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Law360 (September 1, 2020, 4:00 PM EDT )
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| James Murphy |
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| Daniel Payne |
Consequently, the commercial mortgage-backed securities, or CMBS, market is signaling a potential implosion as commercial tenants struggle to pay their rent, delinquencies on commercial mortgages skyrocket,[1] rating agencies downgrade CMBS deals,[2] investors short the CMBS market[3] and whistleblowers allege widespread fraud in the CMBS industry.[4]
If the previous financial crisis is any guide, the next step seems almost certain to be everyone involved suing each other. The first pandemic-induced CMBS lawsuit has already been filed.[5] What should CMBS market participants do now to prepare?
This article outlines the types of cases we expect to see in the event of widespread CMBS litigation. And we offer recommendations on how CMBS market participants can prepare for this litigation risk now.
We believe the types of CMBS cases likely to be filed in the coming months and years may resemble the litigation wave that arose out of the financial crisis in the residential mortgage-backed securities, or RMBS, space.
To be sure, the administration of CMBS trusts may be more complicated than RMBS because foreclosure on large commercial properties is more complex than a residential foreclosure and could involve the appointment of a receiver for the commercial property. Accepting the added complexity for CMBS trusts, the most common RMBS lawsuits were:
- Breach of contract: Some complaints alleged breaches of representations and warranties concerning the quality of mortgage loans sold.
- Fraud: Both common law and securities fraud cases alleged misrepresentations in connection with the offering and sale of mortgage-backed securities.
- Insurer lawsuits: Insurers of RMBS bonds initiated many cases against various parties to recoup their losses on insurance claims paid to fund payments of principal and interest on RMBS bonds.
- Investor v. trustee: Investors brought claims under indenture agreements, the Trust Indenture Act and for violation of fiduciary duty against RMBS trustees alleging failure to pursue repurchase claims against RMBS sponsors, loan originators and others.
- Financial Institutions Reform, Recovery and Enforcement Act: The federal government aggressively sued banks under FIRREA,[6] settling at least nine cases with Wall Street banks for more than $60 billion.[7]
Disputes between classes of bondholders were not as common in the RMBS space, although they are likely to arise in the CMBS market. CMBS bondholders can clash over how losses taken in the trusts and loan modifications could impact the payment waterfall as well as which class of investors actually has control under the deal documents.
After the initial wave of RMBS lawsuits, a round of indemnity lawsuits arose as defendants that settled or lost at trial sought to recover their losses from parties further up the RMBS stream. All told there were over 750 cases filed nationwide in the RMBS litigation wave alleging over $350 billion in damages.
Preparing for a Potential CMBS Litigation Wave
While the deal structures and documentation in CMBS transactions are not identical to RMBS, there are enough similarities to believe an implosion in the market for CMBS could cause a similar wave of litigation. Assuming we see a surge of CMBS cases, what can parties do now to protect themselves? Here are three suggestions.
1. Commercial real estate loan sellers should review the documentation of their sales.
Banks that originated commercial real estate loans for sale into the CMBS market should review the tail risks associated with those loan sales, including carefully analyzing the language of the applicable contracts.
There are several different areas of legal risks that loan sellers should review, including (1) understanding the scope of the representations and warranties they gave to purchasers in loan sale agreements, (2) what notice requirements may exist for loans discovered to have breaches of representations, (3) the extent of potential repurchase obligations for breaching loans, and (4) what indemnity rights and responsibilities the party may have.
And commercial real estate loan originators should monitor the performance of CMBS trusts containing their loan collateral for early signs of losses.
In analyzing their potential exposure, parties should consider the applicability of a statute of limitations defense. In the RMBS context, the U.S. Court of Appeals for the Second Circuit clarified that breach of representation and warranty claims governed by New York law were time-barred if not brought within six years after the applicable representations and warranties were made.[8]
2. Assess risk disclosures and reserve methodology in a deteriorating market.
Companies should assess their methodology for valuing commercial real estate assets on their balance sheets — whether whole loans or CMBS — and for setting reserves for potential losses in a deteriorating market. Likewise, public companies should consider updating disclosures of risks associated with CRE and CMBS portfolios on their balance sheets.
Regulators can be expected to eventually scrutinize crisis-era disclosures as they did after the financial crisis, so extreme care should be taken.
3. Set up legally defensible processes for handling claims.
If a CMBS litigation wave materializes, the first claims are likely to be repurchase demands to sponsors of CMBS deals and to originators of commercial real estate loans contained in CMBS trusts. Companies receiving such claims should establish a consistent approach in responding to repurchase demands and take precautions to ensure that the process is protected by attorney-client privilege and attorney work product to the extent possible.
In the RMBS litigation, courts found that loan sellers had a contractual duty to respond to repurchase demands, and therefore concluded that, in most circumstances, work done to investigate and respond to repurchase demands, even by lawyers, was not protected by attorney-client privilege or attorney work product.[9]
Commercial real estate loan sellers and CMBS issuers should be proactive if they hope to achieve a different result this time. It is vital that parties receive objective legal advice in connection with responding to repurchase demands backed by the threat of litigation.
Although we believe the anticipation of CMBS litigation in general is already well-founded,[10] anticipating litigation is the beginning, rather than the end, of the work-product analysis.[11] Another key consideration is that communications among the lawyers for the various parties may not be privileged even if those parties arguably have common interests in the trust or the collateral within the trust.[12] Parties should take great care in setting up their processes to protect open dialogue with counsel from discovery in later litigation.
Conclusion
The wild card in this analysis is the U.S. government. It appears the government has taken to heart at least some of the lessons of the financial crisis. The government has provided some support to small businesses to pay their rent and the Federal Reserve has engaged in some sporadic purchases of CMBS on the open market.
Will these actions be enough? Time will tell.
In the meantime, warning signs of a CMBS litigation wave are blinking red, and proactive companies are well-advised to act now to evaluate potential claims and to assess and limit their exposure.
James A. Murphy is chairman and co-founder of Murphy & McGonigle.
Daniel M. Payne is a shareholder at the firm.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] "CMBS Delinquency Rate Surges for the Third Month; Nears All-Time High," Trepp.com (July 2020), available at https://info.trepp.com/hubfs/Trepp%20June%202020%20Delinquency%20Report.pdf.
[2] See, e.g., "Moody's Considers Downgrading $6.2 Billion in CMBS Loans," Mark Heschmeyer, CoStar.com (April 20, 2020), available at https://www.costar.com/article/1491379774/moodys-considers-downgrading-62-billion-in-cmbs-loans; "Fitch mulls downgrades for 15 hotel/resort CMBS deals due to coronavirus impact," Glen Fest, Asset Securitization Report (March 19, 2020), available at https://asreport.americanbanker.com/news/fitch-mulls-downgrades-for-15-hotel-resort-cmbs-deals-due-to-coronavirus-impact.
[3] "Icahn is shorting the commercial real estate market, which he says is going to 'blow up'," Michael Sheetz, CNBC.com (March 13, 2020), available at https://www.cnbc.com/2020/03/13/icahn-reveals-his-biggest-short-position-amid-market-turmoil-commercial-real-estate.html.
[4] "Whistleblower: Wall Street Has Engaged in Widespread Manipulation of Mortgage Funds," Heather Vogell, ProPublica (May 15, 2020), available at https://www.propublica.org/article/whistleblower-wall-street-has-engaged-in-widespread-manipulation-of-mortgage-funds.
[5] Cascade Funding LP – Series 6 v. The Bancorp Bank, Case No. 651841/2020 (May 25, 2020, N.Y. Supreme Court). Cascade Funding involves a $900 million deal for a pool of commercial real estate loans that the purchaser sought to back out of when it allegedly found it could not securitize the pool in the midst of the March 2020 economic shutdown. The case is ongoing.
[6] FIRREA was enacted more than 20 years ago in the wake of the savings and loan crisis but was lightly used until the Financial Crisis. Section 951 of FIRREA, codified at 12 U.S.C. § 1833a, authorizes the DOJ to bring a complaint seeking civil money penalties against persons who violate one or more of 14 enumerated criminal statutes (or predicate offenses) affecting financial institutions or government agencies like bank fraud and false claims against the government. Certain of these offenses require the government to prove that the violation of the underlying criminal statute was one "affecting a federally insured financial institution. Although FIRREA does not define "affecting," in 2013 a federal district court affirmed the Department of Justice's "self-affecting" theory that banks that engaged in misconduct could "affect" themselves for purposes of FIRREA. United States v. The Bank of New York Mellon
, No. 11 Civ. 06969 (S.D.N.Y).FIRREA became a favorite tool of the DOJ because of it provided latitude to go after banks for their own alleged misconduct and because of its 10-year statute of limitations.
[7] "Submission on Behalf of SIFMA to the United States Department of Justice," Nov. 3, 2017, at fn 2, available at https://www.sifma.org/wp-content/uploads/2017/11/SIFMA-FIRREA-White-Paper-110317.pdf.
[8] Lehman XS 2006-4N v. GreenPoint Mortgage Funding Inc.
, 991 F.Supp.2d 472 (S.D.N.Y. 2014). [9] MBIA Ins. Corp. v. Countrywide Home Loans, Inc.
, 93 A.D.3d 574, 575 (N.Y. App. Div. First Dep't 2012) ("…documents and information concerning defendants' repurchase review, generated in response to plaintiff's repurchase requests, are discoverable [because] the record shows that processing repurchase requests was an inherent and long-standing part of defendants' business…. [D]efendants' were, and always had been, contractually obligated to conduct repurchase reviews and such reviews were, and always had been, conducted by defendants' own staff of underwriters and auditors.").[10] Indeed, we recently presented a CLE detailing the coming wave of CMBS litigation: https://www.pli.edu/programs/cmbs-litigation-wave-the-covid-19-fallout?t=ondemand.
[11] MBIA, 93 A.D.3d at 575 ("that litigation appeared imminent is of no moment" in deciding whether defendants' work done in response to repurchase demands is privileged).
[12] See Ambac Assur. Corp. v. Countrywide Home Loans, Inc.
, 27 N.Y.3d 616 (2016) (recognizing "the existing requirement that shared communications be in furtherance of a common legal interest in pending or reasonably anticipated litigation in order to remain privileged from disclosure," and rejecting an expansion of "the common interest doctrine to protect shared communications in furtherance of any common legal interest.").For a reprint of this article, please contact reprints@law360.com.
