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Working Out Mortgage Loans and B Notes

Presented by: Richard D. Jones

Dechert LLP

to

ACREL

I. Common Split Mortgage Loan and Subordinate Debt Structures 1

A. Whole Mortgage Loan 1

B. Split Mortgage Loan 1

C. Pari-Passu Loan Structure 1

D. A/B Loan Structure 2

E. Variations of the A/B Loan Structure 2

F. Economic Terms of A/B Loan Structure 2

G. Allocation of Payments in the A/B Loan Structure 2

H. Participated Mortgage Loan 3

I. Comparison of A/B Loan Structure to a Senior / Subordinate Participated Loan Structure 4

J. Other Types of Split Loan Structures 4

K. Second Mortgage Loan 4

L. Mezzanine Loan 5

M. Comparison of A/B Loan Structure to Mezzanine Loan Structure 5

II. Brief Overview of Some of the Provisions in a CMBS Pooling and Servicing Agreement Relevant to Workouts of Mortgage Loans - A Typical CMBS Transaction with a B Note 7

A. Key Parties to CMBS Transactions and Their Roles 7

B. The Servicing Standard 9

C. Servicer Advancing 10

D. Special Servicing of a Mortgage Loan 12

III. Typical Rights of a B Note Holder Under an Intercreditor Agreement 14

A. Generally 14

B. B Note Holder Cure Rights upon Borrower Default 14

C. B Note Holder Purchase Option 14

D. Servicing an A/B Loan 15

E. Control Appraisal Event 17

F. Transfers of the B Note 17

IV. Practical Advice for Dealing with a Defaulted Mortgage Loan at the Initial Stages 18

A. Investor’s first steps when a mortgage loan default has occurred or is about to occur 18

B. Relevant documents 19

C. The “Controlling Holder” or “Controlling Party” 19

D. The true nature of the default 20

E. Parties that must be informed of the default 20

F. Delivery of the formal notice of default to borrower 20

G. Replacing special servicer 21

H. Short term rights an investor should consider (Cures) 21

I. Short term rights the investor should consider (Purchase Options) 22

J. Consider whether the servicer or the controlling party should require a “pre-negotiation” or “pre-workout” letter from the borrower? 23

K. Initial strategy options an investor needs to consider 23

V. Effects of Securitization on the Process of Formulating a Workout Strategy 25

A. Certain parties will be communicating with the borrower during the workout 25

B. Subordinate Interest Holder’s Influence Over Workout Strategy 25

C. Factors that Delay Formulation of a Workout Strategy 26

D. Potential Conflicts of Interest inherent in the Workout Process 26

VI. How Does the Securitization Affect Certain Workout Strategies 27

A. Extending the Maturity Date 27

B. Additional Funding for the Borrower 28

C. Loan Assumptions 28

D. Incurring Additional Debt 28

E. Addition or Substitution of Collateral 28

F. Debt Forgiveness 29

G. Selling the Defaulted Loan 29

I. Common Split Mortgage Loan and Subordinate Debt Structures

A. Whole Mortgage Loan (See “Exhibit A”)

1. A mortgage loan is a loan from a lender to a borrower, the repayment of which is secured by a lien on the borrower’s interest in real property

2. A “whole” mortgage loan is a mortgage loan which is evidenced by a single promissory note and which has not been otherwise “split” into different lender interests

B. Split Mortgage Loan

1. A “split” mortgage loan is a mortgage loan which either is evidenced by more than one promissory note or which has been otherwise “split” into different lender interests

2. The most common types of split mortgage loans:

a. Pari passu loans

b. A/B loans

c. Non-CMBS syndicated loans

C. Pari Passu Loan Structure (See “Exhibit B”)

1. A “pari passu” loan structure is a mortgage loan structure where the mortgage loan is evidenced by two (or more) separate promissory notes, each executed by the borrower and secured by the same collateral

2. It is sometimes referred to as an “A/A” loan structure

3. Primary elements of the pari passu loan structure:

a. Evidenced by more than one promissory note

b. Payments on the notes are made pro rata and pari passu to the A-1 and A-2 Note holders

c. Losses are borne pro rata and pari passu by the A-1 and A-2 Note holders

d. Each pari passu A Note can be sold into a separate securitization

e. The pari passu loan structure is similar to the typical “syndicated loan” structure, but the rights given to the holders of the notes in a CMBS pari passu loan are typically different from those in a syndicated loan

f. Control over the servicing of the whole loan (all of the pari passu notes) typically resides in the master servicer and special servicer for the first pari passu note securitization

g. Advancing may be handled in a variety of ways

D. A/B Loan Structure (See “Exhibit C”)

1. Primary elements of the A/B loan structure:

a. An A/B loan is a mortgage loan evidenced by two separate promissory notes, each executed by the borrower, and each secured by the same collateral

b. The A Note is generally senior to the B Note in rights to payment of principal and interest

E. Variations of the A/B Loan Structure

1. A-1/A-2/B – pari passu senior notes and one or more subordinate notes

2. A/B/C – multiple subordinate notes

3. A/B with mezzanine – one or more subordinate notes, with additional structurally subordinate mezzanine loans made to the parent or parents of the mortgage borrower

F. Economic Terms of A/B Loan Structure

1. The A and B Notes have a senior / subordinate payment structure

2. The A Note holder is paid interest and principal first

3. The B Note holder is paid interest and principal second

4. Other:

a. the B Note serves as “credit support” for the A Note

b. In light of the B Note’s subordination and higher risk, the yield on the B Note is typically higher than the yield on the A Note

G. Allocation of Payments in the A/B Loan Structure

1. The priority of payments between the A Note and the B Note is referred to as the “waterfall”:

a. Lender / servicer expenses are always paid first, including reimbursement of advances, costs and expenses, as well as servicing fees

b. “Pre-Event of Default Waterfall”: The A Note receives interest and scheduled principal, and then the B Note receives interest and scheduled principal (See “Exhibit D”)

c. “Post-Event of Default Waterfall”: The A Note holder receives interest and principal first, until the A Note is paid in full, prior to the B Note receiving any payments (See “Exhibit E”)

2. Triggers that change the waterfall payments from “Pre-Event of Default Waterfall” to “Post-Event of Default Waterfall”:

a. Any monetary event of default under the loan documents

b. Material non-monetary events of default under the loan documents

3. When an event of a default exists under the mortgage loan, workout effects of payments to the A Note and B Note holders:

a. All payments to the A Note holder are made as though no workout occurred

b. If the principal balance, interest rate or scheduled payments on the mortgage loan are reduced, or any other material modifications are made to the mortgage loan, the full economic effect of the modifications are borne by the B Note holder (up to its then-remaining principal balance)

c. Only after the B Note has been wiped out is the A Note affected by any workout

H. Participated Mortgage Loan (See “Exhibit F”)

1. Primary elements of a Participated Mortgage Loan

a. A participation is not a direct loan to a borrower; thus a participant is not a creditor of the borrower

b. A participation is an undivided interest in a single loan

c. A participation interest is a contractual interest in a mortgage loan created pursuant to a participation agreement between the participants

d. Participations are not evidenced by promissory notes

e. Participations may be senior / subordinate or pari passu

2. Purpose of the Participated Mortgage Loan Structure

a. Allows lender to split the mortgage loan without creating a separate promissory note

b. Because the issues and structural elements of an A/B loan and the senior / subordinate participation structure are similar, for ease of reference, “B Note” in this presentation is intended to refer both to subordinate notes in an A/B loan and to subordinate participations in a senior / subordinate participation structure

I. Comparison of A/B Loan Structure to a Senior / Subordinate Participated Loan Structure

1. An A/B mortgage loan is a loan evidenced by two separate promissory notes, each executed by the borrower, and each secured by the same collateral

2. A subordinate participation is a contractual interest in a loan made by the original lender. Only the lender has privity with the borrower

3. In a senior / subordinate participation structure, the subordinate participant is not a creditor of the borrower because there is no contractual relationship between the subordinate participant and the borrower. Instead, the subordinate participant is a creditor of the senior participant

4. In the A/B loan structure, the B Note holder is a creditor of the borrower because the borrower has executed a promissory note in favor of the B Note holder

J. Other Types of Split Loan Structures

1. First and Second Mortgage Loans

2. Mortgage / Mezzanine Loan Structure

K. Second Mortgage Loan (See “Exhibit G”)

1. Primary Elements of Second Mortgage Loan

a. The first mortgage lender has a first mortgage and a first lien on the real estate and the second mortgage lender has a second mortgage and a second lien on the real estate

b. Second mortgage lender has a separate note and a separate mortgage on the real estate from the same borrower

c. The second mortgage lender has a mortgage on the real estate which is subordinate to the first mortgage

d. The lien of the second mortgage on the real estate is wiped out by a foreclosure of the first mortgage

e. The second mortgage lender has limited or no rights to participate in the workout of the first mortgage

L. Mezzanine Loan (See “Exhibit H”)

1. Primary elements of a Mezzanine Loan

a. The mortgage lender has a mortgage and a first lien on the real estate

b. The mezzanine lender does not have a mortgage or a lien on the real estate

c. The mezzanine lender does not lend to the mortgage borrower

d. The mezzanine lender has a pledge of equity

e. If the mortgage is foreclosed, the mezzanine lender’s equity pledge will be worthless (because the mortgage borrower will own nothing)

M. Comparison of A/B Loan Structure to Mezzanine Loan Structure

1. Legal Structure / Collateral

a. An A/B loan is a mortgage loan (composed, in part, of A Note and B Note) made by the mortgage lender to the mortgage borrower, secured by a lien on real estate

b. A mezzanine loan is a loan made by mezzanine lender to the mezzanine borrower (parent of the mortgage borrower), secured by a pledge of the equity interests in the mortgage borrower

2. Servicing

a. The B Note is serviced by the master and special servicer of the A Note, subject to certain consent and consultation rights held by the B Note holder or an “operating advisor” acting on behalf of the B Note holder

b. The mezzanine lender services its own loan, independently of the servicing of the mortgage loan

3. Control Rights

a. The B Note holder has little or no control over its investment, with the exception of certain specific consent and consultation rights over specific servicing matters

b. The B Note holder often has the right to appoint the special servicer

c. The mezzanine lender has sole control over its mezzanine loan servicing, subject to specified restrictions set forth in the mezzanine intercreditor agreement

4. Cure Rights and Purchase Options

a. B Note holders and mezzanine lenders typically have various cure rights and options to purchase the A Note or the mortgage loan (as applicable)

5. Exercising Remedies

a. The B Note holder assigns its right to foreclose upon the mortgage to the A Note holder, which exercises remedies on behalf of both the A Note and B Note holders. The mezzanine lender, however, can foreclose upon the equity pledge (subject to certain conditions and restrictions)

b. Unlike an A Note, which is always cross-defaulted with the B Note (i.e., a default under the B Note constitutes a default under the A Note (and vice versa)), a mortgage loan generally is not cross-defaulted with the mezzanine loan (i.e., a default under the mezzanine loan does not, in and of itself, constitute a default under the mortgage loan). The mezzanine loan, however, is cross-defaulted with the mortgage loan (i.e., a default under the mortgage loan automatically constitutes a default under the mezzanine loan)

6. Transfers

a. B Note holders’ and mezzanine lenders’ rights to transfer their interests are generally the same. Either the proposed transferee must be a “Qualified Transferee” or rating agency confirmation must be obtained

II. Brief Overview of Some of the Provisions in a CMBS Pooling and Servicing Agreement Relevant to Workouts of Mortgage Loans - A Typical CMBS Transaction with a B Note (See “Exhibit I”)

A. Key Parties to CMBS Transactions and Their Roles

1. Loan Originator / Loan Seller

a. Originates or acquires mortgage loans for sale into securitization

b. May create pari passu or senior / subordinate notes or participations in the mortgage loans prior to sale into a CMBS transaction

c. Generally has a limited role following sale of the mortgage loans into securitization (although it may retain a servicing role in CMBS transaction or be required to repurchase a mortgage loan it sold into the CMBS transaction for a material breach of representation or material document defect)

2. Depositor

a. Purchases mortgage loans which will be included in the CMBS transaction, and deposits those mortgage loans into the trust formed pursuant to the documentation governing the CMBS transaction

3. Trustee

a. Holds “legal title” to the each mortgage loan sold into a CMBS transaction

b. Administers the CMBS trust and performs certain fiduciary duties for the certificateholders

c. Acts as paying agent in respect of payments to be made to certificateholders

d. Acts as “back-up liquidity advancer” in respect of the senior portion of the mortgage loans included in the CMBS transaction

4. Master Servicer

a. Generally responsible for day-to-day administration of each mortgage loan, including any subordinate interests in such mortgage loan (e.g., making collections, processing certain routine requests of the related borrowers)

b. Makes liquidity advances of unpaid principal and interest in respect of each whole mortgage loan and each senior portion of a mortgage loan or portion thereof included in the CMBS trust

c. Makes property protective advances in respect of each mortgage loan

d. Required to meet certain eligibility requirements (e.g., must be on rating agency approved lists)

5. Special Servicer

a. Generally responsible for administering and servicing defaulted mortgage loans (including any related notes or participation interests held outside the CMBS trust) and implementing workouts, foreclosures or other default resolution strategies (including any related notes or participation interests held outside the CMBS trust)

b. Primary party interfacing with the borrower in respect of workouts and foreclosure

c. Required to meet certain eligibility requirements (e.g., must be on rating agency approved lists)

6. Controlling Certificateholder

a. Generally the most subordinate class of CMBS certificates that has not experienced realized losses in excess of 75% of the original principal balance of such class

b. If there is no B Note holder or subordinate participation holder related to a particular mortgage loan included in the CMBS trust, or if such subordinate holder is no longer in the control position, the controlling certificateholder typically has the right to:

i. Replace the special servicer

ii. Approve (subject to being overridden by the special servicer where the Servicing Standard would require the special servicer to take a different course of action) most major servicing decisions related to workouts of the related mortgage loan and other default resolution strategies proposed by the special servicer

B. The Servicing Standard

1. standards the master servicer and special servicer must apply in performing their servicing and workout

2. the same standard that the master servicer or special servicer uses to service its own loans and assets, or those of a third party, whichever is higher

a. With a view to the timely collection of all mortgage loan payments

b. In respect of defaulted mortgage loans, with a view to the maximization of “net present value” of such mortgage loan

3. Each of the master servicer and special servicer must act in good faith and use reasonable judgment in accordance with:

a. applicable law

b. the terms of the pooling and servicing agreement

c. the terms of the mortgage loan documents, and

d. the “Servicing Standard”

4. The master servicer and special servicer must disregard certain conflicts of interest in applying the Servicing Standard:

a. Any relationship with the borrower

b. The ownership by such servicer of any related CMBS certificates, any related note or participation interest, or any related mezzanine debt

c. The obligation to make advances

d. The rights of such servicer to be paid any servicing fee or servicing compensation

e. The ownership or servicing of any other loans or properties outside of the pool

5. The master servicer and special servicer must take certain interests into account under the Servicing Standard:

a. The master servicer and special servicer must service and administer mortgage loans and the portions thereof held outside of the CMBS trust (including any B Note or subordinate participation interest) for the benefit of each of the holders as a collective whole

b. The master servicer and special servicer typically do not service any mezzanine loans related to any mortgage loan included in the CMBS trust

6. The general relevance of the Servicing Standard to a workout:

a. The special servicer must abide by the Servicing Standard in formulating and taking action in respect of workout strategies for any mortgage loans included in the CMBS trust and any note or participation interest related to such mortgage loan which is held outside the CMBS trust

b. Actions proposed to be taken in respect of a workout or disposition of a defaulted mortgage loan by a party with control rights, such as the controlling certificateholder or the holder of any note or participation interest related to such mortgage loan which is held outside the CMBS trust, will be subject to override by the special servicer in accordance with the Servicing Standard

C. Servicer Advancing

1. There are two types of advances that master servicers are generally required to make:

a. “P&I Advances”

b. “Servicing Advances”

2. “P&I Advance”

a. An advance of delinquent payments of principal and interest due in respect of each mortgage loan or portion thereof included in the CMBS trust

b. In the event of a maturity default of a mortgage loan, P&I Advances will be the debt service payments that would have been payable by the related borrower had the mortgage loan not matured

c. Intended to provide liquidity (which is needed in order to maintain the ratings on the CMBS certificates), not credit support

d. P&I Advances are not typically made in respect of any B Note or subordinate participation interest

e. P&I Advances may be reduced by “Appraisal Reduction Amounts”

3. The “Servicing Advance”

a. An advance of amounts needed to preserve and protect the value, use or operation of, or to realize upon, the mortgaged property securing each mortgage loan (including any notes or participation interests held outside the CMBS trust)

b. Certain circumstances require the master servicer or special servicer to make advances:

i. When such servicer has made a “nonrecoverability determination” (i.e., generally that the advance would not be ultimately reimbursed from the final recovery made on the mortgage loan in respect of which such advance was made)

ii. Since the servicers will have priority on recovering advances in any liquidation or disposition scenario, nonrecoverability determinations are not common

4. The Advance Reimbursement Mechanism:

a. First, from related late collections from borrowers

b. Second, from liquidation proceeds, condemnation proceeds, insurance proceeds or REO property revenues from the related property

c. Third, if the advance is determined to be nonrecoverable, out of general collections from the related mortgage loan or any other mortgage loan included in the CMBS trust

5. Interest is generally payable in respect of unreimbursed advances:

a. “Advance interest” is payable on the principal amount of unreimbursed P&I Advances and Servicing Advances for as long as they remain unreimbursed, and typically such interest accrues at the prime rate

b. Advance interest is paid to the servicer making the advance prior to payments made on the CMBS certificates or any note or participation interest held outside the CMBS trust

c. Advance interest is typically paid first from default interest and late charges received from the related borrower, and then from general collections

6. The general relevance of advancing in the context of a workout:

a. Advances which are not reimbursed from late collections from the borrower may result in shortfalls in payments to holders of the CMBS certificates or notes or participation interests held outside the CMBS trust

b. If interest on advances is not ultimately recovered from late payments or default interest paid by the borrower, such amounts may result in shortfalls in payments to holders of the CMBS certificates or notes or participation interests held outside the CMBS trust

c. Advances and advance interest will typically be a component of any purchase price payable by a holder of a defaulted mortgage loan purchase option and is typically required to be paid by the holder of a B Note or subordinate participation interest in exercising its cure rights

D. Special Servicing of a Mortgage Loan

1. A mortgage loan becomes a specially serviced loan if any of the following events (called “servicing transfer events”) occurs:

a. The borrower fails to make a scheduled monthly payment, and the payment is past due for a certain period, typically 60 days

b. The borrower fails to make the balloon payment (or if the borrower has a refinancing commitment and is continuing to make monthly payments, the refinancing does not occur within a certain period following the balloon default, typically 60-120 days)

c. The master servicer believes that a payment default is imminent and not likely to be cured within the related servicing transfer grace period

d. A non-monetary default that materially impairs the value of the mortgaged property or materially adversely affects the CMBS certificateholders occurs and continues for a certain period (typically, the cure period set forth in loan documents or 30 days if none is specified)

e. A borrower insolvency event occurs

f. Foreclosure proceedings are commenced

2. The Special Servicer is generally entitled to 3 types of fees (as well as other ancillary servicing compensation):

a. Special Servicing Fee

b. Workout Fee

c. Liquidation Fee

3. The Special Servicing Fee:

a. A fee payable in respect of each specially serviced loan (for as long as such loans remain specially serviced loans)

b. Calculated by multiplying the “Special Servicing Fee Rate” (a per annum rate) by the aggregate outstanding principal amount of each specially serviced loan

4. The Workout Fee

a. A fee equal to a percentage (typically, 0.50% to 1.00%) of collections of interest and principal as they are received in respect of each specially serviced loan which has been returned to performing status by the special servicer

5. The Liquidation Fee

a. A fee equal to a percentage (typically, 0.50% to 1.00%) of liquidation proceeds received by the CMBS trust from a sale of the mortgage loan or other final disposition, foreclosure or liquidation of the mortgage loan by the special servicer

b. In many cases, the special servicer is not entitled to a Liquidation Fee if the specially serviced loan is sold pursuant to a purchase option in respect of the mortgage loan held by a mezzanine lender, a subordinate interest holder, or a party exercising its “fair value purchase option,” if the option is exercised within 60-90 days of the event which triggers the right to exercise the purchase option

6. The effect of special servicing compensation on subordinate CMBS certificateholders and/or holders of subordinate interests in mortgage loans:

a. Generally, these fees will attach to the mortgage loan through final pay-off or disposition

b. These fees are not typically reimbursable by the related borrower unless incorporated into the terms of the workout, so such fees generally will result in shortfalls to the subordinate noteholders, subordinate participation holders and/or subordinate classes of CMBS certificates

III. Typical Rights of a B Note Holder Under an Intercreditor Agreement

A. Generally:

1. Cure rights

2. Defaulted loan purchase option

3. Servicing

4. “Control Appraisal Event”

5. Transfers

B. B Note Holder Cure Rights upon Borrower Default

1. The B Note holder has the right to cure the borrower’s defaults within:

a. The same cure period as the borrower, plus

i. For monetary defaults, 5 business days

ii. For non-monetary defaults, 30 calendar days

b. There is typically a limit of 3 or 4 consecutive cures, as well as a limit of 6 to 9 cure episodes over the life of the mortgage loan

C. B Note Holder Purchase Option

1. B Note holder has the right to purchase the A Note upon the occurrence of certain triggering events of default, the B Note holder has the right to purchase the A Note from the A Note holder at the “Defaulted Mortgage Loan Purchase Price”

a. The same loan defaults that trigger a change in the payment waterfall from the “Pre-Event of Default Waterfall” to the “Post-Event of Default Waterfall”

i. Monetary events of default

ii. Material non-monetary events of default

2. The “Defaulted Mortgage Loan Purchase Price” (See “Exhibit J”)

a. The Defaulted Mortgage Loan Purchase Price typically does not include yield maintenance, prepayment premiums or default interest

b. The Defaulted Mortgage Loan Purchase Price may or may not include Special Servicing Fees, Workout Fees or Liquidation Fees

D. Servicing an A/B Loan

1. Generally:

a. The master and special servicers of the securitization pool service the whole loan on behalf of both the A Note and B Note holders

b. The servicing agreement for the securitization of the A Note will typically provide that the servicers must service the loan in the best interests of both the A Note and B Note holders as a collective whole, taking into account that the B Note is subordinate to the A Note

c. The B Note holder typically may appoint the special servicer for the mortgage loan, so long as no “Control Appraisal Event” has occurred (which is described below)

2. Rights of the B Note holder in connection with the A Note holder’s servicing activities

a. For certain important servicing activities, the B Note holder has consent rights

b. For certain less important (but still material) servicing activities, the B Note holder has consultation rights

c. The A Note holder must obtain the consent of the B Note holder at certain times.

i. So long as no Control Appraisal Event has occurred, the A Note holder must receive the B Note holder’s consent in connection with certain enumerated actions, typically including:

ii. Any modification or waiver that extends the maturity date

iii. Any reduction, deferral, or forgiveness of interest, principal, or monthly debt service

iv. Any modification or waiver of provisions restricting additional indebtedness

v. Any modification of a monetary term of the loan

vi. Any foreclosure of the mortgage

vii. Any acceptance of substitute or additional collateral, or any release of collateral

viii. Any waiver of a “due-on-sale” or “due-on-encumbrance” clause

ix. Any release of the borrower or any guarantors from liability

x. Any transfer of the property or ownership interests in borrower, unless permitted by the loan documents

xi. Any vote on a plan in a bankruptcy proceeding

xii. Any modification or waiver of insurance provisions

xiii. Note: The scope of actions over which the B Note holder has a consent right is often negotiated and will vary from transaction to transaction

3. The A Note holder is not always required to comply with advice or instructions from the B Note holder if doing so would cause the A Note holder to violate (the “Servicing Standard Override”):

a. Applicable law

b. The terms of the loan documents or the intercreditor agreement

c. The Servicing Standard

d. The terms of the pooling and servicing agreement or the REMIC provisions relating to the securitization of the A Note

4. B Note holder restrictions with respect to bankruptcy proceedings

a. Although the B Note holder has a consent right over any vote on a plan in a bankruptcy proceeding, the B Note holder agrees:

i. Not to commence a bankruptcy proceeding against the borrower until the A Note holder has been paid in full

ii. To execute any proofs of claim and consents and to assign to the A Note holder its right to vote any claims in any bankruptcy proceeding

b. Note: The assignment by a B Note holder of its bankruptcy claims was found unenforceable in a recent case

E. Control Appraisal Event (See “Exhibit K”)

1. The “Appraisal Reduction Amount” for any mortgage loan equals the sum of:

a. the outstanding principal balance of such mortgage loan, plus

b. all accrued and unpaid interest on such mortgage loan, plus

c. all unreimbursed advances and interest on such advances in respect of such mortgage loan, plus

d. all unpaid real estate taxes and assessments, insurance premiums, ground rents and other amounts which were required to be deposited in any escrow account (but were not deposited) in respect of such mortgage loan minus the sum of:

e. 90% of the appraised value of the related mortgaged property, plus

f. the amount of any escrows held in respect of the related mortgage loan

2. The A Note holder must order an appraisal of the property:

a. 60 days after an uncured delinquency

b. 60 days after any modification of the interest rate, principal balance, amortization schedule, or any other material economic loan term

c. 60 days after a receiver is appointed, or immediately after an insolvency event or the property becomes REO property

d. Upon any other event which the A Note holder believes would materially and adversely impair the property’s value

3. The purpose of the Control Appraisal Event concept

a. The purpose of a Control Appraisal Event is to provide the B Note holder with certain consultation and consent rights only so long as the B Note principal balance (as calculated pursuant to the “Control Appraisal Event” formula) remains above a threshold level (generally a minimum of 25% of its original principal balance)

F. Transfers of the B Note

1. Restrictions on transfer:

a. The B Note holder may not transfer more than 49% of the B Note without the A Note holder’s consent (and, after a securitization, receipt of rating agency confirmation), unless the transfer is to a “Qualified Transferee”

b. The B Note holder may transfer 49% or less of its interest in the B Note without the A Note holder’s consent

c. Generally, the B Note holder may not transfer any part of its interest in the B Note to the borrower or an affiliate of the borrower

2. The “Qualified Transferee”

a. Certain entities (such as REITs, banks, insurance companies, pension funds, investment companies, etc.) that:

i. Have total assets in excess of $600,000,000 and capital surplus or shareholders’ equity of $250,000,000; and

ii. Are regularly engaged in the business of making or owning commercial real estate loans or operating commercial mortgage properties

b. Trustees in connection with a securitization of the B Note (for example, in CDO or commercial paper conduit transactions)

c. Investment funds owned at least 50% by an entity that is otherwise a “Qualified Transferee”

3. The B Note holder can pledge its interest in the B Note, so long as the pledge is:

a. Qualified Transferee; or

b. an entity whose long-term unsecured debt is rated “A” (or its equivalent) or better by each rating agency; or

c. any other entity, so long as a rating agency confirmation is obtained

IV. Practical Advice for Dealing with a Defaulted Mortgage Loan at the Initial Stages

A. Investor’s first steps when a mortgage loan default has occurred or is about to occur

1. Find the relevant documents

2. Figure out who is in “control”

3. Determine the exact nature of the default

4. Evaluate impact of sending out default notices

5. Consider short term rights (cure and purchase options)

6. Analyze initial strategy options

B. Relevant documents

1. The investor should get copies of applicable operative documents, which may include:

a. Pooling and Servicing Agreement

b. Co-Lender or Participation Agreement

c. Mezzanine Intercreditor Agreement

d. Final versions of all the key mortgage loan documents

e. Repo, warehouse or CDO documents, as applicable

2. There may have been changes to documents post-closing, so request copies of any amendments

C. The “Controlling Holder” or “Controlling Party”

1. The master servicer or special servicer, as applicable, of the mortgage loan will be the party in direct communication with the borrower

2. However, the master servicer or special servicer, as applicable, typically must consult with and take directions from a “controlling party” in dealing with a troubled mortgage loan

3. Possible “controlling parties” include:

a. The B Note holder (or most subordinate noteholder or participant if there is more than one subordinate note)

b. The holder or holders of a pari passu A Note (this may include the servicer of such pari passu A Note if the same has also been securitized)

c. “Rake bondholder” within the securitization vehicle

d. The holders of the “controlling class” of CMBS certificates

4. Note that if a B Note or participation interest has been financed (i.e., through a repo or warehouse facility) or included in a CDO, then there may be further issues to consider with respect to the exercise of control rights

D. The true nature of the default

1. The servicer and the investor should gather all relevant information about the default or potential default, such as:

a. Relevant correspondence to and from borrower, including any default notices delivered to borrower

b. Most recent cash flow statements, asset status reports and other financial information about the borrower and the property

c. Most recent appraisal of the property

2. The loan documents should be reviewed to determine if the facts trigger more than one type of default (for example, a monthly payment default might also constitute a breach of covenants regarding the payment of taxes and insurance)

3. Different types of defaults require different types of workout strategies

E. Parties that must be informed of the default

1. The servicer needs to give notices of the occurrence of any default or potential default to the following parties (as required under the applicable operative documents):

a. B Note holders or subordinate participants

b. Holders of pari passu A Notes

c. Mezzanine lenders

d. Any repo or warehouse lenders that are “pledgees” and have requested default notices

2. The servicer should also check the relevant documents to determine whether non-controlling parties are also entitled to notice

F. Delivery of the formal notice of default to borrower

1. The servicer and the controlling party need to discuss the impact of delivering a formal notice of default to the borrower, such as:

a. Whether a notice of default will lead to a change in the payment waterfall and prevent further payments to the subordinate note holders

b. Whether there will be any unintended negative impact on the borrower or the project as a result of the default notice (e.g., problems with NY condo conversion loans and the Attorney General’s office or jeopardizing a potential refinancing or sale of the property)

c. Whether a notice of default will lead to a transfer of the mortgage loan to special servicing

d. Whether a notice of default will trigger any negative results for the controlling party (such as margin calls or defaults) under any repo or warehouse financing

G. Replacing special servicer

1. The party in the control position should consider whether to replace the special servicer for the mortgage loan

a. Generally a minimum of 30 days’ notice is required and the costs are the responsibility of the party exercising the replacement right

b. Generally there is no right to replace the master servicer, only the special servicer. Therefore, if the mortgage loan has not been transferred to special servicing, exercising this right will have a reduced impact

c. Benefits include more participation in the process for the controlling party and the potential to negotiate for reduced special servicing and workout fees

H. Short term rights an investor should consider (Cures)

1. The B Note holder should decide whether or not to exercise its right to cure a default:

a. Consider likelihood that mezzanine lenders or any more subordinate note holders will cure the default

b. Analyze different cure periods available to the various parties (i.e., sequential or concurrent) and when they lapse

c. Possible benefits of curing a non-balloon default:

i. Avoid incurring servicing costs and servicer advances

ii. Delay trigger for a “control appraisal” test thereby preserving control for the subordinate noteholder

iii. Potential to prevent waterfall from shifting into strict subordination with all payments going to A Note

iv. Potential to delay the transfer of the loan to special servicing (including the increased special servicing fees or workout fees)

d. Consider impact of an uncured default on repo financing

I. Short term rights the investor should consider (Purchase Options)

1. The B Note holder should determine whether and when it would be appropriate to exercise a purchase option

a. Consider whether or not mezzanine lenders or more subordinate noteholders or participants are likely to exercise their own purchase options first

b. Evaluate time periods and rights available to each party to exercise purchase option (i.e., does a mezzanine lender have a purchase option that would trump a B Note holder’s option)

c. Need to calculate purchase price under the co-lender or participation agreement

d. Consider alternative of using “fair value purchase option” under pooling and servicing agreement

i. What is the “fair value” price

ii. Compare “fair value” price to negotiated purchase price in participation or co-lender agreement

e. Need to consider transition of servicing arrangements away from pooling and servicing agreement

i. Does the co-lender or participation agreement contain servicing provisions which “spring back” if the A Note is no longer securitized

ii. Is a replacement servicing arrangement in place if needed

iii. If controlling party does not agree with proposals from the servicer or special servicer, exercising replacement rights to get a new special servicer may be just as effective as a purchase of the entire mortgage loan

f. Whether purchase of A Note enhance likelihood of an acceptable resolution

i. If controlling party is already actively involved in strategy to address the default, what more is to be gained by owning the entire mortgage loan

ii. If workout proposals which the controlling holder wants to accept are limited by the Servicing Standard or the fact that the A Note is securitized, then a purchase of the A Note out of securitization may be the only viable option

J. Consider whether the servicer or the controlling party should require a “pre-negotiation” or “pre-workout” letter from the borrower?

1. It depends on the specific facts of each deal

a. Purpose of such a letter is generally to have the borrower (and often guarantors) acknowledge the existence of defaults, waive defenses and release any potential claims against the lender as a pre-condition to workout discussions

b. Letter also makes clear that all negotiations and discussions are non-binding and can be discontinued at any time

c. Borrowers may object to providing such letters. Objections are stronger in circumstances where borrower has come to lender prior to the actual default (i.e., in anticipation of an impending maturity default)

K. Initial strategy options an investor needs to consider

1. Servicer and the controlling party should make some threshold decisions on overall initial strategy for addressing the troubled mortgage loan

2. There are basically three categories:

a. Amendments of the loan

b. Forbearance and standstill arrangements

c. Enforcement of remedies

3. Amendments to the mortgage loan

a. The servicer and the controlling party should consider whether amending the mortgage loan is a viable resolution

i. The underlying terms of the mortgage loan documents can be amended to remove the default, for example an amendment can:

a) extend the maturity date to eliminate a balloon default

b) reduce principal or the interest rate to address payment defaults

c) revise or remove a financial covenant

b. Amendments are permanent changes to the underlying terms of the mortgage loan with the intended result being a performing loan with all existing defaults cured

c. Addressing any subsequent defaults will generally require beginning the process all over again

d. Amendments may often require the B Note holder or subordinate participant to go back and get credit committee approval

4. Forbearance or Standstill Agreements

a. The servicer and the controlling party should analyze whether a forbearance agreement is an appropriate way to address mortgage loan defaults

i. In forbearance or standstill arrangements the lender agrees to forbear from exercising any remedies for a set period of time, as long as the borrower satisfies certain negotiated conditions

ii. This is different from a loan amendment because

a) the defaults are not cured or permanently waived, so the loan remains technically in default

b) the lender’s agreement to forbear is only temporary and may be terminated if the borrower fails to meet any of the forbearance conditions, and

c) the loan documents are not actually amended

iii. Forbearance agreements are often the first step towards an amendment (as they can sometimes be entered into more quickly than a formal amendment)

iv. Forbearance agreements may be used to give a borrower some breathing room while it tries to refinance or sell its property or may be appropriate to address temporary defaults resulting from seasonal or situational circumstances

v. Forbearance agreements do not constitute a waiver of any defaults, just a standstill on enforcement. Therefore, if a forbearance agreement is breached or expires, the lender may pursue its remedies

5. Enforcement

a. If neither an amendment nor a forbearance agreement is an appropriate solution (or if a borrower has breached the terms of a forbearance agreement), enforcement may be the best option

i. The exercise of remedies can take many forms, and may be against a borrower or a guarantor or the property depending on the loan documents

ii. The later sessions discuss in great detail the enforcement process

V. Effects of Securitization on the Process of Formulating a Workout Strategy

A. Certain parties will be communicating with the borrower during the workout

1. The special servicer is typically the only party that is entitled to communicate with the borrower following an event of default

2. The B Note holder is generally forbidden from communicating with the mortgage borrower under the terms of the co-lender agreement

3. The B Note holder instead will exercise its consent and consultation rights through correspondence with the special servicer

B. Subordinate Interest Holder’s Influence Over Workout Strategy

1. The B Note holder or the holder of the controlling class of certificates has significant influence over the workout process as a result of:

a. its right to replace the special servicer

b. its exercise of consent and consultation rights

2. Absolute veto right over any proposed workout strategy

a. Neither the B Note holder nor the controlling class has an absolute veto right over any proposed workout

b. The Servicing Standard always controls

c. Special servicers have a duty to all certificateholders and subordinate noteholders collectively

C. Factors that Delay Formulation of a Workout Strategy

1. Delays in formulating a workout strategy can result from a number of things, including:

a. Delivery of required notices

b. Allowing cure periods to run

c. Additional or extended “grace periods" imbedded in servicing transfer events

d. Required approvals of B Note holders, controlling class certificateholders, or even a pari passu note holder

e. Preparation of and revisions to asset status reports

f. Existence of mezzanine loans

2. Other Factors Affecting the Formulation of a Workout Strategy

a. The REMIC rules which govern the securitization may make it more difficult to modify a loan in anticipation of a default

b. Other factors which often influence balance sheet lenders, such as accounting and tax ramifications, are not concerns of the special servicer

D. Potential Conflicts of Interest inherent in the Workout Process

1. Since a B Note holder or controlling class certificateholder has the right to appoint the special servicer, such B Note holder or controlling class certificateholder may want to appoint itself or an affiliate as the replacement special servicer

2. Such a situation would put the special servicer in a direct conflict of interest with the other certificateholders in light of such holder’s subordinate position

3. The special servicer is obligated to specially service the defaulted mortgage loan in accordance with the Servicing Standard, which means, among other things, without regard to any conflicts of interest to which it may be subject

4. Additional or more complex conflicts of interest may result from such holder owning other positions in the capital stack (e.g., related a mezzanine loan)

5. The existence of conflicts of interest should be carefully considered by the special servicer before implementing any workout strategy due to potential liability for breach of the Servicing Standard

VI. How Does the Securitization Affect Certain Workout Strategies

A. Extending the Maturity Date

1. Limitations a securitization places upon the parties’ ability to extend the mortgage loan maturity date

a. All securitizations place outside limits on an extended maturity date of a mortgage loan

b. The extension limitations depend upon the type or age of the securitization

c. Almost all pooling and servicing agreements do not allow extensions past a certain date prior to the "rated final distribution date“

i. For most fixed rate conduit and fusion deals, this is not an issue since the rated final distribution date is typically more than 20 years past the original loan maturity date

ii. Large loan floating rate securitizations have more significant constraints, often as short as 2-3 years or less

iii. Some older single loan securitizations have virtually no extension

iv. flexibility unless 90%-100% of the certificateholders consent

B. Additional Funding for the Borrower

1. Additional funds available to the borrower

a. A CMBS trust will not be able to make additional loan funds available to the mortgage borrower as a part of a workout

b. Deferral of debt service payments and/or unreimbursed advances is generally permitted, but some pooling and servicing agreements contain limits on the duration and amount of such deferrals

c. New funds can still come from the sponsors of the borrower or the B Note holder

C. Loan Assumptions

1. Limitations a securitization places upon the mortgage borrower’s ability to sell the property and have the mortgage loan assumed

a. The pooling and servicing agreement generally places restrictions upon waivers of the “due-on-sale” clause

b. Depending upon the size of the mortgage loan, loan assumptions may be subject to rating agency confirmation

D. Incurring Additional Debt

1. Limitations a securitization places upon the mortgage borrower’s ability to incur additional secured debt or mezzanine debt

a. The pooling and servicing agreement generally places restrictions upon waivers of the “due-on-encumbrance” clause

b. Depending upon the size of the mortgage loan or the “all-in” debt service coverage ratio or loan-to-value ratio, any consent to additional secured debt or mezzanine debt may be subject to rating agency confirmation

E. Addition or Substitution of Collateral

1. Limitations a securitization places upon the mortgage borrower’s ability to add or substitute collateral for the mortgage loan

a. The pooling and servicing agreement and the REMIC rules place restrictions on the ability of the servicer to permit changes to the collateral for the mortgage loan

b. In addition, material changes to the collateral for the mortgage loan (which are not specifically contemplated in the mortgage loan documents) may be subject to rating agency confirmation

F. Debt Forgiveness

1. Limitations a securitization places upon the servicer’s ability to reduce interest and/or principal payments or write down the principal balance of the mortgage loan

a. The B Note holder or most subordinate certificateholder would bear the full impact of any such reductions or write downs until wiped out, prior to the other certificateholders incurring any losses

b. The B Note holder or controlling class certificateholder will have a consent right over any such action, subject to the Servicing Standard Override

c. Some single loan securitizations may require consent of all or substantially all impacted certificateholders

G. Selling the Defaulted Loan

1. Limitations a securitization places upon the servicer’s ability to sell a defaulted mortgage loan

a. Other than pursuant to the defaulted mortgage loan purchase option granted under an intercreditor agreement, typically the CMBS trust may sell a defaulted loan only indirectly through the “fair value purchase option”

i. The fair value purchase option is the right of the holder of such option to acquire the mortgage loan at a ”fair value” price determined by the special servicer

ii. The “fair value” is the fair value of the mortgage loan, as determined by the special servicer from time to time in accordance with the Servicing Standard, taking into account expected recoveries from other potential workout strategies, such as modifying the mortgage loan or foreclosing and disposing of the REO property

iii. Under the pooling and servicing agreement, the fair value purchase option is initially given to one or more parties, typically the special servicer and the controlling class certificateholder, and such option is freely assignable by such party (except to the mortgage borrower or any of its affiliates)

EXHIBIT A

WHOLE MORTGAGE LOAN

EXHIBIT B

PARI-PASSU LOAN STRUCTURE

EXHIBIT C

A/B LOAN STRUCTURE

EXHIBIT D

PRE-EVENT OF DEFAULT WATERFALL

EXHIBIT E

POST-EVENT OF DEFAULT WATERFALL

EXHIBIT F

PARTICIPATED MORTGAGE LOAN STRUCTURE

EXHIBIT G

SECOND MORTGAGE LOAN STRUCTURE

EXHIBIT H

MEZZANINE LOAN

EXHIBIT I

TYPICAL CMBS TRANSACTION WITH B NOTE

EXHIBIT J

DEFAULTED MORTGAGE LOAN PURCHASE PRICE

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EXHIBIT K

CONTROL APPRAISAL EVENT

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The Defaulted Mortgage Loan Purchase Price is a cash price equal to:

A “Control Appraisal Event” exists if:

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