Daily Development for Wednesday, March 30, 2005
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

LENDER LIABILITY; SPECIAL SERVICERS: Special servicer loses suit by borrower for return of lease termination fee, plus big punitive damages judgment..

1601 McCarthy Blvd. v. GMAC Commercial Mortgage Corp., Case No. CGC-03-425848, California Superior Court  (Unreported trial court decision)

When commercial mortgage loans are securitized, it is common to have at least two servicers appointed:  a primary or master servicer, who will service the loans in the securitized pool so long as they are current, and a special servicer who will take over servicing of defaulted loans.  The special servicer is typically designated by the holder of the securities having the lowest priority (commonly termed the “B piece”).  Indeed, in some cases the purchaser of the “B piece” will directly serve as special servicer.  This close relationship is usually justified on the ground that, since the holder of the “B piece” will sustain the first losses in the event of loan delinquency, it should have a strong voice in resolving delinquencies.

In the present case the special servicer was GMAC Commercial Mortgage Corp., which serves as primary servicer or special servicer on a very large number of subterfuge loan pools.  The borrower on the loan in question, 1601 McCarthy, owned an office building in Milpitas, California.  Its anchor tenant requested and received a release from its lease, in return for a payment of a $7.2 million lease termination fee.  The fee was deposited in a trust account held by GMAC, with the apparent intention that it was to be released to 1601 McCarthy when it found a replacement tenant.

When a new tenant was found, however,  GMAC refused to release the fee to 1601 McCarthy. Initially, GMAC attempted to renegotiate the language of the loan agreement as a way of establishing its right to pay the termination fee down on the loan balance.  When this was unsuccessful, GMAC then claimed that the lease termination had resulted in a “material adverse change” in 1601 McCarthy’s financial condition, and hence that the borrower was in technical default.  (Apparently there was no monetary default by 1601 McCarthy.)

 The borrower’s lawyers claimed that GMAC had refused to refund the fee as a device for forcing the borrower into foreclosure.  The jury found that GMAC had violated the loan agreement by withholding the funds.  It assessed a punitive damage award of $33 million on top of the return of the $7.2 million fee!

Reporter’s Comment:  The description above was pieced together from news reports, since the case is not officially reported.  1601 McCarthy was represented in the judicial action against GMAC by Keker & Van Nest. On its face, there is nothing terribly unusual about the substantive decision After all, a mortgagee, or the servicer for a mortgagee, is bound by the loan documents.  Of course, the “material adverse change” language sometimes found in loan agreements as a basis for declaring a default is “squishy” language; all borrowers’ financial positions fluctuate to some extent, and a mortgagee or servicer who relies on this as the sole basis for a default had better have strong evidence of a very serious financial problem.  In the present case, the jury was apparently convinced that the “material adverse change” was a subterfuge, and that GMAC was trying to “steal” the building.

Editor’s Comment 1:  Also based upon rumor and hearsay, the editor understands that GMAC was the “B Piece” holder (or partial holder) as well as the special servicer here.  This complicated things for GMAC.  The jury seems to have seen GMAC’s conduct as an attempt to convert a high-risk, high-return investment into a windfall profit.

There is a distinct danger for “B Piece” holders when mortgage borrowers weaken.  These investors don’t really make out unless and until the loan is paid to maturity or prepaid in such a way that  prepayment premium pays off in the same way that a payment to maturity would.  Thus, even though the borrower’s security still exceeds the amount owed on the loan, a default and foreclosure for the loan amount is a disaster for the “B Piece” holder.  Hence, as special servicer, it will look at long term borrower viability issues very differently.  Borrowers are going to have to get used to this if they are going to seek the price benefits of securitized lending.

Editor’s Comment 2: If, as Reporter Dale Whitman suggests, the borrower was not in default, then it is of some interest that the “special servicer” was involved in the deal at all.  Perhaps the loss of a major tenant was an event triggering GMAC’s involvement.

The Reporter for this item was Dale Whitman of the Missouri/Columbia Law School.

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