Structuring and Enforcing Real Estate

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1 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, pm Eastern 12pm Central 11am Mountain 10am Pacific Td Today s faculty features: 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. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10.

2 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.

3 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.

4 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 or robin.jones@pillsburylaw.com.

5 Basic Introduction to Mezzanine Lending By: Robert (Robin) C. Jones, Jr. March 7, 2014 RobinJonesLaw.com 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

6 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

7 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

8 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.

9 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% B- note 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% B- note 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.

10 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.

11 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 Estate Law Practice www. NYLJ.com Intercreditor Agreements 2.0: Lessons Learned in the Tranches Monday, November 21, 2011 By Mark S. Fawer and Carolyn M. Austin THE 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 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. 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

12 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 Many intercreditor agreements 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;

13 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 cgi?input=treppwire 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 percent rate. Id. at Misc. 3d 1216(A), 918 N.Y.S. 2d 396 (unpublished table decision), 2010 WL (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 (NRB), 2009 WL (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 or reprints@alm.com. #

14 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 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 (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 , Ltd., CV , 2011 U.S. Dist. LEXIS (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 /2012 (Sup. Ct. N.Y. Cnty. Oct. 17, 2012) 5. Wells Fargo Bank, N.A. v. Mitchell's Park, LLC, 2012 WL (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) Gratiot Avenue Holdings, LLC v. Chesterfield Development Co., 835 F.Supp.2d 384, (E.D. Mich. 2011) (2012) 8. Nonrecourse Mortgage Loan Act, Mich. Comp. Laws 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. LaSalle Bank N.A. v.mobile Hotel Properties, LLC, 367 F.Supp.2d 1022 (E.D. La. 2004) Error! Unknown document property name.