Mortgage loan sellers/originators make representations and warranties regarding loan terms, borrower structure and collateral in the mortgage loan purchase agreements (MLPAs) entered into between the mortgage loan sellers and the entity creating the CMBS securitization (typically a special purpose entity subsidiary of the sponsor, called the “Depositor”). The Depositor assigns the mortgage loans and its rights under the MLPAs to the securitization trust, including rights against the seller for a breach of the related mortgage loan representations and warranties. The servicer for the trust is charged with assessing whether to pursue a claim against the seller for a breach in accord with its servicing standard.
Although transactions in CMBS 1.0 benefitted from 40 to 50 customary representations and warranties, as the lending cycle turned and investors began to experience losses the timing became ripe to address a number of challenges:
- lack of consistency and scope;
- inability to easily compare differences between deals; and
- no suitable framework for dispute resolution for breaches.
Consequently, CMBS investors embarked on an effort to establish a stronger set of representations and warranties. Simultaneously, Congress decided to significantly increase regulation of the financial markets by enacting the Dodd-Frank Act. One of the new law’s provisions specifically provided for enhanced representations, warranties and enforcement mechanisms among the permissible types of the newly required “risk retention.” The convergence of these two forces spurred the Commercial Real Estate Finance Council (CREFC) and its members to address these issues and to bring about positive changes to the CMBS structure in order to provide incentives for investors and lenders to return to the market. The Model Representation & Warranty Task Force, one of the CREFC groups established to address CMBS 2.0 structures, began a series of meetings and negotiations among sellers/originators (those making representations and warranties) and investors and special servicers (those benefitting from the representations and warranties, or charged with enforcing them).
The Model Representation & Warranty Task Force has produced a model set of representations and warranties that builds on the significant and substantial representations and warranties from CMBS 1.0, but provides consistency and an expanded scope. For example, in a given set of representations and warranties variances in word choice could have a significant impact on meaning and legal consequence. Changing “and” to “or” could result in a completely different outcome on a claim for breach.
The resulting Model Representations and Warranties (Model Reps) endeavored to draw a balance between the various factors affecting loan performance. Commercial real estate lending has inherent risks related to the local economy, changes in tenant leasing demands, tenant bankruptcies, natural disasters, and broader economic calamities such as the recent Great Recession. The Model Reps were not intended to be a guaranty of payment or absolution from all investment risks; rather, an assurance that underwriting and due diligence was performed in a manner consistent with the practices of prudent commercial mortgage loan originators making loans intended for securitization. The Model Reps therefore cover, among other items, the following four broad topics and related underlying subject matter.
- Loans: documentation; lien status; REMIC compliance; lien release issues; additional indebtedness
- Property Collateral: condition; inspection; insurance coverage; zoning; licenses; fee or ground lease; environmental review
- Borrower: financial reporting requirements; non-recourse carve-out guaranty; Single Purpose Entity (SPE) requirements
- Lender Origination Standards: customary underwriting, due diligence and origination practices; lease estoppels; sponsor and guarantor background checks
The Model Reps establish language agreed upon by a significant number of sellers/originators and investors/servicers as to scope, content and meaning.
Some key differences of the Model Reps from CMBS 1.0 include:
- a representation that the origination, due diligence and underwriting of the mortgage loans complied in all material respects with the lender’s origination, due diligence, underwriting procedures, guidelines and standards for similar commercial and multifamily loans intended for securitization;
- specific representations as to the lease estoppels sent and those received in order to verify cash flow expected from the property;
- details regarding the due diligence and background checks performed on borrower sponsors and guarantors; and
- expanded scope of SPE criteria, clarity in the scope of non-recourse carve-out guarantees, and insurance coverage.
The Task Force concluded that the Model Reps project represent a fair and firm representation of prudent loan origination practices as well as an appropriate scope of coverage. Unfortunately, the Notice for Proposed Rulemaking (NPR) for Risk Retention Rules, published April 29, 2011 [76 Fed. Reg. 24090], did not follow the directive under the Dodd-Frank Act and gave no benefit to enhanced representations and warranties. Moreover, investors thus far in CMBS 2.0 have not indicated a willingness to pay up for enhanced representations and warranties. Unsurprisingly, no CMBS issuance through Q3 2011 has utilized the Model Reps, reflecting issuer/originator reluctance to take on the added exposure for no pricing benefit.
In order to address allegations of loan seller representation and warranty breaches efficiently and effectively, the Task Force devised and recommended implementation of mandatory mediation in connection with representation and warranty disputes (Model Dispute Resolution and Remedies). In CMBS 1.0, the special servicer would determine whether adequate grounds existed to pursue a seller for a breach of representations and warranties, and then weigh the cost and time necessary to bring legal action pursuant to its standard of care to maximize recovery to the trust. This is a fact intensive assessment: Is there a material loss in value or economics to the trust that is directly related to a breach of a representation by the seller? Can that charge be successfully brought in court if the seller disputes the claim and refuses to cure or repurchase the loan? With lawsuits costing hundreds of thousands of dollars and lasting several years, this is often a difficult determination. Moreover, there were instances of both sellers refusing to acknowledge responsibility for representation breaches, as well as aggressive pursuit of breach claims of questionable merit. Finally, the pooling and servicing agreements (PSAs) in CMBS 1.0 often did not compensate special servicers through liquidation fees if it was the result of a loan seller repurchase obligation which could have the effect of disincentivizing pursuit of seller breach claims. Fortunately, most PSAs now allow such compensation if the repurchase occurs more than 90 days after the initial request is made.
The Model Dispute Resolution and Remedies process is designed to minimize the time, quickly pinpoint the issues and utilize experienced CMBS professionals as mediators. The process calls for the parties in any dispute to first submit the dispute to a “Mediation Agency” certified by CREFC to conduct a non-binding mediation. The parties may not commence any action until the earlier to occur of completion of the mediation (including a 10 day “cooling off” period if not resolved) and 90 days following the mediation request. However, the special servicer may proceed with the loan workout or liquidation if it determines it is in the best interests of the certificateholders to do so under its servicing standard. CREFC is in the process of creating CMBS Mediation Guidelines and establishing a Mediation Advisory Board to provide Mediators with experienced experts.
While none of the CMBS issuances through Q3 of 2011 have utilized either the Model Reps or the Model Dispute Resolution and Remedies language, the significant cooperative efforts by investors, loan originators, issuers, servicers and other industry participants in the CREFC undertakings bode well for recovery in CMBS 2.0 and an improved CMBS infrastructure.
Beginning September 26, 2011, Rule 17g-7 requires that rating agencies include in any report accompanying a credit rating a description of the representations, warranties and enforcement mechanisms available to investors for the rated transaction, as well as a description of how they differ from those in "issuances of similar securities.” During the Rule’s comment period, several industry associations and rating agencies suggested allowing comparison to industry standards instead. Using, for example, the CREFC Model Reps and Model Dispute Resolution and Remedies as a basis for comparison would have the obvious benefit of a single, unified standard. The SEC rejected using industry standards because it was concerned that reliance “exclusively on industry standards for the purpose of required comparisons could create unintentional gaps in disclosure.” Given the bipartisan effort of industry participants in creating the CREFC model standards, this Rule misses a unique opportunity to foster standardization and ease of comparison, and ultimately will likely result in needless additional time and expense. The feared gaps in disclosure were not described and are not readily discernable. Having each rating agency develop its own respective comparison will likely frustrate rather than facilitate investor review and analysis.
Fortunately, initial indications are that several rating agencies will at least follow the format and wording of the Model Reps, scaled back to reflect in substance the scope of recent, post-2008 CMBS issuances. Thus far those transactions have substantially the same representations and warranties found in CMBS 1.0 transactions. But moving toward standardized presentation and format is a good step to facilitate investor review and comparison, and may ultimately lead toward adoption of all or a significant portion of the CREFC Model Reps. However, the degree to which issuers and originators will embrace the more stringent Model Reps will depend on two key factors: (i) whether the final Risk Retention Rules give some benefit to use of enhanced representations and warranties, and (ii) whether investors are willing to pay up for the increased issuer/originator exposure.
As the market moves toward the Model Reps, loan originators will need to adapt their underwriting, due diligence and closing procedures to trap the increased information and comply with the more stringent requirements. While this imposes more work, the CMBS market should benefit from these structural improvements.