INTERCREDITOR AGREEMENT RIGHTS AND REMEDIES; ONE SIZE DOES NOT FIT ALL

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1 INTERCREDITOR AGREEMENT RIGHTS AND REMEDIES; ONE SIZE DOES NOT FIT ALL John P. McNearney Husch Blackwell Sanders LLP 720 Olive Street, 24 th Floor Saint Louis, Missouri (314)

2 I. Introduction Today s financing arrangements come in a myriad of shapes and sizes. There are conventional portfolio lenders who intend to originate and hold their mortgage investments. There are securitized lenders who intend to sell their loans on the secondary markets. There are highly-regulated federal banks and life companies and less-regulated investment and hedge funds. These different lenders face different degrees of regulatory and ratings agency requirements and demands on the conduct of their business. Lenders appetites for risk vary. Some lenders insist on blanket liens and prohibit any other indebtedness to the borrower or its equity owners. Other lenders recognize the need for an ongoing business operation to have multiple financing sources. Lenders views of the level of subordination needed in exchange for their consent to additional financing sources range from pure lien subordination to various levels of payment subordination. Borrower types vary from the husband and wife, to the single purpose entity to the tenancy-in-common. The lender who forecloses his lien on one type of borrower faces different challenges than if he foreclosed his lien on others. Collateral types differ. Some collateral is subject to speedy decline in value and others less so. Some collateral can be successfully severed and removed from the remaining borrower assets that compose the business, some cannot. Allocating the risks between multiple lenders with interests in the same borrower or business venture, defining the scope of each of their collateral pools, and successfully navigating which lender can reach which collateral pool and when is a very difficult task. This article will: (a) explore the relationships between just two samples of intercreditor arrangements: (1) mezzanine financing versus first mortgage financing; and (2) agricultural land financing versus A-2

3 agricultural operating lenders; and (b) explore current caselaw treatment of intercreditor agreements. II. Mezzanine Financing versus First Mortgage Financing Many real estate transactions involve only a senior, first lien, mortgage in favor of a Mortgage Lender. However, it is not uncommon for a borrower to grant a second mortgage on its property to obtain more loan proceeds. The use of subordinate mortgages presents two issues for the first lien Mortgage Lender: (i) the foreclosure of its lien on the property can be complicated and delayed by the presence of a second mortgagee, and (ii) the borrower may become over-leveraged and unable to support the debt of the two loans. Furthermore, as more transactions are potentially subject to securitization, rating agencies have been concerned about the risks posed by subordinate mortgages. As a result, Mezzanine Financing has developed in the real estate capital markets. Mezzanine financing can be described as junior financing secured by the direct or indirect ownership interest in the entity owning the property, rather than the property itself, in favor of a Mezzanine Lender. For example, in a typical Mezzanine Loan, the property owning borrower (the Mortgage Borrower ) would be a single member limited liability company which owns the applicable property (the Mortgaged Property ). The mezzanine borrower (the Mezzanine Borrower ) would be the single member of the Mortgage Borrower and would pledge its interest in the Mortgage Borrower as security for the Mezzanine Loan. The Mezzanine Lender would have a claim against the equity interest in the Mortgage Borrower, but not against the Mortgaged Property or Mortgage Borrower even in the context of a first mortgage foreclosure. Upon an equity foreclosure of the Mezzanine Loan or exercise of other remedies, the Mezzanine Lender could become the controlling equity holder of the Mortgage Borrower; A-3

4 therefore, a Mortgage Lender may want to pre-approve the Mezzanine Lender. The mortgage debt and mezzanine debt may be initiated simultaneously or in sequence with either debt coming first. If the Mezzanine Loan is to come later, the Mortgage Borrower will have to negotiate to have the option for subsequent debt with agreed upon parameters set forth in the mortgage financing documents. A. Mortgage Financing Documentation Transactions involving senior mortgage financing typically involve the following set of loan documents: a note setting forth the indebtedness and payment terms; a first mortgage lien on the property involved in the transaction and securing the note; an assignment of leases and rents; a guaranty; an environmental indemnity agreement; and a loan agreement that sets forth the terms of the loan (sometimes omitted where the loan terms are set out sufficiently in the note and mortgage). The mortgage or loan agreement for mortgage financing will typically include an acknowledgment that (i) the existence of the Mezzanine Loan does not violate the transfer and encumbrance covenant of the mortgage financing documents and (ii) any foreclosure of the Mezzanine Lender under its pledge agreement will not require the Mortgage Lender s consent or violate the transfer restrictions. The mortgage financing loan documents should include an acknowledgment that the Mezzanine Loan constitutes permitted indebtedness under the Mortgage Loan. Mortgage Lenders will also typically include a provision in their loan documents that allows the lender to terminate the property manager if the debt service coverage ratio falls below a specified level and reserves the lender s right to approve any replacement manager. This is because Mortgage Lenders are often concerned about the performance of the property manager as well as the equity owners of the Mortgage Borrower. The debt service coverage ratio is a common gauge of managerial performance. By having the right to terminate the property A-4

5 manager, Mortgage Lenders retain significant control over the loan without declaring a loan in default. B. Mezzanine Financing Documentation The loan documents for mezzanine financing parallel those used for Mortgage Loans. The terms of the loan are set forth in a loan agreement, and the indebtedness is evidenced by a junior note, which is secured pursuant to a pledge agreement. The pledge agreement pledges the equity interest of the Mezzanine Borrower in the Mortgage Borrower as collateral to secure the note. A Uniform Commercial Code ( UCC ) financing statement is filed to perfect the Mezzanine Lender s security interest. Additionally, a guaranty of the Mezzanine Borrower s obligations could be required. Typically, the Mezzanine Loan agreement will include provisions that strictly prohibit any additional indebtedness secured by the Mortgaged Property or at the Mortgage Borrower level. The Mezzanine Lender will also generally prohibit any transfer of the Mortgaged Property without his consent. The mezzanine financing documents should also include an obligation by the Mezzanine Borrower to comply with the terms of the Mortgage Loan and state that a default under the Mortgage Loan constitutes a default under the Mezzanine Loan. The Mezzanine Lender must be able to gain control of the Mortgage Borrower if there are problems at the level of the Mortgage Loan so that the Mezzanine Lender, having exercised its remedies, can address the cure of the Mortgage Loan defaults. Furthermore, a Mezzanine Lender will want to have a provision that allows her to review decisions made with respect to the Mortgaged Property. This is because the Mezzanine Lender s interests (e.g., to keep cash flow high and reinvestments in the business low) conflict with the Mortgage Lender s interests (e.g., to reinvest excess cash flow into the Mortgaged Property and protect its collateral, while providing sufficient cash flow to service the mortgage debt). This A-5