As the economic crisis impairs the value of commercial mortgage-backed securities (CMBS) that collateralize loans to real estate investment trusts (REITs) to finance their investments, there is the prospect of increased margin calls, requiring REITs to provide additional funds to make up shortfalls in value. The case of AG MIT CMO, LLC et al. v. Royal Bank of Canada et al., No. 20-2547 (S.D.N.Y.), which recently settled, is worth examining for its echoes of the past and some important lessons going forward for REITs regarding the valuation of collateral and enforcement of rights under repurchase agreements.
AG vs. RBC
The litigation arose in late March when RBC issued such margin calls to AG. RBC then sought to auction off $11 million of the REIT’s CMBS, which prompted AG to commence proceedings against the bank, seeking a temporary restraining order and preliminary injunction to prevent what it described as an “opportunistic” fire sale of its assets.
Plaintiffs complained that the bank’s use of margin calls were threatening the REIT market to the “brink of collapse,” and argued that RBC’s actions were at odds with government measures aimed at restoring liquidity to the markets. Further, AG disputed RBC’s “entirely subjective and self-serving” calculation of market value, which it contended was “unilaterally determined” based on a temporarily illiquid market. The complaint was not received soon enough to prevent the auction, which had already begun, but a settlement was reached among the parties earlier this month.
Echoes of the Past
The case highlights how COVID-19 has thrown into question what constitutes a “recognized market” for the purpose of selling securities, similar to disputes that followed the 2008 financial crisis related to enforcement of repurchase agreements that documented subprime mortgage warehouse financing to originators. Parallels can be drawn between AG’s arguments and the 2011 case of Sher v Barclays, No. 11-1982 (D. Md.), in which the Trustee for Thornburg Mortgage challenged the bank’s “improper margin calls” based on “inappropriately low valuations” that were made in late 2007 when the subprime mortgage market was in disarray. Plaintiff contended that Barclays did not use commercially reasonable methods to liquidate the securities and failed to sell the assets in a recognized market.
Similarly, much of the dispute in the case centered on the bank’s calculation of market value as it pertained to the securities. The repurchase agreement in question did not specify the source to be used, but rather, provided that this should be obtained “from a generally recognized source agreed to by the parties.” Agreement on such a source reflecting true value becomes an issue in a seriously depleted market, providing grounds to challenge an auction sale as not “commercially reasonable.”
Lessons to be Learned
All of this underscores the need for greater clarity in repurchase agreements. In addition, keeping abreast of policy changes in such a fluid time is critical. In AG v. RBC, plaintiffs argued that the defendants’ conduct contravened Governor Cuomo’s Executive Order No. 202.9, which essentially instructs banks to grant forbearance to any person or business experiencing financial hardship as a result of COVID-19. Emergency executive orders that have been coming thick and fast in response to the daily challenges posed by the pandemic should be examined, as these may afford REITs some protection when faced with margin calls and the prospect of asset liquidation. For now, RBC remains the outlier in respect of its aggressive actions, but margin call activity may continue for as long as the CMBS market remains depressed.
The valuation issues that arose in mortgage warehouse lending in the last financial crisis caught many by surprise. (As a warehouse lender once said to me back then, “What do you mean I can’t just assign a value to the collateral and give the borrower credit? That’s what the agreement says.”) There’s no reason for parties to be taken by surprise this time around. But in the same way that viruses mutate, the next strain of repo litigation – this time arising from an economic crisis of a different nature – will be subtly different from what went before. Enforcement provisions in repurchase agreements will need to be reevaluated in a different light in the midst of the pandemic. Participants should assess their risks and rights under current provisions to prepare for long-term impact on collateral markets.
Joel Melendez, a member of the Insolvency, Creditors’ Rights & Financial Products Practice Group of Davis & Gilbert, contributed to this post.
Emily Hatchett, a paralegal in the Insolvency, Creditors’ Rights & Financial Products Practice Group of Davis & Gilbert, assisted with this post.