Activist investor Carl Icahn has a new target — one that has long harassed short sellers and property owners: managers of commercial mortgage-backed debt securities.
Icahn funds are suing Rialto Capital Advisors, a prominent special service, for delaying the sale of a Nevada mall and allegedly misappropriating millions of dollars from investors, according to a complaint.
Icahn also alleges that Rialto manipulated valuations to bias service decisions away from certain bondholders.
The suit echoes real estate investors’ longstanding grumblings about CMBS’ special services.
When a CMBS loan runs into trouble, a third party is supposed to service the debt, but there are inherent conflicts. Repairers earn fees while a loan is in special service, leading critics to suspect some are intentionally extending that status.
Deep-pocketed Icahn seeks systemic change, but he has his own motive: He is shorting CMBS mall debt via an index known as CMBX.6, which has brought him huge profits in the past (others mistimed their trades). A change in the way valuations are calculated could allow Icahn to once again take advantage of retail issues.
In this case, Icahn’s grievances stem from a failing mall in Primm, Nevada, near the California border. Five years after the property borrowed money in 2012, it was half vacant and the principal outstanding on the loan was around $67 million. Rialto, as manager of the loan, has appointed a receiver to oversee the property.
That’s when things went south, according to the complaint.
The property, Prizm Outlets, was reappraised in April 2018 for $25.5 million, about $50 million less than the loan balance. According to the complaint, the valuation should have wiped out the most junior bondholders and most of the most junior bonds. Class E bondholders, including Icahn, were meant to become the trust’s controlling class.
“Instead, because it was not in Rialto’s interest – or in the interest of other influential market players – to appropriately acknowledge the losses…Rialto conspired to deny the control to Class E certificates while running Prizm Outlets in the proverbial field,” the complaint said.
Icahn alleges that Rialto used inflated valuations to deny control of the shopping complex to Class E bondholders, who would have demanded an immediate sale of the property or replaced Rialto as a special repairer.
An April 2019 valuation of $28.8 million assumed the center was near 100% occupancy when it was half vacant, according to the complaint.
In October 2019, the repairman ordered another appraisal, this one inflated by a 10-year lease with HeadzUp, an experiential entertainment center, according to the lawsuit. He claims that Rialto signed the lease to create the illusion of improved conditions in Prizm Outlets.
In reality, Rialto had to induce HeadzUp with an upfront payment of $650,000 and the tenant never paid rent, which the complaint alleges Rialto concealed.
Then came the pandemic. In March 2020, class E bondholders were in the driver’s seat. But by then, the value of Prizm Outlets had dropped millions more, and fees totaling millions of dollars had been paid.
A year later, Prizm Outlets was sold to Kohan Retail Investment Group, a reputable buyer of distressed malls, for around $400,000. Rialto had incurred approximately $12.85 million in fees, advances and expenses on the property, meaning investors lost $12.4 million.
The sale resulted in bondholders recording a loss of $62.2 million, the entire principal amount outstanding on the loan. According to a Bank of America analyst, it was the largest loss, both in dollar amount and percentage terms, for a CMBS loan since the 2008 financial crisis.
The Icahn funds claim that other players influence the CMBS market. He points to the Putnam mutual fund and other funds that have sold billions of dollars of protection to the CMBX.6 index. He claims that sellers of CMBX.6 protection have been the main beneficiaries of Rialto’s shares on Prizm Outlets.
The complaint does not provide compelling evidence that Putnam influenced the Nevada mall repairman. Yet he alleges that such behavior is common in the CMBS world.
“The free and fair functioning of the CMBS market is routinely eroded when managers artificially avoid recognizing obvious short-term losses and, in doing so, exacerbate long-term CMBS investors’ losses,” explained Icahn’s attorneys at Kasowitz. Benson Torres. .
Outside observer Shlomo Chopp, an adviser on distressed commercial real estate transactions, said the lawsuit could have big implications for CMBS borrowers, not just investors.
“Borrowers should thank Icahn, as this case will be cited in many foreclosure cases and may even be industry-changing,” Chopp said. “It highlights issues that judges have dismissed for the past 10+ years.”
Chopp explained that when a defaulting borrower alleges his loan servicers are playing games to rack up fees, judges throw him out, thinking “you owe money, so whatever – pay.”
“At the same time, late interest and fees are piling up, so most borrowers walk away or settle because the inconvenience is too great,” he said.
Rialto did not return a request for comment.