Loan-to-own: Predatory or practical?

The collapse of the commercial real estate market in New York has sparked a phenomenon that is being widely debated in legal and financial circles: Is loan-to-own an act of bad faith or simply a smart business move?

Lenders are increasingly willing to foreclose on defaulted loans for office towers, malls and multifamily high-rises. But some developers are crying foul over what they say are “pretextual” defaults, created by a lender to help third-party investors snap up distressed assets on the cheap.

These battles — which center on whether lenders are unfairly colluding with third-party investors on loan sales — have begun to play out in the courts, including two of the most high-profile cases, involving 3 Columbus Circle and 510 Madison Avenue.

Attorneys and other market observers say determining whether a loan-to-own gambit is predatory — and therefore open to a court challenge — largely boils down to the intentions of the new owner and the lender as the deal unfolded.

“To me it’s a question of whether [the default] is happening anyway, or did an owner-operator come in and try to engineer a default or force a borrower into default in order to cut the loan terms short and take over the building?” said Stephen Meister, a partner at Meister Seelig & Fine. “Buying a loan-to-own is not, in and of itself, predatory.”

Meister has represented borrowers in a number of high-profile deals in which the lender attempted to foreclose on a distressed office property but was accused of either failing to act in good faith or creating a default when the borrower was attempting to make good on the loan.

On the residential side of the market, predatory lending is the practice of issuing mortgages to borrowers who can’t afford them, and then imposing enormous interest-rate hikes, fees or hidden default provisions that buyers failed to understand or could not predict. That practice, of course, was largely blamed for the subprime foreclosure crisis and subsequent credit crunch.

On the commercial side, the definition of “predatory” is different.

“It’s not the loan that’s predatory,” Meister said. “It’s the conduct of the lender during the administration of the loan.”

Lenders, for example, have been accused of leading borrowers into believing they can work out a deal, while secretly negotiating behind the scenes with investors to buy out defaulted loans at a discount.

Sheldon Chanales, a commercial real estate partner at Herrick, Feinstein, argues that in most cases of alleged predatory lending, the banks and other financial institutions are acting in good faith and well within the law.

“You’re talking about in most cases there was a clear monetary default under the law,” said Chanales, who has represented numerous lenders and borrowers, ranging from Arbor Realty Trust in the foreclosure of a Manhattan crane collapse site on 51st Street to Young Woo & Associates in its acquisition of the AIG headquarters.

“A borrower borrows money from a lender and signs a bunch of loan documents. Those loan documents almost invariably give the lender the right to sell the loan virtually without restrictions,” he added.

Others said it seems unlikely that a judge would believe that a lender can hoodwink an experienced developer into an unnecessary default provision.

Last year, Meister represented developer Harry Macklowe in an epic battle to prevent Manhattan-based landlord SL Green from taking over 510 Madison, the speculative office tower in Midtown.

SL Green acquired the building’s senior mortgage from Union Labor Life Insurance for $170 million, a significant discount from the original $267.5 million price tag, and later bought one of the property’s mezzanine loans. It attempted to foreclose on the property after an appraisal showed the loan was underwater, but Macklowe fought back, claiming an agreement existed to extend the construction deadlines and that lenders were attempting to “contrive a default.”

Macklowe prevailed in the court case, securing an extension until March 2011, and the building was later sold to Boston Properties for $275 million, thus getting Macklowe off the hook at one of his last major office towers, though SL Green still made a hefty profit on the sale of the debt.

SL Green declined to comment, but in court filings, the company argued that New York State law allows lenders to sell distressed loans to outside investors to enforce its contractual rights in a default case.

“The problem with [Macklowe’s] fabricated theory is that, even if it were true, there is nothing wrong with purchasing a commercial loan for the purposes of enforcing it,” lawyers for SL Green argued in court filings. “These manifestly are not consumer loans by large institutions to overmatched, uninformed borrowers. SL Green did not even originate the loans; it acquired them on the active market for distressed commercial real estate loans, which is a fundamental component of the real estate financial market.”

Just weeks after selling the 510 Madison position, SL Green swooped into another battle over an allegedly predatory deal involving 3 Columbus Circle. But this time, the firm came in as a so-called white knight for developer Joseph Moinian.

Moinian is facing foreclosure by Deutsche Bank and the Related Companies — which joined forces to purchase Moinian’s debt at a discount — after he defaulted at the tower, the former headquarters for Newsweek that was previously called 1775 Broadway.

Moinian attempted to work out a deal with CWCapital, the loan’s special servicer, but Related and Deutsche stepped into the fray. According to Moinian’s $200 million lawsuit against Related and Deutsche, CW engaged in a “predatory scheme” with the duo, which plans to demolish the building and develop a mixed-use tower with a department store.

Meister, who is representing Moinian, has argued in court that the process was ridden with bad faith and that the lenders tried to impose a $54 million prepayment penalty on Moinian so he would never be able to make the loan current, thus giving Related an easy road to a new development site. “[The] lender’s demand for a bogus prepayment charge is designed to accomplish [the] defendant’s predatory goal — stealing the property from Mr. Moinian.”

CWCapital, in a November court filing, argued that Moinian initiated the default to try to work out the loan, but was warned that buyers were interested in purchasing the debt and that the lender had every right to sell.

“Contrary to [Moinian’s] present allegations, CWCapital engaged in good-faith negotiations with [Moinian] over a period of months regarding a potential restructuring or modification of the loan,” said Alex Guggenheim, senior vice president of CWCapital, in a sworn affidavit.

Moinian entered a deal with SL Green, which deposited a check in late November that will pay off what it says is the true balance of the loan, and warned that if Deutsche Bank and Related declined to accept the offer, they will face months of litigation. They declined to accept.

Lenders in this case and others maintain that they have the right in a defaulted building to sell the loan to willing buyers.

“There’s no moral hazard involved in owning a lender position and using the right to exercise your position,” said Chanales. “Welcome to capitalism.”