A dispute between an investor and the special servicer on a loan has spilled out into court.
Special servicer Rialto Capital Advisors is being sued for allegedly trying to keep a borrower unnecessarily in default, a situation that would result in more fees earned by the servicer but would sting other loan certificateholders. The investment firm 400 Capital Management, an investor on the loan, filed the suit in New York on Tuesday.
It’s the latest legal challenge for one of the nation’s largest special servicers by volume. As of June, Rialto was the named special servicer on more than 5,000 loans with a total unpaid principal of more than $94 billion, according to Morningstar. About $24 billion of that principal is associated with loans in active special servicing. The plaintiffs are asking a judge to restrain the servicer from acting on its plan.
“This is totally outside the norm of what’s expected in the industry,” Daniel Hendler, an attorney for the plaintiff with McKool Smith, said of Rialto’s proposal.
At the center of the complaint is a piece of Herald Square real estate, 215 West 34th Street and 218 West 35th Street. The borrower, associated with Jenel Real Estate, took out $130 million on the property in 2015.
The loan is set to mature January 6, 2026. But the borrower hasn’t been able to refinance and get the funds needed to pay off its debt. That’s in part because two key tenants will see their leases expire in the next two years.
The loan was sent to special servicing in October and then missed a payment in November. But the property is stable, the plaintiff says. Net operating income is more than double its debt service payments, the property is fully leased and has about $6 million in annual excess cash flow.
“It’s highly improper for Rialto to treat a performing loan as being in default,” the complaint reads.
Rialto has proposed extending the loan by two years, with an option for a third year. Although this would typically be considered a loan modification, 400 Capital wrote in its complaint, Rialto has allegedly proposed calling the agreement a “forbearance agreement.” That would keep the loan in special servicing with Rialto, allowing the servicer to collect more in fees and nearly $10 million in default interest on top of regular payments, according to the complaint.
400 Capital argues Rialto’s plan is unusual in that it would allow the servicer to essentially cut the line — privileging payouts to itself, like servicing fees and default interest, over payments toward the principal.
“What a special servicer really should do in the case of a distressed loan is manage it in a way that will maximize the recovery of the loan for the trust that it services,” Hendler said. In this case, he said, that would mean taking the excess cash flow to pay down the principal of the loan, increasing its creditworthiness.
“Instead, what Rialto is proposing to do with that excess cash flow is put it in its pocket,” Hendler said.
Rialto did not immediately respond to a request for comment. However, in a letter to the plaintiff provided in court exhibits, the servicer said it’s entitled to the default interest by its agreements. Its plan would also mean excess cash would be kept in an account and out of the borrower’s hands, meaning more security for the loan.
Rialto, through its investment affiliate Rialto Capital Management, is the country’s largest buyer of CMBS B-piece notes. Those notes give the investor the ability to select the special servicer on the loan, including selecting its own affiliate.
The servicer has gained a reputation for aggressive techniques. New York landlords who borrowed from the since-collapsed Signature Bank have accused the company of “unlawfully manufacturing” defaults, The Real Deal reported earlier this year.
The company has responded that it is playing by the rules, only exercising rights in rare cases, and remains committed to borrowers.