Hope for Hotels, Malls and Other CMBS Borrowers
March 15th 2020. The City of Boston closed bars and restaurants in South Boston section of the city. Disney is closed. Colleges have sent students home. Airlines are flying near empty planes. Cruise ships are empty. New York Governor Cuomo created a one mile quarantine “containment zone” in New Rochelle. We are in the midst of spring break and one Orlando hotel owner told us his hotel was at 11% occupancy (and that was one day before Disneyworld shutdown.)
All of these events are directly tied to coronavirus.
While the outbreak will eventually be brought under control, the financial health of hotels and malls may not recover as quickly. Even those properties that can make their debt service are most likely out of compliance with their non-monetary loan covenants.
As many borrowers are about to find out, dealing with a special servicer is neither easy nor pleasant. Before everyone reading this post gets too depressed, there is hope. First, a brief discussion of CMBS loans. (If you have a conventional loan, keep reading as much of this applies to you too.)
In a traditional lending relationship, the borrower goes to a bank and borrows money. The bank holds the note. Should problems later arise, there is already a relationship between the parties and both the bank and the borrower have an incentive to quickly fix the problem. Banks don’t want bad loans on their books.
None of this applies to CMBS loans.
CMBS is short for Commercial Mortgage Backed Securities. Today, many lenders package and sell commercial loans as soon as they are written. They make their money from the sale of the loan and not from charging interest over a fixed period of years. Once the loan is sold, the bank is no longer involved in the transaction.
The loan is sold to a trust. That trust typically holds dozens or hundreds of notes. The trust itself is merely a legal fiction. It has no office, no employees. It is “owned” by a series of bondholders; typically, institutional investors.
Day to day operation of the trust is performed by a master servicer. Banks such as Wells Fargo usually perform these functions for a small monthly fee. Under the documents controlling the trust - typically called a “Pooling and Servicing Agreement” - the master servicer has extremely limited duties. It collects the monthly debt service payment, makes sure the taxes and insurance are paid and reviews any required financial documentation from the borrower.
Important for this discussion is that the master servicer has NO discretion to alter any terms of the loan. Literally a day late or a dollar short means the loan is sent to special servicing. The same happens if your financials put you “out of covenant.” It doesn’t matter to the master servicer that you are paying on time, if the loan requires a specific occupancy rate and you projections, your loan is sent to special servicing.
If a problem arises or if the borrower wants to make changes to the loan terms, the master servicer hands off those responsibilities to the special servicer. Companies such as Rialto, CWCapital, LNR Partners and C-III are some of the larger CMBS special servicers in the United States.
The special servicer is typically appointed by the bottom most tranche within the trust. Think of the trust like a waterfall. The top tranche gets the first dollars paid each month by the borrower. Then the next tranche and the next and so forth. The top tranche gets paid first meaning it is least at risk. The tranche most at risk is the last to be paid. And typically, it has the right to select the special servicer.
The special servicer has a fiduciary duty to the trust. Never the borrower. Its job is to make sure that the trust is paid.
Special servicers get paid only when the loan is in special servicing. If you are thinking that is an inherent conflict, you are right. A bank wants to see a troubled borrower get back on its feet as quickly as possible. A special servicer has a direct financial interest in seeing the borrower remain in special servicing for as long as possible. As long as the bondholders get paid, the special servicer has little to fear.
The loan documents typically give almost limitless power to the special servicer. Unlike the master servicer which gets paid $1000 per month or so, the special servicer is often paid through forbearance charges, late fees and the like.
In our experience, if a hotel or other property is truly underwater, most special servicers will work with the borrower. Their mission is to make sure the trust gets paid. The flip side of the coin is that borrowers that have lots of equity in the property really need to watch out. Special servicers can keep the property in special servicing for months, collect huge fees and then when there is no more equity remaining, sell the property and pay off the bondholders (trust).
Worse, in many pooling and servicing agreements the special servicer is allowed to acquire the property itself. That is yet another inherent conflict of interest. Banks are not allowed to hold real estate acquired from foreclosures but special servicers can.
If the special servicer sees lots of equity but a cash poor borrower, it can easily run up fees and subsequently buy the property at auction. In this scenario, the borrower doesn’t have the cash to stop the foreclosure, the trust gets repaid and the special servicer gets the property at a huge discount.
Who regulates these special servicers? No one and that is another reason why they get away with so much unethical conduct.
So how is there hope?
Despite the broad powers possessed by special servicers, they still have a duty of good faith and fair dealing. In other words, if they get too greedy, they may have to answer to the court.
There is little case law that actually defines what “good faith” means. Much of the law is oriented to identifying what lenders and special servicers can’t do. Courts have interpreted acts of bad faith to include evading the “spirit of the bargain”, lack of diligence, abuse of a power, and interference with or failure to cooperate in the other party's performance.
Certainly, trying to keep the borrower from getting back on its feet while simultaneously trying to rack up fees and take the property for one’s own portfolio could be considered a failure to cooperate.
Doctrine of Impossibility
Most CMBS trust documents say the loan is governed by New York law. Normally, lenders and special servicers like New York law.
Simply because the contract or loan agreement specifies that New York law applies doesn’t mean that out-of-state borrowers must travel hundreds or thousands of miles to seek justice. This means if you have a hotel in Orlando you can still sue in Orlando, the only difference is that the court will use New York law.
The coronavirus pandemic might cause many trusts and servicers to rethink New York as their jurisdiction of choice.
Many contracts have force majeure clauses but these are almost never found in loan documents. Force majeure is a legal term meaning an unforeseeable event prevented fulfillment of a contract. Riots, earthquakes and hurricanes are common examples.
While helpful in contracts, we doubt you will see such a clause in a CMBS loan document.
That brings us to the doctrine of impossibility. Not dependent on a contractual provision, the doctrine of impossibility is a common law term. That means it is rooted in court precedents and legal custom.
The doctrine of impossibility is an excuse for the nonperformance of duties under a contract, based on a change in circumstances that makes performance of the contract literally impossible. In the lending context, it means a borrower may be excused from the loan terms if performance is “impossible.”
Courts generally set a high standard for the defense. Even the word “impossible” implies the bar is quite high.
The good news for borrowers is that New York specifically recognizes the doctrine of impossibility. In the Empire State, that doctrine is interpreted to mean (1) “performance is objectively impossible” because of an “unanticipated event”, by law or an act of God or (2) there has been a change in circumstances so central that it would be contrary to public policy to require the parties to adhere to their original agreement.
New York courts have expressly allowed the doctrine of impossibility in cases where there was “impossibility due to an act of government.”
In the context of coronavirus, a hotel borrower can argue that compliance with the loan terms is “objectively impossible” because travel, government proclaimed self-quarantines and public gathering restrictions drove occupancy to near zero.
The Doctrines of Impracticality and Frustration of Purpose
Other legal doctrines such as the doctrine of impracticality (California) and the doctrine of frustration of purpose may also offer some relief.
We understand that these are complex legal terms to understand. In context of the coronavirus pandemic, we believe courts will be especially sympathetic to businesses forced to close because of public health authorities instructing (or ordering) people to self-quarantine and avoid unnecessary travel.
In most instances, the disruptions will be temporary. We believe Americans will resume traveling, flying and cruising once the crisis is over. Borrowers won’t be asking to be permanently excused from their loan obligations, instead they just need a break while they are closed.
Business Interruption Insurance and Insurance Bad Faith
Thousands of hotel owners are revisiting their insurance policies right now. Often there is coverage for business interruption (although many policies have exclusions for losses caused by contagions or epidemics). We have also seen policies that provide coverage where there are losses caused by a “government authority.”
In any insurance case, the devil is always in the details. Insurance companies have a poor track record of paying big claims voluntarily. After the SARS scare a number of years ago, several insurance companies tinkered with the exclusions in their policies to make it difficult to collect when the loss is caused by an epidemic.
Under the doctrine called bad faith, insurance companies can be held liable for:
- Intentional underpayment of a claim
- Wrongful denial of a claim
- Failure to provide a reasonable explanation for the denial of a claim
- Failure to properly investigate a claim
- Failure to timely investigate or pay a claim
- Misrepresenting provisions within the insurance policy
Having a good lawyer is essential if your insurance carrier refuses to pay a legitimate claim.
For more information, visit our CMBS litigation and workout page or our insurance bad faith information page. Ready to see if you have a case? Contact Mahany Law today online, by email [hidden email] or [hidden email], or by phone at 888.249.6944. We do not charge for initial consultations. Our services are available nationwide.