Presenting a live 90‐minute webinar with interactive Q&A
Structuring and Enforcing Real Estate Mezzanine Intercreditor and B Note Agreements: Latest Developments
Lessons for Lenders from Past Workouts and Real Estate Bankruptcies on Enforceability and Remedies
THURSDAY, APRIL 24, 2014
1pm Eastern
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12pm Central | 11am Mountain
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10am Pacific
T d ’ faculty
Today’s
f
l features:
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Mark S. Fawer, Partner, Arent Fox, New York
Jerry L. Hall, Counsel, Pillsbury Winthrop Shaw Pittman, Washington, D.C.
Robert (Robin) Childress Jones, Jr., Retired Partner, Pillsbury Winthrop Shaw Pittman,
Washington, D.C.
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Perspectives on Real Estate
Spring 2009
Intercreditor Agreement Treatment of
Recourse Guaranties: Split the Baby?
by Robert (Robin) C. Jones, Jr.
In this era of troubled real estate investments, it is
critical to understand the relative rights of the senior
lender and the mezzanine lender in a loan default
situation, particularly with respect to the separate
recourse guaranties provided to each lender by the
borrower. The lenders’ respective rights (including
subordination) are spelled out in the intercreditor
agreement between the two lenders; however, the
treatment of the recourse guaranty rights against the
sponsor is often unclear or not fully thought through.
Most importantly, the rights of the mezzanine lender under its separate guaranty
may be blocked or curtailed at the point when having the recourse guaranty is
most crucial to the mezzanine lender.
The Recourse Guaranty
One of the most important documents in a typical mezzanine lending transaction is the recourse guaranty
from the sponsor (the ultimate owner of the borrowing entities) to each lender. The mezzanine lender and the
senior mortgage lender will have their own separate guaranty from the sponsor. The terms of the guaranties
will be identical, except that the mezzanine lender’s guaranty will cover not only the mezzanine borrower’s
“recourse acts,” but also those of the senior borrower, while the senior lender’s guaranty will cover only the
recourse acts of the senior borrower.
The recourse guaranty is, of course, primarily a deterrent sanction against specific, deliberate borrower
actions that mirror the exculpation exceptions in the underlying non-recourse loan agreement. The events
covered by recourse guaranties fall into two basic categories: (a) “bad boy” acts, such as fraud, waste,
misappropriation of rents or insurance proceeds, breach of single-purpose entity provisions, etc., and (b)
certain major events, such as non-permitted transfers, voluntary bankruptcy and collusive involuntary
bankruptcy (which I will refer to as “breaking the thread” events). The “bad boy” acts give the lender a claim to
the extent of its losses caused by the covered event, while the “breaking the thread” events make the entire
loan immediately recourse to the sponsor.
Mezzanine Loan Architecture
The architecture of mezzanine lending is built on the principle of separate collateral and rights: the mezzanine
lender is not the beneficiary of the senior lender’s mortgage and has no claim against the senior borrower
(including the right to participate as a creditor in a bankruptcy of the senior borrower). Similarly, the mezzanine
lender’s equity collateral is normally defined in the intercreditor agreement as “separate collateral” against
which the senior lender has no claim, and the mezzanine lender can exercise unsubordinated remedies
against its equity collateral and receive and retain the proceeds thereof irrespective of whether there is a
senior loan default, including senior borrower bankruptcy. To the extent of any cash flowing from the property,
the rights of the mezzanine lender are fully subordinate to the claims of the senior lender, and in the event of a
senior borrower default, the senior lender is entitled to payment in full before any property cash is released to
the mezzanine lender. A senior borrower default thus gives the senior lender the right to block the payment of
property-derived cash flow to the mezzanine lender until the default is cured. Under the intercreditor
agreement, the mezzanine lender has the right to cure any senior borrower default and restore its ability to
receive the cash flow from the property once the senior lender is current. Thus, in exchange for the agreement
not to compete with the senior lender for the property or claim against the senior borrower, the mezzanine
lender receives the unfettered right to proceed against its separate borrower and collateral (as distinct from
taking a subordinate mortgage and subordinate claim against the common property owner/borrower).
Competing Rights of the Lenders to Recourse Guaranty Claims
Because recourse guaranties have a common debtor in the sponsor, questions invariably arise as to how
each lender's rights should be construed with respect to claims against the sponsor under such guaranties.
Are such claims "common collateral" since there is a common obligor, or are they "separate collateral"
protecting separate lender interests? Should the mezzanine lender’s recourse claims against the sponsor be
stayed or subordinated to any pending or potential senior lender recourse claims? What if only the mezzanine
lender’s recourse guaranty is triggered, such as in the event of only a mezzanine borrower bankruptcy, which
is neither a senior lender default nor a senior lender recourse event?
The proper approach should be to look at the specific recourse events for guidance, and to allocate (and
where appropriate, subordinate) those rights based on the interests that the guaranty aims to protect. Where
the primary effect of the recourse event is on one lender’s collateral and the collateral already has applicable
subordination provisions in effect under the intercreditor agreement, then the subordination of the recourse
claim should follow the subordination that applies to the affected collateral. For example, stealing rents or
committing waste on the property primarily affects the real estate and cash flow from it, for which the
subordination priorities are clearly in favor of the senior lender. Even though such events are also recourse
events for the mezzanine lender, it would be appropriate to require the mezzanine lender to stand still while
the senior lender pursues its recourse claim, or to turn over any recoveries on such mezzanine recourse
claims to the senior lender for application to the senior debt.
In contrast, in the event of a mezzanine borrower-only bankruptcy (when there is no senior borrower
bankruptcy), the mezzanine lender should not be restricted in pursuit of its mezzanine claim as (a) there is no
comparable claim triggered under the senior recourse guaranty, and (b) the mezzanine recourse guaranty is
customarily part of the mezzanine lender’s “separate collateral.”
Similarly, a non-permitted transfer of the property (or of the equity in the senior borrower) is disastrous for the
mezzanine lender as its equity collateral is unhinged from the property and it is left with the then-empty shell
mezzanine borrower. (Or, as Shakespeare said in Sonnet LXXIII, “bare ruined choirs, where late the sweet
birds sang.”) In such event, the mezzanine lender has nothing left but its recourse guaranty claim, and ought
to be allowed to pursue it.
A senior borrower bankruptcy, however, raises somewhat different and more complex issues.
Effect of Senior Borrower Bankruptcy
Consistent with the mezzanine architecture of separate loans and borrowers, in a bankruptcy of the property
owner, the mezzanine lender does not even have a seat at the table, and is at risk of recovering nothing
whatsoever if the equity is wiped out, as is often the result in a bankruptcy. The mezzanine recourse guaranty
thus bridges that gap by providing alternate recourse to the sponsor and, in that circumstance, is much more
vital to the mezzanine lender than to the senior lender. The senior lender still would have access to the
mortgaged property for its recovery, with a bankruptcy functioning essentially as delay for the senior lender in
getting to its collateral, whereas the mezzanine lender risks being left with nothing in a senior borrower
bankruptcy. This makes it important for the mezzanine lender to have an unsubordinated right under the
intercreditor agreement to pursue the recourse guaranty in the event of a senior borrower bankruptcy. Indeed,
most mezzanine lenders take the view that they are not underwriting a senior borrower bankruptcy and are
certainly not compensated for taking that risk in the mezzanine loan pricing. While a mezzanine borrower
bankruptcy could be viewed for the mezzanine lender as analogous to a senior bankruptcy for the senior
lender (simply as a delay in the ability to access the collateral), in a senior borrower bankruptcy, the
mezzanine lender is at risk of being cut off from its collateral entirely unless it can foreclose on its equity
collateral and step into the position of the owner of the senior borrower.
Interestingly, in some recent major deals the trend in intercreditor agreements is to treat the recourse guaranty
exactly opposite of what would be logically expected. The mezzanine lender is given the unsubordinated right
to pursue the guaranty when it is only delayed in reaching its equity collateral (mezzanine-only bankruptcy
when the senior lender does not itself have a recourse claim), but has to turn over recourse guaranty
proceeds in the event of a senior bankruptcy. As discussed above, a senior borrower bankruptcy is precisely
the event where the structure breaks down for the mezzanine lender, and the recourse guaranty becomes its
primary collateral. If the mezzanine lender had the benefit of a perfected junior mortgage, so that it would have
a continued (though subordinated) claim against the underlying property, subordination of the recourse
guaranty would then be inconsequential.
Accordingly, the better result would be for the mezzanine lender to be able to pursue its recourse claim when
it has nothing else left (or is at risk of losing its connection to the property), and to subordinate such recourse
claims when they relate to damage to the senior lender’s property collateral.
Robert (Robin) C. Jones, Jr., is a partner
in Pillsbury’s Washington, DC, office. He
can be reached at 202.663.8274 or
[email protected].
Basic Introduction to Mezzanine Lending
By: Robert (Robin) C. Jones, Jr.
RobinJonesLaw.com
March 7, 2014
This memorandum briefly introduces some of the key concepts in mezzanine lending; my
powerpoint presentation at the conference will explore the subject in greater detail and discuss
the issues that arise from these concepts and the mezzanine architecture in real estate
transactions.
Background:
The term “mezzanine financing” can encompass many potential ways of structuring multilayered or tiered debt. The term “mezzanine” generally refers to the intermediate layer
sandwiched between the senior lender and the borrower equity (like the mezzanine tier in a
theater between the orchestra seats and the upper circle).
In “corporate” mezzanine debt, the mezzanine lender will typically have the same
borrower/obligor as the senior lender and be unsecured (or have a junior interest in some or all of
the senior lender’s collateral). Even with a subordination agreement from the junior lender, the
senior lender in this “traditional” structure has concerns about the mezzanine lender questioning
or interfering with the administration of its senior loan or its collateral rights, and with junior
claims against the common borrower.
As a more “senior lender-friendly” alternative, real estate mezzanine lending (particularly in
rating agency-driven CMBS transactions) seeks to ameliorate these issues with a structuralsubordination architecture utilizing separate borrowers and collateral. This structure involves a
senior loan secured by a mortgage on the real property and a junior (or “mezzanine”) loan
secured by the equity interests in the entity that owns the real property. The CMBS mezzanine
lender will make its loan to the parent of the property owner (the senior lender’s borrower) and
will take security in the equity of the senior borrower, rather than taking a junior lien in the
senior borrower’s assets (a second mortgage) or being unsecured. This structure is particularly
suitable to the creation of multiple layers of mezzanine debt to attract investors with higher
yield/risk objectives and can be supplemented by the creation of subordinate layers within the
mortgage loan (referred to as “B-notes”).
A senior/junior relationship may manifest itself in (a) right of payment, (b) right of security or
(c) structural subordination. Senior rights of payment are normally established by contractual
intercreditor or subordination agreements, while seniority in security or lien can be established
by (i) priority of filing (first in time), (ii) contractual intercreditor or subordination agreements or
(iii) by taking different collateral with different seniority characteristics (assets vs. equity in the
entity owning the assets). Structural subordination is a function of the architecture of the
borrower entities – e.g., if the assets are held by an operating subsidiary, a lender to the holding
company parent will effectively be junior to a lender to the operating subsidiary.
The documentation issues for the junior or “mezzanine” tier of debt vis-à-vis the borrower are
similar in most respects to “single-tier” or “ordinary” debt (with, of course, the collateral being
an equity pledge). The key deal difference is the intercreditor relationship between the senior
lender and the junior lender, including potential bankruptcy issues, which are not shared by
transactions involving only a single level of debt. These issues are not necessarily unique to
mezzanine loan transactions, but they do represent an additional layer of complexity from simple
single level debt secured by a real estate mortgage.
Bankruptcy Issues
There is virtually no commercially acceptable method of completely eliminating all bankruptcy
risk from a real estate financing arrangement. All other things being equal, a mezzanine
financing arrangement would be subject to the same bankruptcy risks to which any other real
estate financing would be subject. However, most mezzanine financings are structured such that
the mezzanine lender has a claim only against the equity owner of the real estate-owning entity,
and not the real estate-owning entity itself. This structure is designed to exclude the mezzanine
lender from participating in a bankruptcy case of the real estate owning entity.
Many larger mezzanine financing arrangements are part of a larger transaction which is made
pursuant to commercial mortgage securitization market requirements. These requirements
provide various protections designed to reduce or limit the bankruptcy risks to both the mortgage
lender and the mezzanine lender involved, including requiring that the constituent borrower
companies are special purpose entities or “SPEs”, and that voluntary and collusive involuntary
bankruptcy filing are deterred by a recourse guaranty.
SPEs
Such financing arrangements generally require that each of the real estate owning entity and
the direct owner of the real estate owning entity (as well as each additional borrower entity in
a multi-stack mezz financing) must be a special purpose, bankruptcy remote entity
commonly referred to as an “SPE”. An SPE is an entity, formed at the time of the
transaction, that is unlikely to become insolvent as a result of its own activity and that is
designed to be insulated from the consequences of any related parties’ insolvency. The
following general criteria provide the framework for SPEs:
• Restrictions in both the transactional documents and the organizational
documents (see examples in Exhibit A) intended to limit or eliminate the ability
of an SPE from incurring liabilities other than the mortgage loan or mezzanine
debt, including (i) restrictions and/or limitations on other indebtedness and (ii)
limitations on purpose of the SPE and the activities in which it may engage (i.e.,
can only own and operate the mortgaged real estate or can only own the equity
interests of the real estate owning entity, as the case may be).
• Restrictions intended to insulate the SPE from liabilities of affiliates and
third parties, including (i) the requirement that the organizational documentation
and the transaction documents contain separateness covenants (see examples in
Exhibit A) and (ii) the requirement that a non-consolidation opinion be delivered
with respect to the SPEs.
• Restrictions intended to protect the SPE from dissolution risk, including
(i) absolute prohibitions on liquidation and consolidation for so long as the
mortgage or mezzanine loans are outstanding, (ii) restrictions on merger of the
SPE, and sale of all or substantially all of the assets of the SPE, without the prior
written consent of the lender; and (iii) the requirement that the SPE have
appropriate single-purpose, bankruptcy-remote equity owners (e.g., SPE general
partners with respect to an SPE limited partnership, or an SPE member holding a
meaningful economic interest with respect to an SPE limited liability company,
or, perhaps, a similarly structured single member LLC). Free transferability of
the project equity would apply above the SPE structure where other SPE
restrictions would also not apply.
• Restrictions intended to limit a solvent SPE from filing a bankruptcy
petition (or taking any other insolvency action). Such provisions include the
requirement that the SPE (and/or any SPE constituent entity) have an independent
director or independent manager whose vote is required prior to the filing of any
bankruptcy (or taking any other insolvency actions) or a so-called “golden share”
held by a lender and coupled with an organizational document requirement that
the holder must affirmatively vote for any insolvency action.
• Provisions in the transaction documents intended to make it economically
painful if the SPE were able to file a bankruptcy petition, such as providing for an
exception to the non-recourse clause or a springing guaranty against individuals
or related entities or a springing lien against other real estate or collateral (see
below under “Recourse Guaranty”).
The foregoing restrictions are designed to make it unlikely that the owner of the real estate
owning entity, and the real estate owning entity itself, will be able to file or sustain a
bankruptcy case, thereby preventing the mezzanine lender from foreclosing on the equity
interests of the real estate owning entity (see below under “Control of the Real Estate
Owning Entity”) or the mortgage lender from foreclosing on the real estate that secures its
loan.
Recourse Guaranty
It is customary in most real estate lending transactions to require a “recourse guaranty” from
the sponsor of the project, preferably the controlling individual(s) or a substantial company
with assets and net worth. The guaranty is not a general payment guaranty of the loan, but is
limited to losses from such property-related “bad boy” acts such as (i) fraud or intentional
misrepresentation, gross negligence or willful misconduct (including voluntarily altering the
legal existence of the mezzanine borrower or the property owner, changing the state of
formation of the mezzanine borrower or the property owner or the location of any collateral
or changing the registered name of the mezzanine borrower or the property owner such that
the perfection or priority of the liens granted lender are adversely affected), (ii) breach of
environmental and hazardous substances representations and covenants; (iii)
misappropriation, misapplication or conversion of insurance proceeds, condemnation awards
or rents received following an event of default, or collected in advance, (iv) nonpermitted subordinate financing or voluntary liens, (v) non-permitted assignment, transfer,
or conveyance of the property or any interest therein, (vi) waste and (vii) failure to pay
taxes.
The recourse guaranty goes on to attempt to address the bankruptcy concerns of the lender by
making the entire debt recourse to the sponsor in the event of a voluntary bankruptcy action
of the mezzanine borrower or the property owner or of an uncontested or collusive
involuntary bankruptcy action of the mezzanine borrower or the property owner, as well as
breach of single purpose entity covenants leading to a substantive consolidation.
This recourse guaranty protection is particularly important in the context of the structural
subordination of a normal mezzanine transaction where the mezzanine lender would be
unable to participate in the bankruptcy of the property owner as it is not a creditor of that
entity and where a bankruptcy of the mezzanine borrower would, through the automatic stay,
prevent the mezzanine lender from taking control of the property owner by foreclosing on its
collateral (the equity interests in the property owner). Since the mezz lender can also be
cleaned-out by such property owner acts as a non-permitted transfer or liening of the
property, these events are also usually made full recourse as well.
Control of Cash Flow
In real estate financing arrangements, a lock box is often required in which the lenders have
control of the cash flow to ensure that all operating expenses and debt service are paid. This
mechanism has the effect of reducing the bankruptcy risk from involuntary bankruptcy
filings and eliminates or reduces the number of claimants in a case, thus providing an
opportunity for the lender to buy claims or prevent cramdown in the event the entity were to
become subject to a bankruptcy filing. The cash management agreement typically provides
for a “waterfall” series of payment priorities, giving each successive lender an opportunity to
cut off the cash flow to junior lenders and the equity in the event of a default.
Control of the Real Estate Owning Entity
Because the mezzanine lender typically obtains a security interest in the equity of the real
estate owning entity, the mezzanine lender’s primary default remedy is to obtain control of
the real estate owning entity upon foreclosure of the equity interest. Upon obtaining control,
the mezzanine lender obviously is in a better position to limit, if not eliminate, bankruptcy
risk (and may have the opportunity to use bankruptcy as a weapon against the senior
lender). In the intercreditor agreement, the mezzanine lender will generally have agreed with
the mortgage lender on the scope of the mezzanine lender’s rights upon foreclosure of the
equity interests, which in turn may reduce the mortgage lender’s bankruptcy risk as well.
Use of voting or proxy provisions in the pledge agreement to allow mezz lenders to take preforeclosure control of the pledged entity has gained recent focus as well.
Intercreditor Agreement
As discussed further below, the intercreditor agreement is a central document in
mezzanine financing arrangements. Intercreditor agreements spell out the rights of the mortgage
lender and the mezzanine lender upon default, foreclosure and bankruptcy.
Documentation Issues: Intercreditor Relationship:
The central intercreditor issues in multi-layered debt transactions involve the respective
rights and remedies of the different lenders – from the point of the mezzanine lender, who
may take what action against the borrower or its owner(s), when (and subject to what
limitations) may such action be taken and what are the consequences to the mezzanine lender
of the action or inaction (e.g., stepping into responsibility for non-recourse clause exceptions
or having to cure existing senior defaults). These issues are normally addressed in a
negotiated intercreditor agreement between the lenders, although some of them are or could
be addressed in a structural fashion or in the loan documents with the borrowers.
Intercreditor Agreements (growing out of the CREFC Form)
The CRE Finance Council (“CREFC”; formerly known as the Commercial Mortgage
Securities Association or “CMSA") is the trade association for lenders, investors and
servicers engaged in the $3.1 trillion commercial real estate finance. In addition to activities
relating to issues such as accounting standards and terrorism insurance, which impact all
types of lending, CREFC has established loan documentation and reporting standards and
prepared a standard format for secondary market post-issue information.
The CREFC form Intercreditor Agreement was intended to standardize what is often a
highly-negotiated document between the senior mortgage lender and the mezzanine lender in
order to facilitate securitization and is included in my conference materials. Drafted in 2002
by Tim Stafford of Dechert, it offers a reasonable demarcation between the senior and
mezzanine lenders (though the mezz will generally view it as oriented towards the senior
lender). The market has evolved considerably since this form was created and most law firms
active in CMBS work have developed a their own intercreditor agreement to address their
clients’ orientation; my conference materials include “first draft” examples of such forms,
with each of a senior lender and mezz lender slant.
Subordination Within the Mortgage Loan
Another way of creating multiple layers of subordinate debt in a real estate transaction involves
slicing the mortgage loan itself into multiple slices, commonly referred to as “B-notes”. B-notes
may be used in a mortgage loan-only structure or in conjunction with a mezzanine loan structure.
B-notes may be documented as participation interests (where one lender holds the mortgage note
and sells undivided participations to other lenders) or as a co-lender structure where the borrower
issues each lender its own note. The former are governed by a “participation agreement” and the
latter by a “co-lender agreement”, but the substantive intercreditor issues are similar in either
case.
All the B-notes are secured by the mortgage and vis-a-vis the borrower are part of a single
“whole loan”. The co-lender or participation agreement (as applicable) will provide for payment
priorities, governance and loan management – typically through a servicer as hired manager and
the juniormost B-Note as the “controlling holder”, with a workout specialist “special servicer”
appointed if a major default occurs. The “controlling holder” right is to veto servicer actions,
with the ability to replace the special servicer with or without cause.
The theory is that the junior controlling holder can be trusted to act in the interest of the entire
stack so long as it has sufficient skin in the game. A controlling holder can lose its status if it
suffers actual or appraisal losses in the value of its note below 25% of its original value,
whereupon the next senior B-note holder becomes the controlling holder. Once a below-25% Bnote holder loses controlling holder status, it is at risk for the decisions of the servicer and
controlling holder, which could include a workout that forgives or restructures the below-25% Bnote without its consent.
Some B-note transactions (particularly two-lender deals) provide for greater senior holder
consents, but even there junior consent rights are usually lost if the junior note is below 25% of
its original value.
EXHIBIT A
Sample SPE Documentation Provisions
Examples of Restrictions on Additional Indebtedness
The ability of an SPE to incur indebtedness, other than the mortgage loan or the mezzanine loan,
is typically limited, such as the following:
•
Subject to a cap on the aggregate amount of trade indebtedness that may be
incurred (which maximum amount, in the case of an SPE mortgage borrower often may
be less than 2% of the principal amount of the indebtedness, and is generally zero or less
than a de minimis amount in the case of the equity owner of the real estate owning
entity);
•
Incurred in the ordinary course of business;
•
Related to the ownership and operation of the mortgaged property;
•
Required to be paid within 60 days from the date such trade payables are first
incurred by the real estate owning entity (and not merely 60 days from the date on which
the trade payables are due); and
•
Not evidenced by a promissory note.
Examples of Separateness Covenants
In order to increase the likelihood that an SPE will be insulated from the liabilities and
obligations of its affiliates and third parties (and not substantively consolidated with them), the
SPE agrees to abide and, as applicable, its shareholders, members, partners, and affiliates should
agree to cause the SPE to abide by the following separateness covenants with respect to the
SPE:
•
To maintain books and records separate from any other person or entity;
•
To maintain its accounts separate from any other person or entity;
•
Not to commingle assets with those of any other entity;
•
To conduct its own business in its own name;
•
To maintain separate financial statements;
•
To pay its own liabilities out of its own funds;
•
To observe all partnership formalities;
•
To maintain an arm’s-length relationship with its affiliates;
•
To pay the salaries of its own employees and maintain a sufficient number of
employees in light of its contemplated business operations;
•
Not to guarantee or become obligated for the debts of any other entity or hold out
its credit as being available to satisfy the obligations of others;
•
Not to acquire obligations or securities of its partners, members, or shareholders;
•
To allocate fairly and reasonably any overhead for shared office space;
•
To use separate stationery, invoices, and checks;
•
Not to pledge its assets for the benefit of any other entity or make any loans or
advances to any entity;
•
To hold itself out as a separate entity;
•
To correct any known misunderstanding regarding its separate entity; and
•
To maintain adequate capital in light of its contemplated business operations.
A
N E W
Y O R K
L A W
J O U R N A L
S P E C I A L
S E C T I O N
Real EstateLaw Practice
Intercreditor Agreements 2.0:
Lessons Learned in the ‘Tranches’
By Mark S. Fawer
and Carolyn M. Austin
T
HE CREDIT CRISIS in the commercial
real estate market continues. Trepp,
LLC recently reported that “the tone in
the CMBS market has been acutely negative
for the past three months,” with 9.56 percent
of outstanding U.S. commercial mortgage
backed securities loans in delinquency as
of September 2011.1
As the rate of default continues or even
accelerates, some mezzanine lenders, forced
to dust off the intercreditor agreements
entered into with senior lenders in happier
times, may be surprised to learn that their
rights and protections are surprisingly
limited. This article will focus on the next
chapter in structured commercial real estate
finance and, in particular, on certain key
components of the intercreditor agreement,
with an eye toward how mezzanine
lenders may better protect themselves
in the next generation of intercreditor
agreements.
Make Key Provisions Work
Senior real estate loans are secured by
mortgages on real property. Mezzanine
financing is secured by a pledge of the
ownership interests in the entity owning
the property, rather than the property
itself. The owner of the property is
typically a “special asset entity” whose
sole asset is the real property that is the
Mark S. Fawer is a partner, and Carolyn M. Austin an
associate, at Dickstein Shapiro in New York.
subject of the senior lender’s mortgage.
The mezzanine lender’s pledged equity
collateral is, therefore, one step removed
from the real estate. Thus, foreclosing on
the equity collateral (or the threatened
ability to do so) is often the mezzanine
lender’s primary remedy when confronted
with a mezzanine borrower’s default,
especially if there is also a looming default
by the senior borrower under the senior
loan that threatens to wipe out the equity
via a senior lender’s foreclosure of the
mortgage covering the real property.
A mezzanine lender in that situation must
move quickly, and a foreclosure of the
pledge of membership or partnership
interest in the property owner may
generally be effected under the Uniform
Commercial Code within 45 to 90 days
after sending a notice of sale. Though
far shorter than the time it would take
in New York to obtain a judgment of
foreclosure in a judicial foreclosure of
a mortgage, a mezzanine lender may
be racing against the clock if unduly
impeded by a straitjacketing intercreditor
agreement.
The relationship between senior and
mezzanine lenders is governed by an
intercreditor agreement. The typical form
of agreement contains certain standard
provisions concerning the subordination
of the mezzanine loan to the senior loan
and the relative rights and obligations
of each lender to the other. Below is an
examination of certain material provisions
and practical drafting solutions designed
to anticipate the needs of the mezzanine
lender in the context of a borrower’s default
and potential workout of the loan.
www. NYLJ.com
Monday, November 21, 2011
Right to Foreclose
Other than timely repayment, the
bedrock issue for the mezzanine lender
is its ability to realize upon its collateral
what is often referred to as “separate
collateral” or “equity collateral” in the
event of a default and in effect take over
the senior borrower as the owner of the
property. Many intercreditor agreements
contain onerous conditions to a mezzanine
lender’s right to foreclose, among which
and perhaps most significantly, is that any
existing senior loan default must first be
cured as a condition to the mezzanine
lender’s right to foreclose.
In Bank of America, N.A. v. PSW NYC
LLC (the Stuyvesant Town Case), 2 the
court enjoined the mezzanine lender
from foreclosing on the pledged equity
without first repaying the senior lender’s
outstanding indebtedness in full (the senior
loan had been previously accelerated). The
decision turned on the interpretation of a
provision in the intercreditor agreement
entitled “Foreclosure of Separate
Collateral,” which allowed the transfer
to a Qualified Transferee of title to the
equity collateral
subject to (i) the Senior Loan…
provided, however, that…all defaults
under (1) the Senior Loan and (2)
the applicable Senior Junior Loans,
in each case which remain uncured
or unwaived as of the date of such
acquisition have been cured by such
Qualified Transferee.3
Notwithstanding that “such Qualified
Transferee shall cause, within ten (10)
days after the transfer, (1) Borrower…to
Monday, November 21, 2011
reaffirm in writing…all of the terms and
conditions and provisions of the Senior
Loan Documents and the related Senior
Junior Loan Documents, as applicable,
on Borrower’s or the applicable Senior
Junior Borrower’s, as applicable, part to
be performed,”4 the court rejected the
mezzanine lender’s argument that this
provision should apply to require the
Qualified Transferee’s cure of the Senior
Loan default only after the mezzanine
lender foreclosed and transferred its
equity to such Qualified Transferee.5
This condition to the mezzanine lender’s
right to foreclose on its equity was a
land mine that effectively left it without
a viable remedy. Mezzanine lenders should
therefore strive to avoid any limitation
on the exercise of their right to foreclose
(or otherwise realize on any “Separate
Collateral” that is not also collateral for
the senior loan), and to make sure that any
such foreclosure should never be an event
of default under the terms of the senior
loan. At the very least, the intercreditor
agreement should clearly provide that
any cure of a senior loan default need
not occur before or as of the completion
of a mezzanine loan foreclosure sale as
a condition of such sale, but rather may
occur thereafter.
Qualified Transferee
As in the Stuyvesant Town case, many
intercreditor agreements provide that (i)
a mezzanine loan may be transferred by
a mezzanine lender and (ii) the pledged
equity may be transferred in a foreclosure
or deed-in-lieu of foreclosure of that pledged
equity—in each case, only to a “Qualified
Transferee.” Here, the object should
be to expand the universe of “Qualified
Transferees”: The more broadly the term
Qualified Transferee is defined, the more
liquid the mezzanine loan and the pledged
equity become.
For instance, at a public UCC foreclosure
sale of the pledged equity, the mezzanine
lender (who may “credit bid” up to the
amount it is owed) could benefit from
an active auction with many third-party
bidders. However, an overly restrictive
Qualified Transferee definition could chill
the interest in the auction and the bidding
process itself. Even if the mezzanine lender
is the winning bidder, it may wish to assign
its winning bid to a Qualified Transferee.
A mezzanine lender should take care,
therefore, to include in the definition of
Qualified Transferee itself and its affiliates
(especially since it may wish to take title
to the equity in a special purpose entity)
and as broad an array of institutional and
industry players as possible. Furthermore,
since most definitions also include “net
worth” or “liquid asset” requirements,
care should also be taken to keep these
thresholds as low as feasible.
A broader definition of Qualified
Transferee may also permit mezzanine
lenders to more easily infuse new capital
into a deal. Often intercreditor agreements
restrict mezzanine lenders from transferring
more than 49 percent of their interest in
the mezzanine loan unless the transfer
is to a Qualified Transferee. In a workout
scenario, a mezzanine lender may well
find itself in the best position to infuse
new capital into a failing project (such as
through a protective advance); however, an
overly restrictive definition of a Qualified
Transferee may unduly limit the mezzanine
lender’s ability to syndicate the mezzanine
loan and bring in that money from a thirdparty co-mezzanine lender.
Timing Restrictions
Mezzanine lenders often obtain a guaranty
as additional security for their loans. The
intercreditor agreement will commonly
prohibit the mezzanine lender from enforcing
its guaranty until the senior loan is paid
in full. A mezzanine lender, however, may
need to enforce its guaranty prior to the full
repayment of the senior loan, especially to
deter “bad boy” acts, like a bankruptcy filing;
bad faith interference with the enforcement of
remedies; and breaches of certain obligations,
such as unpermitted modifications to the
senior loan documents.
In Highland Park CDO I Grantor Trust,
Series A v. Wells Fargo Bank, N.A., 6 the
mezzanine lender’s rights in connection
with the enforcement of its guaranty were
essentially eviscerated by the enforcement
limitations contained in the intercreditor
agreement. In Highland, the mezzanine
lender was barred from exercising its rights
or remedies under its guaranties until the
senior loan was fully paid off. The court
based its decision on the subordination
provision of the intercreditor agreement
whereby the mezzanine lender is prohibited
from receiving any payments on the
mezzanine loan before the senior loan is
repaid in full. The mezzanine lender argued
this section applied only to payments
received from the borrower, not from any
guarantor. The court did not agree with
the mezzanine lender’s interpretation.
Accordingly, care should be taken in
drafting the intercreditor agreement to give
a mezzanine lender the unimpeded right to
enforce its guaranty against the guarantor
to judgment (or less ideally, the right to
enforce the guaranty with the obligation
to apply the proceeds of any judgment in
repayment of any then-outstanding senior
loan obligations), or to permit the mezzanine
lender to enforce the guaranty to the extent
that the senior lender fails to do so after a
stated period of time.
Often intercreditor agreements
restrict mezzanine lenders
from transferring more than
49 percent of their interest
in the mezzanine loan unless
the transfer is to a Qualified
Transferee.
Replacement Guarantor
M a n y i n t e rc re d i t o r a g re e m e n t s
require that in the wake of a mezzanine loan foreclosure, the mezzanine lender
must provide a replacement guaranty in the
event that the original guaranty securing a
part of the senior loan is released. Because
there is nothing inherent in a mezzanine
loan foreclosure that results in a release
of a senior loan guarantor, a mezzanine
lender should avoid agreeing to provide a
replacement guarantor, indemnitor, pledgor,
or other obligor under the senior loan
documents so long as the original stays in
place.
Loan Amendment Rights
Intercreditor agreements usually
provide that neither the senior lender
nor the mezzanine lender, without the
consent of the other, may modify certain
material terms of its respective loans,
such as:
• increase in loan amount, interest rate,
or other monetary obligations;
• extension or shortening of the
maturity date;
• conversion or exchange for other
indebtedness or subordination to other
indebtedness;
• modification of transfer provisions;
Monday, November 21, 2011
• extension of the period during which
voluntary prepayments are prohibited or
penalized;
• modification of partial release prices;
and
• modification of the terms concerning
the application of casualty proceeds.
However, senior lenders often want, and
obtain, much greater latitude to modify
the senior loan in a default or workout
scenario, often placing limits only on the
senior lender’s right, without the mezzanine
lender’s consent, to enter into otherwise
prohibited modifications from a narrower
list.
The prudent mezzanine lender, on the
other hand, should try to eliminate the
workout carveout altogether, or at least
maintain, even in the context of a workout,
as many of the limits on a senior lender’s
ability to modify as would prevail absent
a workout. Otherwise, a mezzanine lender
may find itself defenseless to stop senior
loan modifications which compromise the
mezzanine lender when it most needs the
protections against such modifications.7
Senior Loan Buyout
Typically, intercreditor agreements
provide the mezzanine lender with an option
to purchase the senior loan. The focus here
should be on two major issues: option price
and timing of the exercise of the option.
From the perspective of the mezzanine
lender, the option price should be no
greater than “par” (i.e., the sum of the
outstanding principal balance, accrued
but unpaid interest at the contract rate, and
unreimbursed lender expenses), but should
exclude late charges, default interest, and
exit and prepayment fees. In terms of timing,
an option should be exercisable at any time
after the occurrence and continuance of a
senior loan default and remain open until a
certain period of time after the senior lender
commences a foreclosure action.
Cure Periods
Intercreditor agreements generally
provide that a senior lender must
give the mezzanine lender notice of
defaults under the senior loan and an
opportunity to cure the default. The
timing and curing of defaults (which
may often match whatever is provided
to a senior borrower in the senior loan
documents) should be contingent on the
type of default: monetary; non-monetary
susceptible to cure prior to completion of
a foreclosure by a mezzanine lender; nonmonetary not susceptible to cure until
following a foreclosure by a mezzanine
lender; and those not susceptible to cure
at any point.
For monetary defaults, the cure period
should be at least five business days after
the later of: (i) the receipt by senior lender
of a notice of default and (ii) the expiration
of senior borrower’s cure period set forth
in the senior loan documents.
For non-monetary defaults susceptible
to being cured prior to completion of a
mezzanine lender’s foreclosure action, the
cure period should be at least as long as that
given to the senior loan borrower (but the
cure period should only start after notice
has been given to the mezzanine lender).
For non-monetary defaults susceptible to
cure following the completion of a mezzanine
loan foreclosure sale, the cure period
should only commence after completion of
the foreclosure sale, and the cure period
thereafter should be at least as long as the
cure period set forth in the senior loan
documents.
For those defaults not susceptible to being
cured by a mezzanine lender or a Qualified
Transferee (e.g., the bankruptcy of the
senior borrower, a failure by a guarantor
of a net worth test, a default based on the
performance of an individual, or a default
arising from the failure of the senior borrower
to timely complete construction), the senior
lender should either waive the default or
modify it to apply only to any future default
arising from the mezzanine lender’s or
Qualified Transferee’s actions following a
foreclosure of the pledged equity.
Protective Advances
A mezzanine lender may be faced with
a situation where it may want or need
to make a “protective advance,” usually
for the payment of property taxes,
maintenance costs, insurance premiums
or other items (including capital items)
reasonably necessary to protect the
real property or the mezzanine lender’s
collateral from forfeiture, casualty, loss, or
waste. A mezzanine lender should ensure
that nothing in the intercreditor agreement
prohibits it from making reasonable
protective advances and adding that
amount to the principal balance of the
mezzanine loan, notwithstanding the
existence of a default under the senior loan
or a prohibition against increasing its loan
amount.
Conclusion
The time and effort spent by a mezzanine
lender and its counsel to better address in an
intercreditor agreement a mezzanine lender’s
rights concerning the administration and
enforcement of its loan could greatly reduce
the contractual barriers that may otherwise
exist to maximizing its loan repayment or
recovery later. Of course, pursuit of more
favorable intercreditor provisions must
be tempered with an overall awareness
of deal terms and market conditions and
practitioners are advised to take a holistic
view when approaching each issue. For
those looking to buy mezzanine loans
with an in-place intercreditor agreement
negotiated by a predecessor mezzanine
lender, the intercreditor agreement should
be reviewed carefully in advance to assess
the risks of a less than ideal agreement.
In sum, to avoid or minimize the risk of
“tranche warfare” with senior lenders,
mezzanine lenders should heed the words
of the fabled General George S. Patton,
who said: “A pint of sweat saves a gallon
of blood.”
•••••••••••••• ••••••••••••••
•
1. “U.S. CMBS Delinquency Report-September
’11,” TreppWire, Oct. 3, 2011, at 1, available at
http://www.trepp.com/m/Press_release/displayFile.
cgi?input=treppwire201110.pdf.
The
overall
commercial real estate market, with the exception
of hotel properties, has shown an increase in
delinquency rates, with multifamily properties
remaining the worst, having a delinquency rate
increase of 52 basis points for a 16.96 percent rate.
Id. at 3.
2. 29 Misc. 3d 1216(A), 918 N.Y.S. 2d 396
(unpublished table decision), 2010 WL 4243437 (Sup.
Ct. N.Y. County 2010). The senior loan was secured
by mortgages covering the Manhattan apartment
commonly known as “Stuyvesant Town.”
3. Id. at *2.
4. Id. at *3.
5. It is worthwhile noting that had the court allowed
the mezzanine lender’s foreclosure to proceed,
the mezzanine lender would still have had to cure
the senior loan default or, absent a successful loan
restructuring (in or outside of bankruptcy court),
run the risk of a mortgage foreclosure and having its
equity wiped out.
6. No. 08 Civ. 5723 (NRB), 2009 WL 1834596 (S.D.N.Y.
June 16, 2009).
7. For example, if a senior lender were permitted
to increase the principal balance of its loan without
the consent of the mezzanine lender, the security
and value of the mezzanine loan would be further
impaired since the senior lender would be adding
more debt, the repayment of which has priority over
the repayment of the mezzanine loan.
Reprinted with permission from the November 21, 2011 edition of the NEW
YORK LAW JOURNAL © 2012 ALM Media Properties, LLC. All rights reserved.
Further duplication without permission is prohibited. For information, contact 877257-3382 or [email protected]. # 070-09-12-26
CITED CASES
The Georgian case bankruptcy materials: PACER address is ecf.mdb.uscourts.gov for
debtor Stellar GT TIC LLC (jointly administered with VFF TIC LLC), case number 11-22977.
The docket numbers are Document 15 (Joint Chapter 11 Plan of Reorganization) and Document
16 (Disclosure Statement).
1.
Bank of America., N.A. v. PSW NYC LLC, 29 Misc. 3rd 1216(A), 918 N.Y.S. 2d
396 (Table), 2010 WL 4243437 (Sup. Ct. N.Y. Cnty. 2010)
2.
In re JER/Jameson Mezz Borrower II, LLC, 461 B.R. 293 (2011)
3.
U.S. Bank Nat’l Ass’n v. RFC CDO 2006-1, Ltd., CV 11-664, 2011 U.S. Dist.
LEXIS 156734 (D. Ariz. Dec. 6, 2011)
4.
Stipulation attached to So-Ordered Transcript of October 16, 2012 Proceedings,
Docket No. 33, U.S. Bank Nat’l Ass’n v. LH Hospitality LLC, Index No. 653351/2012 (Sup. Ct.
N.Y. Cnty. Oct. 17, 2012)
5.
Wells Fargo Bank, N.A. v. Mitchell's Park, LLC, 2012 WL 4899888 (United
States District Court, N.D. Georgia 2012)
6.
Wells Fargo Bank, N.A. v. Cherryland Mill Ltd. P’ship, 812 N.W.2d 799 (Mich.
Ct. App. 2011)
7.
51382 Gratiot Avenue Holdings, LLC v. Chesterfield Development Co., 835
F.Supp.2d 384, 393–94 (E.D. Mich. 2011)
8.
Nonrecourse Mortgage Loan Act, Mich. Comp. Laws § 445.1591 – 445.1595
(2012)
9.
CSFB 2001–CP–4 Princeton Park Corporate Center, LLC v. SB Rental I, LLC,
410 N.J. Super. 114, 980 A.2d 1 (N.J. Super. Ct. App. Div. 2009)
10.
La. 2004)
LaSalle Bank N.A. v.Mobile Hotel Properties, LLC, 367 F.Supp.2d 1022 (E.D.
Error! Unknown document property name.