News

Where Distress Goes, Lawsuits May Follow

February 2010

The environment of troubled assets and loans can give rise to litigation, and even buyers can face legal liability

By Paul Bubny

While it’s not true that behind every distressed situation sits a lawsuit or two, the environment of troubled assets is conducive to litigation. The legal fallout from a default can land on borrowers, lenders, special servicers – and, if they’re not careful, investors.

“You’re going to see a lot more litigation come out of this, as a result of all the debt that has to be refinanced over the next three years,” says Stuart M. Saft, chair of the global real estate practice at New York City-based law firm Dewey & LeBoeuf LLP. Citing Deutsche Bank, he notes that as much as 60% of the total debt that’s coming due in the next three years can’t presently be refinanced – a horrendous problem in the making. “All of these participants will be looking for ways to get their pound of flesh.”

Complicating matters – and increasing the potential for lawsuits – is the sheer complexity of the securitized transactions that comprise about one-quarter of the commercial debt set to mature between now and 2013. “The lenders realize that they’re sitting on this debt that they can’t really figure out how to proceed with,” says Saft. “They may decide to go after whoever brought them into the loan in the first place and take the position that there hasn’t been full disclosure on what the risks were.”

A similar scenario can apply in the case of mezzanine financing. “You have a hedge fund go in and take what they thought was a very safe senior mezz position and suddenly their position is underwater; they have to tell their investors something,” Saft says. That “something” can take the form of a lawsuit, also on grounds that the hedge fund wasn’t told everything.

Investors who allegedly didn’t get all the necessary information when they sought financing on four high-end resorts ended up filing for bankruptcy, and recently slapped Credit Suisse and Cushman & Wakefield with a $24-billion class action lawsuit. Both companies have said the suit lacks merit, and Saft doesn’t think there will be many more like them. That’s partly because real estate-related bankruptcy filings are uncommon, notwithstanding high-profile examples such as the General Growth Properties filing.

“It’s very difficult for real estate owners to just throw a building into bankruptcy,” he says. “The last time we went through problems similar to the ones we’re currently facing, it happened all the time.” Congress then amended the Bankruptcy Code in 1994, creating special provisions for single-asset real estate firms and making it difficult to do workouts, Saft says. He suggests this is why there have been so few real estate bankruptcy filings in the past two years.

The GGP filing was different in that the retail developer filed for various entities that controlled individual GGP properties. So it wasn’t just a single-asset real estate case, Saft says. “Most real estate is owned in a single entity in order to shield it from any other liabilities, so that limits the ability to use bankruptcy as an avenue for solving the problems.”

Keeping down the incidence of bankruptcy is the prevalence of non-recourse debt in most commercial mortgages. The exception to the non-recourse provision, Saft says, is carve-outs in which an action such as a bankruptcy filing would be considered an “event” that gives the lender the chance to seek recourse. In that case, “the lender can then go after the borrower for the full outstanding amount.”

Some of these events can arise from so-called “bad-boy guarantees,” says Howard Landsberg, partner with accounting firm Weiser Real Estate Advisors. Such guarantees may be intended to assure that borrowers are not, for instance, insolvent or commingling funds. Landsberg is currently handling a case where the borrower defaulted on their loan, with the collateral eventually trading in a sheriff’s sale. As a result, the lender took a hefty loss. That lender is now suing the principals of the special-purpose vehicle that was the borrower under the bad-boy guarantee.

“The lender is saying, ‘you did not hold yourselves out as an SPV under the loan agreement, and because you did not, we’re holding you liable for what we lost,’” Landsberg explains. Although such guarantees are common, he says they haven’t been enforced very often – until recently. “People are trying to recover as much as they can.”

The existence of the non-recourse loans doesn’t preclude litigation on the other side of the borrower-lender divide. For example, Saft says, a borrower may argue that the lenders interfered with its operation of the property. “You have the borrowers attempting to sue the lenders, which is rarely successful, but lenders nevertheless don’t want to get bogged down in the litigation,” he says. Or a lender may sue the borrowers on grounds of deception. “It has nothing to do with the non-recourse carve-outs; they think that the borrower has borrowed $300 million on this property and has $100 million hidden away in a bank account somewhere,” he says.

Borrowers and lenders have different motives for avoiding court proceedings and going the workout route instead. “The borrowers are looking to buy time, and to a large extent, that’s what workouts are all about – trying to buy time until the markets improve,” says Saft. “The lenders are in a much stickier position, because they’re concerned about what the rating agencies and regulators are going to say.” As a result, lenders often prefer to restructure the debt to avoid having to create “a huge loss reserve” for the amount of this loan. The most instrumental party to any restructuring is often the special servicer, and even with their heavy caseloads, they would do more to move workouts along – if only they could. The need to abide by the pooling and servicing agreements on loans frequently leaves servicers with their hands tied, lest they be liable to investors or bond trustees.

“Nobody, when they were writing the PSAs, could have possibly envisioned what we’ve gone through in the past year and a half,” Saft says. “As a result, the servicers have become extremely conservative in proceeding. They believe that if they do anything that contradicts the PSA, they will get sued.”

If borrowers and lenders try to avoid going to court, Saft sees a rise in tranche warfare – or, as he puts it, “cannibalism” among lenders. “You may have lenders in an inferior lien position going against more senior lenders, saying that the senior lenders have placed them at risk.” Although investors in properties or notes don’t face such immediate threat of litigation, there are circumstances where the residue from a distressed situation can get on their hands.

For example, says Paul Fried, managing director at Traxi, “When you’re a distressed investor, presumably what you’re buying has a bunch of history behind it. What you don’t know is if any of that history amounts to liability on the part of the lender that sold the note. And you don’t know if there are liabilities in buying the note that could force a borrower response.” Doing the customary due diligence on distressed loans or bank-owned properties may not yield this information, because the lender is not obligated to provide all of the prior owners’ files to the would-be buyer. “Beyond what the bank will give you or you can find in public records, you’re on your own,” Fried says.