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Scott A. Weinberg |
Jerry H. Herman |
In part two of their article examining the complex restructuring landscape for CMBS hotel loans, DLA Piper attorneys Scott Weinberg and Jerry Herman explain the dynamics of working with a special servicer to unwind and workout these loans. Part one of the series provided background and statistics on distressed CMBS hotel loans and the basics of CMBS hotel loan structures, parties and servicing standards.
5. Are the servicers restricted from taking certain actions in a workout?
One of the most common statements regarding CMBS loan workouts is that there are actions the servicer cannot take because of tax restrictions. While there is truth to that statement, in most workout situations, the restrictions that exist will not be meaningful.
The mortgage pools of CMBS loans are creations of the tax code known as a Real Estate Mortgage Investment Conduit or REMIC. While the REMIC rules do prohibit a loan servicer from entering into a “material modification” of a loan prior to an event of default, most workouts will occur after such an event has occurred, negating the effect of the restriction. There are no specific restrictions against such common borrower requests as forbearance, forgiveness of loan principal, reduction of interest rate or (generally speaking) a maturity extension.
The servicer may also be granted rights pursuant to the loan documents to change property managers and possibly even to change flags, but in reality there are usually direct non-disturbance agreements with the manager and/or comfort letters from the franchisor in place which will prohibit such action.
Furthermore, recently issued regulations by the I.R.S. appear to provide further flexibility under REMIC rules to CMBS servicers in situations “where the holder or servicer believes that there is a significant risk of default of the loan” and “based on all facts and circumstances, the holder or servicer reasonably believes that the modified loan presents a substantially reduced risk of default, as compared with the pre-modification loan.” In such situations, the regulations list types of modifications not likely to cause REMIC qualifications to be at risk, and also states that discussions between a servicer and borrower concerning a modification may occur before a loan default.
6. Who controls the servicer during a workout (i.e., which party is the real decision maker)?
Though the special servicer is the party who has primary authority for running the workout, there are certain actions it cannot take without the consent of the “controlling (or directing) holder.” The party that is the controlling holder is typically the holder of the most junior interest in a loan, though there are typically provisions to shift to another party upon certain triggers if such interest no longer has economic value. This junior interest can be outside the trust, but cannot be in the form of a separate mezzanine loan.
Among the decisions that require consent are loan extensions, interest-rate reductions and principal forgiveness. A controlling holder might more appropriately be called a “vetoing holder,” because while it has the power to veto a servicer’s request to take such actions, it cannot typically affirmatively force a servicer to take action.
In any event, if the servicer and the controlling holder cannot agree on a course of action after a specified amount of time has passed, the servicer is authorized to take action in accordance with accepted servicing practices. While this may sound like a drastic action, in practice it will almost never happen because the special servicer is appointed by the controlling holder.
7. What borrower actions can trigger recourse?
In virtually all CMBS loans, the loan documents provide that upon the happening of certain specified events (the “non-recourse carve outs”) a principal of the borrower, typically an individual, will become personally liable for any loss or damage that the lender suffers or, in some cases, for the entire loan amount. While many of these events are obvious “bad-boy” type events such as fraud, misappropriation or non-permitted subordinate debt, others are more subtle and can be triggered by an unwitting borrower experiencing cash flow issues.
For example, many loans contain a carve out if the borrower “admits its inability to pay its debts as they mature.” A borrower facing a cash flow shortage might think it is being proactive by sending a letter to the servicer detailing when cash will run out, but in several instances we’ve seen, servicers have responded by declaring the borrower in default and threatening recourse. Worse still, that item is often lumped together with other bankruptcy or insolvency type carve outs in the full recourse (as opposed to loss or damage) section.
Another item to watch is failure to pay real-estate taxes. While most loans provide for escrows to pay such amounts and typically provide first payment priority in the cash flow waterfall, most loans also state that after the occurrence of an event of default, the lender may apply cash flow in any order it chooses, as well as apply reserves to payment of the debt. Thus even an unrelated technical event of default (e.g., a failure to deliver required interim financial statements) could permit the lender to use monies previously earmarked for real estate taxes to repay principal and then pursue the carve-out guarantor for real-estate tax payments going forward.
8. So what can a borrower facing a CMBS hotel workout do to prepare for dealing with the servicer?
Due to the above described CMBS complexities and “tranche” interests, it is essential that a borrower facing a distressed CMBS loan:
• understands the CMBS servicing parties and holders, constraints, rules and alternatives applicable to its loan, as well as the rights and roles of the hotel’s franchisor and manager;
• works through the master servicer to connect with the special servicer as early as possible with a comprehensive plan and all needed financial and property information , and without having the loan going into default;
• demonstrates to the servicer an ability to provide some form of financial commitment to add value to the asset underlying the loan and its collateral; and
• starts such process at least six-nine months ahead of the loan’s scheduled maturity.
Concluding remarks
Trying to predict whether or not the complexities of hotel CMBS loans, including the potential liability of special servicers to tranches with divergent interests, will make CMBS loans more susceptible to further “extending and pretending” or to consensual workouts versus foreclosures, and REO sales should best be left to a soothsayer. Nonetheless, with the “flood” of CMBS hotel loans now moving to the special servicer, we will begin to get some answers to the questions and issues raised in this article. While each CMBS hotel loan involves unique facts, the economic condition of the hotel industry, the availability and cost of debt and equity capital, and the role regulators will play in assessing the valuation of hotel loans on lenders’ financial statements will all be critical to the outcome of how distressed CMBS hotel loan situations are resolved. Stay tuned!
Scott A. Weinberg, Partner, DLA Piper LLP (US)— New York City Office, concentrates on real estate finance matters, including securitizations (scott.weinberg@dlapiper.com).
Jerry H. Herman, Of Counsel, DLA Piper LLP (US)—Washington, DC Office, specializes in hospitality and real estate transactions (jerry.herman@dlapiper.com).
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