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.