- PSA Issues “Servicing Standard” vs. Servicer Compensation Issues.
- “Servicing Standard” vs. Servicer Compensation Issues. Servicers are bound by a “servicing standard” imposed under the PSA and must avoid conflicts of interest, employ a standard of care higher for the pooled loans than its own loans, take into account the interests of all certificate holders (including B-Note holders and pari passu holders), and seek timely recovery on a net present value basis.
- Hot Buttons for Trusts—Size of Defaulting Loan in Relation to the Specific Trust Portfolio. Trusts will be concerned with P&I, out of pocket expenses, yield maintenance, and interim occupancy agreements, which allow a buyer to occupy the property either before or after a sale.
- Hot Buttons for Servicer. On the other hand, servicers will be concerned with default interest, servicing fees, and workout fees.
Types of Workouts
- Forbearance. Forms of forbearance can include reserve waivers; deferred payments of interest, principal, and reserves; or conditional agreements not to exercise remedies for a period of time not to exceed two years. A form of forbearance agreement follows this article.
- Reinstatement. Reinstatement entails resolution of the default and immediate reinstatement of the loan to performing status.
- Modification. Modification entails permanent relief or major changes to the loan instruments.
- Lender Exit. The lender may want to exit the relationship and, if so, the lender has at its disposal various methods, including sale of the loan instruments, deeds in lieu of foreclosure, consensual receiverships, a receivership sale (in some states, prejudgment receivership sales are permitted), and a friendly foreclosure.
- Borrower Exit. Borrowers also have exit strategies they may wish to employ, including assumption, a discounted payoff, a short sale, and defeasance.
Workout Strategies
Lenders and Decision Makers
What type of loan—i.e., CMBS or non-CMBS loan—is in distress? Recall that CMBS loans have REMIC strict guidelines to follow, so the PSA will need to be consulted and counsel must determine who (special servicer, directing certificate holder, mezz lender, companion noteholder, trustee) needs to consent.
Collateral Status
Just as complicated is the question of the status of the collateral. The types of issues that affect workouts include:
a. Type (classification) of property.
b. Physical and financial condition of the property.
c. Fair market value of the property compared to outstanding loan amount.
d. Underlying major tenant default (i.e., “it is not borrower’s fault”).e. Can current income support operations?
f. Maturity default?
g. Are there deferred maintenance issues?
h. Types of guaranty agreements and current financial condition of guarantor.
i. What dark clouds loom in the near future for this type of property?
j. Are there any positive factors for a workout?
How Did the Default Happen?
Both sides have to understand how the default happened. Was it caused by the fault or neglect of the borrower? What are general market conditions (e.g., rising interest rates, no interest rate cap, lack of insurance, changing market demographics)? Is this a single major tenant insolvency or an asset class issue such as a dying regional mall or office building in a struggling downtown area? The reason the property went into default will determine workout possibilities and choices.
Who Is in Charge?
Having determined how the default happened, the next question is who is in charge of the property at present. If the person now in charge was in charge when the default occurred, the lender will want to know whether a change of control is necessary (without exercising excessive lender control), what the quality and reputation of the sponsor are, and whether the property is self- or third-party managed. The lender will also ask whether it makes sense to put a receiver in charge or otherwise find a method to dispossess the borrower.
Are There Borrower or Guarantor Issues That Need to Be Resolved?
The lender will want to know if there are disputes among the ownership groups and the reputation of the ownership group. The lender will also want to know if a workout creates any publicity concerns.
How Realistic Are the Borrower’s Asks?
A borrower may need to give to get and the lender will want to know what the sponsor’s commitment is to the property. The borrower will also need to know that extension without investment in capital expenditures to address deferred or unperformed maintenance might leave the lender in a worse situation and is not appealing to a lender. The ultimate question here will be whether the borrower is realistic with the property asset class position in the current market.
Suit
Despite the best efforts of the parties, or sometimes as the result of a lack of best efforts, a workout may not be fruitful and litigation becomes necessary. But litigation can be a workout by other means. At this point, the interests of the parties are completely adverse because the lender may seek to dispossess the borrower and interrupt the flow of money yet the borrower wants to maintain ownership and use its ownership to continue to receive funds while fighting the lender or stalling the process while looking for a white knight.
Discovery
It is hoped that the parties were forthright with each other during the workout phase, but court-based discovery forces parties to be more honest than they might have actually been. The lender will probably be forced to admit gaps in loan instruments and perhaps weaknesses in loan administration, and the borrower may need to admit poor planning or execution in the project or, worse yet, situations that call into play the “bad boy” acts that bring a recourse carveout guaranty into play. These discovery disclosures can and often do shift the leverage between the parties and may create a new opportunity for resolution.
Receivers and Interim Relief
Another point that may affect the relative leverage between the parties is the possible appointment of a receiver or other interim relief. The appointment of a receiver will deal a significant blow to a belligerent borrower as it will probably lose the income stream that was funding the fight against the lender. The appointment of a receiver, however, is not all rosy for the lender because the receiver will take direction from the court, not the lender, and the lender will have to pay for the receiver. Appointment of a receiver may be a two-edged sword for the lender. In some states, the receiver enjoys a “super priority” lien similar to DIP (bankruptcy debtor in possession) financing that primes all other lenders and claims. Likewise, the receiver may be directed by the court to spend funds to protect the collateral or the tenants, which may work to the detriment of the lender.
Assignments of Rent
Another pressure point is the possibility of the court permitting the lender to enforce an assignment of rents provision. This is a form of a “Goldilocks” pre-trial remedy for the lender because it gets to redirect the stream of income away from the borrower without having to pay for a receiver and without having to worry whether a receiver will take a direction not desired by the lender. Often these assignments are collateral assignments that were agreed to in the loan documents, a fact that makes it difficult for the borrower to contest the enforceability of the assignment. Although a borrower need not cease its defenses upon the granting of an order enforcing an assignment of rents, the borrower’s tasks will certainly be more difficult and will require funding from alternative resources, either the borrower’s reserves or contributions from the owners.
Pursuit of Guaranty
Another pressure point is a possible claim against the guarantors. This course of action, however, is difficult for the lender unless there is clear evidence bringing the guaranty into play. A failed attempt by the lender to bring the guaranty into play may embolden the borrower and shift leverage back to the borrower.
Judgment
Unless significant appeal issues exist, a final judgment against the borrower will end the litigation and may give the parties another opportunity to work out the loan. Unless the lender has no desire or ability to take over the property, a final judgment shifts the leverage to the lender. But a lender not willing or able to take over the property without an ability to pursue the guarantor may have won a Pyrrhic victory as the borrower may just walk away from the property.
Post-Judgment Proceedings
Post-judgment proceedings absent a guaranty are limited and probably won’t lead to a workout. But post-judgment discovery of assets may disclose fraudulent conveyances and possible courses of action against third parties. Again, this may shift the leverage to the creditor.
Bankruptcy
Bankruptcy may be the ultimate form of workout because many real estate projects are single-asset entities and bankruptcy proceedings in a single-asset case are often resolved quickly and geared toward consensual resolution. Various points in the process offer a great opportunity for workouts, and the lender that has been involved in the workout process from the start, especially if it already has conducted a Chapter 11 analysis, has an advantage over other creditors and can use the bankruptcy process to its advantage.
Pre-Packs
“Pre-packs” (i.e., pre-packaged bankruptcies) have become more common and favor the lender who has worked with the borrower toward a possible resolution. A pre-pack essentially takes a workout resolution agreed to by the lender and the borrower and has it approved by the bankruptcy court, often to the advantage of the lender and the borrower and the disadvantage of the other creditors.
Section 362 Relief
Another point in the bankruptcy process that offers an opportunity for a workout is the filing of a motion for relief from the automatic stay. Some borrowers file bankruptcy to seek an alternative forum to the litigation that did not work to its favor. If so, an order granting relief from stay under Section 362 of the Bankruptcy Code sends the case back to the prior litigation forum. As to be expected, this shifts leverage for a possible workout back to the lender.
Section 363 Sale
The Bankruptcy Code offers another opportunity for lenders because the bankruptcy court can, over the objection of the debtor, order a Section 363 lease or sale of the property. This again dispossesses the borrower and sells the property, shifting the leverage back to the lender. The prospect of a Section 363 order may cause the recalcitrant borrower to reconsider a workout.
Modification Through Chapter 11 Plan
The final method by which a workout can be accomplished during the bankruptcy process is through confirmation of a Chapter 11 plan of reorganization, which includes the agreed-upon terms of the workout. The lender typically is secured and, as a result, has the ability to control the process to a certain extent through its vote on a proposed plan of reorganization. Practitioners should note, however, that a plan of reorganization can be confirmed over the objection of objecting creditors, i.e., a cramdown, and Subchapter V debtors can confirm a plan over creditor objections without a cramdown order.
Conclusion
There are many opportunities for workouts of a loan as it works its way through the process, with leverage going back and forth between lenders and borrowers.