Carl Icahn vs. Rialto, CMBS Servicers

Carl Icahn and Adam Singer of Rialto Capital (Getty Images. Rialto Capital, illustration by Kevin Cifuentes for The Real Deal)

Activist investor Carl Icahn has a new target — one that has long bothered short sellers and homeowners: stewards of commercial mortgage-backed securities debt.

Icahn’s funds are suing Rialto Capital Advisors, a prominent specialty services firm, for delaying the sale of a Nevada mall and allegedly siphoning millions of dollars from investors, according to a complaint.

Icahn also alleges that Rialto manipulated ratings to steer service decisions away from certain bondholders.

The lawsuit reflects long-standing complaints by real estate investors about CMBS’s special servicers.

When a CMBS loan goes into trouble, a third party is supposed to service the debt, but there are inherent conflicts. Service providers earn fees while a loan is in special administration, leading critics to suggest some are deliberately extending that status.

The well-funded Icahn seeks system change, but he has his own motive: he drains CMBS mall debt through an index called CMBX.6, which has brought him huge profits in the past (others have mistimed their trades). Changing the way ratings are calculated could allow Icahn to start profiting from retail woes again.

In this case, Icahn’s complaints stem from a faltering retail center in Primm, Nevada, near the California border. Five years after the property borrowed money in 2012, it sat half-vacant and the unpaid principal on the loan was approximately $67 million. Rialto appointed a trustee to oversee the property as administrator of the loan.

Then, according to the complaint, it went downhill.

The property, Prizm Outlets, was revalued in April 2018 for $25.5 million — about $50 million less than the loan balance. According to the complaint, the rating should have wiped out most of the subordinated bondholders and most of the second-most subordinated bonds. Class E bondholders, including Icahn, should become the controlling class of the trust.

“Instead, because it was not in Rialto’s interest — or in the interest of other influential market participants — to adequately acknowledge losses… Rialto planned to withhold control of the Class E certificates while it took Prizm Outlets to the proverbial floor,” it says in the complaint.

Icahn alleges Rialto used inflated valuations to deny control of the retail complex to Class E bondholders, who have demanded an immediate sale of the property or replaced Rialto as special administrator.

An April 2019 estimate of $28.8 million put the center at almost 100 percent occupancy when it sat half-empty, according to the complaint.

In October 2019, the service provider ordered another appraisal, inflated by a 10-year lease with HeadzUp, an experiential entertainment facility, the lawsuit alleges. It is claimed that Rialto wrote the lease to create the illusion that conditions at the Prizm Outlets would improve.

In reality, Rialto had to arrange for HeadzUp with a $650,000 upfront payment and the tenant never paid rent, which Rialto allegedly concealed in the complaint.

Then came the pandemic. Until March 2020, Class E bondholders were responsible. But by then, Prizm Outlets had dropped in value by millions more and millions of dollars in fees had been paid.

A year later, Prizm Outlets was sold to Kohan Retail Investment Group, a well-known buyer of distressed malls, for about $400,000. Rialto had borne around $12.85 million in fees, advances, and expenses on the property, meaning investors lost $12.4 million.

The sale resulted in bondholders posting a loss of $62.2 million, the entire outstanding principal of the loan. According to a Bank of America analyst, this was the largest loss in both dollars and percentage for a CMBS conduit loan since the 2008 financial crisis.

The Icahn Funds claim that other players are influencing the CMBS market. It is pointing the finger at mutual fund Putnam and other funds that have sold billions of dollars of protection to the CMBX.6 index. It claims that sellers of CMBX.6 protection were the main beneficiaries of Rialto’s actions against Prizm Outlets.

The complaint does not provide a smoking gun showing Putnam influenced the service provider at the Nevada mall. Nevertheless, it is claimed that such behavior is common in the CMBS world.

“The free and fair operation of the CMBS market is routinely undermined when service providers artificially avoid acknowledging obvious short-term losses, thereby compounding long-term losses for CMBS investors,” argued Icahn’s attorneys at Kasowitz Benson Torres.

An outside observer, Shlomo Chopp, an adviser to distressed commercial real estate deals, said the lawsuit could have a major impact on CMBS borrowers, not just investors.

“Borrowers should thank Icahn as this case is cited in many foreclosure cases and may even transform the industry,” Chopp said. “It brings to light issues that judges have dismissed for the last 10+ years.”

Chopp explained that when a defaulting borrower claims their loan servicers gamble to collect fees, the judges dismiss it on the grounds, “You owe the money, so who cares — you pay.”

“At the same time, arrears interest and fees are piling up, so most borrowers either walk away or settle down because the downside is too great,” he said.

Rialto did not respond to a request for comment.

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