CMBS_A:B Tranching of Commercial Real Estate-Secured Loans : An Overview

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A/B Tranching of

Commercial Real Estate –

Secured Loans: An Overview

February 13, 2012

Presented By

Thomas R. Fileti

Morrison & Foerster LLP

Los Angeles, California

la-1155754

1

A/B Tranching of Commercial Real Estate –Secured Loans

A/B Participation Arrangement -- Overview

• A and B holders participate in a single loan to the same

borrower.

• A and B holders share the same collateral and other rights

and remedies under the loan documents.

• The loan is divided into A and B portions or ―tranches.‖

• A holder will have a claim to the payments that are made on

the loan and other recoveries that is prior to the claim of the

B holder.

• B trance is the riskier, ―first loss‖ position of the loan.

2

A/B Participation Arrangement -- Documentation

• The A and B portions of the loan or ―tranches‖ may be

evidenced by separate notes held by the A and B holders,

or may be evidenced by a single note payable to A holder

with separate participation certificate issued by A Holder to

B Holder.

• The A and B holders will generally enter into a co-lender or

participation agreement that sets forth the priorities of their

respective positions, the manner in which the interest rate

on the loan will be apportioned to the respective A and B

positions, the holders’ respective voting or decision-making

rights, and various other terms.

A/B Tranching of Commercial Real Estate –

Secured Loans

3

• Types of Loans that May Be Tranched:

• a loan originated by a single ―lead lender‖ that is the sole

party with a direct debtor/creditor relationship with the

borrower.

• a syndicated loan that is administered by an administrative

agent for all lenders, in which each A and B holder has a

direct, several debtor/creditor relationship with the

borrower.

• an A tranche or a whole loan that (subject to the rights of

the B participant) is the asset of a securitization trust.

The co-lender or participation arrangement will vary,

depending upon the loan type.


Secured Loans

4


Secured Loans

A Noteholder

Borrower/

Owner (SPE)

Property

B Noteholder

Co-Lender Agreement

A/B Note Structure – Syndicated Loan(single mortgage securing an A note and a B note)

Borrower Sponsor

Administrative Agent for Noteholders*

*Could be A Noteholder or B Noteholder

5


Secured Loans

A/B Participation Structure(single mortgage securing a single note

with A and B participations)

Lead/Named

Lender of Whole

Loan

(A Participant)*

Borrower/Owner

(SPE)

Property

First Mortgage

Whole A/B Loan

B Participant

Borrower Sponsor

Participation Agreement

*Could be the trustee of a Securitization Trust

6

Rating Agency Requirements for A/B participations

• These have had a profound influence on the manner in

which A/B participations have been structured, even in the

case of loans in which the A tranche is not intended to be

transferred to a securitization trust.


Secured Loans

7

• ―Pari Passu‖ Priority: Before certain ―subordination events‖

occur, the payments to the A holder and B holder have equal

priority

• ―Sequential‖ Priority: After the subordination events occur, the

payments to the A holder have priority over the payments to

the B holder

• Even under a sequential waterfall, the payments to the A

holder for default interest, late charges, prepayment premiums

or similar items may be subordinated to the recovery of the B

holder’s principal and non-default rate interest.

“Pari Passu” vs. “Sequential Pay”

Payment Priority

8

• ―Subordination events‖ can include any payment of

default, but these events can also track the triggers for

special servicing (e.g., ―imminent‖ payment event of

default; bankruptcy filing; non-payment event of default

that has material adverse effect)

“Pari Passu” vs. “Sequential Pay”

Payment Priority

9

• As with any co-lender arrangement, the identity and

sponsorship of the co-lenders or co-participants are threshold

issues for each of the holders to consider at the time when

they first enter into the co-lender or participation arrangement

• Restrictions on transfer can vary depending on the type of loan

involved in the arrangement

Identity of the B Participant/Transfer Restrictions

applicable to the B Participant

10

• In an A/B participation arrangement involving a loan originated

by a lead lender:

• Lead lender will likely have approval rights over transfers by

the other participant.

• Transfers to certain categories of institutional investors may

be exempt



11

• If the A/B arrangement is structured in relation to a syndicated loan:

• B holder’s transfer rights track the arrangements that apply to lenders

generally.

• B holder may have relatively unfettered rights to grant ―mere‖

participation interests to parties that will not have privity with the

borrower.

• For a ―true‖ assignment (novation), B holder is required to obtain the

consent of the administrative agent for the lenders, and to comply with

other restrictions (which may include a consent from the borrower).

• The consent rights of the administrative agent or the borrower may be

limited if the proposed assignee is a financial institution or other ―eligible

assignee‖ that complies with certain suitability tests.



12

• In A/B participation agreements involving a mortgage loan in

which the A tranche is an asset of a securitization trust:

• the holder of the B tranche is required to obtain a rating

agency confirmation for a true assignment of more than a

49% interest in the B tranche, unless the assignee is a

―Qualified Transferee‖.

• Typically, ―Qualified Transferee‖ means an institutional-type

holder that meets certain ―Eligibility Requirements‖

(typically, $600,000,000 in gross assets and $250,000,000

in net worth).



13

• Generally, each A/B arrangement will prescribe a standard of

care upon the lead lender, agent or servicer. This is the

―servicing standard.‖

• In its simplest form, the servicing standard may require the

lead lender, agent or servicer to service the loan with the same

degree of care which it normally exercises in connection with

similar real estate loans held for its own account, in which no

participations are involved.

Servicing Standard

14

• In transactions in which the loan or A tranche is intended to be an

asset of a securitization trust, the standard (typically defined as

―Accepted Servicing Practices‖) requires the loan to be serviced

based on the higher of

(a) the same care, skill, prudence, and diligence with which the servicer

services and administers similar mortgage loans for other third-party

portfolios, giving due consideration to customary and usual standards of

practice of prudent institutional commercial mortgage lenders servicing

their own loans and to the maximization of the net present value of the

mortgage loans, and

(b) the same care, skill, prudence and diligence that the servicer uses for

loans that the servicer owns.

Servicing Standard

15

• Usually, but not universally, the servicing standard for an A/B

participation requires the servicer to service the loan ―with a

view to the best interests of the holders as a collective whole‖

but taking into account the relative priorities of the A tranche

and the B tranche, the subordination of the B tranche to the A

tranche or other language to similar effect.

Servicing Standard

16

• The lead lender, agent or servicer is typically allocated

responsibility for normal administrative decisions with respect

to the loan (e.g., approval of loan disbursements, budgets,

insurance, leases), for modifications or waivers that are

immaterial and for much of the administration of property taken

back in foreclosure.

Approval and Consultation Rights of B Participant

other than in Securitized Loans

17

• Each holder (whether A or B) that is adversely affected by proposed

modifications or waivers that relate to the fundamental economic

terms of, or credit or collateral support for, the loan is typically

granted approval rights over such modifications or waivers. These

―Unanimous Decisions‖ typically include:

• changes in interest rate, fees or term

• forgiveness of principal or changes in commitment amounts

• changes in or release of collateral

• release of the borrower or guarantor

• changes in overall voting rights of the lenders



18

• A controlling group of the holders is typically granted the

authority to approve of other material consents and waivers

such as the decision to accelerate, to commence foreclosure,

or to waive or modify financial covenants or insurance

requirements.

• That controlling group may be defined as a majority or super-

majority of all lenders (e.g., 51% or 66-2/3% of all lenders) or

one or more specific classes of the lenders (e.g., a 51% or 66-

2/3% majority, determined separately, for the class of A holders

and the class of B holders) or, for certain decisions, the B

holders exclusively.



19

• If the B holder does not keep the A tranche current, in some, but not

all cases, the B holder may run the risk of losing certain of its voting

or other rights – but not its approval rights with respect to the

Unanimous Action Items.

• Consequently, the B holder can never be in a position where the A

holder could agree to reduce the principal owed to the B holder,

release the collateral for the B position or take other steps that are

covered by the Unanimous Decisions even if B holder is not curing

defaults on the A tranche or holds a position that is highly impaired.

• In these cases, an impasse over loan modification terms after a

default would lead to a requirement for the agent or servicer to

commence, and proceed with, foreclosure of the collateral and the

pursuit of other realization efforts.



20

• In cases where the mortgage loan is intended for securitization, the

servicer or special servicer is the agent that makes all decisions.

• However, a ―controlling‖ or ―directing‖ holder is authorized to provide

direction to the servicer in connection with various material decisions,

typically including the following:

• Any modification or waiver that extends the maturity date

• Any reduction, deferral, or forgiveness of interest, principal, or monthly

debt service

• Any modification or waiver of provisions restricting additional

indebtedness

• Any modification of a monetary term of the loan


in Securitized Loans

21

• Any foreclosure of the mortgage

• Any acceptance of substitute or additional collateral, or any release of

collateral

• Any waiver of a ―due-on-sale‖ or ―due-on-encumbrance‖ clause

• Any release of the borrower or any guarantors from liability

• Any transfer of the property or ownership interests in borrower, unless

permitted by the loan documents

• Any vote on a plan in a bankruptcy proceeding

• Any modification or waiver of insurance provisions

• However, the controlling holder does not ordinarily have the power to

direct the servicer to take action or to initiate action. Consequently,

the role of the controlling holder is generally a reactive one.



22

• Initially, the B holder is designated as the controlling holder (as

the subordinate holder with the ―first loss piece‖).

• However, the B holder will lose this status if a ―Control

Appraisal Event‖ occurs following an ―Appraisal Reduction

Event.‖

• If a ―Control Appraisal Event‖ so occurs, then the next most

senior holder (i.e., the A holder, but in reality, the ―controlling

class‖ within the securitization trust) will become the controlling

holder.



23

• A ―Control Appraisal Event‖ results from a decline in the value

of the real property security for the loan to a degree which

causes a significant impairment of the collateral for the B note,

following certain defaults or other ―Appraisal Reduction

Events.‖

What is a “Control Appraisal Event”?

24

• Generally, whether a Control Appraisal Event exists hinges upon

whether the value of the real property collateral for the loan, as

determined after an ―Appraisal Reduction Event,‖ plus the cash

reserves that are maintained for the loan, fall below a level which

supports a stated percentage of the principal of the B tranche plus

100% of the principal of plus interest and other sums due on the A

tranche.

• For these purposes, Standard & Poors requires the collateral to be

valued at 90% of its current appraised value, and pegs the

percentage of the impairment of the principal of the B tranche at

which a Control Appraisal Event is triggered at the point where the

collateral value covers less than 25% of the principal of the B

tranche.


25

• To illustrate these principles with a highly simplified example, assume

a $100,000,000 mortgage loan has been tranched into a $75,000,000

A tranche and a $25,000,000 B tranche.

• Assume that the loan is interest-only and no principal payments have

been made.

• Assume that following an Appraisal Reduction Event (discussed

below), the servicer has obtained an appraisal of the mortgaged

property that contains a $90,000,000 conclusion of value.

• Further assume that $1,000,000 of interest has accrued and is past

due, there have been no advances, all property taxes, assessments,

insurance premiums and ground rent are paid current, no other sums

are due on the loan, there are no reserves and no realized losses

have been allocated to the loan.


26

• First, the ―Appraisal Reduction Amount‖ is calculated. This amount is

the portion of the whole loan obligations that are not covered by the

collateral value.


27

• Expressed as a formula, this amount equals the amount by which:

• (a) $101,000,000, representing the sum of:

• $100,000,000 (the outstanding principal balance of such mortgage loan),

plus

• $1,000,000 (all accrued and unpaid interest on such mortgage loan), plus

• $0 (for unreimbursed advances and interest thereon in respect of such

mortgage loan; unpaid real estate taxes and assessments, insurance

premiums, ground rents and other unpaid amounts which were required to

be deposited in any escrow account; and other unpaid sums on the

mortgage loan), exceeds

• (b) $81,000,000 ($90,000,000 appraised value of the related mortgaged

property multiplied by 90% ―haircut‖), plus $0 (the amount of any

escrows or reserves held in respect of the related mortgage loan).

• Using these assumptions, the Appraisal Reduction Amount equals

$20,000,000 ($101,000,000 minus $81,000,000).


28

• A Control Appraisal Event exists if:

(x) the initial balance of the B tranche ($25,000,000), minus the

sum of:

(i) the payments of principal that have been allocated to the B tranche

($0),

(ii) the Appraisal Reduction Amount ($20,000,000) and

(iii) actual realized losses that have been allocated to the B tranche

($0), is less than

(y) 25% of the initial balance of the B tranche ($25,000,000) minus

the payments of principal that have been allocated to the B tranche

($0).

• Based on these assumptions, a Control Appraisal Event exists

because (x) $5,000,000 ($25,000,000 minus $20,000,000) is less

than (y) $6,250,000 (25% x $25,000,000).


29

• Because it is based upon an appraisal, and not the actual realization

of losses on the loan, the Control Appraisal Event definition attempts

to forecast future losses, and reallocates control rights away from the

B holder and to the A holder at the point where there has been a

significant impairment of the value of the collateral for the B tranche,

and thus erosion of the cushion for the A note that is provided by the

first loss position of the B tranche.

• In the parlance of the market, this is supposedly the point at which

the holder of the B tranche no longer has ―skin in the game.‖


30

• As noted above, a Control Appraisal Event can only arise after an

―Appraisal Reduction Event.‖

• These events typically include:

• the expiration of sixty (60) days after an uncured delinquency occurs in

respect of the mortgage loan

• the expiration of sixty (60) days after the date on which a reduction in the

amount of the monthly payments on a mortgage loan or a change in any

other material economic term of a mortgage loan (including an extension

of the scheduled maturity date) becomes effective as a result of a

modification of such mortgage loan

• the expiration of sixty (60) days after a receiver has been appointed

• immediately after the voluntary or involuntary bankruptcy of a borrower

• immediately upon a mortgage property becoming having been acquired

through a foreclosure


31

• Once a Control Appraisal Event exists, the servicer is required to

obtain an appraisal, and conduct a determination as to whether a

Control Appraisal Event exists or continues to exist. The servicer is

typically required to update this process at least every six (6) months.

• Typically, one or more of the classes of the holders (usually, the class

that has lost the control rights as a result of the Control Appraisal

Event) will have rights to demand reappraisal more frequently, at its

expense.


32

• It is not uncommon, even in the case of A/B participation

arrangements relating to loans that will not be securitized, for Control

Appraisal Event features to be utilized for purposes of determining

the controlling holder for the loan.

• However, one can find more flexibility in structuring the definition of

Appraisal Reduction Amount and the formula for whether a Control

Appraisal Event exists, in non-securitized deals. For example, the

collateral may not be valued based on a 90% ―haircut‖ but rather on

the basis of 100% of its appraised value, or only certain types of

accruals or sums due on the A tranche or loan may be taken into

account in calculating the Appraisal Reduction Amount (such as non-

default rate interest).


33

• Based on the securitization approach, modifications affecting

fundamental economic terms can be approved by the controlling

holder. Literally, this authority would permit the controlling holder to

consent to a workout that results in the cancellation of principal or

other material changes to the loan terms.

• If left unchecked, and if the A holder is the controlling holder, the

securitization approach would empower it to agree by the ―stroke of a

pen‖ to authorize the special servicer to cancel the principal due to

the B holder or to make other changes in terms that would adversely

affect the B holder, without any requirement for consent from the B

holder. There is no protective feature for ―Unanimous Decisions.‖

The Servicing Standard Override

34

• The special servicer is obligated to service the loan based on

Accepted Servicing Practices. Thus, if the direction from the

controlling holder is not consistent with Accepted Servicing Practices,

the servicer should decline to proceed with the direction from the

controlling holder, and may proceed with the proposed course of

action that the servicer had previously recommended. This provision

is commonly known as the ―servicing standard override.‖


35

• However, unlike the approach reflected in the Unanimous Decisions,

the servicing standard override does not contain bright lines and is

based on rather vague concepts of ―the best interests of the lenders

as a collective whole‖ or ―taking into account the relative priorities of

the A tranche and the B tranche.‖

• This lack of bright lines may invite disputes, particularly in cases

where the special servicer is considering a reduction/forgiveness of

principal or other action that would materially adversely affect the B

holder.


36

• The B holder typically has the right to cure monetary defaults

attributable to the A tranche, within a stated cure period, subject to

certain special provisions and limits:

• Typically, B holder can cure by tendering cure amounts exclusive of

default rate and late charges so long as cure is timely made within the

stated cure period.

• Typically, the B holder’s cure rights are subject to certain negotiated

consecutive or lifetime caps (e.g., such as no more than X times during

any consecutive 12 month period, or no more than Y times during entire

loan term). The magnitude of these cure rights usually relates to the

length of the term of the loan.

B Holder’s Cure Rights

37

• There are various benefits to the B holder from curing a default,

which include (i) delay trigger for a Appraisal Reduction Event

thereby preserving control for the subordinate noteholder; (ii)

potentially, prevent waterfall from shifting into ―sequential‖

subordination with all payments going to A tranche; and (iii)

potentially, delay the transfer of the loan to special servicing

(including the increased special servicing fees or workout fees).

B Holder’s Cure Rights

38

• Many market A/B transactions include a purchase option that is

exercisable at the election of the B holder upon the occurrence of a

subordination event. The option then remains exercisable up through

the completion of a foreclosure under the loan, or a transfer in lieu of

foreclosure.

• In mortgage jurisdictions where a judgment of foreclosure must be

obtained, the term of this option is potentially several years in length.

• There is typically no requirement for the B holder to pay any option

consideration either in connection with the initial grant of the option or

in connection with the exercise of the option. Typically, no good faith

deposit or down payment is required, even in connection with the

exercise of the option.

B Holder’s Purchase Option

39

• The elements of the purchase price are highly negotiated. Although

many market transactions involve a purchase option price at ―par‖

(i.e., principal, plus accrued non-default interest, plus advances made

by the A holder, but excluding default rate interest or prepayment

premiums), in other cases the price is established on a basis that is

equivalent to the amount the borrower would need to pay at the time

if it were to elect to repay the Loan in full (inclusive of default rate,

prepayment premiums and all other items).

• Alternatively, the ―par‖ purchase price may be limited only to

situations where the B holder has kept the loan current once the

Borrower defaulted.


40

• This option may be based on the expectation that it should result in

no skin off the nose of the more senior holder.

• However, if the B holder becomes a debtor in a bankruptcy case, the

purchase option may be regarded as an executory contract of the B

holder that cannot be terminated (including through foreclosure upon

the loan) without obtaining relief from the automatic stay in the B

holder’s bankruptcy case.


41

• In an A/B participation arrangement involving a lead lender and a B

participant, it would be highly unusual for the B participant to have

rights to replace the lead lender as the servicer of the loan.

• In connection with syndicated loans involving A/B tranching, rights to

remove the administrative agent can be a function of which tranche of

the deal—the A tranche or the B tranche—the administrative agent

holds.

Rights to Replace the Agent/Servicer

42

• In syndicated loans that are not tranched, the usual removal provision

permits the other lenders (in some cases, acting unanimously, in other

cases, acting through a super-majority of the holders other than the

administrative agent) to remove the administrative agent, but only for

gross negligence or willful misconduct.

• In cases where the administrative agent is the A holder, the B holder’s

rights to replace the administrative agent are generally limited to cases

of gross negligence or willful misconduct. However, B holder may

need to enlist the support of all or a super-majority of the other lender.

• If the administrative agent is the B holder, the A holder may expect to

have rights to replace the administrative agent if a Control Appraisal

Event exists, so that the B holder cannot preserve, through the

prerogatives of the administrative agent, the control over the loan

which it is supposed to forfeit as a result of the Control Appraisal

Event.


43

• In the case of securitized loans, for so long as the B holder is the

controlling holder, it will have rights to replace the special servicer (but

not the master servicer). The considerations that may lead the B holder

to replace the existing special servicer may include:

• the B holder may prefer an alternative course of action with respect to the

A/B loan to the course of action proposed by the existing special servicer

and may have received some assurances that the replacement special

servicer it seeks to designate will adopt that alternative;

• the initial special servicer (or an affiliate) may own other positions in the

capital stack that would create conflicts with the interests of the B holder;


44

• because the impact of special servicing fees will generally be borne by the B

holder, the B note holder may be motivated to seek a replacement special

servicer that will accept lower fees, thereby reducing the losses allocated to

the B holder; or

• the B holder may have an existing working relationship with, or greater

confidence in the expertise of, the proposed replacements. If the B holder

itself is an approved special servicer, the B holder may wish to appoint itself

(or its affiliate) as special servicer to streamline the decision-making

process.


Documents

CMBS_A:B Tranching of Commercial Real Estate-Secured Loans : An Overview