Friday, October 29, 2010

Rights and Restrictions in Intercreditor Agreements

Mitchell Berg and Salvatore Gogliormella

New York Law Journal

October 20, 2010

As the delinquency rate for U.S. commercial mortgage-backed securities reaches record highs,1 restructurings and foreclosures of distressed real estate loans are becoming increasingly important components of the real estate practice. Where those loans form part of a capital structure that combines mortgage debt and one or more tranches of mezzanine debt, it is important for lenders at all levels of the capital structure to be mindful of the limitations and protections contained in intercreditor agreements. This article briefly describes certain of the key provisions in such agreements.

Acknowledgement of Separateness of Loans. Although mortgage and mezzanine lenders frequently have recourse to certain shared collateral (most often, "nonrecourse carveout" guaranties from a common guarantor), the structure is designed to provide mortgage lenders and lenders of each tranche of mezzanine debt with separate collateral for their respective loans. (For securitized mortgage loans, this separateness is critical to obtaining the requisite blessing of the rating agencies.) Accordingly, each lender generally acknowledges in the intercreditor agreement that it does not (and will never) have a claim against the borrower under any other loan in the capital structure or a security interest in the separate collateral securing any other such loan, and that each of the other lenders is entitled (subject to certain rights and restrictions which are described below) to exercise remedies with respect to its separate collateral.

Subordination of Junior Loans. Although mezzanine loans are by their nature structurally subordinate to mortgage loans and more senior mezzanine loans, intercreditor agreements expressly affirm such subordination.2 Accordingly, the right of each mezzanine lender to receive payment in respect of its loan is generally subject and subordinate to each senior lender's right to receive payment. Notwithstanding such subordination, as long as there is no event of default under a more senior loan and no bankruptcy case involving a more senior borrower, a mezzanine lender is entitled to collect and retain any amounts due and payable under its loan documents. In the context of a default or bankruptcy, some agreements prohibit a mezzanine lender from accepting or receiving virtually any payment. Other agreements permit a mezzanine lender, even under those circumstances, to accept, for example, (a) the proceeds of any foreclosure of its equity collateral or (b) funds from sources other than an obligor under a senior loan or the collateral for a senior loan.

Transfers of Loans. Typically, mezzanine lenders are prohibited from transferring more than a 49 percent interest in their respective loans unless either (a) the rating agencies confirm in writing that the transfer will not result in a downgrade, qualification or withdrawal of the applicable ratings or, if the mortgage loan has not been securitized, the mortgage lender consents to the transfer or (b) the transferee meets the definition of a "qualified transferee."3 A mortgage lender is generally permitted to transfer all or any part of its interest in the mortgage loan in its discretion. Similarly, a mezzanine lender may generally transfer all or any part of its interest without the consent of the owner of any junior mezzanine loan. All lenders, however, are typically prohibited from transferring all or any part of their respective interests to an affiliate of any borrower.

Foreclosure of Separate Collateral. A mezzanine lender is typically permitted to foreclose or otherwise realize upon the equity collateral for its loan (or accept title to such collateral in lieu of foreclosure) without obtaining the consent of the mortgage lender (or, if the mortgage loan has been securitized, confirmation from the rating agencies that such action will not result in a downgrade, qualification or withdrawal of the applicable ratings) and the other senior lenders, but only if certain conditions are satisfied, including that the transferee of title to such collateral be a qualified transferee and that the property will be managed by a qualified manager following the change in ownership.
In granting injunctive relief last month to the trustees of a securitized mortgage loan made to the owners of Stuyvesant Town and Peter Cooper Village, a New York court interpreted a common provision in intercreditor agreements to require a mezzanine lender to cure all curable defaults then existing under any more senior loan prior to foreclosing on its equity collateral.4 If the exercise of remedies by the mezzanine lender will result in the removal of any guarantor, indemnitor or other obligor with respect to more senior loans, the transferee must in most (but not all) cases provide (i) a replacement guaranty, indemnity or other agreement which is substantially similar to the one being replaced and (ii) an opinion of counsel that such replacement will not constitute a "significant modification" of the mortgage loan (within the meaning of §1.860G-2(b) of the Treasury Regulations). A new non-consolidation opinion is generally required within a specified period of time after the exercise of remedies if one was delivered in connection with the closing of the mortgage loan. Each lender generally waives any transfer or assumption fees and any default that would otherwise arise solely by virtue of a foreclosure of a more junior loan.

Modifications. Intercreditor agreements typically give lenders at each level of the capital structure consent rights over modifications of loans at other levels.5 While the types of modifications which require consent vary appreciably from one agreement to another, there is considerable overlap. Modifications that commonly require consent include: (a) an increase in the principal amount of the loan (generally excluding increases resulting from advances by the lender to protect the collateral for the loan), (b) an increase in interest rates or payments, (c) the imposition of new or increased fees, (d) an increase in the amount of any prepayment fee or premium or yield maintenance charge or an extension of the period during which any such fee, premium or charge is imposed or during which prepayments are prohibited, (e) the acceptance of any so-called kicker (based on cash flow or appreciation) or any similar equity-type participation, (f) an extension or shortening of the term (other than pursuant to an existing extension option), (g) an amendment of the transfer or release provisions, (h) a modification of the timing, manner or method of application of payments under the cash management system, and (i) the imposition of new or stricter financial covenants.
However, each lender is generally given significantly greater flexibility to modify its loan—with only a handful of modifications requiring consent—in the case of a work-out or any compromise or release while an event of default is outstanding. The modifications that may require consent in such circumstances include increases in principal amount, increases in prepayment fees and the acceptance of equity participations.

Bankruptcy. A mezzanine lender is generally prohibited, for as long as any senior loan remains outstanding, from causing, soliciting or directing a bankruptcy or other insolvency proceeding with respect to a senior borrower. Although a mezzanine lender is not a lender to the borrower under a more senior loan, in the event that a junior lender is nonetheless deemed to be a creditor in a bankruptcy case involving the senior borrower, it is prohibited from taking any action in such case without the consent of the senior lender (except to the extent necessary to protect its equity collateral in its capacity as a pledgee), and the senior lender is authorized (and granted a power of attorney) to exercise all rights and take all actions which the junior lender would otherwise be entitled to exercise or take in connection with the case.

Rights of Cure. Before commencing to exercise any of its remedies, a senior lender is typically required to notify all junior lenders of the default and to give them an opportunity to cure the same. In the event that the mortgage loan and one or more mezzanine loans is in default, a mezzanine lender is generally obligated to cure defaults under all senior loans simultaneously in order to preserve its right to cure any of them.

In the case of a monetary default, each junior lender typically has a period of between five and 10 business days after its receipt of the senior lender's default notice (or after the expiration of the senior borrower's cure period [if any], whichever is later) in which to cure the default. In general, a junior lender cannot cure the senior borrower's failure to pay monthly debt service for more than a limited number of months (usually between four and six) unless the junior lender is diligently exercising its remedies against its equity collateral and in all events loses its cure right if a bankruptcy case is commenced with respect to the senior borrower.

In the case of a non-monetary default, each junior lender generally has a specified period of time in which to cure the default. These cure periods can run concurrently for all junior lenders or, alternatively, sequentially, with the junior-most lender being given the first opportunity to cure and each remaining junior lender having an additional cure period if the lender immediately junior to it failed to cure the default.

Each cure period is typically subject to extension so long as the junior lender is diligently pursing the completion of such cure (or, if the default cannot be cured or can only be cured following a foreclosure by the junior lender of its equity collateral, the completion of such foreclosure), the senior lender receives timely payment of all monthly debt service and all other amounts owed to it, (c) no bankruptcy case is commenced with respect to the senior borrower (although many agreements provide for reinstatement of the cure right upon a dismissal of the bankruptcy case), and (d) there is no material impairment of the value, use or operation of the property.

Purchase Option. If a senior loan has been accelerated or certain other events have occurred after a default under the senior loan, then, upon written notice to the owner of such loan, the junior-most lender in the capital structure typically has the right to purchase such loan, provided that it simultaneously purchases all loans junior to such loan and senior to its own loan. If it fails to exercise such right, the other junior lenders (in order of priority from most junior to least junior) may exercise it.

The purchase price for each loan is generally equal to the sum of all amounts outstanding under such loan (other than, in most cases, exit fees, liquidated damages, prepayment fees or premiums, yield maintenance charges, and, in some cases, late charges, default interest, and special servicing, workout or liquidation fees). The purchase option typically expires (a) upon a transfer of the collateral by foreclosure sale or by deed or assignment in lieu of foreclosure (so long as the junior lenders had, in the aggregate, not less than 30 days in which to exercise such option)6 or (b) if the condition giving rise to the purchase option fails to exist. Lenders are generally prohibited from entering into any agreement with a borrower (or an affiliate of any borrower) to purchase a senior loan in order to circumvent a requirement to pay exit fees, liquidated damages, prepayment fees or premiums or yield maintenance charges.

Restricted Rights for Borrower Affiliates. Intercreditor agreements generally provide that a lender which is an affiliate of a borrower will not be entitled to exercise many of the rights that would otherwise be available to it under the agreement. In some cases, a lender which became such an affiliate by virtue of foreclosure (or acceptance of title in lieu of foreclosure) of the equity collateral for another loan may exercise such rights as long as it does so without taking its equity interest into account.

Conclusion

Intercreditor agreements are critical roadmaps in navigating the landscape of post-default indebtedness. They should be carefully reviewed both by lenders to distressed real estate borrowers and by potential buyers of both mezzanine and mortgage debt.

Mitchell Berg is a partner at Paul, Weiss, Rifkind, Wharton & Garrison. Salvatore Gogliormella is an associate at the firm.

Endnotes:

1. See TreppWire, Monthly Delinquency Report, Oct. 4, 2010.
2. One mezzanine loan in the capital stack is senior to another if the equity interests securing it were issued by an entity whose ownership of the mortgage borrower is more direct than that of the entity whose equity interests secure the other loan.
3. A "qualified transferee" is generally an institutional lender, investment fund or other entity which meets (or whose investors meet) specified financial tests and, in some cases, is in the business of making or owning commercial real estate loans.
4. Decision on Motion for Preliminary Injunction, Bank of America, N.A. v. PSW NYC LLC, No. 651293/2010 (N.Y. Sup. Ct. Sept. 16, 2010).
5. Where a tranche of debt is held by more than one party, those parties often enter into a co-lender agreement with respect to (among other things) the manner in which consent rights, cure rights and purchase options granted to that tranche under the intercreditor agreement will be exercised. The intercreditor agreement will frequently dictate who is entitled to act on behalf of the lenders in a tranche in the absence of a co-lender agreement governing the issue.
6. In some cases, any lender that is offered a deed or assignment in lieu of foreclosure is required to notify all junior lenders of such offer and to reject such offer if any of the junior lenders exercises its purchase option.

Monday, October 25, 2010

Adverse Possession Trends in New York

Adam Leitman Bailey and John M. Desiderio

New York Law Journal

October 13, 2010

In 2008, the New York State Legislature enacted sweeping changes to those provisions of the Real Property Actions and Proceedings Law (RPAPL) that govern the circumstances under which title to real property may be acquired by adverse possession.1 The Legislature acted primarily to reverse the ruling of the Court of Appeals in the case of Walling v. Prysbylo.2 Under principles of New York adverse possession law nearly two centuries old, the Court had ruled that the Wallings had acquired title to a strip of land belonging to their neighbors, the Prysbylos, by treating the property as their own for the requisite 10-year period, despite the Wallings' admitted knowledge of the Prysbylos' record ownership of the disputed parcel. Contrary to Walling, under the amended RPAPL, no person may now acquire title to land by adverse possession without showing a claim of right to the land founded on a "reasonable basis for the belief that the property belongs to the adverse possessor."3

The 2008 legislation also, by statute, deemed certain encroachments and activities as "permissive and non-adverse" which previously might have been considered as evidence tending to show such use and occupation of the land by the intruder "as owners are accustomed to possess and improve their estates,"4 and, therefore, adverse to the interests of the record owner. Included in this now permissive and non-adverse category are (a) "de minimis non-structural encroachments," such as fences, hedges, plantings, sheds, and non-structural walls,5 and (b) "acts of lawnmowing or similar maintenance across the boundary line of an adjoining landowner's property."6

The RPAPL adverse possession amendments became effective on July 8, 2008, and they "apply to claims filed on or after such effective date."7 However, the question of whether or not the 2008 amendments apply to every case that is filed after July 8, 2008 is one that must be decided on a case-by-case basis, and how that question is answered can make a substantial difference in the outcome of each case.

Recent Appellate Decisions

The issue was squarely presented in Franza v. Olin,8 a Fourth Department case that was the first appellate decision to rule on the question. In Franza, the plaintiff commenced her action six weeks after the 2008 amendments became effective. The plaintiff's verified complaint alleged that she had acquired title to the disputed property by adverse possession as early as 1985 by reason of her use of the land, including lawn mowing, landscaping, and erection of a shed and satellite receiver. The lower court dismissed the plaintiff's claim concluding that the alleged uses of the property were deemed "permissive and non-adverse" under the newly enacted RPAPL 543.

The Fourth Department reversed, holding that the amendments to Article 5 of the RPAPL, as applied to the plaintiff's claim by the lower court, were unconstitutional because they deprive her of a vested property right—title to the property that would have vested long before July 2008. The court stated:
We conclude that the court erred in applying the amended version of article 5 to plaintiff under the facts of this case and that plaintiff is entitled to the application of the version of article 5 in effect when her claim to the disputed property allegedly ripened into title. "Although a statute is not invalid merely because it reaches back to establish the legal significance of events occurring before the enactment,…the Legislature is not free to impair vested or property rights." It is well-settled law that the adverse possession of property for the statutory period vests title to the property in the adverse possessor. "Adverse possession for the requisite period of time not only cuts off the true owner's remedies but also divests [the owner] of his [or her] estate." Thus, at the expiration of the statutory period, legal title to the land is transferred from the owner to the adverse possessor. Title to the property may be obtained by adverse possession alone, and "[t]itle by adverse possession is as strong as one obtained by grant." It therefore follows that, where title has vested by adverse possession, it may not be disturbed retroactively by newly-enacted or amended legislation (Citations omitted).

The defendants in Franza attempted to avoid the constitutional issues by contending that the 2008 amendments were merely "evidentiary" in nature, but the court rejected that argument noting that:

The amendments abrogate the common law of adverse possession and define as "permissive and non-adverse" actions that, under the prior statutory law and longstanding principles of common law, were sufficient to obtain title by adverse possession. Thus, inasmuch as title to the disputed property would have vested in plaintiff prior to the enactment of the 2008 amendments, we conclude that application of those amendments to plaintiff is unconstitutional. (Citations omitted)

Finally, as the court also noted, "RPAPL 501(2), as amended, recognizes that title, not the right to commence an action to determine title, is obtained upon the expiration of the limitations period" (Emphasis in original).

In Barra v. Norfolk Southern Railway Company,9 a case that was commenced in March 2009, the Third Department followed Franza and held that the RPAPL amendments did not apply to a prescriptive easement which was alleged to have vested prior to the effective date of the amendments.

These amendments, which took effect on July 7, 2008, "apply to claims filed on or after such effective date" and, as alleged in plaintiffs' March 2009 complaint, plaintiffs' prescriptive periods all commenced and concluded prior to the effective date. Although a creature of common law, the right to an easement by prescription, as with adverse possession, vests upon the expiration of the statute of limitations for the recovery of real property. Should plaintiffs succeed in proving their claims, titles to the easement would have vested prior to the effective date of the amendments and, consequently, "[they] may not be disturbed retroactively by newly-enacted or amended legislation." Accordingly, notwithstanding the statutory language to the contrary, at trial, plaintiffs are entitled to have their claims measured in accordance with the law of prescription as it existed prior to the enactment of the 2008 amendments (Citations omitted).

However, in a case commenced in September 2008, Ziegler v. Serrano,10 the Third Department, applied the 2008 RPAPL amendments and found adverse possession based on a claim of right under a 1985 deed which the court said provided the adverse possessors with a reasonable basis to believe that they owned the land. The adverse possessor plaintiffs had sued to quiet title. They had received the 1985 deed from the defendant's former husband at a time when he was without legal authority to transfer the property without the defendant's consent. The defendant subsequently commenced an action in 1992 challenging the plaintiffs' title to the property, but the action was dismissed in November 1994 for lack of prosecution.

The court found that the plaintiffs had satisfactorily demonstrated that their possession of the property was adverse, under a claim of right, actual, exclusive, open and notorious, and continuous for a 10-year period. The court stated in addition:

Pursuant to the 2008 legislative enactments to RPAPL article 5, a "claim of right" now requires "a reasonable basis for the belief that the property belongs to the adverse possessor or property owner." Here, it is undisputed that plaintiffs have continuously possessed and exclusively occupied the property in question since the land was conveyed to them in 1985. Throughout this time, plaintiffs undertook numerous acts that were consistent with those of a property owner and sufficient to put defendant on notice, including the payment of all taxes, extensive landscaping, installing a shed and fence, replacing all the windows, the deck, front door, sidewalk and driveway, and prominently displaying their surname on the home's mailbox. Plaintiffs also demonstrated that they occupied the property under a claim of right. Their continued possession of the property since 1985 under the deed and the dismissal of defendant's 1992 action challenging their title, after which defendant took no steps to assert any right to title of the property, provided plaintiffs with a reasonable basis to believe that they owned the property. Upon this proof, plaintiffs made a prima facie showing of entitlement to the property by adverse possession (Citations omitted) (Emphasis added).

The court noted that "[i]nasmuch as the parties to this action have not raised the propriety of applying the 2008 legislation to the facts of the case, we do not pass on the issue." Nevertheless, the court said that "even were we to apply the law as it existed at the time that plaintiffs' title to the property vested by reason of adverse possession, the result reached here would not change."

While the court, citing Franza, properly noted in a footnote that the plaintiffs would have prevailed in any event without applying the 2008 amendments to their case, there is reason to question the court's reliance upon the 2008 amendments as the principal basis for its holding. The defendant's failure to prosecute her 1992 action challenging plaintiffs' title based on the faulty 1985 deed was, at best, an ambiguous action. It was not objectively reliable evidence upon which to find a "reasonable basis" for plaintiffs' belief that the property belonged to them.
It is certainly possible that another court, adjudicating these same facts, could have reached a different result. After the defendant had challenged their title derived from the faulty deed, the continued existence of a "reasonable basis" for plaintiffs' belief was at least questionable. This possibility of inconsistent judgments, based on non-objective evidence, is precisely what then-Governor Eliot Spitzer predicted in his veto message addressed to the Legislature's enactment in 2007 of its first attempted reversal of the Court of Appeals holding in the Walling case.11

In yet another Third Department decision, Sawyer v. Prusky,12 an action commenced in September 2008, in which the plaintiffs alleged they had encroached upon and maintained the disputed parcel as their own "between 1997 and 2008," the court applied the 2008 amendments without any hesitation and upheld the dismissal of plaintiffs' adverse possession claim. The court held that all of the plaintiffs' alleged acts of encroachment and maintenance were deemed permissive under the amended statute. Sawyer was decided on March 18, 2010, one day before the Fourth Department's Franza decision on March 19, 2010. The Sawyer opinion is unclear as to exactly when the period of plaintiffs' adverse possession was alleged to have actually begun and ended. However, if the alleged acts of adverse possession did indeed occur "between 1997 and 2008," then it appears that Sawyer was decided incorrectly and that the rule enunciated one day later in Franza, and acknowledged in the Third Department's own subsequent Barra and Ziegler decisions, supra, should have been applied to permit the Sawyers to prove their claim.

Recent Lower Court Decisions

The lower court decisions in Franza, Ziegler, and Sawyer, supra, which ruled against the adverse possessors in those cases, suggest that the lower courts have not yet fully appreciated the significance of deciding when to apply the law existing pre-RPAPL amendments and post-RPAPL amendments to an adverse possession claim.

In Hartman v. Goldman,13 an action commenced in April 2009, the Westchester Supreme Court applied the 2008 amendments and granted the defendant Goldman summary judgment against the plaintiffs who claimed adverse possession of the disputed parcel based upon the "installation of driveway lights, planting of foliage and shrubbery, landscaping and lawn maintenance,"—all of which the court said were "de minimis and, by statute deemed permissive and non-adverse [citing RPAPL 543]" (Emphasis in original). The plaintiffs had initially alleged that their adverse possession encroachments and maintenance activities had begun "circa 1990," and subsequently attempted to trace the beginning of their adverse possession to 1988.
There were facts in the case which made it questionable whether, during the relevant years, the plaintiffs had ever actually satisfied the 10-year prescriptive period against defendant Goldman or either of two predecessor owners of the disputed parcel. Nevertheless, without making any statement concerning the relevant 10-year period, the court applied the 2008 RPAPL amendments to the plaintiffs' claim without any discussion of whether it was appropriate to do so where an eighteen to twenty-year period of adverse possession prior to the amendments was alleged.14

In a more recent decision, Meckler v. Schnell,15 which was commenced in 2009 and decided after the Fourth Department's Franza ruling, New York County Supreme Court also applied the 2008 RPAPL amendments in finding against a claim of adverse possession. The court held that the plaintiffs were not entitled to claim title by adverse possession to a strip of property 3.75 inches wide which had previously been part of their backyard. The defendants, after purchasing the adjoining property, had removed a backyard fence that separated the plaintiffs' property from the defendants' property and replaced it with a new fence. The defendants had installed the new fence 3.75 inches closer to what their surveyor had determined to be the actual property line (which had the effect of adding 3.75 inches to the defendants' backyard and removing those same inches from the plaintiffs' backyard). The court held that the 3.75 inches to which the plaintiffs claimed title was de minimis (citing RPAPL 543 and the Third Department's Sawyer decision, supra).
Although the plaintiffs in Meckler purchased their property in 1999 (10 years before commencing their action), the defendants purchased the adjoining property only in 2006 and had replaced the backyard fence (with plaintiffs' permission) after their purchase. Therefore, without tacking on the time the fence had been in place during the periods when their predecessors in interest owned their property, the plaintiffs could not have claimed that they adversely possessed the 3.75 inch strip of property for the requisite 10-year period. However, the court's opinion does not discuss any facts concerning the length of time that the old backyard fence was in place prior to plaintiffs' purchase of their property. Nevertheless, the court also cited decisions holding that encroachments of from 1.5 to 3.75 inches were deemed de minimis even before enactment of the 2008 RPAPL amendments.16
In contrast to the situation in Meckler, Rockland County Supreme Court held, in De Lorenzo v. Johnson,17 that a backyard stockade fence erected in 1979-1980, which encroached one half to two feet on defendants' property for 15 years before the defendant took title and 26 years before the defendant took down the fence, was sufficiently adverse to vest the plaintiff with title to the disputed parcel. In this action, which was brought in 2006, the court noted that RPAPL 543(1) did "not apply to matters of adverse possession which occurred prior to the adoption of this amendment" and that "[t]he claim of adverse possession occurred years prior to 2008."

Conclusion

This short review of recent adverse possession decisions issued after the enactment of the 2008 RPAPL amendments shows that, while the law is still evolving, the courts are aware of the significant changes the 2008 amendments have rendered in the law of adverse possession, but that, during this period of transition, the courts must be alert to recognize situations where adverse possession property rights were acquired prior to enactment of the amendments, even in cases where the parties to the action may have failed to address the issue.

Adam Leitman Bailey is the founding partner of Adam Leitman Bailey, P.C., and John M. Desiderio is chair of the firm's Supreme Court Litigation Group.

Endnotes:

1. See L. 2008, ch. 269, §8. Under RPAPL 501(1), an "adverse possessor" is a person or entity who "occupies real property of another person or entity with or without knowledge of the other's superior ownership rights, in a manner that would give the owner a cause of action for ejectment," and, under RPAPL 501(2), an adverse possessor gains title upon expiration of the statute of limitations where the occupancy "has been adverse, under claim of right, open and notorious, continuous, exclusive, and actual."
2. 7 NY3d 228 (2006).
3. RPAPL 501(3).
4. Monnot v. Murphy, 207 NY 240 (1913).
5. RPAPL 543(1).
6. RPAPL 543(2).
7. L. 2008, ch. 269, §9.
8. 73 AD3d 44, 8897 NYS2d 804 (4th Dept. 2010).
9. 75 AD3d 821, —NYS2d— (3d Dept. 2010).
10. 74 AD3d 1610, —NYS2d— (3d Dept. 2010).
11. See Adam Leitman Bailey and John M. Desiderio, "Adverse Possession Changes Make Result Less Certain," NYLJ, Feb. 11, 2009; see also Adam Leitman Bailey and John M. Desiderio, "Adverse Possession (Veto Confirmed Existing Law on 'Claim of Right')", NYLJ, Sept. 12, 2007.
12. 71 AD2d 1325, 896 NYS2d 536 (3d Dept. 2010).
13. Index No. 8003/09, Westchester County Supreme Court, March 30, 2010. (Adam Leitman Bailey, P.C. represented the prevailing party in this action).
14. The defendant contended that, even if the 2008 RPAPL amendments did not apply, the plaintiffs' encroachments and maintenance activities should also be deemed permissive and non-adverse under governing Second Department cases decided prior to July 8, 2008. See, e.g., Simpson v. Kao, 222 AD2d 666, 636 NYS2d 70 (2d Dept. 1995); Giannone v. Trotwood Corporation, 266 AD2d 430, 698 NYS2d 698 (2d Dept. 1999).
15. Index No. 107339/09, New York County Supreme Court, Aug. 20, 2010.
16. See, e.g., Hoffman Investors Corp v. Yuval, 33 AD3d 511 (First Dept. 2006); Zhuang Li Cai v. Uddin, 58 AD3d 746, 871 NYS2d 675 (2d Dept. 2009).
17. Index No. 7710/06, Rockland County Supreme Court, NYLJ, May 25, 2010, p. 28.

Saturday, October 23, 2010

Ten Things to Consider When Drafting Construction Contracts Under New York Law

By: Richard P. Dyer and Jose A. Aquino Fall 2010 Building & Bonding: The Construction Group Newsletter

Whether managing construction of a high-rise project in New York City, a power plant in India or a paper mill in Brazil, the legal disputes in any of those projects may be subject to resolution under New York law. While it is common for domestic construction-project disputes to be governed by the law where the project is located, on large, international projects as well as project-financed jobs, the contracts are often subject to New York law, where the financing parties and their legal counsel often are located. Drafters of such contracts, however, may want to be aware of restrictions by the New York legislature on the "freedom" to contract.

Below are ten aspects to consider.

1. Governing Law. Provisions in private construction contracts that make contracts subject to the laws of another state are void and unenforceable. Section 757(1) of New York's General Business Law provides that a dispute arising from a construction contract must be resolved by New York state laws. The only exception to this prohibition is a contract with a material supplier.

2. Forum Selection. Provisions in private construction contracts that require dispute resolution in another state are void and unenforceable. Section 757(1) of the General Business Law provides that any litigation, arbitration or other dispute resolution arising from the contract must take place in New York state. The only exception to this prohibition is a contract with a material supplier.

3. Suspension of Work. Provisions that prohibit suspension of work under a private construction contract for nonpayment are void and unenforceable. Section 757(2) of the General Business Law provides that a construction contract cannot contain a provision "stating that a party to the contract cannot suspend performance under the contract if another party to the contract fails to make prompt payments under the contract."

4. Periodic Payments—Disputes. Parties to a private construction contract cannot avoid expedited and binding arbitration of disputes over nonpayment or late payment of periodic applications for payment. In September 2009, section 756-b(3) of the General Business Law was amended to allow a contractor, subcontractor or supplier to use arbitration as a permissive remedy for nonpayment. The statute now provides that where an owner, contractor or subcontractor fails to make a timely payment, the aggrieved contractor, subcontractor or supplier can use binding expedited arbitration to resolve the payment dispute. A provision in the parties' contract providing that arbitration is unavailable to one or both parties is void and unenforceable.1 Thus, a nonpaying party can be required to participate in binding arbitration under the auspices of the American Arbitration Association, even though its construction contract does not contain an arbitration provision.

5. Periodic Payments—Timeliness. Parties to a private construction contract cannot change by contract the statutory-proscribed periods to pay an invoice. An owner must tender payment of an invoice, including final payment, within 30 days of the approval of the invoice.2 A contractor or subcontractor must tender payment to its subcontractor of the proportionate amount paid by the owner for the subcontractor's work within seven days of having received payment for it.3

6. Retainage. Parties to construction contracts on public projects cannot agree to retention provisions of greater than five percent when the contract or subcontract is supported by a performance bond and a payment bond, and not more than ten percent when no bonds are required or the subcontractor is unable or unwilling to provide such bonds.4

7. Payment Remedies—Payment Bond. A provision in a construction contract conditioning a subcontractor's or supplier's right to pursue a claim on a payment bond on exhaustion of other legal remedies is void and unenforceable.

8. Indemnification. Owners, contractors, subcontractors, architects and engineers are prohibited from passing along the risk of their own negligence to other parties.6 Section 5-322.1 of the General Obligations Law provides that an indemnification provision in a construction contract that indemnifies or holds harmless the promisee against liability for damage arising from the promisee's negligence is void and unenforceable. Section 5-324 of the General Obligations Law provides that agreements by owners, contractors, subcontractors or suppliers to indemnify architects, engineers and surveyors from liability caused by or arising out of defects in maps, plans, designs or specifications prepared, acquired or used by such architects, engineers or surveyors are void and unenforceable. One court interpreted the statutes as serving the "particular needs for those least able to effectively fend for themselves. . . ."7

9. Mechanic's Lien Rights. Any kind of contractual language that attempts to limit or eliminate a contractor's lien rights is void and unenforceable. Section 34 of New York Lien Law provides in pertinent part: "Notwithstanding the provisions of any other law, any contract, agreement or understanding whereby the right to file or enforce any lien created under article two is waived, shall be void as against public policy and wholly unenforceable."

10. Pay-When-Paid. A provision in a subcontract making a general contractor's obligation to pay its subcontractor contingent on the general contractor's own receipt of payment from the owner for the subcontractors—commonly referred to as a "pay-when-paid" clause—is void as against public policy. New York courts reason that such a clause is contrary to public policy because it removes a subcontractor's right to enforce a mechanic's lien against an owner in contravention of section 34 of New York Lien Law.8 Although New York courts are likely in theory to enforce a pay-when-paid clause when the contract is governed by the law of another state,9 the New York Prompt Payment Act prohibits non–New York choice-of-law provisions in contracts for construction projects within New York state. Thus, it would appear that a pay-when-paid clause in a contract providing that it is governed by the law of another state would be enforceable only if the contract was entered into before January 14, 2003, the effective date of the statute.10

Notes

1. N.Y. Gen. Bus. Law § 757(3) (Consol. 2010).
2. N.Y. Gen. Bus. Law § 756-a(3)(a)(ii).
3. N.Y. Gen. Bus. Law § 756-a(3)(b)(ii).
4. N.Y. Gen. Mun. Law § 106-b, N.Y. State Fin. Law § 139-f.
5. N.Y. Gen. Oblig. Law § 5-322.1.
6. N.Y. Gen. Oblig. Law §§ 5-322.1 & 5-324.
7. Ali El Chami d/b/a Everything Store v. Automatic Burglar Alarm Corp., 106 Misc. 2d 559, 434 N.Y.S.2d 330 (Civil Court, Kings County 1980).
8. West-Fair Electric Constructors v. Aetna Casualty & Surety Co., 87 N.Y.2d 148, 638 N.Y.S.2d 394 (1995).
9. Welsbach Electric Corp. v. MasTec North America, Inc., 7 N.Y.3d 624, 859 N.E.2d 498 (2006).
10. N.Y. Gen. Bus. Law § 757(1).

Disclaimer: This article is prepared and published for informational purposes only and should not be construed as legal advice. The views expressed in this article are those of the author and do not necessarily reflect the views of the author's law firm or its individual partners.

Why Buying Loan Notes Isn’t the Same As Buying Real Estate

By Patrick M. McGeehan

In response to the depressed state of the real estate and capital markets, large amounts of capital are now chasing opportunities to purchase defaulted commercial real estate loans at a discount. Not since the savings and loan crisis in the late 1980s has the market expected a comparable volume of loans to be sold.

For savvy buyers, this is a chance to earn enviable returns. However, it also is an opportunity for those who do not fully understand the nature of what they are buying to lose money — lots of money.

Depending on the quality of the loan documents and the history of the loan, the borrower may have defenses and claims that can seriously delay a foreclosure on the collateral and reduce the ultimate return to the loan buyer.

Discussions at industry trade shows and seminars that focus on buying distressed mortgage debt often only address the need to price and evaluate the underlying real estate. While the real estate asset securing the loan ultimately is the source of repayment, a buyer of these loans must realize that he is not buying the real estate collateral.

Instead, the buyer is literally acquiring a stack of paper comprising the loan documents that embody certain legal obligations and rights of the lender and borrower. That is a fundamentally different asset from the real estate.

Assuming there is no fatal flaw in the loan documents, the rights of the lender will include the right to foreclose on the mortgage and become the owner of the real estate. But depending on the facts and circumstances, that may be an easy path or a long hard road.

Modeling the masters

A valuation methodology for purchasing defaulted mortgage loans should take into account, on a net present value basis or capitalization rate basis, both the cash flow and liquidation value of the real estate, as well as the expense and length of time it will take to convert the loan into ownership of the real estate collateral.

In the early 1990s, the Resolution Trust Corporation developed a valuation methodology, the Derived Investment Value (DIV) methodology. The DIV took into account all of the unique attributes of distressed debt that make valuing it different from valuing the underlying real estate.

Such factors included the length of time required to complete a mortgage foreclosure and the widely differing mortgage foreclosure procedures from state to state, depending on whether the process is judicial or non-judicial foreclosure.

Other important factors that the DIV methodology took into account included the length of time to recover the collateral out of a borrower bankruptcy proceeding, the time period to market and sell the real estate after foreclosure, assumptions regarding the availability of interim cash flow to the lender, and expenses that would be incurred by the lender in the entire process. These basic principles contained in the DIV methodology largely remain valid today.

Similarly, discussions of due diligence in connection with purchasing defaulted mortgage loans all too often focus only on the attributes of the underlying real estate and not the mortgage loan itself. Ultimately, the length of time and the cost of converting the paper into owning the real estate will depend on the specific attributes of the mortgage loan.

For example, are there material flaws in the loan documentation? Have events occurred since the loan was originated that have provided the borrower defenses and claims that can be used to contest a foreclosure? Are there title problems such as liens prior to the mortgage?

Most of these due diligence issues can be addressed by careful review and analysis of the loan documents and loan servicing files, including the relevant correspondence files, and through public record searches.

Bankruptcy risk

One unique and important loan documentation consideration is whether there is a “carve-out guaranty,” also known as a “springing guaranty.” In effect, this is a guaranty under which the person controlling the borrower has agreed that he or she will become liable on a recourse basis for the loan, if certain “bad” actions are taken by the borrower. Typically, the guarantor under such a guaranty will become personally liable for the loan if the borrower files bankruptcy.

A bankruptcy filing by the borrower is generally something the lender wants to avoid. The bankruptcy imposes an immediate prohibition, an automatic stay, against the pursuit by any creditors of their claims against the borrower, including a mortgage foreclosure by the lender.

At a minimum, the borrower bankruptcy will cause the lender to incur significant additional legal costs and may materially delay recovery by the lender of its collateral. Carve-out guaranties are behavior control devices that are intended to impose the adverse consequence of recourse liability on the person controlling the borrower so as to make it less likely that they will choose to put the borrower in bankruptcy.

These kinds of guaranties have been found to be enforceable by the courts and have proven to be an effective deterrent to bankruptcy filing and enhance the value of the mortgage loan.

Gauging the risk of whether the borrower will file bankruptcy is an important part of pricing a distressed debt purchase, and knowing whether or not you will have an effective carve-out guaranty as part of your loan documents is very important.
Of course, due diligence of loan documentation and files can only be conducted to the extent such items are made available by the seller for review. Hopefully, deficiencies in this regard can be addressed with adequate seller representations and warranties.

The loan seller should, at a minimum, confirm the outstanding balance of the principal and interest of loan and should identify the specific instruments that constitute the loan documents, including any loan document amendments.
Additionally, the loan seller should confirm the completeness of the due diligence file and identify any material correspondence to or from the borrower and to or from governmental entities regarding the real estate.

It certainly appears that 2010 will present great opportunities in the distressed debt marketplace for those who invest wisely. However, as with all strategic investments, buying at the right price is everything, and to do that you have to know what it is you are buying: a stack of paper comprising the loan documents that needs to be carefully evaluated.

Thursday, October 21, 2010

Choosing a Defeasance Consultant

Borrowers may need help navigating this complicated exit strategy.

October 2010

By Regan Campbell

With commercial real estate credit markets slowly beginning to thaw, borrowers are beginning to explore the costs and requirements associated with exiting existing real estate debt. If the loan has been sold into a commercial mortgage-backed securitization, borrowers will likely find that their only alternative is to go through the loan defeasance process.

At its most basic level, a defeasance is a substitution of collateral and assignment of debt. The borrower is required to purchase a portfolio of government securities that will produce cash flows matching the debt service schedule of the original loan. This portfolio replaces the real property as collateral for the loan, enabling the borrower to obtain a release of the lien on the real estate property to facilitate a sale or refinance. Simultaneously, a new, or successor, borrower assumes the portfolio of securities as well as the payment obligations of the original loan. While the process sounds relatively straightforward, in actuality it is a complicated procedure involving numerous parties and considerable documentation.

Why Hire a Defeasance Consultant?

Although many borrowers are familiar with the basic process, most still opt to engage a consultant to assist in navigating the financial and legal aspects of the transaction. In addition to bringing clarity and order to an otherwise cumbersome process, a good defeasance consultant will play a key role in reducing the final cost by structuring and coordinating the purchase of an efficient defeasance portfolio and establishing the successor borrower entity in a way that returns a portion of the accumulated interest or residual value back to the original borrower.

Because defeasance is both an economic and legal process, it can take anywhere from three to six weeks to complete. The transaction brings a multitude of people to the table: the original borrower and its counsel, the loan servicer and its counsel, an independent accountant, the securities intermediary, a title and/or escrow agent, the successor borrower and its counsel, rating agencies, and the special servicer.

Rather than the borrower and its counsel trying to manage the players and the process, the consultant should serve as a single point of contact for all coordination, including facilitating all conference calls, ensuring that documents and comments are circulated in a timely manner, and making sure that all requirements meet the borrower’s closing timeline.

In addition to overseeing the entire process, the consultant also should be able to structure the portfolio of securities -- typically U.S. Treasuries or agency securities, such as those issued by Fannie Mae or Freddie Mac. This replacement collateral must produce cash flows that match the debt service payments of the original loan, while still adhering to legal and industry standards, as well as making sure the types of securities that can be used to structure the portfolio adhere to the loan document requirements. This task is further complicated by gaps in the issuance of securities as well as the goal of price efficiency. Each servicer interprets the rules and requirements differently and it’s important that the consultant is familiar with the nuances of each servicer’s interpretation.
Once the portfolio has been structured, the defeasance consultant should coordinate the purchase of the securities on behalf of the borrower, ideally by holding a competitive auction. By including several market-maker banks, with each providing simultaneous real-time pricing, the borrower has the best chance of receiving the most efficient pricing possible.

The following example illustrates the importance of the auction process. A borrower needed to defease a CMBS loan with an outstanding balance of $14.7 million and five years remaining until maturity. The securities auction included four banks and resulted in a spread in price levels of more than $110,000 on the cost of the securities.

Bank Cost of Securities
1 $16,359,157.07
2 $16,375,000.00
3 $16,468,473.67
4 $16,471,633.05

The consultant holding the auction should not have any relationships or affiliations that would impact pricing or result in a undisclosed brokerage fee that would be passed on to the borrower.

Finally, the consultant should also be able to establish the successor borrower, the single-purpose entity that assumes the rights and obligations of the original borrower on the loan. The successor borrower entity should assume all shortfall liability, meaning that if there was a shortage in funds available to make a payment for any reason, the successor borrower would be the entity responsible (not the original borrower). This provision is key for the defeasance to be considered a complete extinguishment of debt for accounting purposes.

Obtaining Defeasance Cost Estimates

Many borrowers often obtain an estimate of the cost to defease by using one of a number of available Web-based calculators. Most calculators provide a general idea of the cost of the substitute collateral as well as third-party fees. It is a good idea to use the results from at least two different calculators to make sure there is not a significant discrepancy in the assumptions made by the consulting firm. Because the market for U.S. Treasuries is very liquid and relatively efficient, the price of the portfolio should not vary significantly from one consultant to another. In much the same way, many of the third party fees are not set by the consultant and should be consistent across the various estimate results. If a borrower finds that one calculator produces results that are much lower than others, then it is best to follow up with a call to determine the source of the inconsistency.

If a borrower is further along in the process and desires a detailed, accurate estimate of potential defeasance costs, it will need to provide the consultant with copies of the primary loan documents such as the promissory note and loan agreement or deed of trust, the property address, and a targeted closing date. With this information, the consultant can tailor the estimate to the specific defeasance terms and servicing requirements of the loan. This is an excellent time for the borrower to ask questions about the process and the consultant’s role, as well as get a feel for the level of service a consultant will provide throughout the transaction. A borrower will be placing a large amount of responsibility in the hands of the consultant, and the initial estimate phase provides a valuable opportunity to determine how responsive and attentive a firm will be.

Interpreting the Estimate

Every defeasance estimate should include three primary components: the cost of the defeasance collateral, third-party fees, and estimated residual value that will be returned to the borrower.

The most significant of these components is the cost of the defeasance portfolio. Ideally the estimate should be based on live market pricing of an actual optimized portfolio, as opposed to a generalized estimation using benchmark Treasury rates. Again, there should not be a significant variance in the estimated portfolio costs from various firms. If a discrepancy exists, it is possible that the estimates they are comparing were not prepared on the same date or at roughly the same time; even slight movements in Treasury rates will have an impact on the cost of the portfolio.
The second item is a comprehensive list of third-party fees a borrower can expect to incur as part of the defeasance, including those of the servicer, servicer’s counsel, certifying accountant, security intermediary, defeasance consultant, successor borrower, and successor borrower’s counsel. Most of these entities operate on a fixed fee schedule, and the consultant has very little if any control over the fees charged by the servicer and their counsel. All of the other third parties are typically selected by the consultant and the fees are usually negotiated by the consulting firm. The consultant should be able to explain these fees and explore whether any discounted fees may be offered.

The final estimate component is the amount of residual value associated with the defeasance and the amount of this value the consultant is willing to return to the original borrower, either at the close of the defeasance or at the maturity of the original loan.

What Is Residual Value?

There are two sources of defeasance residual value: interest income, also referred to as float, and the prepayment of a defeased loan. Interest income will accrue in the defeasance account as a result of timing mismatches between the cash coming into the account from the coupon payments or maturities of the defeasance collateral, and the outgoing debt service payments for the loan. This cash will typically earn interest at money market rates and will accumulate over the life of the defeased loan. The largest portion of this float will come from the balloon payment. For example, if the loan is a $25 million interest only loan that matures on October 26, 2016, the security that would be used for the balloon payment would be the September 30, 2016 bond. The $25 million would sit in the defeasance account for 26 days, earning interest at the current money market rates.

The second source of residual value comes from the prepayment of the defeased loan. The original loan documents will often permit the borrower to prepay the loan at par three to six months prior to the maturity date. However, the documents also usually require that the defeasance collateral provide for payments through the maturity of the loan -- regardless of whether this prepayment window exists. Unless the right to prepay the loan post defeasance is explicitly prohibited, the successor borrower assumes this right when it takes assignment of the debt and the securities. In these instances the successor borrower will pay off the loan and any excess defeasance collateral no longer required is then sold on the open market. The profit gained from the sale of these securities belongs to the successor borrower.

Combined, the float income and value of prepayment can result in a significant amount of residual value. The borrower should make sure the consultant acknowledges this value, provides an estimate of the total value, and finally discusses the amount of this value that will be returned to the original borrower, either on a projected present value basis at the close of the defeasance, or as a percent of the actual amount available in the successor borrower account at the maturity or prepayment of the loan. When comparing estimates, it is important to evaluate not only the percentage of residual value that will be returned, but also the total amount projected. If there is a significant difference in the residual projection, one of the estimates may contain errors or inaccurate assumptions.

If the loan documents allow the lender or loan servicer to set up the successor borrower entity, the consultant may not have control over the residual value and how it will be distributed. They should still be able to predict the amount that will be available so that the borrower can work to negotiate a sharing arrangement directly with the servicer.

The Right Consultant

One of the most important steps in the defeasance process is the selection of the right consultant. By engaging someone to handle the legwork of the defeasance process, the borrower can focus on the real estate portion of their deal, comfortable in the knowledge that they have hired someone who will look out for their best interest, get the best execution possible, and close the deal on time.

Thursday, October 14, 2010

Census Data: New York, New Jersey Homeowners Pay Highest Property Taxes

September 28, 2010

New data released today by the Census Bureau on owner-occupied housing shows Northeast homeowners tend to pay the most in property taxes, with the highest taxes being in New York and New Jersey. Louisiana and much of the South tend to have the lowest property taxes on homeowners.

The 2009 rankings released in September have changed little from the 2008 rankings released last year.

Homeowners in the Northeast, specifically in New Jersey counties and New York counties (outside New York City), pay the highest property taxes.

The report ranks 792 high-population counties (over 65,000) and all 50 states based on the highest median property taxes paid - both in dollar amount and as a percentage of home value.
The top 10 counties in median real estate taxes paid for 2009 are, from 1 to 10: Westchester County, NY ($9,044); Nassau County, NY ($8,940); Bergen County, NJ ($8,708); Hunterdon County, NJ ($8,671); Rockland County, NY ($8,542); Essex County, NJ ($8,245); Passaic County, NJ ($7,939); Morris County, NJ ($7,904); Union County, NJ ($7,793); and Somerset County, NJ ($7,720). The national median is $1,917.

The top 10 counties in median real estate taxes as a percentage of median home value for 2009 are, from 1 to 10: Monroe County, NY (2.89%); Niagara County, NY (2.87%); Wayne County, NY (2.78%); Chemung County, NY (2.61%); Chautauqua County, NY (2.61%); Erie County, NY (2.60%); Onondaga County, NY (2.50%); Camden County, NJ (2.50%); Steuben County, NY (2.49%); and Madison County, NY (2.43%). The national median real estate taxes paid divided by the national median home value is 1.04 percent.

The top 10 states in median real estate taxes paid for 2009 are, from 1 to 10: New Jersey ($6,579); Connecticut ($4,738); New Hampshire ($4,636); New York ($3,755); Rhode Island ($3,618); Massachusetts ($3,511); Illinois ($3,507); Vermont ($3,444); Wisconsin ($3,007); and California ($2,893).

The top 10 states for median real estate taxes as a percentage of median home value are, from 1 to 10: New Jersey (1.89%); New Hampshire (1.86%), Texas (1.81%); Wisconsin (1.76%); Nebraska (1.76%); Illinois (1.73%); Connecticut (1.63%); Michigan (1.62%); Vermont (1.59%); and North Dakota (1.42%).

Friday, October 8, 2010

NY Foreclosures—Former Homeowners Denied Stay of Ejectment Actions —Unclean Hands—Defendants Had Acted to "Delay, Impede and Impair Lender's Efforts to Foreclosure"

September 15, 2010

By: Scott Mollen

A former homeowner brought an order to show cause seeking to "enjoin certain ejectment proceedings." The lender had commenced a foreclosure action in 2006. A judgment of foreclosure and sale had been granted in Aug. 2007. Following four "serial bankruptcy petitions (two separate Chapter 13 petitions filed by each Defendant) and an Order to Show Cause…a public auction sale of the premises [had been] conducted [in Dec. 2009]." The lender was the sole bidder and had received title pursuant to a referee's deed in the foreclosure action. Thereafter, lender sought and obtained a writ of assistance, which was issued in February 2010. In April 2010, a defendant sought the subject stay, asserting that he was in negotiations with a bank representative and that he was too sick to move in 72 hours.

The court explained that "consummation of a public auction of a property in foreclosure extinguishes all equity of redemption." Since "judicial sympathy is not a recognized defense to an action claiming foreclosure of a mortgage…," the court assumed that the defendant was appealing to the "equity jurisdiction of this Court." However, the court found that the defendants had been "fully aware of the pendency of this action and that each of them affirmatively undertook acts that were calculated to delay, impede and impair Plaintiff in the exercise of its rights under the Note, Mortgage and Judgment of Foreclosure & Sale. In this endeavor, Defendants have been unfailingly successful. Indeed, the record is replete with ample proof that Defendants have lived in the home 'rent free' so to speak, for a period in excess of four years and further, that Plaintiff has been forced to bear the expense of both casualty insurance to protect its interest in the premises as well as the property taxes levied thereon by the Town…."

Given the defendants "unclean hands," the court held that "equity should not rightly intervene on their behalf." Accordingly, the court denied the defendants' motion, vacated a prior stay and granted the lender leave to continue its ejectment proceeding.

HSBC Bank USA NA v. Blum, New York Law Journal, June 22, 2010, p. 29, col. 1, Sup. Ct., Suffolk Co., Spinner, J.