Of CounselSpecial Servicers' Changing Roles Make Impact
On Distressed Asset Buyers
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Over the past couple of years there have been some new developments in the CMBS special servicing world that have had significant impact on the availability and disposition timing of distressed loans and properties. Some CMBS participants view the acquisition of CMBS special servicers by active third party real estate players as creating conflicts of interest in the exercise of fair value option rights and the retention of outside service providers. Further, the adverse effect of the economic downturn on the performance of commercial real estate along with resulting tranche warfare has resulted in increased litigation directly affecting distressed asset sales.
CMBS servicers are, of course, required to adhere to a servicing standard, typically stated as “a duty to the bondholders as a whole with a view to maximization of return on a net present value basis.” The standard is deliberately vague (i.e. it’s not formulaic) in order to provide servicers with maximum flexibility inside of REMIC vehicles subject to restrictive tax code rules and regulations. But the standard has become the subject of much questioning by investors as servicers struggle with balancing the best approach for the bondholders as a whole with the demands of subordinate creditors and their own ties with parent and affiliated companies.
Within the past two years, a number of major CMBS special servicers (C-III, LNR, CW Capital and Berkadia) have undergone changes which have resulted in their ownership by one or more noteworthy commercial real estate firms. Some of those firms are active real estate owners and operators and also have affiliated companies which perform property management, brokerage, financing and construction services. Some parent firms have also publicly stated their desire to acquire distressed properties through the exercise of the “fair value option” rights granted to special servicers and controlling certificate holders in CMBS 1.0 transactions. Investors in CMBS have expressed a great deal of concern over the exercise of these rights and the use of affiliated service companies citing the potential for conflicts of interest which could lead to actions prejudicing the interests of CMBS bondholders and have begun to take action to challenge special servicer actions.
Bondholders and subordinate B-note and mezzanine lenders have also disputed servicer actions in the resolution of defaulted loans. In some cases, B-note and mezzanine lenders have undertaken litigation to dispute property valuations which extinguish any rights to repayment which they may have. More recently, there have been several actions commenced where CMBS investors have sought to enjoin servicer action in an attempt to preserve rights as controlling certificate holders.
At this point in the real estate cycle it is unclear whether the existence of conflicts of interest in CMBS loan resolution will result in a complete overhaul of the process. Regardless of future changes, however, the servicing standard and bondholder rights are established for CMBS trusts already in existence and, in the absence of a complete miracle, it is unlikely that all interested parties can agree on a modification of the pooling and servicing agreements governing these pools.
One thing that can be certain, however, is the unfavorable effect disputes over conflicts of interest will have on the availability of product for those interested in acquiring specially serviced assets. As special servicers take note of the grievances of bondholders and justifiably become concerned over criticism and possible litigation which might come their way, the loan resolution process will likely be slowed. The servicers will take all necessary steps to justify their actions in an attempt to protect themselves from claims which may not be covered by the trust indemnification provisions. And most certainly, if litigation is commenced before completion of a transaction, loan and REO purchasers will find themselves slowed or even barred from completion of contemplated transactions after they have already expended significant funds for due diligence, legal and associated transaction fees.
Distressed asset purchasers would be wise to take these concerns into account as they evaluate asset acquisitions. The possibility of delay or involvement in litigation could have a serious effect on the value of an asset. In contemplating an asset purchase, the distressed asset investor may be wise to give added consideration to pricing, timeliness and certainty of execution, breakup fees and coverage of legal costs. In the past, such considerations may have resulted in the loss of a deal to another bidder, but in today’s world it might just be that “buyer beware” is the best advice to follow.
John D’Amico is Hartford, CT-based of counsel at Updike, Kelly & Spellacy PC, and a member of the firm’s corporate department. He may be reached at jdamico@uks.com. The views expressed here are the author’s own.
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WASHINGTON, DC-A forthcoming report from Delta Associates shows that distressed commercial real estate in the United States totaled $166.9 billion in January 2012, down $4.7 billion since October 2011.
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