BANKRUPTCY, INSOLVENCY AND ENFORCEMENT
ISSUES IMPACTING CMBS MORTGAGE LOANS
June, 2001
Katherine A. Burroughs, Esq.
Dechert
90 State House Square
Hartford, CT 06103
860/524-3953
I.
II.
Overview
A.
General Market Conditions.
B.
Traditional Commercial Real Estate Loan Enforcement Issues Affecting CMBS
Loans.
C.
Impact of CMBS Structure on Loan Enforcement and Workouts.
D.
Bankruptcy Issues.
General Market Conditions
A.
Overall Markets Clearly Weakening.
1.
Most forecasters anticipate economy will grow only modestly during
2001; some predict recession.
2.
Standard & Poor’s estimates economic growth in the first quarter of 2001
at .2%, and predicts annual growth for the year of 1.50%.1
3.
Contrast with economy in 2000, which grew in first three quarters at a rate
of 5%.2
1
Peter Kozel, Ph.D “Outlook for Property Markets in a Slower Growing Economy and the
Implications for CMBS Credit Performance,” Standard & Poors’s CMBS Quarterly
Insight: In the Face of Economic Slowdown, April 20, 2001 (the “S&P Quarterly
Insight”).
2
Id.
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B.
C.
Property Markets Feeling Effect
1.
In 1999 studies done by Fitch IBCA and Standard & Poor’s, respectively,
of rated CMBS deals, each rating agency found mortgage delinquencies to
be approximately .5%.3
2.
By the end of 2000, that rate had risen to .95%.4
3.
CMBS mortgage delinquencies are predicted to continue to rise to 1.5%2.0% by the end of 2001, and between 2.0%-4.0% by the end of 2002.5
4.
While these delinquency rates are relatively low compared to the 4%-7%
mortgage delinquency rates of the early 1990’s, they do represent a
substantial deterioration in the performance of CMBS mortgages.6
Certain Markets More Stressed Than Others
1.
Among CMBS mortgage loans rated by Standard & Poors, nursing homes,
which make up about 2.5% of overall collateral, comprise nearly 18% of
outstanding delinquencies, as of the end of the first quarter 2001.7
2.
Hotel/lodging properties represent 12% of collateral, and account for
nearly 25% of delinquencies.8
3.
Credit-tenant loans also have suffered disproportionately, in part as a
result of several high profile corporate downgrades, including Pacific Gas
& Electric, Co. and Pathmark Stores, a grocery store chain.9
3
Roy Chun, “CMBS Delinquencies - Viewing the Real Estate Behind the Numbers”,
Commercial Mortgage Insight, December, 1999. “CMBS Conduit Loan Defaults by
Property Type”, Commercial Mortgage Special Report (Fitch IBCA, New York, New
York) April 6, 1999.
4
Kozel “Outlook for Property Markets” Standard & Poor Quarterly Insight (the “Kozel
Article”).
5
Id.
6
Larry Kay and Roy Chun, “Delinquencies Top $1 Billion,” Standard & Poor Quarterly
Insight (the “Delinquencies Article”).
7
See Delinquencies Article.
8
Id.
9
Id.
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III.
4.
Certain regional economies, most notably those dependant on
manufacturing in the Midwest and South, have suffered a disproportionate
deterioration in loan performance.10
5.
In addition, the dot.com “bust” and ongoing power crisis make
California’s economy an open question.
Traditional Commercial Real Estate Loan Enforcement Issues Affecting CMBS Loans
A.
Traditional issues raised by defaulted commercial mortgage loans are not changed
by the CMBS environment.
B.
Analyzing the Problem Loan.
1.
Lender, acting through the special servicer, must identify cause of the
default. Requires an understanding of the business aspects of the property,
including review of financial and operating statements, physical condition
of property, understanding of relevant market and micro-market,
understanding of financial and business capabilities of management, and
analysis of other factors that may be impacting property.
a.
C.
10
Often more challenging because of segmentation of servicing
responsibility, and fact that special servicer often not involved until
after defaults have occurred.
2.
Lender must determine if it is willing and/or likely to be able to do a deal
with current management of the borrower, or if current management is the
root of the problem (incompetent, dishonest, etc.) such that only viable
solution is replacement by lender or other third party.
3.
Lender must understand rights under loan documents, including rights to
terminate and/or replace management, control of cashflow from property,
including lockbox or other cash management arrangements, control over
budgets, lease approval rights, and existence of other collateral such as
letters of credit, reserves, or guarantees.
4.
Lender must understand its legal remedies under loan documents, as well
as understand the likelihood of its practical realization upon those
remedies, including local law and procedure with respect to obtaining a
foreclosure sale, appointment of a receiver of rents and activation of an
assignment of leases.
Strategy Development.
See Kozel Article.
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D.
1.
Once lender understands the issues (business and legal) with respect to
problem loan, it must develop a strategy.
2.
If lender retains confidence in borrower, lender may seek a consensual
workout, perhaps involving a forbearance on exercise of remedies while
debt is restructured in order that loan ultimately will perform.
3.
If situation is not “hostile” but lender and borrower acknowledge they no
longer can work together, parties may enter into an agreement between
borrower and lender for some form of forbearance while property is
marketed with goal of either removal of borrower and assumption of loan
by third party, or sale of property and payoff of lender.
4.
If lender cannot reach any agreement with borrower, lender may initiate
litigation or other unilateral remedies to obtain control over property
and/or cashflow.
Lender Leverage.
1.
One key to a lender’s success in a loan workout is the lender’s leverage.
2.
Principal guaranty and recourse debt are perhaps the most effective
sources of leverage.
3.
Control over the cashflow is another source of leverage. That control may
be created through lockbox style cash management. Lockboxes may be
“hard”, where all cashflow goes directly from tenants into a deposit
account over which borrower has no control; or “soft”, where the borrower
is obligated to cause the cash to be deposited into such account. Some
loans have a lockbox from inception; others have a “springing” lockbox
that is activated upon a “trigger event” such as an event of default, or
failure to maintain certain debt service coverage ratios.
4.
Another way a lender may attempt to obtain control over cashflow is by
activating its assignment of leases, and notifying tenants to pay the lender
directly. While this may be effective, it also raises potential lender
liability risks for the lender, including concerns about being deemed a
mortgagee in possession as well as potential scrutiny with respect to the
use of monies received from tenants. It also may result in tenants
withholding rent. Activating an assignment of leases may not be a
prudent strategy with multifamily properties, as collecting rent from
residential tenants may create liability to those tenants under state
landlord/tenant laws.
5.
A lender may also seek to obtain leverage by initiating foreclosure
proceedings (whether judicial or non-judicial) and/or seeking the
appointment of a receiver of rents to take possession of the property. This
may be the ultimate strategy in order for the lender to take back the
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property, or it may be a tactical move to gain negotiating leverage by
creating risk of loss of control over the property and/or the cashflow for
the borrower.
IV.
Impact of CMBS Structure on Loan Enforcement and Workouts
A.
B.
Additional Issues Contributing to Loan Defaults Unique to CMBS Loans.
1.
The CMBS structure does create certain additional issues which may
contribute to loan defaults.
2.
A borrower will be unable to obtain many of the accommodations made
by portfolio lenders, in part because of the REMIC restrictions on
modification of loans, and in part because of the restrictions placed on
servicers in Pooling and Servicing Agreements. Borrowers may actually
default on their loans in order to circumvent REMIC restrictions and/or
accomplish other goals, such as prepayment during a lockout period.
Borrowers may also be more likely to file bankruptcy in order to obtain
judicial relief from restrictions imposed by REMIC structure.
3.
CMBS servicers often lack the ability to respond to many issues that could
avoid defaults, for example by making additional loan advances or doing
preemptive loan modifications.
4.
CMBS loans usually have substantial lockout periods during which
borrower can not prepay loan at all, or is required to undertake a complex
and expensive defeasance.
CMBS Loan Servicer Structure.
1.
The CMBS loan servicer structure is likely to have a significant impact on
real estate workouts.
2.
Bifurcation between loan origination, servicing and workouts
a.
in traditional portfolio lending, there is continuity in the
origination, servicing and workout of loan.
b.
by contrast, CMBS loan originators usually have no ongoing
relationship with loan.
c.
general loan servicing is performed by the “master servicer” which
has no other relationship to borrower or economic interest in asset
(1)
within master servicing organizations, there often is a
division of servicing responsibilities into different groups,
each responsible for a separate function, such as monitoring
of payments, escrow analysis, review of financial
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statements and advancing from reserves, with no single
person responsible for loan
d.
3.
C.
defaulted loans are sent to “special servicer” for resolution.
Special servicers have expertise in loan workouts and often have a
financial interest in CMBS trust which owns loan, which creates an
alignment of economic incentives. The special servicer usually has
no background or history with loan, collateral or borrower,
however.
Fee pressure on master servicers. Master servicers receive much of their
compensation based upon “float” on monies received from borrowers.
a.
actual “servicing fee” income very thin (often less than 1 basis
point) and based upon outstanding balance of loans
b.
as CMBS pools season, master servicers will be receiving less and
less compensation, but still will be obligated to service assets
which are more likely to require more and more active servicing
CMBS Loan Structures
1.
CMBS loans usually have similar “structures”, which have both positive
and negative implications for workouts
2.
Lender “positives” include:
a.
Cash management - Many CMBS loans have lockbox style cash
management.
b.
More control over property management. CMBS loans often
include assignments of management agreements, lender rights to
replace management, approval rights over replacement
management, and management attornment to the lender.
c.
Bankruptcy remote. CMBS borrowers are almost always
bankruptcy remote, which means they are entities set up for the
sole purpose of owning and operating a certain piece of real estate,
have restrictions in their organizational documents which preclude
them from engaging in any other kind of business or incurring any
other kind of debt, and covenant to keep their business and
financial affairs separate and distinct from their affiliates. In
addition, they may also have independent directors, which means
at least one member of the governing board of the borrower is an
individual with no affiliations with the borrower’s equity owners.
The purpose of making a borrower bankruptcy remote is to
minimize the likelihood that it will file bankruptcy. In addition, in
the event a borrower does file, the mortgage lender is likely to be
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the only significant creditor, thereby giving the lender certain
leverage in the workout and/or bankruptcy negotiations. As part of
the “bankruptcy remote” due diligence done in the closing of most
large CMBS loans, the lender will require the borrower’s counsel
to render a legal nonconsolidation opinion, discussing the
bankruptcy remoteness of the borrower, and in particular opining
on the issue of whether the bankruptcy of the borrower’s equity
holder would result in the assets of the borrower being included in
such a bankruptcy.
d.
3.
D.
Financial reporting. Most CMBS loans require regular financial
reporting as well as periodic inspections of the mortgaged
properties.
CMBS loan “negatives”, include:
a.
Non recourse. Virtually all CMBS loans are non recourse, and
many do not include any kind of guaranties, which substantially
reduces Lender coverage.
b.
Less flexibility. A CMBS REMIC trust has less flexibility to
restructure a problem loan. For example, a REMIC trust has very
little ability to substitute collateral, take additional collateral,
bifurcate debt, or take an equity or contingent interest position. In
addition, a CMBS REMIC trust is restricted in its ability to operate
an REO property.
c.
Servicing structure. In the CMBS environment, the original lender
will almost never be involved in the monitoring of a loan or the
workout of a defaulted loan.
d.
Advancing restrictions. A CMBS trust is unable to lend additional
money as a solution to correct a problem loan.
Other Issues Unique to CMBS Structure.
1.
Assignments. When loans are sold into CMBS securitizations the security
documents may not be properly assigned to the CMBS trust.
2.
Incomplete loan files. The loan files held by the servicer are often
incomplete. The complete file must be requested from Trustee, and even
that file may be missing key components, such as ground lessor estoppels
and title policies.
3.
Identity of client. As a practical matter, the responsibility for transaction
is with special servicer, but the real party in interest is Trustee.
a.
litigation should proceed in name of Trustee not servicer.
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V.
b.
may occasionally have conflict issues between servicer and trust.
c.
privilege issues.
4.
Standing of loan servicers. In re Nunez, 2000 WL 655983 (E.D.N.Y.
2000) a federal district court reversed a bankruptcy court decision holding
that loan servicers had no standing to appear on behalf of securitization
trusts which owned loans.
5.
Disclosure of information. Loan servicers routinely receive requests to
discuss aspects of specific defaulted loans with rating agencies and CMBS
investors.
6.
Breach claims. When loans are sold into securitizations, the loan seller
makes various representations and warranties about the loans. These reps
typically include that the loan documents are enforceable, that there have
been no modifications to the loan, that the loan is secured by a first lien on
the property and that the loan was originated and serviced prior to sale in
accordance with customary standards. A breach of a representation or the
failure of the loan seller to properly assign a loan and the loan documents
to the trust may give rise to a right to “put” the loan back to the loan seller.
Bankruptcy Issues
A.
B.
Bankruptcy Remoteness
1.
Hallmark of CMBS loans is the “bankruptcy remote” nature of borrower.
2.
Bankruptcy remote is not bankruptcy proof, however, and in the event that
the borrower and lender are unable to reach a resolution, and particularly
if the lender is proceeding with litigation to take control of the property
and/or the cashflow, the borrower may file bankruptcy.
3.
Independent directors may in fact have liability for failing to vote for
bankruptcy when it is best interests of borrower and/or its creditors,
including unsecured creditors.
What provisions of the Bankruptcy Code are most likely to impact a lender in a
commercial real estate bankruptcy?
1.
Single Asset Real Estate. Bankruptcy Code Section 101(51B) “single
asset real estate”, which is defined as multi-family or commercial real
property which generates substantially all of a debtor’s income, on which
no other substantial business is being conducted except operating the real
property, and which is encumbered by secured debt not exceeding
$4,000,000.
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2.
Automatic stay. Bankruptcy Code Section 362 automatically stays any
actions against the debtor or its property until such time as the bankruptcy
court grants relief from stay. In addition, any actions taken in violation of
the bankruptcy stay are void (or voidable) as a matter of law. Section
362(d)(3) provides that secured lender with a claim against “single asset
real estate” is entitled to relief from the automatic stay within 90 days of
the filing of a bankruptcy petition, unless within that time the debtor (i)
has filed a plan with a reasonable possibility of being confirmed, or (ii) is
making monthly payments equal to interest on the secured amount of the
lender’s claim, at a fair market interest rate.
3.
Use of cash collateral. Bankruptcy Code Section 363 governs the debtor’s
use of income from the property in which the lender has a perfected
security interest - the lender’s “cash collateral”. The debtor will be
required to obtain court approval to use such funds, and while it is unlikely
that the bankruptcy court will deny the debtor the use of the cash, the
lender will be able to negotiate over the budget, the payments for nonproperty related expenditures, including the debtor’s attorneys fees, and
the financial reporting to be made by the debtor.
4.
Assumption/rejection of contracts and leases. Bankruptcy Code Section
365 gives a debtor the unilateral right to terminate contracts and leases.
This provision gives the debtor leverage to compel the re-negotiation of
these agreements, including management agreements and operator leases.
One significant limitation of Section 365 is if the debtor is the landlord,
rejection of a lease will not terminate the tenant’s right to possession or
corresponding obligation to pay rent. In certain circumstances, however,
Section 365 can be a powerful tool nonetheless, because rejection will be
effective with respect to rights granted a tenant that are not “in or
appurtenant to” the property, which may include various ancillary
provisions in the lease.
5.
Avoidance of Unrecorded Leases. Bankruptcy Code Section 544 gives the
debtor the right to avoid certain “unperfected” interests. This provision
has been used to permit debtors to avoid (and thereby terminate)
commercial leases in which the nondebtor tenant failed to record a notice
of lease.
6.
Preference provisions - Section 547 permits the avoidance of certain
transfers (including creation of security interests) made within 90 days
prior to bankruptcy filing if at the time of transfer the debtor/transferee
was insolvent, the transfer was on account of a prior debt, the
debtor/transferee did not receive new value and the transfer was not
otherwise in the ordinary course of the debtor’s business
7.
Fraudulent Transfers. Section 548 permits the avoidance of certain
transfers made (including the creation of security interests) or obligations
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incurred by a debtor/transferee within 1 year prior to the filing of the
bankruptcy petition if (i) the transfer was made with actual intent to
hinder/delay creditors, or (ii) if at the time of the transfer/incurring
obligation the debtor was insolvent (or rendered insolvent by the
transaction), and the debtor did not receive reasonably equivalent value for
the transfer.
8.
Claims allowance. Bankruptcy Code Sections 502 and 506 govern the
allowance of secured claims, including determinations regarding the
extent to which a lender is secured (i.e., collateral valuation), and whether
a lender will be permitted to include default interest, late fees, yield
maintenance premiums, defeasance premiums and attorneys fees as part of
its secured claim.
9.
Classification of Claims. Section 1122 of the Bankruptcy Code addresses
the classification of claims into “classes” under a plan of reorganization.
This can be an important tactical tool for a debtor to “isolate” hostile
creditors (including the lender), in order to “cram-down” a bankruptcy
plan on such parties.
10.
Control over the filing of a plan of reorganization. Section 1121 of the
Bankruptcy Code grants the debtor the exclusive right to file a bankruptcy
plan during the initial 100 - 120 days after the commencement of a
bankruptcy case. In “single asset real estate” cases, however, if the debtor
does not file a plan within 90 days, the lender may be able to get relief
from the automatic bankruptcy stay. This “exclusive” right to control the
plan process gives the debtor the right to control the “destiny” of the
bankruptcy.
11.
Bankruptcy Plan Disclosure. Section 1125 of the Bankruptcy Code
requires the filing and approval of a disclosure statement, which will
accompany a proposed plan of reorganization when it is sent to parties in
interest. Litigation over the disclosure statement is often the first battle
ground with respect to a contested plan of reorganization, because
objecting parties may seek to prevent a plan from even being sent out for
creditor vote, if the plan is so deficient that it can not be confirmed as a
matter of law.
12.
Plan of reorganization. Section 1129 of the Bankruptcy Code sets forth
the requirements for confirmation of a plan of reorganization. Pursuant to
Section 1129(b), the debtor may propose a plan that in effect unilaterally
rewrites the lender’s mortgage. The term may be extended, the interest
rate reduced, undersecured portions may be “stripped away”, and other
covenants and requirements may be eliminated. The Bankruptcy Code
contains certain protections for creditors who are being “crammed down”
under these provisions, but bankruptcy courts have wide judicial latitude
in this area, which they often exercise in favor of the debtor.
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13.
C.
Dismissal or Conversion of a Bankruptcy. Section 1112 permits a lender
or other party in interest to request the dismissal or conversion of a
Chapter 11 bankruptcy for cause, including continued losses to bankruptcy
estate property and the absence of a reasonable likelihood of
rehabilitation, the debtor’s inability to propose and/or confirm a plan
within a reasonable time period, and substantial delay prejudicial to
creditors. In addition, parties may seek at the outset of a bankruptcy to
have a case dismissed as a “bad faith filing”. While the grounds used by
courts differ, courts will require a showing that the debtor acted in
subjective bad faith in filing the bankruptcy, such as by using bankruptcy
as a litigation tactic rather than to rehabilitate a business, and/or that the
bankruptcy is objectively futile because the debtor will not be able to
accomplish a reorganization.
Select Recent Bankruptcy Cases.
1.
There have been significant case law developments affecting commercial
real estate finance and securitization in the past year.
2.
Attached as Appendix A is a synopsis of several recent bankruptcy cases
in which the courts have addressed, among other issues, the following:
a.
Surcharge of a secured creditor’s collateral
b.
Enforceability of default interest and prepayment charges
c.
Challenges to debtor plans of reorganization
d.
Characterization of CMBS “repo” agreements
e.
Substantive consolidation
f.
Lease rejection and lease avoidance
g.
Bad faith bankruptcy filings
h.
Enforceability of intercreditor agreements
i.
Rights of holders of participation interests
j.
Characterization of sales of assets into securitization
k.
Standing of loan servicers to act on behalf of securitization trust
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APPENDIX A
[Select Recent Bankruptcy Cases Affecting
Commercial Real Estate Finance and Securitization]
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