Archive for September, 2010

Enforcing Defaulted CMBS Loans through Receivership Sales: Risks and Rewards under California’s “One Action” Rule

CMBS servicers are talking about a new way to enforce a defaulted CMBS loan (i.e., a commercial real estate loan held by a CMBS trust). Instead of a traditional foreclosure on the collateral, followed by a sale, some suggest:

(1) filing a lawsuit to have a receiver take possession of the mortgaged property; and

(2) arranging for the receiver to market and sell the mortgaged property subject to the loan.

As part of the transaction, the servicer would likely reduce the loan principal and otherwise modify the loan terms to make buying the property subject to the loan attractive to an independent buyer (the “assuming buyer”).  In return, the assuming buyer would provide some amount of “fresh cash” to the servicer and would formally assume the modified loan.  The fresh cash would be used to pay down a portion of the loan; otherwise, the modified loan and the lien against the property would remain in place.

If this whole process seems somewhat complicated, it is.  Why bother?

The answer lies in the special rules that govern what a CMBS servicer can and cannot do to enforce a defaulted loan and realize on the collateral securing it.

Unlike a bank, a CMBS servicer that forecloses on a property cannot provide a new loan to facilitate a sale of the property to a new buyer.  However, the servicer can generally modify the terms of a defaulted loan, and usually the servicer can also permit a loan (whether or not the loan is in default) to be assumed by a buyer of the property securing the loan.  When both techniques are used in a single transaction, the servicer is able to provide the functional equivalent of a “loan to facilitate” made by a bank — financing for the new buyer’s purchase.

Since financing for commercial real estate acquisitions is relatively difficult to arrange in the current market, the ability of the servicer to provide financing for an acquisition expands the universe of prospective buyers.  This can result in a potentially greater recovery (higher net present value) than that which could be obtained by an all-cash sale after a foreclosure.

How much bigger could that recovery be?  A lot.  For example, in a recent Arizona case, a receiver (Trigild’s Bill Hoffman) was able to arrange for several Phoenix-area apartment complexes to be sold subject to the existing loan (on modified terms) for a total purchase price that was 75% greater than the best all-cash offer ($123 million vs. $70 million). For details, look at the article in the Arizona Republic describing this transaction, click here.

In some states, this two-step approach appears to work without any problem.  But in California, the situation is more complicated.  If the current borrower consents to the sale of the property to a new buyer (which it often does in exchange for a complete or partial reduction in the guarantor’s liability under the guaranty), this approach certainly works.  If the current borrower does not consent, however, things get tricky.  To understand why, we must first take a look at California’s one action rule, set forth at California Code of Civil Procedure Section 726(a).

Basically, California’s one action rule provides that generally a lender may bring only one type of “action” (i.e., court proceeding) to recover on its secured loan: a judicial foreclosure.  A lender who violates the one action rule by pursuing another type of action against the borrower (e.g., a suit on the note) runs two risks:

  1. The first risk is that the borrower will assert the one action rule as an affirmative defense in the lender’s action against it.  In that case, the lender will be required to amend its complaint to seek judicial foreclosure rather than monetary damages or some other form of relief.
  2. The second, more serious risk is that the borrower will not assert the one action rule as an affirmative defense in the lender’s action, and the lender will prosecute its other (non-foreclosure) action to judgment.  In that event, the lender will generally lose its real property security (i.e., the lien of its deed of trust will no longer be valid).  This is sometimes referred to as the “sanction aspect” of the one action rule.

Fortunately for lenders, there are various exceptions to California’s one action rule.  One of these exceptions relates to receivers.  Under this exception (the “receivership exception”), codified at California Code of Civil Procedure Section 564(d), an action by a secured lender to appoint a receiver under California’s receivership law is not an “action” for purposes of California’s one action rule.  In addition, Section 568.5 of the California Code of Civil Procedure gives receivers the right to sell property in their possession, provided (1) that the sale is pursuant to a court order; and (2) that the sale is confirmed by the court.

The challenge is that the interaction of the two California statutes is a grey area in the law:  the language of the statutes governing receivers does not expressly state that the receiver has the right to sell mortgaged real property belonging to the original owner to an assuming buyer, while leaving the existing loan and its lien in place.  And while we think it makes both economic and legal sense for a receiver to have this ability, because there are no reported court cases squarely addressing this issue, we cannot say for sure that such a course of action would be upheld in court.

Of course, one of lawyers’ jobs is to counsel clients about their best course of action even when the law is not precisely clear – and how best to minimize the risks of the business decisions our clients make.

If a CMBS servicer wishes to enforce a defaulted loan in California by arranging for a sale of the property through a receivership to an assuming buyer, without the current borrower’s consent, the transaction must be structured to minimize the legal risks.

So what are those primary risks? Simply put, that either (a) the current borrower might make a one action rule challenge to the validity of the transaction or, (b) the assuming buyer might later make a one action rule challenge to the enforceability of the secured loan (and the related lien against the real property). And how can a servicer resolve them?

The gist of any challenge by the current borrower would be that, under the one action rule, a judicial foreclosure is the only action that the servicer may pursue to enforce the loan. To avoid or defend against this possible challenge, the servicer could seek a court order authorizing the receiver’s sale of the property subject to the lender’s lien pursuant to California’s receivership law permitting a receiver to sell property in its possession if a court so orders.  In its motion and proposed order, the servicer would need to ask the court to make a specific finding that such a sale would not violate the one action rule because of the receivership exception to that rule.  If the servicer were to obtain such an order, the current borrower’s rights to attack it would be cut off at the end of the applicable appeal period.  So the risk of a one action rule challenge by the current borrower can be mitigated by obtaining such an order, then waiting until the appeal period for the order has run before actually closing the sale of the property.

The gist of any challenge by the assuming buyer would be that the lender’s action to appoint a receiver to sell the property constituted its only allowed action to enforce the loan and, therefore, the lien of the deed of trust would no longer be valid after the sale.  The assuming buyer could argue that the receivership exception allows the appointment of a receiver for ordinary purposes (such as the preservation of property or the collection of rents), but does not authorize the receiver to sell the property without the original borrower’s consent unless the lender forecloses on the property first.  Bottom line, the assuming buyer could argue that the sale of the property without the original borrower’s consent is, essentially, the “one action” allowed to a lender — which in turn, would mean that the lender’s lien is extinguished by the sale, as if the sale through a receiver were a nonjudicial foreclosure.

It seems unfair to allow the assuming buyer to invalidate the lien in favor of the party that enabled the assuming buyer to acquire the property in the first place, but the risk of a one action rule challenge by the assuming buyer can’t be discounted because (1) there are no published cases squarely addressing this issue, as noted, (2) California courts are notoriously hostile to lenders on one action issues, and (3) the court’s order allowing the receiver to sell the real property would in fact take away the original borrower’s title to the real property, which is the essence of a foreclosure action.  The worst part of this risk is that there may be no time limit on when the assuming buyer must assert the “sanction aspect” of the one action rule.

The best steps that the servicer can take to mitigate the risk of a one action rule challenge by the assuming buyer include the following:

(a) obtaining a court order specifically addressing this issue (as discussed above);

(b) waiting until the appeal period for the court order has run before actually closing the sale-and-assumption transaction (also as discussed above);

(c) in the loan assumption documents, requiring the assuming buyer to acknowledge and confirm the court’s findings related to the one action rule; and

(d) if circumstances permit (i.e., if there would be no loss of lien priority), structuring the loan assumption so that it constitutes both (i) an allowable assumption transaction under the rules governing CMBS mortgage pools (the so-called REMIC regulations) and (ii) a novation (the substitution of a new obligation for an existing one) under California law. That way, the assuming buyer should be cut off from arguing that the lender had already brought an action to enforce the loan because, by law, the modified loan assumed by the buyer would be deemed a new obligation.

While selling a property subject to the loan may provide significantly enhanced recoveries for CMBS trusts and their servicers, this approach is not entirely risk-free in California.  

However, with careful structuring by the servicers and their counsel, these risks often may be reduced to an acceptable level, particularly in light of the improved loan recoveries that such transactions make possible.



September 2010
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Attorney Advertising. This blog is a periodical publication of Maura O'Connor, a partner of Seyfarth Shaw LLP and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. You are urged to consult a lawyer concerning any specific legal questions you may have. The contents are intended for general information purposes only and represent the individual views of Maura O'Connor only. Any tax information or advice contained herein is not intended to be and cannot be used by any taxpayer to avoid tax penalties that may be imposed on the taxpayer.