Hotel operator Extended Stay Inc. and numerous of its affiliates filed for bankruptcy protection in June 2009, the result of a highly leveraged acquisition at the top of the market. This July, the bankruptcy court signed off on Extended Stay's proposed plan of reorganization, allowing the company to be sold for approximately $3.9 billon to a private equity group. The sale price resulted from an auction and was close to the $4.1 billion of CMBS mortgage debt the company had outstanding.

From the outset, the case pitted some of the fundamental tenets of CMBS deals, particularly those embedded in the common pooling and servicing agreement, against the law and rules of the US bankruptcy process. PSAs have constructs of value and agreed-upon methods of decision making that may collide with valuation methodologies and voting concepts under the Bankruptcy Code. And perhaps the largest question looming over any CMBS deal that ends in bankruptcy is how a plan of reorganization might be confirmed.

As background, in CMBS, the mortgage(s) are transferred to a trust. When investors buy CMBS certificates, they are buying interests in the trust and agreeing to the provisions of the PSAs governing the transaction. Among the constructs in those documents is that: a special servicer will be appointed to deal with defaulted loans in order to protect all of the certificate holders pursuant to a market-defined servicing standard, a well-defined waterfall will govern the proceeds received upon foreclosure or other asset resolution, and the certificate holders hold only beneficial interests in a trust, and not underlying mortgages or debt, and thus have no standing as holders of debt to show up in court-whether in foreclosure, bankruptcy or otherwise-to protect their interests. This

is all delegated to the special servicer, who should be the only party able to vote on a bankruptcy plan. Yet, under bankruptcy law, a class of creditors can accept a plan of reorganization if creditors holding at least two- thirds in dollar amount and one- half in number vote in favor of the plan.

The concern in the Extended Stay case from the outset had been how a plan of reorganization could be voted on and confirmed if the CMBS structure impeded voting in a manner consistent with the Bankruptcy Code. Needless to say, the judge was well aware of this risk from the beginning, when several AAA certificate holders showed up in court on Day One to protect what they perceived to be their interests. The judge repeated throughout the case that even though he was permitting certain holders to be represented and speak their views, he would not decide if such parties had the right to vote on a plan of reorganization until the end of the case. Fortunately, the final plan contemplated a cash payment of roughly $3.9 billion to the CMBS certificate holders, paying off around 95% of the mort gage debt at par, permitting the special servicer under the PSA to obtain the necessary approvals to vote in favor of the plan without dissent. But had the final bidding for the company yielded a significantly lower value, or one that would be paid partly in cash and partly in debt or equity, the result likely would have been quite different, and the court would have been faced with the prospect of overriding the voting mechanisms within the PSA in order to move forward on a workable plan of reorganization.

CMBS dodged a bullet in Extended Stay because the bankruptcy judge in the end was not faced with the decision of whether to blow up a PSA in order to effectuate a reorganization or treat certificate holders with no ostensible standing like ordinary creditors before him. If such a result had occurred, it would alter the very nature of buying into a structure where enforcement is delegated to the special servicer. It is unclear how future courts may rule when this issue next arises, so cautious investors should be aware that the next bankruptcy court to handle a complicated CMBS, financed borrower might not respect the CMBS structure, and price their investment accordingly.

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CMBS Market Dodges a Bullet

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