The IRS Issues New Regulations Designed To Facilitate CMBS Workouts

Author(s): Bruce E. Prigoff, Richard H. Rosenthal, Adam B. Weissburg

Source: CCN Client Alert

9/29/2009

On September 15, 2009, the Treasury issued new regulations that are intended to make it easier for servicers to modify ‘conduit’ loans without jeopardizing a REMIC’s favorable tax treatment. As discussed below, the changes are intended to facilitate loan modifications necessitated by the general decline in the values of commercial real estate and the absence of new credit, and seek to do two things: (a) grant greater flexibility to borrowers to shore up deficiencies in loan to value ratios; and (b) allow servicers to modify loans earlier than usual where it is relatively certain (or at least likely) that the loan will not be repaid at maturity. It remains to be seen, however, whether these regulations will spur modifications of CMBS loans as servicers will still need to comply with the terms of pooling and servicing agreements to modify such loans, which terms may impose more rigorous standards for approval of such modifications. In addition, though the regulations may remove a perceived hurdle to a servicers ability to modify a CMBS loan prior to it being in default (or imminent default), it is likely that servicers will still give priority to the large (and growing) number of CMBS loans that are actually in default, or as to which default is imminent. Finally, these regulations do not affect any rights of third parties, such as subordinate certificate holders, co-lenders, junior participants, mezzanine lenders, etc., to consent to such modifications.

Regulations Allowing Additional Non-Significant Modifications. Federal tax law provides that "significant" modifications to loans that are held in REMIC trusts will result in significant adverse tax consequences to the bondholders, under certain circumstances. However, certain modifications are deemed by the IRS not to be "significant," and, therefore, do not have adverse tax consequences. To the present list of modifications that are deemed to be not significant, the IRS now adds (i) changes in collateral or a guarantee, or credit enhancement of an obligation, and (ii) changes to the recourse or non-recourse nature of a loan. However, as will be discussed below, to take advantage of these exceptions the modified loan must continue to be principally secured by real property.

There are two tests of whether the obligation continues to be principally secured by real property at the time of such modification. Either the fair market value (“FMV”) of the property must be at least 80% of the “adjusted issue price of the modified loan” (which probably means 80% of the outstanding principal balance of the loan), or, alternatively, the FMV of the secured property after the modification must equal or exceed the FMV of the secured property before the modification. The servicer's belief regarding the FMV of the property must be based on a "commercially reasonable valuation method" such as (i) a current appraisal performed by an independent appraiser, (ii) an update of the origination appraisal that takes into account the passage of time and changes to the property, or (iii) the sales price of a substantially contemporaneous sale in which the buyer assumed the loan. In addition, the servicer must not actually know, or have reason to know, that the FMV test is not met. Thus, in the absence of a substantially contemporaneously sale in which a loan was assumed, to effect such a modification either a new appraisal must be obtained or the origination appraisal updated.

It should be noted that the requirement that the loan ‘be principally secured by real property’ after a modification, applies to releases which the borrower has a unilateral right to under the Loan Documents. In addition, releases of less than ten percent (10%) of the property, previously thought to be insignificant modifications of a loan, will now be subject to the requirement that the modified loan meet the ‘principally secured by real property’ test, i.e., appraisals may be required.

Regulations Permitting Modifications When a Default is Reasonably Foreseeable. More significantly, a newly released Revenue Procedure makes clear that with respect to significant modifications, a default will be considered to be “reasonably foreseeable” and therefore will not have adverse tax consequences if such modifications will result in a “significantly reduced risk of default.” Presently, for a significant modification to be characterized as “reasonably foreseeable” and, therefore, not to result in adverse tax consequences, it is commonly believed that a default has to exist or be imminent. By clarifying that the “reasonably foreseeable” standard is not whether a default exists or is ‘imminent,’ but, rather, whether circumstances presently exist that present a significant risk of default in the foreseeable future, the IRS is attempting to facilitate pre-default workouts of presently performing loans that are at risk of becoming non-performing in the foreseeable future. The example given by the IRS is of a currently performing loan that matures in one year. Due to the current state of the credit markets and the financial condition of the property, it is anticipated that the loan will not be repaid at maturity. That is, default is not imminent, but it is, nevertheless, reasonably foreseeable. Accordingly, an extension is permitted without triggering adverse tax consequences because it will significantly reduce the risk of future default. This, obviously, provides Borrower’s additional time to seek modifications, which may be difference between salvaging or losing the project.

The servicer must reasonably believe that there is a significant risk of default upon maturity of the loan or earlier. This belief must be based on a “diligent contemporaneous determination of that risk, which may take into account (i) credible written factual representations made by the borrower, if the servicer neither knows or has reason to believe that such representations are false,” and/or (ii) the servicer’s general knowledge of “current economic conditions in the relevant credit market.” Thus, the servicer may rely on a written representation from the Borrower to the effect that it believes that it is not probable that it will be able to repay the loan at maturity, so long as the servicer does not know, or have reason to know, that such representation is false. Though not specified by the regulations, a conservative approach would be for such assertions by the borrower to be supported by credible information. How far in the future a default may occur is a factor for the servicer to consider, but a maximum period is not imposed. And even though the loan is presently performing, a servicer may determine that a default is reasonably foreseeable.

The Impact of Pooling and Servicing Agreements, and Other Agreements That Provide Consent Rights To Third Parties. It should be noted that notwithstanding the IRS’ attempt to facilitate pre-default modifications, servicers may not be able to enter into such modifications if a default does not exist or is not, at a minimum, imminent. Many types of modifications can only be made of specially serviced loans, and must be approved by the special servicer. Accordingly, such loan must be transferred to special servicing which often requires that, at a minimum, a default be imminent. Also, at noted above, these regulations do not affect any rights of third parties, such as subordinate certificate holders, co-lenders, junior participants or mezzanine lenders, to consent to modifications of a loan, or to delay the transfer of a loan to special servicing.

Conclusion. Though some servicers may feel that these regulations increase their ability to enter into modifications, we understand that some servicers feel that these changes will not materially change how requests for loan modifications are treated. It should also be recognized that these regulations only affect the constraints imposed by REMIC, and do not modify the obligations of servicers under pooling and servicing agreements, the rights of third parties to consent to modifications, or the practical limitations on servicers’ abilities to respond to requests for loan modifications.