FEATURE ARTICLE, APRIL 2004

PREPARING FOR COMPLEX FINANCING
Complex ownership structures add to uncertainty with troubled or defaulted loans.
Steven Blonder

Not that long ago, a real estate purchaser or developer would enter the local bank with his longtime lawyer, visit with the local banker and, after a conversation or two, would walk out with a commitment to fund a project. At the closing, documents would be signed, money would be exchanged, and someone would saunter over to the local recording office to record the necessary documents. Sounds simple.

Real estate deals, for the most part, no longer come together in this fashion. Whether residential or commercial, even local real estate deals now involve multinational financing sources often requiring complex financing structures with seemingly endless underwriting or due diligence processes. Cross-collateralizations and escrows are the norm. Ownership is now held by real estate investment trusts (REITs) and other investment vehicles, while the loans themselves are bundled, securitized and sold on the public market.

As real estate activity continues, the increasing certainty assumed to be assured by the lengthy deal documents effectuating particular transactions merely masks the increased uncertainty resulting from the new ownership forms and financing structures. From the perspective of a lender or a borrower, the underwriting process is a springboard for a host of other issues that may not come to light until years after the consummation of a transaction. These new structures have added to the uncertainty in dealing with troubled or defaulted loans, as exemplified by several recent court cases.

One recent case, litigated in Michigan, illustrates how even the most thorough planning and complicated structuring can be undone by a seemingly ministerial act. In this case, a buyer had purchased property on a non-recourse basis after putting down 3 percent cash. The remainder of the purchase price was financed via a conventional mortgage. Approximately 40 days after the closing, the title company recorded the deed and mortgage as consecutive documents at the local recorder’s office. Thirty days after that, the borrower declared bankruptcy. The lender had securitized the loan as part of a larger transaction and was facing a repurchase request from the agent.

The bankruptcy estate had few assets other than the property with which to satisfy the creditors. The bankruptcy trustee initiated litigation to void the mortgage as a preference, thus reducing the secured mortgagor to an unsecured creditor and creating assets to satisfy all of the creditors on a pro rata basis. The bankruptcy trustee’s claim was that, although the mortgage and deed were recorded in accordance with state law, the two were not recorded within the 10-day time period prescribed by the Bankruptcy Code (during which time a creditor can perfect a lien granted during the 90-day preference period).

The counterargument stemmed from the concurrent recording of the deed and the mortgage. Even though the borrower took possession at the closing, the borrower only obtained an equitable interest in the property at that point. When the deed and mortgage were recorded, the actual transfer took place under state law and the parties substituted their equitable interests for legal interests. As such, the entire transaction was a contemporaneous exchange for new value. The important fact is that the mortgage could not be invalidated as a preference. The other part of the argument centered on the policy considerations of an adverse ruling.

An informal survey of real estate brokers, developers and owners showed that most believe that the lender in this situation was in the right, particularly in light of the delays plaguing local recording offices due to continued development activity and a large number of refinancing transactions. However, most courts that have addressed these issues have sided with the bankruptcy trustees and have voided purchase mortgages and refinancing transactions as preferences. This Michigan court, however, took a contrarian view by ruling in favor of the lender and recognizing the importance of encouraging lending transactions.

The scenario played out in the Michigan court case is not unique. Rather it merely demonstrates how, in a world of increasingly detailed financing agreements and complicated ownership structures and financing vehicles, uncertainty remains in the process. The ramifications of a single oversight can affect interlocking structures thousands of miles away.

Another example of this uncertainty recently played out in an Oregon courtroom where a bankruptcy filing had an impact on certain commercial mortgage backed securities (CMBS) debt in unforeseen ways and brought certain issues to the forefromt. The case involved a single management company operating 27 hotels under a single brand. The controlling owner of the franchise and management company owned a number of hotels, including holding a majority interest in the 27 hotels at issue. The hotels experienced operating challenges, which were exacerbated by the events of September 11, 2001. Subsequent to the World Trade Center bombing in 1993, although the borrowers negotiated various forbearance arrangements with the non-CMBS lenders, all of the non-CMBS loans were driven into bankruptcy. The controlling owner, the management company, the franchisor and the other hotels did not enter bankruptcy.

The 27 loans, each for a special-purpose entity, were allocated among three pools that each contained other loans as well. The loans had cross-collateralization and cross-default provisions within the separate pools, a fairly common feature. At least one pool expressly permitted the release of the primary debtor from the loan in conjunction with the sale of property to a buyer who would assume any outstanding debt. The properties were managed by a management company affiliated with the borrower. Although the hotel revenues were pledged to the lender, these revenues could be used for operating costs only so long as the existing management company managed the property. The dominoes were in place for a fall.

One potential pitfall arose from the interplay between the servicer for the CMBS pool holding the 27 mortgages and the post-default special servicer of that same CMBS pool. Prior to the bankruptcy filing, the servicer refused to consent to a workout or forbearance, claiming that it needed the consent of the special servicer. The special servicer refused to involve itself in a loan not in default because no servicing transfer event had occurred. Accordingly, the borrower had to trigger a technical default by making a late payment in order to involve the special servicer in the process. The special servicer, however, viewed itself as merely able to release the first lien rather than being able to effect the cross-collateralization lien. The special servicer also refused to make concessions prior to any actual default and, after actual default, it commenced steps toward foreclosure and receivership with an ultimate goal of liquidating the properties.

Once the bankruptcy was filed, the following events occurred:

• the management affiliate was allowed to use hotel revenues for continuing hotel operations, with excess funds being applied to reserves and capital projects — holders of the various CMBS tranches lost out;

• the special servicer initiated litigation claiming mismanagement and commercial defamation — holders of the various CMBS tranches funded more lawyers;

• the special servicer claimed that the borrower had guaranteed the entire debt via a “bad acts” guarantee — the borrower was cornered; but

• hotel management kept vendors current, employees paid, the hotels operating, the traditional lenders happy and the CMBS investors holding the bag.

Although the lessons from this case are many, a few bear special attention. First, the special purpose entities — the ownership structures — provided no effective defenses in the bankruptcy. The fact that employee relationships or vendor contracts are directed to an affiliate may be of little practical effect under the bankruptcy code. Also, the cross-collateralization requirements directly undercut all of the intended separation of entities and risks.

Second, it is fair to question whether the inherent conflicts of interest in the CMBS servicing structure led to this bankruptcy. Put another way, it is fairly well documented that the rate of loan default reported for CMBS pools is higher than a comparable pool of institutional loan pools. In all likelihood, the higher default rate stems from the CMBS structure and the servicers. In this case, the ultimate performance of the non-CMBS loans — after a negotiated forbearance — provides further evidence that the CMBS structure is at fault.

Third, the post-default special servicer’s powers were at issue. On what issues were the various note holders entitled to speak or to vote? What were the restrictions on the special servicer’s powers? Although the special servicer may claim authority, the intersection of a typical servicing agreement and the bankruptcy code leads only to confusion and differing answers.

In both of these examples, the parties thought that they had properly considered all likely ramifications. But each case exemplifies that any comfort to be derived from these increasingly complex financing and ownership structures is just illusory. The only certainty is the increasing uncertainty that these “advances” have in dealing with troubled loans.

With billions of dollars of commercial real estate mortgages having been bundled and securitized, watch for these and other problems to crop up during the next decade. Borrowers need to be prepared with a strategy years in advance of the next economic downturn. Particular areas to watch carefully in the future include the grant of power to and restrictions of power on a CMBS servicer, the structuring constraints on a borrower’s ability to work out a troubled loan and the harsh consequences of a ministerial act.

Steven Blonder is a partner in the law firm of Chicago-based Much Shelist Freed Denenberg Ament & Rubenstein.

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