Future Shock Mortgage Securitization in Bankruptcy

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Apr 1999

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The Supreme Court's decision last term in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of America NT & SA v. 203 North LaSalle Street
Partnership, 119 S.Ct. 1411 (1999)</a>, is a significant victory for the mortgage-lending community. However,
as set forth below, there is serious question as to whether holders of securitized mortgage debt—which
constitutes a significant portion of all commercial mortgage debt today—will be able to take advantage of
the LaSalle decision.

LaSalle establishes a mechanism for undersecured mortgagees to take control of the liened property
in bankruptcy. The basic requisite to control likely will be a prompt cash bid for the equity (ownership)
of the reorganized debtor. For the reasons set forth below, the typical organic documents of a
securitized mortgage pool are likely inadequate to deal with LaSalle, and could indeed result in
situations where the mortgagee is outbid by the existing owners of a single-asset debtor. At least
hundreds of billions of dollars of mortgage debt are subject to this problem. To better understand it,
some background about LaSalle and the structure of securitized mortgage debt will first be set forth.

The LaSalle decision sharply limits the ability of the owners of a single-asset entity (old equity) to
confirm a "new value" plan in bankruptcy over the objection of an undersecured mortgagee. In such plans
(cramdowns), prior to LaSalle, the mortgage lien was stripped down to a low value (based on a
deteriorated market), and old equity was given the exclusive right to propose a capital contribution, which
could be held by the bankruptcy court to be adequate based on a showing that it was "substantial" and
"reasonably equivalent" to the equity value of the reorganized debtor. In substance, old equity exercised
an exclusive option to buy back from the bankruptcy estate ownership of the reorganized debtor. Prior
to LaSalle, old equity typically urged (with some success) that its capital contribution should be relatively
small because there is no equity in the reorganized debtor; the lien stripdown results in a 100 percent loan
to collateral value mortgage.

In LaSalle, the Supreme Court held that old equity may not, over the objection of a class of unsecured
creditors (typically controlled by the mortgagee's deficiency claim), confirm a new value plan when the
opportunity to contribute new capital "is given exclusively to the old equity holders under a plan adopted
without consideration of alternatives." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… S.Ct. at 1414</a>. Under LaSalle, a debtor's cramdown plan
cannot be confirmed unless a provision is made for competing plans or competing bids for the equity of
the reorganized debtor. In many cases, this holding should give the under-secured mortgage lender the
ability to obtain ownership of the debtor and therefore the mortgaged property. This is because the typical
single-asset debt structure is a simple structure consisting of a de minimis amount of trade debt and a
relatively huge amount of mortgage debt. Accordingly, whatever money the mortgagee bids for
ownership of the reorganized debtor will in very large part be returned to the mortgagee when it gets
control of the debtor. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Homestead Partners Ltd., 197 B.R. 706, 719 n.15 (Bankr. N.D. Ga. 1996)</a>

("Since the lion's share of any capital contribution made by [mortgagee] would be returned as a
consequence of the pro rata distribution process, such a dominating undersecured creditor already holds an edge over competing purchasers.").

Although the matter is subject to debate, it is at least as likely as not that the mortgagee cannot credit
bid its lien claim in an auction under LaSalle. This is because the property being sold is not the real
property subject to the lien but the equity of the reorganized debtor. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §363(k)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
Homestead Partners Ltd., 197 B.R. at 719 n.15</a> ("Thus, to the extent that such an auction contemplates
a sale not of the collateral, but of the independent right to control the debtor in the post-bankruptcy world,
the terms of the [Bankruptcy] Code provide no basis for vesting Condor [mortgagee] with such a right
to bid on credit.").

This brings us to the impact of LaSalle on securitized mortgage debt structures in place today. Typically,
at the project level, the borrower (debtor) is a special-purpose "bankruptcy-remote" entity (SPE). The
cornerstone of such bankruptcy remoteness is an "independent director" if the borrower is a corporation,
or a member or general partner that is itself a bankruptcy-remote SPE corporation if the borrower is a
limited liability company or a partnership. The idea is that the independent director will prevent a
bankruptcy filing because the borrower's organizational documents will require that the independent
director (who has no connection to the debtor and presumably understands why he or she was retained)
must approve a bankruptcy filing.

Whether such "bankruptcy-proofing" will prevent future single-asset bankruptcy filings is open to
question. The problem is that an involuntary filing is still possible and, more significantly, the director's
fiduciary duty to the constituent members of the SPE (partners, members or shareholders) may require
that the director approve a bankruptcy filing or suffer significant personal exposure for breach of
fiduciary duty. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Kingston Square Assoc., 214 B.R. 713, 735 (Bankr. S.D.N.Y. 1997)</a> (holding
that an "independent" director of several "bankruptcy-proofed" entities whose consent was needed for
a bankruptcy filing breached his fiduciary duty to creditors and limited partners by failing to ratify
involuntary filings). If the bankruptcy proofing is ineffective, then the protection afforded by the LaSalle
decision, i.e., the mortgagee's ability to cash bid for the equity via competing plan or bid procedure, may
turn out to be a principal bankruptcy protection for mortgage lenders.

In order to avail itself of the LaSalle protection, the mortgagee needs two things: the ability to come
up with cash quickly (since single-asset cases are supposed to move through the system quickly); and
the ability to obtain prompt internal authorization to make such a bid or to file a competing plan.
Promptitude is important since LaSalle gives the court a tool to move the case quickly, i.e., there is no
reason to delay the auction.

The requirements of ready cash and quick authority are simple enough for a bank, insurance or
finance company. But, if the mortgage is held in a securitized mortgage pool, the perspective
changes—completely. Typically, the pool is held in a trust. The trustee of the trust typically has limited
duties. The servicing and administration of the mortgage loans on behalf of the trustee is put in the hands
of an independent contractor known as a "servicer." In default situations, the servicer duties, which may
encompass foreclosure and bankruptcy proceedings, are often put in the hands of a "special servicer."
This special servicer, which may be an entity that itself holds a subordinated piece of the securitized debt,
has incentive to obtain good results in any workout or insolvency proceeding since it holds a junior piece
of the debt. However, it is also in potential conflict with senior debt holders since it could take risky
positions to assure return on its piece while sacrificing return on more senior debt. Typically, the
servicing agreement deals with all this by sharply limiting the servicer's authority in default situations.

It is doubtful that many (or perhaps any) servicing documents today give the servicer power to make
a cash bid to purchase the equity in a reorganized debtor or that liquidity facilities for short-term loans
to fund such bids are provided for. In other words, the two prerequisites to take advantage of LaSalle,
authority and cash, are absent in the securitized debt situation. Moreover, amendment of the securitization
documents is often a time-consuming and cumbersome process, thereby defeating promptitude of
response.

The problem outlined above will emerge in the next downturn when a single-asset debtor files a new
value plan, which is set by the court for prompt, competing bids or plans. The servicer may come to the
auction empty-handed, because it has no money or authority. It may lose the auction to old equity or
another competing bidder—and thereby be subjected to a lien strip-down and confirmation of a
cramdown plan. This scenario could be repeated for each individual mortgage in the pool. It is submitted
that prudent servicers and trustees of securitized pools will now begin to explore revision of their
documents. The issues are complex (and largely beyond the scope of this note). For example, should the
servicer bid in its own name and then let the trust later foreclose? Tax ramifications must be understood.
Ultimately, and perhaps after some painful experience (from the mortgage lender's perspective), there
will be fixes in the pertinent documents.

Journal Authors

Robert B. Millner

Journal Date

Thursday, April 1, 1999 - 12:00