Navigating the Structured Finance Waterfall: Smooth Sailing or a Barrel Ride

CRE Finance World, Autumn 2012

Navigating the Structured Finance Waterfall: Smooth Sailing or a Barrel Managing Director Senior Managing Director Senior Managing DirectorRonald GreenspanCynthia NelsonMichael VanderLey Ride over the Falls? FTI Consulting, Inc. FTI Consulting, Inc. FTI Consulting, Inc. E In real estate structured finance, waterfalls are the Worse still, the “what happens to additional interest?” answerordinary interest, or a fee, negotiating a reasonable plan treatmentbecomes even tougher when the waterfall directs dollars towardsresidual classes instead of those bearing actual risk.veryday business language is awash in references towater — “liquid” assets, “liquidity” events, cash “flow,”companies trying to “stay afloat” (perhaps because theytried to “boil the ocean”) and, of course, the “waterfall.” “plumbing” through which cash and control rights flow. was, at best, inconclusive. First, additional interest couldn’t go to interest-bearing certificateholders as interest; their pass-through Most of the time, waterfalls work fine. However, in a restructuring, rates were either fixed, LIBOR plus a spread, or linked to a fixed rocks sometimes lurk beneath the waterfall, and we discover that mortgage rate (which could not be altered even if the underlying the plumbing — which looked great initially — connects differently loan interest rate was changed pursuant to a Chapter 11 plan). than an investor thought it did or has developed a clog not even Second, there was no provision which could reasonably be Drano® can fix. Some recent matters illustrate — and several construed to characterize additional interest as a reserve, fee, important court cases are beginning to define — how the operative prepayment penalty, or yield maintenance. Finally, while arguably documents in structured finance transactions will be interpreted an unscheduled payment, none of the provisions for distributing under certain circumstances; these cases,1 in turn, are influencing unscheduled payments captured additional interest. the initial and secondary market investment calculi and strategies of stakeholders involved in restructuring obligations held in CMBS While it addressed a frequent Chapter 11 outcome, i.e., the loan and CDO structures. interest rate goes down, the plumbing failed to connect additional interest to the interest-bearing certificateholders — the parties at Complicated piping can lead to unintended, or risk and those who should, in theory, benefit most. unexpected, consequences Even the simplest waterfall can contain upwards of a dozen steps The trustee will ultimately have to decide how to distribute and reference at least that many defined terms (usually more). additional interest (absent the likely impossible task of modifying Intended to capture virtually all circumstances that might arise the pass-through rate definitions in the trust agreement). However, during the life of a credit, these provisions occasionally fail to if default and additional interest become part of the deal with adequately address some common restructuring outcomes. the debtor, default interest is likely to be of little or no benefit to certificateholders generally, and additional interest could end Recently, a special servicer embroiled in a Chapter 11 case up being paid out as a principal payment, potentially reducing involving a large, securitized loan was negotiating with the debtor certificateholder NPV, an odd result compared to how those dollars over plan provisions which contemplated extending the loan’s would affect a balance sheet lender’s recovery. maturity date, payment of post-petition default interest and an increase in the post-confirmation interest rate (additional interest). Mezzanine lender control — water doesn’t always flow The special servicer, contractually bound to maximize NPV for all straight downhill certificateholders, sought to confirm how default and additional Following a UCC foreclosure, mezzanine lenders typically obtain interest would flow through the waterfall. Surely, those millions control by beneficially assuming ownership (stepping into the of dollars would flow to the certificateholders put at risk by the shoes) of a mortgage borrower that holds title to real estate. As default and bankruptcy, thus improving their collective NPV, right? a result, acquisition of mezzanine debt is frequently the entry point for distressed and event-driven investors seeking to control Well, maybe not. After reviewing the documents, it was concluded good real estate saddled with bad capital structures. One recent that default interest would (assuming no post-confirmation default) example highlights how control waterfalls in senior/mezzanine likely end up in a non-offered certificate class the sole purpose of intercreditor agreements don’t always flow as mezzanine lenders which was to receive excess default interest (i.e., default interest think they should (or wish they did). not otherwise distributed to cover servicer advances, ordinary interest shortfalls or principal distribution shortfalls). Talk about In U.S. Bank National Association, Trustee v. RFC CDO 2006-1 the pipe emptying into the basement. Since the NPV calculation is Ltd., involving the JW Marriott Star Pass Resort in Tucson (Star identical whether additional dollars are received as default interest, Pass), the fight concerned whether a mezz lender, via a UCC CRE Finance World Autumn 2012 36


CRE Finance World, Autumn 2012
To see the actual publication please follow the link above