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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.

 
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Avoiding The Devil’s Triangle (of Bank Failure, part 3)

In the last post, I described the methods used by the FDIC to “resolve” banks.  This post talks about what steps you can take if you are entering into a contract with a bank, and want to minimize your risk of having your deal pulled apart due to the bank’s failure.

Practical Steps to Take if you are Making a Deal with a Bank that may be Failing

Some kinds of deals have a reasonable chance of riding through a bank resolution.  In packaging banks’ assets (including loans) for sale, regulators have discretion to favor and preserve assets they think are essential to the marketplace.  The type of financial institution with which a company deals may matter also, because regulators can, and do, “play favorites” to ensure that their resolutions and bank closings do not excessively disrupt either geographic markets or market segments. In choosing which troubled banks to take over, and how to handle their receiverships and the ongoing deals those banks were involved in, the FDIC tries to keep some credit available to all creditworthy marketplaces.

In documenting deals with a bank to minimize the risks of its failure, even the most careful attorney faces several handicaps.  As discussed in the prior posts in this series, a bank is not likely to be able to provide timely reliable notification of its adverse or declining financial condition.   So, many of the covenants, certificates or defaults typically used in deals by lawyers to create early warnings and remedies if one party is about to fail do not work well with regulated financial institutions.

For this reason, if you are doing business with a bank, you usually will be best protected against receivership risk by economic, rather than contractual,  deal structuring.

To avoid being sucked into the morass of a bank receivership, first try to carefully select which bank you want to do business with, based on the market data you can find about that bank’s financial health.  Large counterparties dealing with financial institutions frequently distribute their risk across banks, using such mundane approaches as syndicated loan commitments, letters of credit with “confirming banks” (additional banks with undertakings to pay), and other risk-diversifying options.

Deal design may also play a role. Once a bank is near or in receivership, it is more likely that your deal with the bank will survive if it is a mutually positive transaction.  A bank receiver who is rejecting “the bad parts” of deals is not as likely to repudiate or sever off a “good deal.”  Together with your lawyers, you should watch for, and consider fixing, deal structures which put all of the bank’s obligations, or those most expensive or risky to the bank, at the end of a long timeline, such as interest rate resets, automatic extensions and certain unsecured credit funding commitments.  If the bank’s obligations and your company’s obligations come due about the same time, or alternate, there’s much less risk to your company.

If your company is entering into a contract with a bank, you need to work with your lawyer to protect your company in light of bank regulators’ power to reform or reject contracts and deals.   If the bank fails, your company’s post-resolution fortunes may be influenced by variables, including:

  •  whether the bank’s failure presents systemic risk to the financial markets,
  • the quality of documentation, and
  • the applicability of some protected classes of transaction.

Proofs of Claim and Creditors’ Evidence Generally

Anyone with rights against a failed bank, such as a debt, an existing lawsuit, or anticipated damages from a contract repudiation by the receiver, must take timely steps to keep the bank’s regulators officially aware of his or her rights.  Bank receiverships include a bankruptcy-like “proof of claim” process.  Failure to comply can result in a claim being rejected no matter what its merits.  So, creditors must be vigilant concerning notices of deadlines for their claims, and should work with counsel familiar with troubled bank workouts.

Another risk arises in the event of incomplete documentation or approvals.   Current receivership law codifies the special authority requirements set by the courts in the case D’Oench, Duhme & Co. v. FDIC.  The D’Oench, Duhme case held that a contract with a bank would not be honored in its later receivership if it is not in writing, signed by the right parties, formally approved by the bank at an appropriate board level, and correctly and continuously reflected in the bank’s official financial records.   When documenting a transaction with a bank, a company and its lawyers should insist that all important aspects of the deal are fully documented and approved by the bank.   Side letters and similar informal devices risk being repudiated by the FDIC.

In addition, the appearance of a deal may matter.   Because the FDIC’s Purchase and Assumption transactions happen at lightning speed, the receiver’s assessment and resolution of the bank’s commitments, or at least its initial sorting of the obligations (into those worth selling to an acquirer and those slated for liquidation), may be done very quickly.   Transactions that on their face appear economically feasible and perhaps are secured by valuable collateral, but in any case are not extraordinarily burdensome, may fare relatively better.

Finally, what ultimately happens to a creditor’s specific claim against a financial institution often depends on the nature and priority of the class of claim:   whether the creditor is a depositor, borrower, trade creditor, landlord or letter of credit holder.   Some of these specifics will be discussed in the next post.

Happy Thanksgiving!

In a tough year like this one, where so many of our friends, colleagues and neighbors are having very difficult times, it’s important to thank each other for the ongoing support and friendship we receive from each other. 

Many thanks to all of you who read and have enjoyed this blog to date.  Your comments (both public and private) have been frequently thought-provoking and always kind, and have made writing this blog a much more fun project than I would have guessed. 

I hope that you and your families and friends have a warm and pleasant Thanksgiving holiday, and a good rest from the worries of the current commercial real estate world, if only for a few days.

Best regards,

Maura

More on Judicial Foreclosures in California

Judicial foreclosure is generally available in California:  it is the “one form” of judicial action allowed by statute for recovery of a debt or enforcement of a right that is secured by a mortgage or deed of trust on real property.   In addition, if the California property is worth less than the loan balance and the lender seeks a judgment against its borrower for the difference (referred to as a “deficiency”) between the unpaid balance of the secured debt (plus certain expenses) and the greater of (a) the amount produced by the sale of the collateral or (b) the fair value of the collateral, the lender must judicially foreclose.  (Note, however, that some sorts of real estate loans cannot be judicially foreclosed, as discussed below.)

No separate action against the borrower to enforce the debt without foreclosing on the real property is allowed for loans secured by California real property.  In fact, California courts will severely penalize a lender for attempting to collect a debt secured by real estate by means other than foreclosure on the real property collateral.  This can be a significant trap for lenders seeking to collect or work out loans.  

In a judicial foreclosure, the secured lender brings an action to have the court (i) determine that the loan is in default, (ii) order that the security (the California real estate) be sold to satisfy the loan balance, (iii) declare that the borrower is liable for any deficiency arising from an insufficient sale price at the foreclosure sale, and (iv) enter a deficiency judgment against the borrower.

While judicial foreclosure allows most lenders to obtain deficiency judgments against their defaulting borrowers (see below, however, for a significant exception), such foreclosures are time-consuming and expensive.  In addition to the delays inherent in any civil proceeding, in California the borrower/judgment debtor or its successor in interest has a significant period of time after the property is sold to “redeem” it (to buy it back for the amount paid at the foreclosure sale), up to three months if the proceeds are sufficient to satisfy the secured indebtedness with interest and the costs of the action and the foreclosure sale, and up to one year if the proceeds are not sufficient.   Obviously this right of redemption makes reselling the recovered collateral difficult, which is one reason the judicial foreclosure procedure is not commonly completed in California. 

In a major exception to the general rule that deficiency judgments are available in judicial foreclosure actions in California, a deficiency judgment may not be pursued after a judicial foreclosure of a “purchase money” loan, which is defined as either (1) a loan to borrower from the seller of the real property securing payment of the balance of the purchase price of that real property, or (2) a loan given by any lender to a borrower used to pay all or part of the purchase price of a dwelling for not more than four families occupied entirely or in part by the borrower.

Under recently enacted legislation, certain additional requirements apply to foreclosures involving California residential real property.

Judicial foreclosure proceedings almost always take longer than nonjudicial trustee’s sales.  The timetable for notice in a judicial foreclosure depends on whether a deficiency judgment is available.  If a deficiency judgment has been waived or is prohibited, the notice of levy must be served at least 120 days before the notice of sale.   After the 120-day period has run, the levying officer gives an additional 20 days’ notice of sale.   Thus, when a deficiency judgment is not available, the borrower is entitled to 140 days’ notice before the foreclosure sale.  When a deficiency judgment is available, the notice of sale may be recorded and served with the writ of sale immediately on the entry of the foreclosure judgment.   

As with nonjudicial foreclosures, these timetables can be significantly delayed if the borrower files for bankruptcy protection, triggering the automatic stay to preclude foreclosure, or if the borrower brings an action challenging a judicial foreclosure.

More on nonjudicial foreclosures and related topics in later posts.

Workouts 101, Part 3: More Points of Borrowers’ Leverage

Continuing from last week, here are more points of potential leverage for borrowers facing potential workouts or foreclosures.  A borrower should figure out its position and points of leverage before proposing a workout to its lender.

Review the loan documents (including guaranties and correspondence)Or have new counsel do so.  It’s a good idea to bring in new counsel to look at the deal documents, because new counsel will bring in fresh eyes, and will be able to see what’s actually written in the loan documents, rather than what counsel that did the original deal thinkswas done.  (It’s simply human instinct to see what one thinks is there.)  Obviously the new counsel should be experienced in real estate workouts in the state where the property is located, as there are lots of subtle legal issues that are state-specific in this area.  (See my response to Selina Parelskin’s letter on the first week’s post for some of the California issues and a war story — the names have been omitted to protect the guilty.  In the current market, we’re unfortunately seeing a lot of real estate and other transactional lawyers — even former municipal law lawyers — reinventing themselves as workouts lawyers.  While it is certainly possible to learn a new area, in many states including California, the law about how to enforce loans secured by real estate is technically very complex and quite difficult, and we’re  frequently dismayed by the low caliber of advice given by some lawyers to their borrower or lender clients in this arena — it is very common to see basic issues simply missed altogether.)

It is not uncommon for loan documents to contain flaws that could affect their enforceability — or could at least give the borrower some leverage in a workout.   About 1 out of every 2 or 3 deals we see has had at least one major documentation problem that could be used by a borrower to increase its leverage.  For example, a few problems I’ve seen over and over in 20 years of practice are the failure to attach the proper legal description; inadequate or ineffective guaranty waivers (there’s one of 3 needed waivers that is frequently missed in California); and incorrect UCC filings (very important in loans secured by certain asset types:  you can’t run a hotel after foreclosure without its beds, furniture, etc.).

Also, sometimes correspondence with the lender will disclose that the lender agreed to do certain things, and has not done so; this can provide leverage to the borrower.

Basically, a business and legal review of the property and the loan documents should be done to fix any potential defaults or similar problems the borrower can fix (such as a failure to deliver required information that could trigger a default) and to develop leverage.  That allows the borrower to make a proposal reflecting a practical solution to the problems facing the property that is likely to be accepted by the lender. 

Maintenance and waste.  Early in a workout, a key issue for borrower/owners will be to make sure that the property is not wasting (generally having its value significantly diminished by lack of care).  

Specifically, borrowers should assess and confirm that the condition of the property doesn’t deteriorate to where it triggers covenant breaches that make it more likely the lender will foreclose rather than doing a workout. 

Also, it’s fairly common for “non-recourse” loans to have a carve-out, reimposing personal liability, for some grave defaults often including significant waste.  In such cases, it’s in the borrower’s  interest not to risk personal liability by letting the improvements start to fall apart. 

 Insurance coverages.  Financed owners should check their casualty and liability insurance coverage for the property, to confirm that adequate coverage is in place; premiums are paid;  and all needed policies are up to date, in force, and sufficient to satisfy any loan covenants about mandatory minimum coverage.   

 Other areas of personal or pass-through liability.  Another set of issues, where the borrower should analyze the situation and try to get ahead of the game, is any other loan document clauses that give the lender direct right against assets beyond the property itself … like the borrower’s principal (if the borrower is a corporation, LLC or other entity) or any guarantors.   

 At the outset of a possible workout, a borrower should carefully check whether:

  • There is an unfulfilled capital contribution obligation, a possibility of future mandatory capital calls.
  • There is an argument that the property’s ownership vehicle is undercapitalized and can be ignored (sometimes called “veil-piercing”), and liabilities passed through to the next level of ownership.
  • There is personal liability for real estate taxes.
  • There is a guaranty (or arrangement that amounts to a guaranty) that can be called.
  • The legal fees incurred by one party in a default or workout must be reimbursed by, or can be demanded from, the other side.
  • If an investor and developer are in partnership (or similar arrangement), what further calls or liability can be placed on the investor.
  • Officers, directors or partners have personal liability for actions taken or not taken … and whether there is directors and officers insurance in place to address those risks.
  • What exactly has been granted as collateral for the loan?  There may be omissions that the lender will wish to see corrected.  A borrower can sometimes agree to correct such omissions in order to negotiate for concessions it needs to work out the loan and return the project to profitability.

Only a thorough legal review up front by experienced local real estate workouts counsel will give the borrower the understanding of its situation and potential liability that will allow it to do a thorough business review and to then understand what the best possible outcome is — and negotiate a workout that moves as much in that direction as possible under the circumstances.

More on workouts from the lender side to follow, and a new thread shortly.  If you have ideas for topics to be addressed, questions, concerns, agreement/disagreement or other comments, just let me know.


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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.