As commercial loans continue to default at a brisk pace, the controlling classes of certificate holders in CMBS are likely to change with increasing frequency. These changes have the potential to bring with them shifts in the identity of the parties that have authority to approve the sale of defaulted loans.
As illustrated by a recent lawsuit, these changes can lead to expensive disputes between buyers and sellers of defaulted CMBS loans.
In December 2011, Bridge Funding Inc., a company in the business of purchasing mortgage loans, signed an agreement of sale to buy a defaulted loan out of a CMBS Trust. The contract was executed, on behalf of the Trust, by its special servicer at the time (“Original Servicer”).
The day before the scheduled closing in January 2012, Original Servicer informed Bridge that it had been replaced as special servicer for the Trust and no longer had authority to close the sale. The new special servicer (“Replacement Company”) refused to close, arguing that Original Servicer did not have authority to enter into the agreement of sale at the time it did and, therefore, that the contract was void and unenforceable.
In other words, Bridge was caught in the middle of a dispute between two special servicers.
Faced with this untenable situation, Bridge retained my firm to protect its interests and filed a lawsuit against both the Trust and Original Servicer. After the parties took expedited discovery, the Trust agreed to close on the agreement of sale, thus resolving Bridge’s claims. This case, the facts of which are summarized below, presents a cautionary tale for both purchasers of defaulted CMBS loans, and the special servicers who sell them.
The Agreement Of Sale
In November 2011, Bridge learned that Original Servicer was offering for sale out of a Trust a defaulted loan that was secured by a property Bridge was interested in acquiring. After negotiations between the parties, Original Servicer accepted an oral offer by Bridge to buy the loan and sent a contract memorializing the parties’ agreement. After a few weeks of additional negotiations, the parties agreed on a new closing date, and Original Servicer sent Bridge a revised contract, which Bridge signed.
Changes In Control Behind the Scenes
Unbeknownst to Bridge, while it was negotiating with Original Servicer to purchase the loan, changes in control within the Trust were afoot. An affiliate of Original Servicer (“Affiliate”) for some time had been the Majority Controlling Class Certificate holder and the Controlling Class Representative for the Trust. The day after Bridge and Original Servicer reached their oral agreement for the sale of the loan, the Trustee of the CMBS issued its monthly distribution report, which indicated that the Controlling Class of the Trust had changed four days earlier. Replacement Company was the Majority Controlling Class Certificate holder for the new Controlling Class.
A few weeks later, on the same day that Bridge signed the agreement of sale, the new Majority Controlling Class Certificate holder replaced Affiliate as Controlling Class Representative. A week after that, the new Majority Controlling Class Certificate holder appointed Replacement Company to take over as special servicer for the Trust.
The Attempted Closing
Eight days after Replacement Company became the new special servicer, as Bridge was preparing for the scheduled closing on the loan it had purchased, Original Servicer notified Bridge for the first time that it no longer was special servicer for the Trust and advised Bridge to contact Replacement Company to finalize the sale. When Bridge did so, however, Replacement Company, on behalf of the Trust, refused to close, claiming that Original Servicer had lacked authority to sell the loan when it did and, therefore, the sale agreement it negotiated with Bridge was unenforceable.
Litigation Commences
Bridge filed its lawsuit against both the Trust and Original Servicer. The suit alleged that Original Servicer had actual or, at a minimum, apparent authority to enter into the agreement of sale on behalf of the Trust and, therefore, that the court should order specific performance; for example, order the Trust to close on the loan sale.
Bridge argued, in the alternative, that if, as Replacement Company claimed, Original Servicer lacked actual or apparent authority to enter into the agreement of sale, Original Servicer was liable to Bridge for making numerous misrepresentations about its authority to sell the loan. Bridge also asked the court to preliminarily enjoin the Trust from selling the loan until the court resolved the authority issue.
The Litigation Positions
Replacement Company, which defended the Trust against Bridge’s specific performance claim, took the position that, due to the change of Controlling Class Representative, Original Servicer was required by the Pooling and Servicing Agreement for the Trust (the “PSA”) to obtain permission to sell the loan from the new Controlling Class Representative. Since Original Servicer had not obtained such permission, the Trust argued, Original Servicer lacked actual authority to sell the loan, thereby rendering Bridge’s agreement of sale void and unenforceable.
Bridge attacked this argument on three different grounds. First, Bridge claimed that the parties entered into the agreement of sale for the loan before the change in Controlling Class Representative became effective.
Second, the PSA that governed the particular Trust at issue did not require Original Servicer to obtain approval from the Controlling Class Representative to sell a loan out of the Trust.
Lastly, even though it was not required to do so, Original Servicer had obtained weeks before the change of Controlling Class, permission from Affiliate, the then-Controlling Class Representative, to sell the loan and nothing in the PSA required Original Servicer to start over again and obtain new approvals whenever the Controlling Class Representative changed.
As it happened, the court never had to resolve the thorny issue of whether Original Servicer had actual authority to sell the loan. When it became clear through discovery that the Original Servicer had held itself out as an agent of the Trust that possessed authority to sell the loan on behalf of the Trust and no one told Bridge and Bridge knew nothing about the various changes in control within the Trust, Replacement Company acknowledged that Original Servicer had apparent authority to sell the loan, and agreed to close on the sale to Bridge.
That may not resolve all aspects of the dispute, however. As Bridge exited the case, Replacement Company was threatening to assert claims against Original Servicer.
LESSONS LEARNED
As mounting defaults lead to more frequent changes in the controlling classes of CMBS, the issues that arose in this case may become increasingly common. Potential changes in the identity of the parties that have authority to approve transactions relating to defaulted loans may impact not only buyers and sellers of defaulted loans, but also borrowers. Indeed, borrowers seeking loan modifications may need to start questioning whether the special servicer with whom they are negotiating has authority, or may soon lose authority, to modify the loan.
Both buyers and sellers of defaulted loans, as well as borrowers, would be well advised to consider ways to protect themselves from ending up in a dispute like the one into which Bridge was dragged. For instance, buyers attempting to purchase a defaulted loan out of a CMBS or borrowers attempting to modify a defaulted loan should consider investigating whether the controlling class of the CMBS is on the cusp of changing and obtain whatever assurances they can from the special servicer, Majority Controlling Class Certificate holder, Controlling Class Representative or Trust to protect against the repercussions of such a change.
For their part, special servicers, when nearing a change in controlling class, should consider suspending for a few days before and after the issuance of monthly trustee distribution reports any actions, including sales or modifications or loans, that might require approval from the controlling class representative. Precautions like these may help buyers, special servicers and borrowers spend more time at the closing table, and less time in the courtroom.
Stephen Shapiro is a partner in the Philadelphia office of Schnader Harrison Segal & Lewis LLP, and co-chair of Schnader’s Financial Services Litigation Practice Group. Shapiro can be reached at sshapiro@schnader.com.
