IRS Removes Roadblock to Modifying Securitized Loans

John O'Neill and Scott Andrew Sterling
January 25, 2010 — 1,216 views  
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On September 16, 2009, the Internal Revenue Service (IRS) attempted to remove one of the many roadblocks to modifying securitized loans that are not yet in default but are likely to be in default at or prior to maturity. Revenue Procedure 2009-45 provides a safe harbor allowing real estate mortgage investment conduits (REMIC) to modify certain mortgage loans without triggering certain negative tax consequences to the REMIC. Since the existing REMIC rules and regulations permit only a modification of a loan that is occasioned by a default or a reasonably foreseeable default, borrowers with currently performing loans and pending maturity dates have had tremendous difficulty and experienced significant delay in getting the master servicer to transfer servicing responsibilities over to the special servicer to even begin considering an extension or other loan modification proposal.

While a welcome development from the perspective of borrowers seeking to proactively address anticipated problems with currently performing loans, there are still problems with the IRS’s solutions. In addition, both master and special servicers will continue to be bound by contractual provisions contained in Pooling and Servicing Agreements that govern and limit their authority to modify securitized loans.

Background

In Revenue Procedure 2009-45, the IRS succinctly identified one of the fundamental problems facing the securitized commercial mortgage loan market:

In particular, borrowers under many of the commercial mortgage loans that will mature in the next few years are concerned that they will encounter great difficulty in obtaining refinancing for these loans. Because they had always anticipated using the proceeds from refinancing to satisfy the principal balance at maturity, the borrowers are often at risk of defaulting when their loans mature. This may be true even for loans in which the underlying commercial real estate is providing more than enough cash flow to satisfy debt service before maturity.

The IRS also understands that “many industry participants believe that a loan modification necessary fails to be ‘occasioned by default or reasonably foreseeable default’ unless the loan is not performing or default is imminent.”

In attempting to acknowledge that the appropriate time to talk about modifying a loan may be well prior to the date that the loan would go into default, the IRS has created a safe harbor for servicers and borrowers to discuss modifying otherwise performing loans. In particular, the IRS has granted servicers leave to anticipate defaults even if the loan is performing and to look beyond the near term in determining if a default is possible.

Issues With IRS Position

This new loan modification safe harbor presents a few problems for servicers. The first problem is that the special servicer will have to determine whether or not, at the time of contribution of the loans to a REMIC, more than 10 percent of the loans contributed to the pool were at least 30 days overdue or a default was reasonably foreseeable (emphasis added) with respect to such loans. While this information may be available or even readily available, it will still require the special servicer (and/or their counsel) to make a factual determination with respect to the loan pool as opposed to just the loan itself. In addition, the servicer will have to make a threshold determination as to whether or not a default was reasonably foreseeable for one or more loans contributed to the REMIC or investment trust. While it is clear that the determination of a reasonably foreseeable default was to be made at the time of contribution to the REMIC, reasonable foreseeability (emphasis added) unfortunately is still a subjective standard that is determined after the fact, which may give pause to the special servicer or their counsel.

The special servicer will be required to make two additional determinations. First, the special servicer will be required to reasonably determine, based on a diligent and contemporaneous review of the facts and circumstances at the time of the modification, that there is a “significant risk of default” with respect to the pre-modification of loan at or prior to maturity. The special servicer will be entitled to rely, in part, on written factual representations from the borrower as long as the special servicer neither knows, nor has reason to know, that such representations are false, but the special servicer will still have to make an independent determination. Second, based on all the facts and circumstances, the special servicer will have to reasonably determine that the “modified loan presents a substantially reduced risk of default, as compared with the pre-modification loan.”

Interaction With Servicing Standard

Notwithstanding the IRS’s actions, master and special servicers are still contractually bound by the terms of Pooling and Servicing Agreements, which restrict their ability to modify loans and in particular performing loans. These agreements were written at a time prior to the IRS’s new position and are difficult to modify to address changes in the economy at large. Even if a loan falls squarely within the IRS’s new safe harbor, master and special servicers alike will need to refer to contractual parameters delineating whether or not an otherwise performing loan can be transferred to a special servicer and/or if additional consents need to be obtained. Also, each of the special and master servicer will need to comply with their contractual servicing standards in evaluating whether or not a loan may be modified. What is clear is that servicers will need to confirm that a modification of an otherwise performing loan complies with both their contractual obligations under the Pooling and Servicing Agreements as well as the new IRS safe harbor.

Conclusion

While the IRS has acted to address some of the industry’s tax concerns with respect to pre-default loan modifications, the servicing industry will still have to evaluate how they are going to implement this regulatory relief in light of their contractual obligations and the competing interests of senior and junior interest holders in securitizations. Also, in light of the rapid spike in actual (as opposed to potential) defaults, servicers will still be triaging their workout requests from borrowers. In short, this was a necessary but insufficient step to clearing the current impasse in the securitization markets.

About the Authors
John P. O'Neill- Boston
Scott Andrew Sterling - Washington

John O'Neill and Scott Andrew Sterling

Holland & Knight