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…