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.
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
holders 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 holders 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 holders 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 Holders 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 Holders 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 Holders 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
holders 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 dealthe A tranche or the B tranchethe 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 holders
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.

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