- IRS Addresses CMBS Pre-Default Loan Modification Rules...But Will It Help?
- October 23, 2009 | Author: H. Scott Miller
- Law Firm: Bingham McCutchen LLP - Hartford Office
On September 15, 2009, the Internal Revenue Service issued Revenue Procedure 2009-45 (“Revenue Procedure”), in an attempt to address concerns about the tax code-based restrictions on the ability of mortgage borrowers, whose loans have been securitized, to negotiate with their servicers in advance of a default or imminent default. While much press was given to this issue and favorable IRS guidance has seemed all but inevitable for the past few months, the real question is whether the Revenue Procedure will have the desired impact.
Commercial mortgage-backed securities (“CMBS”) are the end result of the Real Estate Mortgage Investment Conduit (“REMIC”) sections of the Internal Revenue Code and the underlying Treasury regulations. Under the REMIC rules, mortgage loans can be assigned to a trust, which issues CMBS certificates to investors entitling those investors to payments of principal and interest from the pool of mortgages owned by the trust. The trust’s treatment under the REMIC sections permits the trust to receive funds and pass them to investors without risk of the “double taxation” that would otherwise be applicable if the trust were deemed to be an association taxed as a corporation for federal income tax purposes.
Under the REMIC provisions, mortgage loans held by a REMIC must constitute “qualified mortgages.” In general, unless a specific exception applies — such as a case where a borrower is in default or default is reasonably foreseeable — any “significant modification” to a mortgage loan will be deemed to create a new mortgage loan for REMIC purposes, with the result that such mortgage loan will no longer qualify as a “qualified mortgage” for purposes of the REMIC provisions. Any income earned by the REMIC with respect to a modified mortgage loan that loses its status as a qualified mortgage would be subject to a 100 percent prohibited transaction tax. In addition, impermissible modifications of mortgage loans (depending upon the relative sizes of the loans) could result in the loss of the trust’s status as a REMIC.
With this background in mind, many CMBS master servicers were reluctant to make a determination with respect to a mortgage loan that a “reasonably foreseeable default” existed until the default actually occurred or was imminent. As a result, many servicers refused to discuss loan modifications with mortgage loan borrowers until a default was about to happen or had already occurred. In today’s credit markets, where it has become significantly more difficult to refinance, this is a real issue. To wit, General Growth Properties pleaded an inability to refinance in demonstrating the need for its subsidiary mall owners — with solvent, cash-flowing properties — to file for bankruptcy even though, in some cases, the loans in question would not mature for several years.
Modifications Addressed by Revenue Procedure 2009-45
Revenue Procedure 2009-45 provides CMBS servicers a greater ability to determine when a “reasonably foreseeable” default exists, which would permit the modification of the affected mortgage loans.
The Revenue Procedures contain a number of conditions, of which, the most critical is that the servicer has to make a “diligent contemporaneous determination” that there exists a “significant risk of default” at or before maturity. In connection with this determination, a servicer may take into account factual representations from the mortgage loan borrower if the servicer has no reason to disbelieve the accuracy of the representation. In addition, time to maturity is a relevant factor, but the Revenue Procedure notes that a “significant risk of default” could exist even if the maturity date is in excess of one year in the future.
If the conditions of the Revenue Procedure are met, the Internal Revenue Service will not challenge the REMIC status of the trust on the grounds that the loan modifications were not in response to a “reasonable foreseeable” default and will similarly not find that the subject loan modification is a prohibited transaction.
Clearly, the goal of this Revenue Procedure is to address concerns about the REMIC restrictions that may be impeding the restructuring of a securitized commercial mortgage loan. While this Revenue Procedure likely eliminates the regulatory roadblocks to negotiations, there remain many practical reasons why the Revenue Procedure will not result in more loan modifications.
One reason has to do with the servicing of securitized commercial mortgage loans. Typically, a master servicer administers the securitized mortgage loans by accounting for payments, keeping a register of certificateholders, dealing with payoffs and defeasances, etc. Once a securitized mortgage loan encounters a prescribed level of stress, the servicing of such loan is transferred to a special servicer, which, essentially, has more real estate workout experience to handle the affected loan than the master servicer. However, a typical pooling and servicing agreement (the agreement by which the duties of the master servicer and special servicer are described) prescribes fairly specific circumstances which must occur before the affected loan is transferred for special servicing. These circumstances generally will not permit the transfer of the loan for special servicing in a situation where the only stress results from the fact that refinancing at a future maturity date is not available. As a result, if a loan is not transferred to special servicing, loan restructurings are unlikely to occur because, due to their limited functions, limited experience and inadequate staffing, master servicers are not permitted or well-equipped to make such decisions.
Another reason why the Revenue Procedure may not result in much change has to do with the “Accepted Servicing Practices” that are included in pooling and servicing agreements. The “Accepted Servicing Practices” are the standards that establish the duty of care owed by a servicer to the certificateholders. Essentially, “Accepted Servicing Practices” require a servicer to manage the mortgage loans in the same manner as it would for its own account. The lack of clarity in this servicing standard, however, is likely to make a servicer less willing to modify key provisions of existing mortgage loan documents, because there will, in most cases, still be uncertainty whether extensions of maturities, interest rate modifications and similar significant modifications are within the scope of the “Accepted Servicing Practices.” Due to this uncertainty, servicers may elect to do nothing in order to avoid claims of liability for breaching the servicing standard.
Yet another reason why this Revenue Procedure may have less of an impact than desired is because pooling and servicing agreements that pre-date the Revenue Procedure typically forbid certain modifications on account of the potential negative implications that existed under the REMIC sections prior to Revenue Procedure 2009-45. As a result, unless pooling and servicing agreements are amended or construed to now allow such modifications, it is difficult to see how this Revenue Procedure will mitigate any problems with respect to CMBS currently held by investors.
Long-Term Impact of Revenue Procedure 2009-45
It is difficult to predict the long-term effect of Revenue Procedure 2009-45.
With respect to CMBS issued after the Revenue Procedure, the long-term impact of the Revenue Procedure will be largely dictated by the degree to which its impact trickles down into the documentation. Industry standard pooling and servicing agreements will need to be modified to permit the type of modifications described in the Revenue Procedure, and the manner of execution detailed. If this approach is adopted, the roles of the master servicer, special servicer, “Directing Certificateholder” and other certificateholders in consenting to such significant modifications will need to be thoroughly examined, and current standard procedures will need to be revised.
Another important consideration is that if the impact of Revenue Procedure 2009-45 is ever felt, it could alter the underwriting, credit rating and risk associated with CMBS. The ability to modify and potentially transform mortgaged loans deposited into a REMIC trust could cause investors to view CMBS as being more comparable to managed pools, such as certain Collateralized Debt Obligations (CDOs), where structures have the flexibility to swap out the underlying obligations and are thus subject to different risks than an investment in a CMBS backed by a static pool. Any movement in the application of the REMIC provisions in the direction of permitting changes to the underlying mortgage loans would likely be viewed by the market and credit rating agencies as a move toward a riskier form of investment (and would therefore require higher investment yields for investors). If the CMBS market were to re-emerge, these higher interest rates could affect conduit lenders’ ability to compete in the commercial mortgage loan market.
With respect to existing CMBS, it is difficult to see how Revenue Procedure 2009-45 will have a substantial impact on the number of loan modifications because non-tax concerns are likely to continue to impede loan modifications. Therefore, the occurrence of defaults and foreclosures likely will not be reduced to the detriment of existing borrowers and certificateholders.