Working Out Mortgage Loans and B Notes
Presented by: Richard D. Jones
Dechert LLP
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ACREL
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I.Common Split Mortgage Loan and Subordinate Debt Structures...... 1
A.Whole Mortgage Loan...... 1
B.Split Mortgage Loan...... 1
C.Pari-Passu Loan Structure...... 1
D.A/B Loan Structure...... 2
E.Variations of the A/B Loan Structure...... 2
F.Economic Terms of A/B Loan Structure...... 2
G.Allocation of Payments in the A/B Loan Structure...... 2
H.Participated Mortgage Loan...... 3
I.Comparison of A/B Loan Structure to a Senior / Subordinate Participated Loan Structure 4
J.Other Types of Split Loan Structures...... 4
K.Second Mortgage Loan...... 4
L.Mezzanine Loan...... 5
M.Comparison of A/B Loan Structure to Mezzanine Loan Structure...... 5
II.Brief Overview of Some of the Provisions in a CMBS Pooling and Servicing Agreement Relevant to Workouts of Mortgage Loans - A Typical CMBS Transaction with a B Note 7
A.Key Parties to CMBS Transactions and Their Roles...... 7
B.The Servicing Standard...... 9
C.Servicer Advancing...... 10
D.Special Servicing of a Mortgage Loan...... 12
III.Typical Rights of a B Note Holder Under an Intercreditor Agreement...... 14
A.Generally...... 14
B.B Note Holder Cure Rights upon Borrower Default...... 14
C.B Note Holder Purchase Option...... 14
D.Servicing an A/B Loan...... 15
E.Control Appraisal Event...... 17
F.Transfers of the B Note...... 17
IV.Practical Advice for Dealing with a Defaulted Mortgage Loan at the Initial Stages...18
A.Investor’s first steps when a mortgage loan default has occurred or is about to occur 18
B.Relevant documents...... 19
C.The “Controlling Holder” or “Controlling Party”...... 19
D.The true nature of the default...... 20
E.Parties that must be informed of the default...... 20
F.Delivery of the formal notice of default to borrower...... 20
G.Replacing special servicer...... 21
H.Short term rights an investor should consider (Cures)...... 21
I.Short term rights the investor should consider (Purchase Options)...... 22
J.Consider whether the servicer or the controlling party should require a “pre-negotiation” or “pre-workout” letter from the borrower? 23
K.Initial strategy options an investor needs to consider...... 23
V.Effects of Securitization on the Process of Formulating a Workout Strategy...... 25
A.Certain parties will be communicating with the borrower during the workout..25
B.Subordinate Interest Holder’s Influence Over Workout Strategy...... 25
C.Factors that Delay Formulation of a Workout Strategy...... 26
D.Potential Conflicts of Interest inherent in the Workout Process...... 26
VI.How Does the Securitization Affect Certain Workout Strategies...... 27
A.Extending the Maturity Date...... 27
B.Additional Funding for the Borrower...... 28
C.Loan Assumptions...... 28
D.Incurring Additional Debt...... 28
E.Addition or Substitution of Collateral...... 28
F.Debt Forgiveness...... 29
G.Selling the Defaulted Loan...... 29
1
I.Common Split Mortgage Loan and Subordinate Debt Structures
A.Whole Mortgage Loan (See “Exhibit A”)
1.A mortgage loan is a loan from a lender to a borrower, the repayment of which is secured by a lien on the borrower’s interest in real property
2.A “whole” mortgage loan is a mortgage loan which is evidenced by a single promissory note and which has not been otherwise “split” into different lender interests
B.Split Mortgage Loan
1.A “split” mortgage loan is a mortgage loan which either is evidenced by more than one promissory note or which has been otherwise “split” into different lender interests
2.The most common types of split mortgage loans:
a.Pari passu loans
b.A/B loans
c.Non-CMBS syndicated loans
C.Pari Passu Loan Structure (See “Exhibit B”)
1.A “pari passu” loan structure is a mortgage loan structure where the mortgage loan is evidenced by two (or more) separate promissory notes, each executed by the borrower and secured by the same collateral
2.It is sometimes referred to as an “A/A” loan structure
3.Primary elements of the pari passu loan structure:
a.Evidenced by more than one promissory note
b.Payments on the notes are made pro rata and pari passu to the A-1 and A-2 Note holders
c.Losses are borne pro rata and pari passu by the A-1 and A-2 Note holders
d.Each pari passu A Note can be sold into a separate securitization
e.The pari passu loan structure is similar to the typical “syndicated loan” structure, but the rights given to the holders of the notes in a CMBS pari passu loan are typically different from those in a syndicated loan
f.Control over the servicing of the whole loan (all of the pari passu notes) typically resides in the master servicer and special servicer for the first pari passu note securitization
g.Advancing may be handled in a variety of ways
D.A/B Loan Structure (See “Exhibit C”)
1.Primary elements of the A/B loan structure:
a.An A/B loan is a mortgage loan evidenced by two separate promissory notes, each executed by the borrower, and each secured by the same collateral
b.The A Note is generally senior to the B Note in rights to payment of principal and interest
E.Variations of the A/B Loan Structure
1.A-1/A-2/B – pari passu senior notes and one or more subordinate notes
2.A/B/C – multiple subordinate notes
3.A/B with mezzanine – one or more subordinate notes, with additional structurally subordinate mezzanine loans made to the parent or parents of the mortgage borrower
F.Economic Terms of A/B Loan Structure
1.The A and B Notes have a senior / subordinate payment structure
2.The A Note holder is paid interest and principal first
3.The B Note holder is paid interest and principal second
4.Other:
a.the B Note serves as “credit support” for the A Note
b.In light of the B Note’s subordination and higher risk, the yield on the B Note is typically higher than the yield on the A Note
G.Allocation of Payments in the A/B Loan Structure
1.The priority of payments between the A Note and the B Note is referred to as the “waterfall”:
a.Lender / servicer expenses are always paid first, including reimbursement of advances, costs and expenses, as well as servicing fees
b.“Pre-Event of Default Waterfall”: The A Note receives interest and scheduled principal, and then the B Note receives interest and scheduled principal (See “Exhibit D”)
c.“Post-Event of Default Waterfall”: The A Note holder receives interest and principal first, until the A Note is paid in full, prior to the B Note receiving any payments (See “Exhibit E”)
2.Triggers that change the waterfall payments from “Pre-Event of Default Waterfall” to “Post-Event of Default Waterfall”:
a.Any monetary event of default under the loan documents
b.Material non-monetary events of default under the loan documents
3.When an event of a default exists under the mortgage loan, workout effects of payments to the A Note and B Note holders:
a.All payments to the A Note holder are made as though no workout occurred
b.If the principal balance, interest rate or scheduled payments on the mortgage loan are reduced, or any other material modifications are made to the mortgage loan, the full economic effect of the modifications are borne by the B Note holder (up to its then-remaining principal balance)
c.Only after the B Note has been wiped out is the A Note affected by any workout
H.Participated Mortgage Loan (See “Exhibit F”)
1.Primary elements of a Participated Mortgage Loan
a.A participation is not a direct loan to a borrower; thus a participant is not a creditor of the borrower
b.A participation is an undivided interest in a single loan
c.A participation interest is a contractual interest in a mortgage loan created pursuant to a participation agreement between the participants
d.Participations are not evidenced by promissory notes
e.Participations may be senior / subordinate or pari passu
2.Purpose of the Participated Mortgage Loan Structure
a.Allows lender to split the mortgage loan without creating a separate promissory note
b.Because the issues and structural elements of an A/B loan and the senior / subordinate participation structure are similar, for ease of reference, “B Note” in this presentation is intended to refer both to subordinate notes in an A/B loan and to subordinate participations in a senior / subordinate participation structure
I.Comparison of A/B Loan Structure to a Senior / Subordinate Participated Loan Structure
1.An A/B mortgage loan is a loan evidenced by two separate promissory notes, each executed by the borrower, and each secured by the same collateral
2.A subordinate participation is a contractual interest in a loan made by the original lender. Only the lender has privity with the borrower
3.In a senior / subordinate participation structure, the subordinate participant is not a creditor of the borrower because there is no contractual relationship between the subordinate participant and the borrower. Instead, the subordinate participant is a creditor of the senior participant
4.In the A/B loan structure, the B Note holder is a creditor of the borrower because the borrower has executed a promissory note in favor of the B Note holder
J.Other Types of Split Loan Structures
1.First and Second Mortgage Loans
2.Mortgage / Mezzanine Loan Structure
K.Second Mortgage Loan (See “Exhibit G”)
1.Primary Elements of Second Mortgage Loan
a.The first mortgage lender has a first mortgage and a first lien on the real estate and the second mortgage lender has a second mortgage and a second lien on the real estate
b.Second mortgage lender has a separate note and a separate mortgage on the real estate from the same borrower
c.The second mortgage lender has a mortgage on the real estate which is subordinate to the first mortgage
d.The lien of the second mortgage on the real estate is wiped out by a foreclosure of the first mortgage
e.The second mortgage lender has limited or no rights to participate in the workout of the first mortgage
L.Mezzanine Loan (See “Exhibit H”)
1.Primary elements of a Mezzanine Loan
a.The mortgage lender has a mortgage and a first lien on the real estate
b.The mezzanine lender does not have a mortgage or a lien on the real estate
c.The mezzanine lender does not lend to the mortgage borrower
d.The mezzanine lender has a pledge of equity
e.If the mortgage is foreclosed, the mezzanine lender’s equity pledge will be worthless (because the mortgage borrower will own nothing)
M.Comparison of A/B Loan Structure to Mezzanine Loan Structure
1.Legal Structure / Collateral
a.An A/B loan is a mortgage loan (composed, in part, of A Note and B Note) made by the mortgage lender to the mortgage borrower, secured by a lien on real estate
b.A mezzanine loan is a loan made by mezzanine lender to the mezzanine borrower (parent of the mortgage borrower), secured by a pledge of the equity interests in the mortgage borrower
2.Servicing
a.The B Note is serviced by the master and special servicer of the A Note, subject to certain consent and consultation rights held by the B Note holder or an “operating advisor” acting on behalf of the B Note holder
b.The mezzanine lender services its own loan, independently of the servicing of the mortgage loan
3.Control Rights
a.The B Note holder has little or no control over its investment, with the exception of certain specific consent and consultation rights over specific servicing matters
b.The B Note holder often has the right to appoint the special servicer
c.The mezzanine lender has sole control over its mezzanine loan servicing, subject to specified restrictions set forth in the mezzanine intercreditor agreement
4.Cure Rights and Purchase Options
a.B Note holders and mezzanine lenders typically have various cure rights and options to purchase the A Note or the mortgage loan (as applicable)
5.Exercising Remedies
a.The B Note holder assigns its right to foreclose upon the mortgage to the A Note holder, which exercises remedies on behalf of both the A Note and B Note holders. The mezzanine lender, however, can foreclose upon the equity pledge (subject to certain conditions and restrictions)
b.Unlike an A Note, which is always cross-defaulted with the B Note (i.e., a default under the B Note constitutes a default under the A Note (and vice versa)), a mortgage loan generally is not cross-defaulted with the mezzanine loan (i.e., a default under the mezzanine loan does not, in and of itself, constitute a default under the mortgage loan). The mezzanine loan, however, is cross-defaulted with the mortgage loan (i.e., a default under the mortgage loan automatically constitutes a default under the mezzanine loan)
6.Transfers
a.B Note holders’ and mezzanine lenders’ rights to transfer their interests are generally the same. Either the proposed transferee must be a “Qualified Transferee” or rating agency confirmation must be obtained
II.Brief Overview of Some of the Provisions in a CMBS Pooling and Servicing Agreement Relevant to Workouts of Mortgage Loans - A Typical CMBS Transaction with a B Note (See “Exhibit I”)
A.Key Parties to CMBS Transactions and Their Roles
1.Loan Originator / Loan Seller
a.Originates or acquires mortgage loans for sale into securitization
b.May create pari passu or senior / subordinate notes or participations in the mortgage loans prior to sale into a CMBS transaction
c.Generally has a limited role following sale of the mortgage loans into securitization (although it may retain a servicing role in CMBS transaction or be required to repurchase a mortgage loan it sold into the CMBS transaction for a material breach of representation or material document defect)
2.Depositor
a.Purchases mortgage loans which will be included in the CMBS transaction, and deposits those mortgage loans into the trust formed pursuant to the documentation governing the CMBS transaction
3.Trustee
a.Holds “legal title” to the each mortgage loan sold into a CMBS transaction
b.Administers the CMBS trust and performs certain fiduciary duties for the certificateholders
c.Acts as paying agent in respect of payments to be made to certificateholders
d.Acts as “back-up liquidity advancer” in respect of the senior portion of the mortgage loans included in the CMBS transaction
4.Master Servicer
a.Generally responsible for day-to-day administration of each mortgage loan, including any subordinate interests in such mortgage loan (e.g., making collections, processing certain routine requests of the related borrowers)
b.Makes liquidity advances of unpaid principal and interest in respect of each whole mortgage loan and each senior portion of a mortgage loan or portion thereof included in the CMBS trust
c.Makes property protective advances in respect of each mortgage loan
d.Required to meet certain eligibility requirements (e.g., must be on rating agency approved lists)
5.Special Servicer
a.Generally responsible for administering and servicing defaulted mortgage loans (including any related notes or participation interests held outside the CMBS trust) and implementing workouts, foreclosures or other default resolution strategies (including any related notes or participation interests held outside the CMBS trust)
b.Primary party interfacing with the borrower in respect of workouts and foreclosure
c.Required to meet certain eligibility requirements (e.g., must be on rating agency approved lists)
6.Controlling Certificateholder
a.Generally the most subordinate class of CMBS certificates that has not experienced realized losses in excess of 75% of the original principal balance of such class
b.If there is no B Note holder or subordinate participation holder related to a particular mortgage loan included in the CMBS trust, or if such subordinate holder is no longer in the control position, the controlling certificateholder typically has the right to:
i.Replace the special servicer
ii.Approve (subject to being overridden by the special servicer where the Servicing Standard would require the special servicer to take a different course of action) most major servicing decisions related to workouts of the related mortgage loan and other default resolution strategies proposed by the special servicer
B.The Servicing Standard
1.standards the master servicer and special servicer must apply in performing their servicing and workout
2.the same standard that the master servicer or special servicer uses to service its own loans and assets, or those of a third party, whichever is higher
a.With a view to the timely collection of all mortgage loan payments
b.In respect of defaulted mortgage loans, with a view to the maximization of “net present value” of such mortgage loan
3.Each of the master servicer and special servicer must act in good faith and use reasonable judgment in accordance with:
a.applicable law
b.the terms of the pooling and servicing agreement
c.the terms of the mortgage loan documents, and
d.the “Servicing Standard”
4.The master servicer and special servicer must disregard certain conflicts of interest in applying the Servicing Standard:
a.Any relationship with the borrower
b.The ownership by such servicer of any related CMBS certificates, any related note or participation interest, or any related mezzanine debt
c.The obligation to make advances
d.The rights of such servicer to be paid any servicing fee or servicing compensation
e.The ownership or servicing of any other loans or properties outside of the pool
5.The master servicer and special servicer must take certain interests into account under the Servicing Standard:
a.The master servicer and special servicer must service and administer mortgage loans and the portions thereof held outside of the CMBS trust (including any B Note or subordinate participation interest) for the benefit of each of the holders as a collective whole
b.The master servicer and special servicer typically do not service any mezzanine loans related to any mortgage loan included in the CMBS trust
6.The general relevance of the Servicing Standard to a workout:
a.The special servicer must abide by the Servicing Standard in formulating and taking action in respect of workout strategies for any mortgage loans included in the CMBS trust and any note or participation interest related to such mortgage loan which is held outside the CMBS trust
b.Actions proposed to be taken in respect of a workout or disposition of a defaulted mortgage loan by a party with control rights, such as the controlling certificateholder or the holder of any note or participation interest related to such mortgage loan which is held outside the CMBS trust, will be subject to override by the special servicer in accordance with the Servicing Standard
C.Servicer Advancing
1.There are two types of advances that master servicers are generally required to make:
a.“P&I Advances”
b.“Servicing Advances”
2.“P&I Advance”
a.An advance of delinquent payments of principal and interest due in respect of each mortgage loan or portion thereof included in the CMBS trust
b.In the event of a maturity default of a mortgage loan, P&I Advances will be the debt service payments that would have been payable by the related borrower had the mortgage loan not matured