REMIC Investor Lacks Standing To Object To Sale Of Collateral In Borrower’s Bankruptcy Reorganization

In a recent decision, the Bankruptcy Court for the Southern District of New York concluded that an investor in a Real Estate Mortgage Investment Conduit (“REMIC”) lacked standing to object to the sale of a chapter 11 debtor’s real property, despite that the property served as collateral for loans held in trust by the REMIC for the benefit of its investors.

A Real Estate Mortgage Investment Conduit (“REMIC”) is an investment vehicle that pools together residential and commercial mortgages in a trust, and issues securities to investors in the secondary mortgage market representing beneficial interests in the trust.  A REMIC’s non-taxable income includes payments of interest and principal made by borrowers on the underlying mortgage loans.  Those cash payments then flow to the REMIC’s investors in the form of taxable distributions.

Typically, REMIC investors are required to enter into a Pooling and Servicing Agreement (“PSA”) that designates a “master servicer” to administer the pooled loans in exchange for a fee.  When a loan is in default, administration of the loan is transferred to a “special servicer” whose duty is to maximize recovery on the loan for the collective benefit of all investors.

Disputes regarding proper administration of the REMIC’s assets may arise among the investors and servicers, especially when a substantial percentage of the pooled loans are in default and borrowers file for bankruptcy protection.  For example, in the recent chapter 11 reorganization of Innkeepers USA Trust (which owns and develops hotel properties throughout the United States), certain of the debtor’s hotels served as collateral for loans held by a REMIC.  The REMIC’s special servicer supported the debtor’s proposed sale of the hotels over the objection of one of its minority institutional investors.  The Bankruptcy Court for the Southern District of New York held that the investor lacked standing in its capacity as a REMIC security holder to object to the sale.  See In re Innkeepers USA Trust et al., 2011 Bankr. LEXIS 1164, Case No. 10-13800 (Bankr. S.D.N.Y. Apr. 1, 2011).

The court provided three reasons for prohibiting the investor from participating in the sale proceeding.  First, the investor was not a creditor of the debtor because the investor had no contractual privity or other relationship with the debtor.  The court noted that the investor’s right to distribution payments arose from the PSA and not from the underlying loan documents.  Accordingly, although the investor may hold potential claims against the special servicer for breach of the PSA or breach of fiduciary duty, such claims do not constitute a direct pecuniary interest in the outcome of the debtor’s bankruptcy proceeding to establish “party in interest” standing under the Bankruptcy Code.

Second, under the PSA, the investor had delegated authority to the special servicer to act on its behalf and for the benefit of all investors.  The PSA contained a “no action” clause that prohibited individual investors from instituting any action or proceeding under the PSA unless three conditions had been met: (1) an investor delivered written notice of a default under the PSA to the REMIC’s trustee, (2) investors holding at least 25% of the voting rights made a written request to the trustee to take specific action, and (3) the trustee failed to take the requested action within sixty days.  Because those conditions had not been satisfied, the investor remained subject to the special servicer’s authority to act on its behalf in the bankruptcy proceeding.

Third, if REMIC investors were permitted to advance their individual and conflicting interests in bankruptcy proceedings, then a debtor’s bankruptcy case could be delayed and complicated substantially, and the delegation of authority to special servicers under PSAs would be rendered meaningless.  Thus, the court raised concerns regarding the efficient administration of bankruptcy cases and the integrity of the secondary mortgage market to support its conclusion that the investor lacked standing to participate in the debtor’s sale proceeding.