CMBS investors should think twice before replacing a special servicer
A CMBS loan material default, or the threat of one, will be transferred to special servicing for resolution under the applicable servicing agreement. Resolutions may include extensions, forbearances to outright foreclosures and sales. Servicing agreements require special servicers to act in the collective best interests of the securitization certificate holders to obtain the best economic resolution.
Most securitizations provide that the holder of the most subordinate debt piece are designated the "controlling class." The controlling class may replace the special servicer with or without cause. Some commentators argue this provides the controlling class with undue influence.
Generally, major decisions, actions outside the scope of loan servicing's normal course (i.e., foreclosures, waivers, modifications, etc.) require that the controlling class consent to the special servicer's recommendations. Absent the special servicer determining its proposed course of action is contractually necessary and/or alternative(s) proposed by a controlling class violates the servicing agreement's contractual provisions (the "servicing standard"), the special servicer must follow the controlling class' direction.
Given differing economic interest of debt stack holders (i.e., generally more senior debt holders will prefer quicker asset disposition while junior debt holders may prefer a strategy that keeps the asset in place), major decisions sometimes benefit certain classes over others. This is a dance between special servicer and controlling class which may lead to differences of opinions. Yet all of this may still be permissible under the servicing agreement. Distressed asset management is complicated work requiring strong special servicers. Each asset and each resolution is different. Resolution is costly and time consuming to work out a default.
Changing special servicers during workouts raises significant issues. Each special servicer has different capabilities, expertise and views on the servicing standard. The question becomes if and when a controlling class should replace the special servicer? The change process is long, document intensive and likely expensive.
Starting with the most straightforward case, an investor has purchased the controlling class, and no defaults or major decisions are pending. This is the easiest time to change the special servicer if that controlling class believes another special servicer would better be a better fit.
A more complicated case occurs when major decisions and/or workouts are pending. The existing special servicer is familiar with the asset in the servicing agreement and may already be communicating with the borrower(s). The importance of the relationship with a borrower in a workout is crucial. Workouts are (mostly) contentious. Rapport with a borrower is valuable. Nonetheless, if the controlling class has misgivings or is not in harmony with a special servicer replacement is still viable. While riskier than the scenario above, replacement here is still low to moderate risk.
The highest stakes with the most complexity exist when a major decision/workout is far along, and the special servicer and the controlling class disagree over strategy or there has been a change in the controlling class. Most special servicers are data driven. Assume a workout features a well appraised asset rapidly declining. The special servicer may wish to dispose of the asset quickly. The most senior classes are going to fully recover, but junior classes will forego yield due to an accelerated disposition. These junior classes may wish the special servicer to keep the asset in place. Should the controlling class replace the special servicer? It depends. The questions to ask include: (1) Can the replacement assume duties quickly enough to be effective? (2) Will a replacement do what the controlling class wants? (3) Would replacement negatively impact the current state of the workout?
Questions 1 and 3 are fact and circumstance dependent. Question 2 is the most complex. The worst outcome for a controlling class is replacing an uncooperative special servicer with an equally uncooperative new special servicer. Often what seems reasonable prior to thorough due diligence becomes unreasonable after diligence. Replacing special servicers over philosophical disagreement(s) is warranted. Yet, controlling classes engage in a fool's errand when replacing a special servicer when circumstances necessitate a course of action that any other special servicer would take.
Replacing a special servicer for not taking action because they determined the action would violate the servicing standard might not be a good reason for replacement. If a special servicer will only foreclose notwithstanding valid reasons exist modification, replacement might be a good option. Conversely, a depleting asset and an incapable borrower if the special servicer recommends foreclosure or receivership, a controlling class may prefer to leave that borrower in place (yes, this happens). Replacement is likely a poor choice.
The best advice on replacing special servicers is always be prudent, careful and thoughtful prior to replacing.