a foreclosure. Paramount among the servicer’s considerations is the relative ease with which foreclosures can be completed in the jurisdiction where the property is located. In states like New York or Connecticut, where foreclosure is a judicial process that may take several years to complete, a note sale may be attractive to the special servicer. See Foreclosure Law and Related Remedies (David Campbell et al. eds., 2d ed. 2009), for a state-by-state summary of foreclosure processes and timelines; see also 2011−2012 National Mortgage Law Summary (Am. Coll. of Mortg. Att’ys 2012). By contrast, because foreclosures in states like Texas or Arizona are relatively fast and low cost, the special servicer may avoid a note sale and simply proceed to foreclose.
Another consideration for the special servicer is the type or condition of the property. Special servicers may want to sell the note when the property type is unusual, such as an assisted living facility or hotel. Environmental contamination or similar issues relating to the condition of the property may render the servicer reluctant to cause title to vest in the lender, even if done through a single asset entity and even if such ownership lasts for only a short period of time. Similarly, the lender and servicer may be unwilling to step into the shoes of the property owner if construction at the property remains incomplete or if significant repairs or replacements are necessary. Finally, the dynamic with the defaulted borrower can also influence the special servicer’s decision making. A borrower that intends to fight a foreclosure or otherwise challenge the lender’s right to enforce its remedies can cause the servicer to look for other opportunities to dispose of the defaulted loan (depending on the extent to which the defaulted borrower might actually be able to impair the lender’s remedies). Some note purchasers will restructure the loan without the same restrictions as the special servicer, while others will want to own the property. In the authors’ experience, note purchasers seem to be more aggressive than the special servicers in pursuing collection from guarantors.
Obtaining a Receiver
The special servicer generally will attempt to have a receiver appointed to manage and operate the property once the asset is transferred to it. This is not the case in some jurisdictions, such as New York, Wisconsin, and Ohio, where foreclosing and obtaining a receiver are considered difficult. In certain circumstances in which the borrower is remitting all cash flow to the lender and a loan modification seems probable, such as when a short extension of the maturity date is sought, the special servicer may allow the borrower to continue to operate and manage the property.
Most security instruments provide that, on a default by the borrower, the lender is entitled to the appointment of a receiver for the property. When the language of the security instrument is insufficient to permit appointment of a receiver, the lender may possess a statutory right to appointment of a receiver on a showing of a legitimate threat of waste or other risk to the property. See, e.g., Colo. Rev. Stat. § 38-38-601. In many states, this right is enforceable and in some jurisdictions, appointment of the receiver can even be accomplished without either notice to the borrower or a hearing before the appointment. Borrowers can sometimes negotiate a waiver of an action against the guarantors by stipulating the appointment of a receiver.
In some jurisdictions, particularly where foreclosure is long and difficult, CMBS special servicers are pursuing an alternative to foreclosures and note sales—receiver sales that transfer the property to a buyer acceptable to the lender.
Traditionally, receivers serve the purpose of managing the property and turning over cash flow to the lender either before or during the pendency of a foreclosure. The specific powers and authority of the receiver are typically established by court order, subject to any applicable legal limitations. Depending on these limitations, the receiver can be granted the additional power to market and sell the property, typically with the consent of the lender and the approval of the court. The purchase price for the property will be used to offset the costs of the receivership and pay down all or a portion of the indebtedness.
In some cases, the servicer’s intent in pursuing or accepting a receiver’s sale is to facilitate a sale of the property with an assumption of the defaulted loan (and with a corresponding modification to the loan to the extent permitted under the REMIC rules). Such a sale, in essence, permits the special servicer simply to modify the defaulted loan and continue the servicing under the terms of the pooling and servicing agreement. Such an arrangement, if resulting in a successful loan modification, can yield a better and more easily administered resolution for the certificate holders. If the borrower will not consent to a transfer to a third party and assumption of the loan (usually because the borrower cannot obtain the type of release it wants), the special servicer will need to obtain a court order approving such a transaction.
Further, receiver sales are not available in all states. In some states it is unclear whether a receiver sale is permitted, either because of statutory and case law silence on the issue or because the loan documents do not specifically authorize the receiver to sell the property (thereby leaving the issue to trial judges in the receivership actions to evaluate on a case-by-case basis). Moreover, even when receiver sales are either expressly permitted or simply not prohibited, individual receivers may not be willing to undertake the added responsibilities that come with marketing and selling the receivership property. Further, title companies may not necessarily insure such transfers, and counsel for third-party buyers may be concerned about the validity of such sales. (Many attorneys now wish that either deeds of trust or mortgages specifically permitted receivership sales, or that objecting to a proposed sale by a receiver was a violation of the nonrecourse carve-outs.) One special servicer contacted by the authors advised that receiver sales occur in less than 20% of cases, either because such a process is too difficult or because the special servicer believes that more value can be received if the property is foreclosed on and then sold through the auction process.
Short Sales and Discounted Payoffs
As previously noted, loan modifications on defaulted loans are rare, and the special servicer usually ends up acquiring the property. Further, because of the fiduciary duties placed on special servicers by pooling and servicing agreements, discounted note payoffs and short sales of commercial property rarely occur. The authors estimate that in less than 5% of the cases does a short sale or discounted loan payoff (DPO) occur on a commercial property. Generally, a short sale occurs only when the borrower has brought the buyer to the table and the special servicer is convinced that this arrangement will result in the greatest recovery for the bondholders. Discounted note payoffs for the borrower rarely occur, and, if they do, the discount is not very great and generally not less than the appraised value as determined by the special servicer.
As previously mentioned, loan modifications are difficult for a borrower to obtain. Generally, special servicers will not even commence a loan modification discussion without a pre-negotiation letter and assurance that all cash flow from the property is being delivered to them.
The easiest type of loan modification to obtain is a one- to two-year extension of the maturity date. Even for just an extension, however, the special servicer will require a partial pay down or replenishment of reserve accounts. Occasionally, the servicer will allow interest rate reductions if the “forgiven” interest is accrued. Any interest that is waived under a modification will be due if there is a subsequent default. Once parties reach an agreement in principle to modify a loan, the special servicer will submit a term sheet outlining the deal to an internal committee that generally meets weekly. If the special servicer owns the lowest tranche of the debt, as is frequently the case with some special servicers, no further approval will be necessary. In other cases in which the special servicer is not the representative of the controlling class, the agreement must be submitted to the representative of the controlling class for approval. If that representative does not agree, the special servicer will have to renegotiate the terms with the borrower.
Some special servicers generally only perform third-party servicing of bonds. Some special servicers require the borrower to sign a forbearance agreement before they will begin any loan modification or payoff instructions. These agreements may require the payment of a forbearance fee to the special servicer, which is not applied to amounts owing under the loan.
Deed in Lieu
In lieu of a proceeding to foreclose, the special servicer can agree to accept a deed in lieu of foreclosure from the borrower. Completing deed in lieu transactions with a special servicer is also relatively rare, however. Many special servicers have concluded that it is quicker to foreclose on a property than to negotiate the terms of a release with a borrower. Special servicers do not like giving releases at the time a deed in lieu transaction is entered into because they generally cannot be sure at the time of the release whether the borrower has breached the nonrecourse carve-outs. Sometimes the parties can negotiate a release one year after the deed in lieu transaction.
A deed in lieu transaction is more likely to occur when getting a receiver or foreclosing is a long and difficult process. A deed in lieu transaction, however, does not have the lien-clearing benefits of a foreclosure. If there is a deed in lieu transaction resulting in debt forgiveness, the special servicer must send an IRS form 1099 to the borrower.
Disposition of Property by Special Servicer
Once a special servicer forecloses on a property, it will generally be marketed for sale through special REO web sites set up by the servicer or the lender or by commercial brokers that typically work with servicers. See, e.g., US REO Properties, www.usreoproperties. com (last updated Aug. 28, 2012); CW Capital Asset Management, www.cwcapital.com/SpecialServicing/REO/Pages/PropertiesForSale.aspx (last visited Aug. 28, 2012); REO Properties for Sale, Berkadia, www.berkadia.com/ reo/default.aspx (last visited Aug. 28, 2012); and Auction.com, www.auction. com (last visited Aug. 28, 2012). Searchers can find opportunities to purchase defaulted notes on web sites maintained or supported by lenders and servicers. See, e.g., Auction.com, www.auction.com (last visited Aug. 28, 2012). Because special servicers have an obligation to attempt to obtain the highest price for an asset, they generally market the notes or property broadly and do not make deals with acquaintances or parties that approach them directly. It should be noted that nothing prevents a borrower entity from also bidding on the note or property through those sites. Frequently, this is the only way a borrower can actually obtain a discounted loan payoff. In addition, the amount obtained from such an auction may be less than the borrower actually offered the special servicer during pre-foreclosure negotiations. Generally, a special servicer will not object to a new borrower entity being the purchaser, as long as the borrower did not previously act “improperly.”
Special servicers will approve new leases or lease extensions while they are negotiating with the borrower if no funds are required to be advanced by the servicer or if there is sufficient money in the borrower’s escrow accounts for any required tenant improvements. The special servicer will not advance funds for leasing commissions or tenant improvements before obtaining title to the property. After the special servicer obtains title, and if it is economically advisable, the master servicer can advance the needed funds, subject to recoverability standards based on liquidation value.
Persistent uncertainties about the economy and the commercial real estate market will cause lenders and servicers to continue to be creative in dealing with defaulted loan assets. As highlighted in this article, borrowers have a variety of options they might pursue in negotiations with loan servicers. They should be aware, however, that loan modifications, even those so minor that many borrowers may not perceive them to rise to the level of a modification, will remain difficult to obtain (often with good reason).