Protecting the Interest of Bondholders as the "Controlling Class" in CMBS Investment Pools
As most of you are aware, The Pooling and Servicing Agreement (PSA) is the operative document in defining the rights and obligations of the trustee, master servicer, special servicer, and classes of bondholders. As an overall matter the PSA defines the relationships between the parties to the securitization. It is an agreement that is hundreds of pages in length and incorporates a voluminous amount of reports and ancillary exhibits and schedules to the document itself. Asset managers charged with the responsibility of understanding the investment risks inherent in their CMBS bondholdings have the nightmarish job of reviewing these reports to understand the extent to which their bonds are put at an increasing risk of economic erosion and/or default.
The problem comes in when the "controlling class" of bondholders (which at the outset of the securitization is the "B piece" buyer) which can change if the aggregate certificate balance of the controlling class falls below 25% of the initial Certificate Balance for such class at the time of the closing. In other words, if the B piece's buyers interest, based on certificate balances, falls below 25% of its original balances (usually based on realized losses), then the controlling class will change to the next subordinate class of regular certificate holders which have a balance of 25% or more of their original certificate balance. Reporting these changes is a surveillance obligation of the master servicer and the trustee.
The question of how close a securitized pool is to experiencing a controlling class change can only be determined by digging into the voluminous reports issued by the trustee and the master servicer. Furthermore, those reports are generally only issued as a routine matter to the "directing certificateholder" who is elected by 50% vote of the controlling class certificateholders and must sign agreements that the directing certificateholders are willing to serve in the capacities required under the pooling and servicing agreement (the directing certificateholder is required to provide contact information, meet monthly and carry out the duties imposed upon the directing certificate holder under the PSA).
However, all controlling class holders and indeed most bondholders are entitled to significant reports upon their request. It would seem prudent for bondholders to periodically request and review those reports in order to determine if their investment as bondholders is getting close to a "change of controlling class," and understanding what effect that will have on their bonds.
An additional problem is that sometimes the PSAs are unclear as to the relationship between "appraisal reduction events" which generally apply to cash advancing mechanisms within the pool but not directly on change in the controlling class.
It is incumbent upon bondholders to understand their rights and responsibilities with respect to changes of controlling class and to anticipate notices they may receive from the master servicer or the trustee with respect to such change in control so they can proactively develop a strategy to deal with the management of their bond assets should such a change occur. It is very possible that investment bondholders could end up having the "controlling class" status dropped in their lap with no governance mechanisms in place with which to elect or determine who will act as the "directing certificateholder."
Questions such as the size of the new bondholding class that will act as the controlling class, its various investment motives with regard to the identity of who holds the bonds, as well as the commercial real estate mortgage expertise of the bondholders will all go into a "Bondholder Agreement" under which the new controlling class will make decisions and elect a directing certificateholder.
These important strategy decisions should be proactively developed by bondholder classes as they anticipate a change of control notice from the trustee or the master servicer.
This is clearly not what the bondholders bargained for, but they must develop a road map and a strategy for dealing with controlling these securitized pools should that responsibility get dumped in their lap.
