Today, we’ll be looking at a court’s decision resolving a dispute over the default provisions of a mortgage loan repurchase agreement. Knowing that few readers harvest crops in that vineyard, all we will tell you about such agreements is “what they are.” Most readers know that the best of Wall Street created a financial product that combines a whole (big) bunch of individual mortgage loans, none paying more than (say) 6% and promises that some investors in such a loan collection can earn 18% (or numbers like that). It’s magic and infallible. And, did we say, “risk free”? OK, we’ve been a little tongue in cheek, and most of you have used those clues and are ready to cry out, “CMBS” or “Commercial Mortgage Backed Securities.” [Some might have been thinking “residential,” and called out another acronym, but “six of one, a half-dozen of another.”
Now, the loans that get packaged in one of these modern-day marvels don’t all come from one source. Each such loan has an “originator” that “sells” the loan to the people who puts these packages or loan pools together. And each of those originators makes certain representations about the loan being sold into the pool. If one of those representations is breached and the breach is not cured or if it is impossible to cure, then, pursuant to the terms of the related “mortgage loan repurchase agreements,” the originator must “make good” by buying back the loan.
That’s all we intend to say about just a tiny sliver of a complex investment structure.
The court decision that fuels today’s blog posting comes out of the United States Court of Appeals for the Second Circuit. Its April 27, 2016 decision can be seen by clicking: HERE. The sole plaintiff’s name contains 38 words. For that reason alone, we won’t name the case.
The mortgage loan reviewed by the court was for $81 million and used to purchase a shopping center. On the very day of the loan, it was sold to a syndicator and then immediately placed into a pool containing, in the aggregate, about $5 billion worth of commercial mortgage loans. The pool (a trust) was later “securitized” and then sold to investors.
Had the $81 million loan not gone sour, we would have no story for today. But, thankfully for Ruminations readers, it did. First, a “snowball” started to roll down the mountain. The anchor tenant detected methane vapors in its store. It sent numerous default notices to the borrower (a/k/a, the shopping center landlord). To make things worse for the borrower, the state’s attorney general sued the borrower-landlord for failure to control the methane gases and the state’s environmental enforcement agency determined that the conditions at the property amounted to an “urgent public hazard.”
Based on all of that, the anchor tenant pulled out and terminated its lease. That, as readers might expect, caused the borrower to default in its loan payments, and the rest of that local story, the one related to the borrower, the property, and the loan default, is over.
Whatever else the mortgage loan repurchase agreement might say, it doesn’t say that a pure credit default on the part of the borrower could result in the loan being kicked-back to the originator. On the other hand, the originator made a number of representations when it “sold” the mortgage loan, and one of those was that the originator didn’t know of any material and adverse environmental conditions or circumstances that were not disclosed in the environmental report previously sent to it purchaser, the loan packager.
That representation turned out to be untrue. In fact, the “Closing Counsel Transaction Summary,” prepared by the originator’s attorneys, acknowledged that the environmental report did not reveal that the property was being regulated as a “closed land fill” and had been the subject of numerous “notices of violation” from the state. Also, there was little doubt that these “undisclosed” conditions were materially adverse. After all, the anchor tenant vacated its leased space and terminated its lease. Other tenants exercised their lease’s co-tenancy clauses and bailed out as well. The result was that the property’s operating income couldn’t cover the loan payments.
At this point, readers would be reasonable if they asked, “So, what’s the issue? This sounds like a slam dunk – originator, take back the loan.” Well, the loan will be going back, but not until after the attorneys got paid to get a school lesson about clarity of document drafting.
Here’s the text at issue (slightly edited):
If a material breach exists, “the party discovering such . . . Material Breach shall promptly notify, in writing, the other party . . . .”
“Promptly (but in any event within three Business Days) upon becoming aware of any such . . . Material Breach, the Master Servicer shall, and the Special Servicer may, request that the [originator], not later than 90 days from the [originator’s] receipt of the notice of such . . . Material Breach, cure such . . . Material Breach . . .
“The [originator] hereby covenants and agrees that, if any such . . . Material Breach cannot be corrected or cured in all material aspects within the above cure period, the [originator] shall, on or before the termination of such cure period, either (i) repurchase the affected Mortgage Loan . . . or (ii) . . . at its option replace, without recourse, any Mortgage Loan . . . to which such defect relates with a [substitute mortgage].”
Once the Special Servicer became aware of the Material Breach of the originator’s environmental representation, it was very careful in crafting its notice of “such … Material Breach” to the originator. So careful was the servicer, that it took more than “three Business Days.” It took between two and four weeks (depending on when one thought the Special Servicer learned of the misrepresentation).
When the originator refused to repurchase the defaulted loan, a United States District Court filled up with attorneys representing the originator and representing the trustee responsible for the loan pool, and here is what they argued about: “Was it critical that the initial notice be sent within the required three business days.” This is better understood by looking at the originator’s defense: “The servicer took more than three business days to send us a request to cure the breached representation and therefore, we don’t have to cure it or buy the loan back.” In legal jargon, the originator asserted that sending the cure request within three days after discovery of the breach was a ‘condition precedent” to the originator’s obligations.”
The United States District Court bought that argument and found in favor of the originator. Basically, it held that the originator was off the hook solely because the special servicer took more than three business days to notify the originator.
Off to the appellate court went the legal caravan. There, the judges said, “Not so fast.” They identified three obligations corresponding to the numbering of the cited provisions:
First, a notice‐of‐breach obligation, which requires any party—whether the Trustee, Master Servicer, Special Servicer, or even the [originator]—“discovering” a material breach of representation promptly to notify the other party of its discovery of such breach.
Second, a request‐for‐cure obligation, which requires the Master Servicer, and permits the Special Servicer, promptly, but in any event within three business days of “becoming aware” of the material breach, to request that the [originator] cure the breach within 90 days of the receipt of notice.
Third, a cure‐or‐repurchase obligation, which requires the [originator] either (a) to cure the material breach within 90 days of receiving notice, or (b) if the breach cannot be cured, to repurchase or to replace the defective mortgage loan.
Now, look back to the cited text from the repurchase agreement. Do you see that there is no “notice to cure,” but there is a “notice of breach” and a “request for cure”?
Now, look again carefully. Do you see that two similar but different words are used in subpart 1 and subpart 2? What words? In subpart 1, when a party “discovers” a material breach, it is obligated to promptly “notify” the other. In subpart 2, one of the loan servicers (the “Master Servicer”) is obligated to request that the originator cure the material breach, and the other one (the “Special Servicer”) may (but isn’t obligated to) make such a request. In either case, once the originator receives such a request, it has up to 90 days after receipt of the “notice” to effectuate the cure and if the cure isn’t effectuated within the 90 day “cure period,” the originator would have to buy back the defaulted loan.
Our guess is that almost all readers are confused about what the agreement actually says. We also think that those who think the text is clear are wrong because they are reading it as if it had been clearly written.
Well, we are in good company. The court was confused as well. Its majority held that the 90- day period ran from the date the notice of breach, i.e., the notice under subpart 1, was received by the originator. The dissenting judge thought the 90- day cure period ran from the date the originator received the “request for cure” called for in subpart 2. So, to the majority, it didn’t matter when the “three day or never” notice was sent, if at all. According to its reasoning, the obligation to cure began when the notice called for in subpart 1 was received, and that notice could be sent any time after the sending loan servicer “discovered” the breach.
We aren’t going to weigh in as to which of the two, the majority or the dissenter, had the “better” view because that’s not important to us today. What is important is that all of us realize that this question would never have come up had the “notice, default, and cure” provision been clearly written.
This agreement was crafted by sophisticated lawyers. Yet, it appears that an attorney’s hourly rate is no guaranty of quality output. It may be well-correlated, but not guaranteed. The ones who wrote the contested provision did a lousy job. The language used is as if it came from more than one document. If you want to refer to a “notice,” you need to create a “notice” obligation. If you mean “aware” to be the same as “discover,” then use one word or the other, not both. A court in the year 2000 said this with much more “sophisticated” language, when writing:
The failure to couch the request‐for‐cure provision in the explicit language of condition is particularly significant here because the sophisticated drafters elsewhere employed precisely such language to establish undoubted conditions precedent.
Sophisticated lawyers . . . must be presumed to know how to use parallel construction and identical wording to impart identical meaning when they intend to do so, and how to use different words and construction to establish distinctions in meaning.
While we’re at it, and before we slam the lid shut for today, Ruminations feels the urge to vent about a similar and too common drafting practice, almost a first cousin to what happened here. We, in our agreements, don’t reinforce a party’s obligations by writing them twice, even in identical words, but often in similar, but not identical ones. Words have meanings and if something is stated more than once, a court has an obligation to give life to each statement. In doing so, let’s not be surprised if a court will translate something you intended to be “the same thing” into something never intended. After all, if all of the words in our agreements are important, courts are 100% correct when finding that the extra words have an independent and separate meaning.
[If any reader is curious about how the court dealt with the “condition precedent” issue, try reading the majority’s (not very clearly written) decision. Today, we refuse to go into the weeds with those judges.