Structured Finance in Brief

Updates and Analysis on current structured finance issues, upcoming events and activities of Reed Smith’s structured finance group

CMBS 2.0 IN FOCUS: Class X – a Class Act!

The emergence of European CMBS 2.0 can be directly traced back to Deutsche Bank’s Deco 2011-CSPK which closed in June 2011.  Since that issuance, there have been several deals brought to the market by not only Deutsche Bank but also Bank of America Merrill Lynch and Goldman Sachs as well as three deals arranged by Cairn Capital, a non-bank.  Given that CMBS 2.0 as a financing tool for commercial real estate is here to stay and we are fast approaching the fifth year of this new era, now would seem to be an opportune time to take stock of the CMBS 2.0 product and consider some of the defining structures of these new deals.  Over the course of a series of blogs, we will therefore consider some of the features that can be considered unique to CMBS 2.0.

Class X – a Class Act!

No matter what the vintage of deal, an essential component of structuring a CMBS transaction is to ensure that the “excess spread” (i.e. the positive difference between amounts received on the underlying loans and the liabilities of the issuer) can flow to the originator or its nominee.  Although skimming the margin of the underlying loans is one means by which the excess spread can be obtained, the more prolific mechanism and arguably the most controversial feature of CMBS 1.0 has been the utilisation of Class X notes.

In itself, an X note would seem rather innocuous, it is a class of notes that has a relatively low face value, it is cash collateralised and bears a variable rate of interest which is paid pari passu with interest on the most senior class of notes.  Indeed, the right to receive interest is the only tangible right attached to an X note, given that holders of such an instrument have no controlling powers, no voting rights and no ability to direct the note trustee to take action.

As it is essential for the economics of CMBS that there is a mechanism for the originator to receive the excess spread, the mere existence of an X note in itself is not controversial however what is controversial, is the determination of what constitutes excess spread.  In CMBS 1.0, the excess spread was determined to be the excess of scheduled interest due on the outstanding loans over the aggregate of interest due on the notes and ordinary administrative costs.  With such a formulation of excess spread, an issue arises by the fact that it applies to interest actually due on the loans rather than interest actually received.  The consequence of this is that given the presence of a liquidity facility that can be drawn on to make up the shortfall in amounts received under the loan, then despite a borrower failing to pay interest on a loan this in fact will have no impact on the amount of excess spread received by the holder of an X note.

The controversy of CMBS 1.0 X notes is further exacerbated by the presence of a non accruing interest (NAI) mechanism which provides that when a loss on an underlying loan is crystallised a corresponding amount of such loss is applied on a reverse sequential basis to the principal balance of the higher yielding junior notes.  Assuming the interest on the underlying loan where the loss has been crystallised is less than the coupon of the impacted junior notes, then absurdly the holder of the X note is set to gain a greater amount of interest and therefore derive a greater benefit from a situation where there is an underlying loss on a loan.  Finally, to compound these controversies yet further, given that the payment of excess spread ranks pari passu with payment of interest on the most senior class of notes, then the holder of X notes will always be entitled to receive excess spread before the payment of principal on any class of Notes.

In summary, although the structuring of an X note is a legitimate right of the originator, the structures employed were clearly distortive given that they allowed “excess spread” to be extracted from the deal when in reality there was no excess spread in existence.  Further, losses on loans had no negative impact on X note payment stream and if anything given the presence of NAI mechanics, losses could in fact enhance payments under the X note.  Unsurprisingly, X notes were one of the main structural features addressed in CREFC’s Market Principles for Issuing European CMBS 2.0, where they made the following recommendations:

  • there should be clear and concise disclosure on how excess spread is calculated and who is entitled to receive such amounts;
  • there should be greater disclosure around some of the X notes more controversial structural features such as their ranking in the priority of payments and the role of any liquidity facility; and
  • X note should be structured to specifically take into account the loan default interest, modified interest (following a workout), loan maturity date and loan default.

The concerns raised by the CMBS 1.0 have clearly been taken on board in CMBS 2.0, and the new vintage of deals exhibit structural nuances that have addressed the potentially inequitable features highlighted above.  Deutsche Bank’s Deco 2014-Bonn provides a great example of how these imbalances have been corrected, which first and foremost includes clear disclosure on how excess spread is calculated and its constituent components.  In terms of structure, the Deco 2014-Bonn transaction provides that the liquidity facility cannot be drawn on to make good any shortfall in amounts received under the loan, thus any amounts received under an X note will solely emanate from income received from the securitised loan.  Further, the amount that the Deco 2014-Bonn X holder is entitled to receive is capped at the excess of the amount of all available funds over all payment liabilities, with any X note amount that is greater than this capped amount deferred until the issuer has sufficient funds to make such payment.  Finally, under certain circumstances (following the expected maturity date of the CMBS notes, the occurrence of a special servicer transfer event or service of a note acceleration notice), the right to receive excess spread is subordinated to payment of all interest and principal on the notes.  These features are not unique to the Deco 2014-Bonn deal or indeed the Deco family of deals and a review of a number of other CMBS 2.0 transactions reveal the presence of similar structural features.

For the economics of CMBS, it is crucial that the originator of the loan is able to extract excess spread and the presence of X notes is integral to that.  Between CMBS 1.0 and CMBS 2.0 there has been a clear structural shift in the structuring of X notes, from an instrument where holders could extract money out of a deal even when the loan or the deal is non-performing to the current situation where holders of X notes can only receive excess spread when there is indeed true profit and the deal is performing.  The paradigm shift in the structuring of X notes is a real testament of the industry’s ability to listen to market participants, adopt recommendations and adapt the CMBS product so that it not only meets the needs of investors but also continues to safeguard the true economics of a deal – taking X notes from being suspect to a real class act!

Is CMBS the answer to Italian bank deleveraging woes?

According to a recent report published by Cushman & Wakefield’s (C&W), 2014 was a massive year for the non-performing loan (NPL) market with the execution of a record €80.6bn of European commercial real estate and real estate owned transactions.  Placing this figure into context, the C&W report stated that this “represented growth of 156% on the volume for 2013 with an increase of over €26bn on the totals for 2012 and 2013 combined”.  Looking ahead for 2015, C&W predict that closed transaction volume in 2015 will be in the region of €60-70bn with Italy anticipated to be the next NPL “hot spot”.

The rationale for the spotlight being focussed on Italy stems from the ECB’s announcement in October of their Asset Quality Review (AQR).  The results revealed that four of the eight banks that were deemed to have capital shortfalls were Italian and €9.7bn of a €24.6bn capital void (as of 31 December 2014), was attributable to participating Italian banks.  Given the hugely successful de-leveraging auction process undertaken by many banks in the UK, Ireland and most recently Spain, it is unsurprising that many market observers anticipate that Italy will follow suit with their own form of auction process.  Although going down such a tried and tested route is no doubt a compelling option for the Italian banks, given the huge success of their CMBS 2.0 market I wonder whether the Italian banks may in fact have another string to their bow.

Driven by the fact that CMBS overcomes Italian domestic regulations requiring institutions purchasing syndicated loans to have a banking licence, we have seen significant Italian CMBS 2.0 issuance over the past couple of years.  During the course of 2013 and 2014 there have been a number of notable Italian deals (Gallerie 2013 srl; Deco 2014–Gondola; Moda 2014 Srl) and the deal flow has not abated in 2015 with the recent closing in January of Tibet CMBS Srl. and the pricing of Taurus 2015–1 IT.  In terms of future Italian deal flow, the continued low interest rate environment, the recent announcement of the ECB introducing large scale quantitative easing and investors’ relentless search for yield, the likelihood is that the volume of primary CMBS issuance will increase further during the course of 2015.

For a long time I have held the view that CMBS is the perfect financing instrument to enable yield-driven private equity funds to maximise their returns on the acquisition of NPL’s.  Indeed the feasibility of such a funding tool was explored in a recent article that I had published in the fall edition of CRE Finance World (Europe’s Future Power Couple – CMBS; A Financing Tool for NPL Portfolios).  By employing similar technology to that discussed in the article i.e. transferring the loans to an issuing vehicle that funds such an acquisition through the issuance of CMBS notes to yield driven investors, the Italian banks will in effect have a mechanism to offload a significant volume of non-performing loans.  Although compared to the current crop of CMBS 2.0 deals, the CMBS structures are likely to require some finessing to accommodate the fact that the loans were not originated for securitisation and are likely to be non-performing, such structuring is not insurmountable and is unlikely to stave off investor demand for notes.

Given that at the present time Italy is one of a few countries where there has been significant CMBS issuance since the global financial crisis, but also a country where a number of its banks are under significant pressure to delever, we may therefore be at the perfect juncture in the market for CMBS 2.0 to be deployed as the answer to Italian bank deleveraging woes.

CMBS – it’s time to dance to the beat!

During the European Autumn CREFC conference, a panel of leading CMBS participants were posed the question of whether European CMBS was stuck at the bar while the market danced.  The general consensus of the panel was that although CMBS may have moved away from the bar, it was standing very much at the edge of the dance floor.  Given the disappointing level of CMBS issuance for 2014 compared to 2013 and the roller coaster ride experienced by CMBS participants since the global financial crisis, it is understandable that the panel were reticent to give a more uplifting view on the state of the CMBS market.  But despite CMBS failing to have braved the dance floor in 2014, there is every sign that CMBS has a feel for the beat and that 2015 may be the year that we finally see CMBS throw some shapes.

Although CMBS issuance for 2014 was low compared to 2013 (the so-called CMBS revival year), nevertheless it was a hugely successful year for the product on the basis of the types of deals and structures that were tested in the market.  The past year can in many ways be regarded as the year that the industry laid the foundations for re-establishing CMBS as a properly functioning financing tool for European commercial real estate (CRE).  Indeed, if the dancing metaphor is further applied, 2014 was the year that CMBS successfully learned the basics in a remedial dance class.  Notable developments in CMBS 2.0 during the course of 2014 include:

  • the emergence of CMBS structures more closely resembling the CMBS 1.0 conduit style deals with multiple loans and multiple borrowers of CRE;
  • an extension of the geographical landscape of deals with issuance of not only more CMBS deals secured by CRE located in the UK, Germany and Italy but new deals backed by CRE located in the Netherlands, France and Greece;
  • an increasing volume of CMBS deals backed by secondary CRE;
  • the tightening of spreads on CMBS notes; and
  • a notable shift away from CMBS primarily being used to refinance properties to financing new acquisitions.

The solid foundations established during 2014 will no doubt be built on during the course of 2015 with deals secured by assets in new and more challenging jurisdictions and the CMBS 2.0 structures further refined and finessed.  Given the prevailing market conditions, the outlook for CMBS in 2015 is extremely upbeat.  On account of the continued low interest rate environment, the recent announcement of the ECB introducing large scale quantitative easing and investors’ relentless search for yield, CMBS is increasingly looking like a desirable proposition for the fixed income investor.  Equally, there is a growing demand by borrowers for CMBS as it is regarded as a key financing tool to: (i) plug the funding gap between huge market refinancing requirements and available debt; and (ii) provide the much needed leverage (particularly in the case of yield-driven private equity buyers) to maximise equity returns on the acquisition of new properties.

Following the CMBS revival year of 2013 and the encouraging developments in 2014, it is my hope that 2015 will be the year that the CMBS product not only builds on the 2014 developments but also has the volume of issuance which the CMBS product justly deserves.  Metaphorically speaking, CMBS is more than capable of hitting the European dance floor, it has got the moves, it likes the beat and most importantly the market demands CMBS to dance.  Given the proven  success of CMBS, its versatility as a financing instrument for CRE and the genuine demand for it as a funding tool, personally I don’t just want to see CMBS hit the dance floor – I want to see it win a contest!

The issue of sanctions

Much has been written regarding the recent EU and US sanctions targeting the Russian capital markets, military and oil sectors (our own commentary can be found here) and the broad nature of the sanctions has, it would seem, produced some (probably) unintended consequences when applied to the mechanics of day to day capital markets operations.  On their face, the capital markets sectoral sanctions are designed to cut off the ability of the sanctioned companies to access funding in the equity and debt markets.  Hence, broadly speaking, anybody who must comply with EU or US sanctions cannot participate or deal in any new debt or equity issued by a sanctioned entity once they have been put on the sanctions lists.  Existing debt or equity issued prior to the implementation of sanctions is grandfathered.

However, what is an ‘issuance’ of new debt or equity?  Clearly a new bond with a new ISIN code raising capital would be an issuance and the same would be true if an SPV were to issue a bond and on lend the monies to a sanctioned entity.  But what about a new depositary receipt (DR)?  DRs allow investors to invest in the equity of a company without holding the equity of such a company directly and are themselves typically issued by large financial institutions.  If a sanctioned entity were to issue new equity, a financial institution would not be able to issue corresponding DRs as that would mean dealing with the new equity in breach of sanctions.  But what if a new DR was being issued in respect of the grandfathered equity of a sanctioned entity?  Would that be a new ‘issuance’ prohibited by sanctions?  After all, no new monies would actually make their way to the sanctioned entity.  In the US, OFAC in its FAQs say ‘no’ (see FAQ 391 here) and the issuance of such DRs seems to be allowed.  In the UK, H.M. Treasury (and the Financial Conduct Authority) seem to say ‘yes’ (though there is no official interpretation on the point, evidence found here suggests this is the case) and no new DRs can be issued in respect of any and all equity of sanctioned entities.  Apart from highlighting the fact that different regulatory authorities can take opposing views on similar topics, it does mean (if we accept that the H.M. Treasury view as correct) that it is not necessary for any new capital to flow to a sanctioned entity for an ‘issuance’ to be prohibited by sanctions.

This principle does however raise interesting questions of interpretation when applied to other areas of capital markets, for instance in respect of Reg S and Rule 144A bonds or DRs.  It is common for an issuance for DRs or bonds to include a global Reg S instrument and a global Rule 144A instrument in respect of the same class of bond or DR.  This allows an issuance to be marketed to a wider pool of investors and the size of each global instrument at issuance is set to reflect the initial investor base.  However, if the instruments are traded in the secondary market that initial allocation sometimes needs to be adjusted depending on the status of an incoming investor.  Mechanically this is done by reducing the size of one of the global instruments and increasing the size of the other global instrument by a corresponding amount.  If the increase in the size of a global instrument is in respect of an existing grandfathered bond or DR issued by a sanctioned entity is such increase prohibited by sanctions (on the basis that it represents a new issuance)?  No new capital actually flows to the sanctioned entity but as we have seen, at least according to H.M. Treasury, that is not a necessary criterion for an action to be prohibited by sanctions.  So is such ‘switching’ between different types of global instruments a new issuance of debt or equity or is it merely an investor convenience?  All lobbying efforts to H.M. Treasury please.

Quelle horreur!

€32,000,000.  A horror indeed for Colliers International UK (plc) (Colliers) as Mr Justice Blair awarded that amount to the issuer of the Titan Europe 2006-3 CMBS (Titan).  The judgment was for the loss suffered by Titan in relation to the negligent valuation by Colliers of a property in Nuremberg originally occupied by the (now bankrupt) German mail order giant Quelle (see judgment of Titan Europe 2006-3 plc v Colliers International UK plc (in liquidation) [2014] EWHC 3106 (Comm) here).

Aside from questions that arose in relation to the valuation of the property itself, the case considered pertinent questions of loss and reliance in relation to securitisation issuers, namely whether:

  • Titan was the right entity to bring the claim; and
  • Titan could be said to have relied on the valuation provided by Colliers.

The judge rules in favour of Titan in both instances.  In relation to who was the correct claimant, while the judge agreed with Collier’s contention “viewed from an economic perspective…it is the investors in the Notes that suffer the loss” he then went on to state that “it does not follow that in law Titan has not suffered a loss in respect of which it can bring claim” and ultimately that Titan had suffered a loss the moment it acquired a chose in action worth less than the price paid for it.  The reasoning on this point appears to have been two fold.  Firstly, Mr Justice Blair was content to apply previous case law in Paratus AMC Ltd. v Countrywide Surveyors Ltd. [2012] PNLR 12 in which it has been established that the contractual spreading of loss did not affect that incident of the basic loss arising in itself and secondly, the court accepted that, in these types of transactions, “the distribution of loss can be difficult to pin down, and depends on when investments were acquired, market movements, and the performance of the rest of the transaction”.

Although, it should be borne in mind that Mr Justice Blair did caveat the findings on this point by stating “I note that a different answer to the “correct claimant” question might arise in a different case, depending upon the contractual documentation and the arguments in that case”.  Given that the Titan Europe 2006-3 structure is quite a common one for CMBS transactions, one could imagine that this would most likely be tested in other, perhaps simpler structures, e.g. single asset, single tranche and single noteholder deals, where the loss to the noteholder would correspond in timing and value directly and demonstrably to the negligent valuation.

In relation to arguments relating to reliance, the judge sensibly ruled that establishing reliance by Titan on the valuation provided by the Colliers did not require the directors of Titan to have read the valuation report itself.  It was enough that the directors had reviewed the preliminary offering circular which contained the valuation of the property (and in particular the loan to value of the of the Quelle loan) which backed up the corresponding warranty from the originator, Credit Suisse, contained in the sale agreement relating the loan.

Overall, the case demonstrates the willingness of the court to recognise the complex nature of the securitisations and at the same time not allow that to hinder recoveries where a loss has been suffered by an SPV issuer and, ultimately, by the noteholders.


Following the onset of the financial crisis in 2007, any mention of ‘commercial mortgage backed securities’ or ‘CMBS’ was regarded as a dirty word and at one point the term was destined to face certain extinction.  Seven years on, several issuances later and following a prolonged upswing in financial market sentiment, not only is the term CMBS back in favour but it is also positively trending.  The upcoming issuance of £750 million of CMBS notes secured by the Westfield Stratford City shopping centre will not only be a defining point for CMBS issuance in 2014, but can also be considered a key step forward towards the re-establishment of CMBS as an essential funding tool for commercial real estate (CRE).

At the end of 2013, many commentators were estimating that CMBS issuance for 2014 would be in the realm of €10-15 billion.  Assuming that Deutsche Bank and Credit Agricole CIB can successfully launch the Westfield transaction, then CMBS issuance for 2014 will sit at just under €11 billion and therefore exceed the lower realm of this €10-15 billion estimate.  As industry participants head off on their summer breaks, there should be a level of euphoria that the CRE industry will have already surpassed the total issuance for 2013 (€8.7 billion) with  a number of months of the year still to run.  With rumours of further deals in the pipeline, there is every chance that 2014 could be regarded as a bumper year for the CMBS asset class.

Although the numbers are encouraging and certainly demonstrate that CMBS has a seat at the European CRE financing table, one of the most striking things about the re-emergence of a European CMBS market has got to be the dominance of various trends, which at times have dwarfed some of the more compelling stories in the market.

Following Deutsche Bank’s €754 million Florentia multifamily issuance at the end of 2012, multifamily transactions came to dominate in 2013, with mega issuances by issuers such as Taurus 2013-1’s €1 billion note issue and GRF 2013-1’s €4.3 billion note issue. Although these deals have given the CMBS asset class a much needed boost, on account of the fact that the payment streams for such notes primarily stem from individuals funding their private residences, the classification of such properties as true commercial real estate has always been questionable.

Against the backdrop of multifamily transactions, there were two CMBS issuances that can be regarded as hugely significant as they ushered in a new era for CMBS 2.0.  Firstly, there was the eagerly awaited Debussy transaction, a CMBS secured by a number of Toys r’Us stores with a CMBS structure that is notable for containing a number of industry firsts.  However the most significant feature of the Debussy structure is that it in effect created a blueprint by which shadow banks, such as investment funds, can provide CRE bridge financing to a borrower and then exit this position through the issuance of CMBS notes.  The other noteworthy transaction for 2013 was Goldman Sachs widening the CMBS 2.0 geographical net with the issuance by Gallerie 2013 srl of €363 million CMBS notes secured by Italian retail property.  A primary driver for such an issuance was attributable to the fact that domestic regulations in Italy require institutions purchasing syndicated loans to have a banking licence, CMBS overcomes this restriction and provides a financing tool which expands the potential universe of investors.

Off the back of the Gallerie 2013 srl issue, the Italian CMBS trend continued into 2014 with the issuance of €355 million notes by Deco 2014 – Gondola and €198.2 million notes issued by Moda 2014 Srl.  Although maybe not the highest profile deal of the year, but certainly one of the more exciting developments in the industry, has been the issuance by Taurus 2014-1 of £211,500 of CMBS notes secured by properties that have been acquired through the enforcement of defaulted loans.  As a result of the Taurus deal, the market has given a clear nod to the CRE finance industry that CMBS should not be confined to prime commercial real estate.  In stark contrast, with the imminent issuance of the £750 million Westfield CMBS notes, the market has also shown that there is also appetite for mega issuances of CMBS paper secured by a single prime retail property.

Given the lumpy nature of the market, it is difficult to put too much emphasis on the presence of the multifamily and Italian trends however given that there can be said to be trends at all, then this has to be regarded as an industry positive.  At the height of the financial crisis, the CMBS product was subject to intense scrutiny and its role (if any) in financing European commercial real estate was frequently questioned with many commentators reaching the view that CMBS as a funding tool would only ever be used to fund core real estate in prime locations.  Transactions such as those mentioned above clearly demonstrate that not only is the CMBS term not extinct but that CMBS is a versatile funding tool that has a greater role to play for financing commercial real estate than many commentators first predicted or in some cases ever hoped for.

Clash of the Titan 2007-1 (Part III): Controversy Thunders On

Previously in Clash of the Titan 2007-1: Zeus has spoken, we took a brief look at the judgment delivered by Richard Snowden QC.  Another interesting aspect of the case which is beginning to generate commentary is that one of the other pre-conditions to the replacement of the Special Servicer is that the successor Special Servicer “has experience in servicing mortgages of commercial property on similar terms to that required under this Agreement and is approved by the Issuer and the Note Trustee (such approval in each case not to be unreasonably withheld)”.

On this point, the court found that the above clause contains two separate and distinct requirements, each of which must be satisfied before the termination of appointment of the Special Servicer can take effect – (i) the experience of the successor Special Servicer and (ii) the approval by the Issuer/Note Trustee.

Snowden QC confirmed that “given the importance of the role of Special Servicer, there is every reason why that parties should have intended that there should be a proper check on the suitability of the Special Servicer for the task; past experience is one, but only one, of the obvious factors that might be relevant in that regard”.  He has, it seems, implied that the Note Trustee and the Issuer should have significant involvement in the effectiveness of that check.

However, that leaves the question, in deciding whether or not to approve a replacement Special Servicer, how might a Note Trustee exercise this discretion?

Snowden QC gave a few examples of grounds on which the Note Trustee or the Issuer might withhold its approval, which include if the Special Servicer was “for example, incompetent, insolvent or in serious financial or regulatory difficulties, subject to the proviso that such judgment should not be unreasonable… Beyond those examples, I do not think it would be sensible or appropriate for me to attempt to elaborate, on a hypothetical basis, any other factors that the Issuer or Note Trustee might take into account in the exercise of their discretion…  Questions of the proper exercise of a discretion are always highly fact-sensitive, and I am simply not in any position to form any view upon whether, and if so how, the Note Trustee might take into account factors such as whether a proposed successor might adopt a strategy which favoured one group of Noteholders over another.”

We expect the answer to be that the Note Trustee might refuse to exercise its discretion, as it will normally have a right to do so.  However, given that many transactions contain language such that the approval “is not to be unreasonably withheld or delayed”, would it be reasonable for a Note Trustee to withhold its approval without first investigating the relevant considerations?  The Note Trustee will need some considerable time to evaluate its position depending on the circumstances at hand, which at the very least might delay the process of replacement.  There is also a danger to proposed successors of interference from incumbent Special Servicers who might have views on their competitor’s ability to replace them in the role, which might descend into a slanging match and create more nervousness amongst Trustees.

The CMBS 2.0 guidelines we think provide useful insight into the Trustees role.  They state – “The role of the trustee should be limited to oversight of mechanical process and passive monitoring of prescribed objective criteria. CMBS transactions should be structured so that trustees are generally not required to exercise any discretion …”.   This is slightly at odds with the implication in the Titan case that the Note Trustee will have to consider the suitability of the replacement in quite the level suggested in the judgment.  Rest assured, in any event, Trustees will proceed with caution and justifiably so.

Whilst the Titan judgment appeared to have taken away the Fitch RACs roadblock (at least for some transactions with documentation similar to the Titan case), an unintended effect of this would be to potentially provide Class A noteholders with a veto in many deals where Trustees would be unable or unwilling to make a commercial judgment on the suitability of the Special Servicer replacement.  Where Trustees exercise their rights to take instructions from the noteholders on behalf of whom they act, the Special Servicer replacement process (although initiated by the junior noteholders) could ultimately result in the trustees turning to the senior noteholders for their approval, directions and indemnification.

For the incumbent Special Servicer, this judgment brings mixed reactions – bad news for those Special Servicers wishing hide behind Fitch’s unwillingness to provide RACs to frustrate any replacement process but good news for those who think that requiring the Note Trustee to exercise its discretion to approve the replacement Special Servicer will cause even more delays to the replacement process.

Whilst a potential replacement Special Servicer might have expected to be appointed by the Issuer or the Trustee as part of the replacement process, they might not have envisaged the extent to which their activities and experience would be put under scrutiny by the Issuer and/or Trustee, given the comments made by Snowden QC in the Titan case.  It seems it is no longer sufficient that a replacement Special Servicer need to exhibit the relevant experience in servicing commercial mortgage loans, if the replacement provisions in the Servicing Agreement are similar to this case, approval of the appointment of the successor Special Servicer needs much more detailed consideration by the Issuer and the Note Trustee, which in turn might mean replacement Special Servicers providing more information about their business and/or intentions for servicing the relevant loans and having to justify their appointment.  Would this put off certain potential replacement Special Servicers from going into this market – having to perform an already difficult task of maximising recoveries on a loan which may have suffered due to poor decisions in the past and also having to justify why they are so suited to perform that role?

So it is possible that the real consequences of this case – which so many in the market hoped would clarify once and for all the issues with respect to replacement of Special Servicers – might be to make Special Servicer replacement even more difficult and protracted.  Perhaps the final word should come, not from Zeus’ but his lesser known first wife, Metis (who presided over wisdom and knowledge).  Perhaps Metis might have extolled the benefits of a free market and competition…

Clash of the Titan 2007-1 (Part II): Zeus has spoken

Well, maybe not Zeus but Richard Snowden QC no less.  On Valentine’s Day this year, we published our blog entitled “Clash of the Titan 2007-1”. Now that the red roses have wilted, the champagne drunk and the chocolates eaten, let us take a look at what the first instance decision in Titan Europe 2007-1 (NHP) has to say about replacing special servicers in European securitisation deals.

In providing directions to the trustee, Richard Snowden QC considered two important issues: Who is the Controlling Party entitled to serve notice under the Servicing Agreement to require the termination of the appointment of the Special Servicer?  What happens if the Servicing Agreement dictates that RACs are required as a pre-condition to the replacement of the Special Servicer but the condition could not be satisfied due to a rating agency declining to provide RACs as a matter of policy?

The “Controlling Party” is typically the party exposed to the first loss position on the structure i.e. either the B-piece lender or if value breaks in the securitised portion, the most junior class of noteholders, i.e. the “Controlling Class”.

The critical issue with this case was that the offering circular and the transaction documents seemed to contradict each other as to whether the Controlling Party was the Issuer or the representative of the Controlling Class.  The court came to the conclusion that the Servicing Agreement (being the contractual document) trumps the Offering Circular (which whilst informative, was not binding).  The judge applied the rules of interpretation of contract and broadly concluded that if the meaning of the contract was unambiguous then that must have been the intended effect of the parties which led to some very unintended consequences such as unwittingly putting the Issuer (a special purpose vehicle with no skin in the game) in the driving seat as the “Controlling Party”.  Is it commercially right for the judge to instate the Issuer as the Controlling Party when the economic interests in the transaction are held by the Noteholders (and the Controlling Class Representative their supposed spokesperson)?  One of the supporting arguments put forward was that the Issuer had assigned its contractual rights to the Note Trustee and therefore as the benefit of the rights given to the Issuer were capable of exercise by the Note Trustee (in the interests of Noteholders), there was nothing commercially absurd about the Issuer being the Controlling Party.  What follows quite unhelpfully is that Snowden left it to the parties to figure it all out, declaring:

But whilst there would appear to be a need for the Issuer and Note Trustee to consider how such matters might work out between them in practice, [he] did not understand [counsel for the Note Trustee contended that it] would be impossible or commercially unworkable..

In doing so, he leaves open some issues that could impede this CMBS transaction in a manner that might not have been intended.  Instead of bringing the Servicer closer to the ultimate investor and increasing the level of transparency and accountability, we end up rekindling the classic love triangle between the Servicer/Special Servicer, the Issuer and the Trustee borne from the contractual burdens that restrict them.  Whether or not this will have an impact on the investors is yet to be seen.

The court also referred to the Fitch announcement whereby Fitch announced that it would not, as a matter of policy, provide RACs during the replacement of special servicers on EMEA CMBS transactions (see our last blog entitled “What the Fitch??!”).

Whilst the Titan Servicing Agreement required RACs confirming that the termination and/or replacement of the Special Servicer would not cause a ratings downgrade, the Servicing Agreement also provided that, admittedly in another circumstance, if a Rating Agency declines to issue such a confirmation then the relevant provision shall be read and construed as though written confirmation from the Rating Agency declining to issue the confirmation was not required.

On this matter, the court gave the example that if a Rating Agency were simply to stop issuing rating confirmations altogether, then the Special Servicer could not even validly terminate its own appointment no matter that both of the other Ratings Agencies might be willing to give such confirmations, which would not make commercial sense.  In conclusion, Fitch’s policy not to issue Rating Agency Confirmations should not prevent otherwise valid replacement attempts in situations consistent with the Titan, so long as the other requirements are satisfied.  We’ll touch on one of those “other requirements” which is rather controversial in the next blog.

For now, Zeus has spoken and it was indeed an interesting address from Mount Olympus.  However, as the Representative of the E Class Notes has been granted leave to appeal, those may not be the parting last words… See Clash of the Titan 2007-1 (Part III) for a view as to what this judgment means to the various parties in a securitisation of this type and some of the practical issues thrown up by the Titan judgment.

Back(loading) to the Future – the Nuances of EMIR Transaction Reporting Requirements

It’s been barely six weeks since the EMIR trade reporting obligations came into effect on 12 February and, as the regulatory dust begins to settle, parties to derivative transactions are still in the process of assessing their duties under the new regime.  In the lead up to the February deadline, bank and securities firms were busy implementing their client outreach programmes whilst we were busy putting out client alerts and blogging about the new requirements under EMIR.  We continue to help clients with their questions on this significant change to the EU regulatory landscape.

Two aspects of the new trade reporting regime in particular repay some close attention to avoid potential trip-ups.  First, the rules relating to what has been termed ‘backloading’, or, in other words, the requirement to transaction report historic trades.  After some uncertainty in the lead up to implementation, the requirements are now clearer.  Broadly, counterparties need to ensure that all historic trades that were either ‘live’ on 12 August 2012 (the date EMIR came into force), or subsequently became live prior to 12 February 2014 (the date the reporting requirements came into force), are reported.  For these trades, the deadline for reporting will range from just one day to a period of three years after the reporting obligations became effective, depending on the date of the trade and, if applicable, its termination date.  Our client alert sets out these timeframes in more detail.

The second aspect worth paying attention to is how the transaction reporting regime applies to modifications of existing derivative contracts.  In outline, EMIR makes any amendment or variation to an existing trade potentially reportable and the time frame to do so is stringent, requiring reporting within 1 working day.  Precisely what a ‘modification’ looks like has not been spelled out in the regulation and will vary between transactions.  However, it is possible that changes made to any of the reportable information for a transaction, which can be up to 80 data items, could be caught.  As many existing structured finance and securitisation deals continue through the restructuring process, changes to hedging swaps can easily be caught by this requirement and transaction reporting can easily be forgotten in the excitement of the signing and closing process.  A place holder in the signing and closing agenda can be a useful aide memoire.

After the initial rush to meet the February deadline, the questions about the new reporting rules will continue for a while longer.  ESMA have, for example, just confirmed in their latest set of Q&As issued on 20 March that the ‘backloading’ obligations will still apply to transaction counterparties that have been liquidated or become insolvent, albeit the obligation rolls to any entity that assumes their obligations.  Expect the questions to continue!

NPLs – Car Boot Sale!

Time for a spring clean?

Institutions holding non-performing loans (“NPLs”) have been and continue to be, under increasing pressure to divest these and “clean up” their balance sheets in order to free up capital, de-risk and preserve market reputation. Usually, a loan facility becomes non-performing when either payments of principal and interest are past due by 90 days or more, or where payments are less than 90 days overdue, it is expected that payments will not be made in full. Alternatively, other loans can also be regarded as non-performing if they are value impaired (e.g. if the borrower has breached key covenants in its facility or if repayment terms have been altered).

Where a borrower is in financial trouble, it may first look to a lender for restructuring options such as extending its facility, foregoing interest payments or deferring repayments. From a bank’s point of view, holding on to NPLs causes a real issue since they increase a bank’s management costs, with frequent analysis required to monitor the financial position of the borrower and its underlying assets. There are also broader repercussions to consider given that NPLs may tend to limit a bank’s ability to lend. It also potentially drives up interest rate margins thereby creating uncertainty. Divesting NPL portfolios at a discount benefits banks who recoup some value, gain liquidity and distance themselves from the risk factors associated with holding onto distressed assets, such as a potential downgrades in its credit rating or a greater chance of bank insolvency.

Why take on a bad apple?

The reasons for investing into NPL portfolios are varied and divergent. Some may look to sell the loans on the secondary market for a quick profit, others, with management expertise who see potential for improvement in the portfolios and/or future economic factors may hold out for a recovery in its value. There are also some institutions who will buy enough distressed debt to have an influence in the borrower’s restructuring options or insolvency so as to be well placed to acquire control of the company thereby benefiting from profits and value in the business itself.

Buying and selling the loan portfolio

The process of selling a loan portfolio is not always straightforward and is often an expensive exercise (but well worth it if the intention is to gain real risk transfer and capital release). The transaction starts with what may be a lengthy due diligence process on the loans and its underlying security (often replete with incomplete documentation, spread across multiple jurisdictions and involving multiple counsels).

There may also be various loan level issues to tackle which provide impediments to transfer. Potential issues include:

  1. a borrower’s consent may be required to transfer;
  2. security packages may include collateral which is not supported by adequate registration evidence required to show that the seller has a right over the collateral and the subsequent right to transfer it; or
  3. a transfer may only be permissible to a “financial institution” – which can be problematic for sales to private equity firms, hedge funds, pension funds or SPVs.

Potential solutions to these issues include sellers holding the loans on trust with beneficial interest lying with the buyer, efficient and thorough due diligence which flags up issues as early as possible at the outset of the transaction (which can also be instrumental in influencing the price of the portfolio itself, at the bidding stage), amendments to loan documentation or perfecting registration of security to ensure the buyer holds a robust package of collateral.

The seller will almost certainly prefer a transfer by novation wherever possible, creating a direct standalone legal relationship between the new buyer and the borrowers. Transfer by way of assignment (where only the rights and not the obligations are transferred) may not have the effect of removing the loan from the seller’s balance sheet. However, transfer by way of assignment can be useful where the seller’s interest in underlying collateral cannot be novated. Moreover, an assignment can be achieved without notifying the borrower, although this will merely result in an equitable assignment.

What lies ahead for distressed debt?

Following the credit crisis, many institutions in the UK have undergone high profile divestment operations – instigated by the need to comply with stringent capital adequacy requirements. Currently, the ECB is implementing key stress tests amongst the top euro zone banks to ensure balance sheets are looking healthy – with a particular focus on non-performing loans. The distressed debt market is certainly growing and the UK appears to be a popular investment destination in this area together with Greece, Italy, Spain and Ireland. There appears to be a great deal of opportunity for many institutions to recoup distressed debt and estimates suggest that European banks have approximately EUR2.5 trillion of non-core assets available to sell.

So, it’s certainly very true for the NPL market that one person’s trash is another person’s treasure!