CMBS Fair-Value Purchase Option Litigation: Current Issues and Trends
For several years, the commercial mortgage-backed security (“CMBS”) market has been plagued by an abusive scheme involving fair-value purchase options. The scheme is simple: a special servicer or controlling-class representative holds the right under the pooling and servicing agreement (“PSA”) to purchase loans owned by the CMBS trust. They work to acquire the loan at a depressed price through a low appraisal, and then flip it to a purchaser for its true value, reaping millions at the expense of the CMBS trust. Four recent cases addressing this scheme offer lessons for investors who may look to curb this abuse.
Last year, such investors were dealt an initial blow when New York’s intermediate appellate court dismissed two suits over the exercise of fair-value purchase options, concluding they were barred by the no-action clause in the CMBS PSA. See Alden Global Value Recovery Master Fund, L.P. v. KeyBank N.A., 159 A.D.3d 618 (1st Dep’t 2018); M.H. Davidson & Co. v. C-III Asset Mgmt., LLC, 161 A.D.3d 710 (1st Dep’t 2018). Through a no-action clause, a typical CMBS PSA restricts investors from bringing suit. Often the no-action clause requires that, as a condition precedent to filing suit, a certain percentage (e.g., 25%) of investors give written notice of a default to the trustee. By requiring a meaningful group of investors to act, no-action clauses can curb strike suits that waste the trust’s assets. But they can also limit access to courts’ oversight of abusive trust parties when their actions harm a small number of investors—as is often the case when, as here, marginal losses are concentrated on a narrow strip of certificateholders.
In Alden Global, the First Department held that a no-action clause barred claims concerning the exercise of a $59 million purchase option on the Bryant Park Hotel loan, which was refinanced for over $100 million dollars just a few weeks later. 159 A.D.3d at 624-26. Two months later, in M.H. Davidson & Co., the court again barred a challenge to the exercise of a purchase option on two loans totaling over $350 million because of the no-action clause. 161 A.D.3d at 710. In both Alden Global and M.H. Davidson & Co., the exercise of the fair-value purchase options had been completed before the suit was filed. As a result, the only relief available to harmed investors was damages. But because the investors could not satisfy the no-action clause, they were left without a remedy.
More recently, in response to these decisions, investors have sought to take proactive steps to combat abusive fair-value purchase options before they are completed. By preventing the exercise of the fair-value purchase option at all, investors have successfully avoided harm without running afoul of the no-action clause. Two recent cases from New York’s Commercial Division provide helpful guidance for navigating these early-action strategies.
In Metacapital Mortgage Opportunities Master Fund, Ltd. v. Wells Fargo Bank, N.A., No. 656170/2018 (Sup. Ct. N.Y. Cty.), an incoming controlling-class representative (who also held 25% of the voting rights in the CMBS trust) sued the trustee and moved by order to show cause for a temporary restraining order and preliminary injunction to block the exercise of a purchase option. In suing the trustee, the Metacapital plaintiff avoided dismissal by relying on New York law that excuses compliance with the no-action clause for claims against a trustee “because it would be absurd to require [investors] to ask the Trustee to sue itself.” Quadrant Structured Prods. Co. v. Vertin, 23 N.Y.3d 549, 556 (2014) (quoting Cruden v. Bank of N.Y., 957 F.2d 961, 968 (2d Cir. 1992)).
In the CMBS PSA at issue in Metacapital, the special servicer’s right to act was granted by the trustee through a power of attorney. The plaintiff thus asked the Court to direct the trustee to revoke the power of attorney to prevent the exercise of the fair-value purchase option. Metacapital, No. 656170/2018, Hrg. Tr. at 3 (Dec. 17, 2018), NYSCEF Doc. No. 26. The Court granted the requested relief to maintain the status quo pending a hearing on the preliminary injunction. Id. at 5. After obtaining the temporary restraining order, the new controlling-class representative replaced the special servicer. The case later settled. Id., Stipulation (Feb. 12, 2019), NYSCEF Doc. No. 79.
In TCA SPV IV LLC v. Wells Fargo Bank, N.A., Nos. 655359/2018 and 650385/2019 (Sup. Ct. N.Y. Cty.), the loan involved—the Fireman’s Fund loan—was split into two notes held by different CMBS trusts (BACM 05-5 and GECMC 2005-C4) subject to a co-lender agreement. Id., No. 650385/2019, Pet. ¶ 34 (Jan. 18, 2019), NYSCEF Doc. No. 1. Typically in this structure, the deal documents identify one trust’s controlling-class representative as the party permitted to replace the special servicer for the loan. Counter to this convention, the TCA SPA IV deal documents identified the party to exercise these rights by a defined term (the “Fireman’s Fund Controlling Holder”), but did not say who the Fireman’s Fund Controlling Holder was. Id. ¶ 41. Notwithstanding this anomaly, the BACM 05-5 controlling-class representative previously had appointed a new special servicer for the Fireman’s Fund loan.
Then, in the same month that the loan moved to special servicing, another investor wrote the trustee to challenge that special servicer’s appointment by the BACM 05-5 representative. In response to the investor’s letter, the trustee rescinded the prior appointment of the special servicer for the Fireman’s Fund loan and reappointed the first special servicer. Id. ¶ 52. After its reappointment, the first special servicer received an offer to purchase the Fireman’s Fund loan at par value (which, if accepted, would thwart any attempt to exercise the fair-value purchase option at a lower price). Id. ¶ 61. The BACM 05-5 controlling-class representative sued the trustee and moved for a temporary restraining order and preliminary injunction seeking a declaration that it was the proper party to appoint the special servicer for the Fireman’s Fund loan and to block the par sale of the Fireman’s Fund loan. Based on its interpretation of the PSA, the Court first ruled that the controlling-class representative did not have the right to replace the special servicer of the Fireman’s Fund loan. Id., No. 655359/2018, Hrg. Tr. at 73-75 (Sup. Ct. N.Y. Cty.), NYSCEF Doc. No. 60 Two months later, the Court rejected the controlling-class representative’s attempt to block the sale at par. Id., No. 650385/2019, Decision & Order on Motion (Mar. 6, 2019), NYSCEF Doc. No. 75.
Considered together, these four cases offer helpful guidance for investors to consider when facing an abusive exercise of a fair-value purchase option. Some useful strategies include:
- Understanding what the PSA says about the fair-value purchase option and the rights of the controlling-class representative, special servicer, and other investors. The actual deal terms may deviate significantly from industry convention, as in TCA SPA IV, or may provide ways to avoid no-action clause issues, as in Metacapital. Also, certain PSAs grant broad information rights for certificateholders, which require disclosure of reports prepared by the special servicer on property value and disposition strategy (g., Asset Status Reports) and some correspondence between the special servicer and controlling-class representative.
- Partnering with aligned investors. Review the no-action clause and identify what the conditions precedent to suit are. Joining with aligned investors can provide leverage and, ideally, may satisfy the no-action clause’s conditions, avoiding the results in Alden Global and H. Davidson & Co.
- Knowing the controlling-class representative and special servicer. Certain parties are repeat players in purchase-option controversies. Familiarity with these parties and ability to remain in contact with them can facilitate rapid and impactful early intervention.
- Identifying targeted loans early. Know what loans may be subject to the exercise of a fair-value purchase option and actively engage with deal parties to deter misconduct, like the letter sent by investors in TCA SPA IV.
- Carefully monitoring for notices of exercise of fair-value purchase options. Certain PSAs may provide short timeframes to react to the exercise of fair-value purchase options, so careful monitoring for notices of such exercise can ensure maximum time to strategize.
- Offering to “credit bid” properties subject to abusive purchase options. By leveraging the expected return on an investment in the CMBS certificates to bid the property, victims of an abusive purchase option may be able to acquire the property themselves or, at least, deter the special servicer from exercising at a lower price for fear of violating the servicing standard.