Litigation Pitfalls Associated With Mezzanine Finance – Lessons Learned

Mezzanine capital was prevalent in financing real estate development and construction projects before the real estate market collapsed. Developers and owners often used mezzanine loans to fill the gap between cheaper “traditional” debt—for example, a senior loan secured by a first deed of trust on the property—and their own equity. ¹This article presumes a basic familiarity on the part of the reader with the concepts of real estate financing and mezzanine financing. A very basic, but informative, general explanation of mezzanine capital can be found at http://en.wikipedia.org/wiki/Mezzanine_capital (explaining typical mezzanine capital structures). A general definition of mezzanine financing can be found at http://www.investopedia.com/terms/m/mezzaninefinancing.asp.

After the Great Recession began, numerous real estate projects became distressed or broken, and the mezzanine loan agreements that typically accompany mezzanine financing transactions were tested in litigation for the first time. This litigation exposed potentially serious pitfalls in these agreements, and the way mezzanine loan arrangements are typically structured. Pitfalls that can lead to costly and risky litigation, and result in adverse litigation outcomes.

As the real estate and construction industries rebound, mezzanine financing has reappeared as a viable alternative source of capital for developers, owners, and builders. This article identifies two of the most serious litigation weaknesses exposed “in the trenches,” and provides some insight into how real estate practitioners, general counsel, and businesspersons might protect themselves, their companies, and their clients before a dispute arises.

Briefly, these pitfalls are:

• Developers/owners might find that the mezzanine borrower and/or mortgage borrower’s attorney-client privilege, both with in-house and outside counsel, has been lost in the event of subsequent litigation with the mezzanine lender. Losing this privilege can have devastating litigation consequences, and can ultimately lead to the compelled disclosure of sensitive, and potentially damaging, internal communications thought to be privileged at the time they were exchanged.

• The developer/owner’s routine cash flow management practice of meeting the subsidiary borrower entity’s cash needs, in advance of the lender’s funding of loan draws, may trigger litigation under the “bad boy” covenants contained in the nonrecourse carve-out guarantees that the developer/owner typically gives the lender in mezzanine loan transactions. Violation of the bad boy covenants may expose the developer/owner to personal liability for the ordinarily nonrecourse mezzanine loan.

Mezzanine Borrowers Might Find That Their Attorney-Client Privilege Has Been Waived

One of the most devastating litigation pitfalls that can occur with the typical mezzanine loan structure is the subsidiary mezzanine borrower entity’s risk of waiving the attorney-client privilege it enjoys with the parent entity’s in-house counsel and outside counsel, should litigation ensue with the mezzanine lender.

A typical mezzanine real estate finance transaction gives the mezzanine lender a security interest in an intermediary single-purpose-entity created for the purpose of borrowing mezzanine money (the “mezzanine borrower”). ²See e.g. Semler v. Gen. Elec. Capital Corp., 196 Cal. App. 4th 1380, 1398-99 (2011), review denied (Oct. 19, 2011), reh’g denied (July 19, 2011) (explaining in detail this typical mezzanine loan structure). The developer/owner owns the mezzanine borrower, and the mezzanine borrower in turn owns a separate special-purpose-entity (“SPE”) created to own the project (often referred to as the “mortgage borrower,” in recognition of the fact that this entity is the borrower on the senior “traditional” mortgage loan). ³Depending on how the transaction is structured—as well as what the terms of any intercreditor agreement between the senior lender and the junior mezzanine lender may provide—the “mortgage borrower” entity may be the same entity as the mezzanine borrower. In the event of default on the mezzanine loan using this alternative structure, the mezzanine lender would foreclose on direct ownership of the mortgage borrower entity itself. This minor tweak in the exact structure of the mezzanine loan transaction has no substantive impact on the litigation pitfalls identified in this article. The pitfalls identified in this article exist regardless of whether the mezzanine lender is a separate entity, or is the same entity as the mortgage borrower. A parent-subsidiary relationship between the developer/owner entity and the borrower SPE may be created. The mezzanine lender’s recourse in the event of a default on the mezzanine loan is to take ownership of the mezzanine lender by holding a UCC foreclosure sale. ⁴U.C.C. § 9-610. Put simply, the mezzanine lender’s collateral is ownership of the borrower entity and the project, subject to the rights of the senior lender.

In theory, this structure protects the developer from personal liability in the event of a payment default on the mezzanine loan, because the mezzanine loan is generally non-recourse to the developer—subject to certain “bad boy” nonrecourse carve-outs, discussed below—and the mezzanine lender’s only security interest is in the mezzanine borrower entity itself. This structure also gives the mezzanine lender a relatively simple and swift mechanism under which it can quickly take over ownership of the project in the event of default.

A presumably unintended effect of this structure however, could have potentially devastating consequences in the event litigation should arise between the mezzanine lender and the developer/owner. As a practical matter, the officers of the developer/owner entity are often also the officers of the mezzanine borrower entity. Pre-dispute emails with counsel, and other privileged communications, are freely exchanged amongst these officers without regard to which entity the officer is speaking for when the particular communication is exchanged. Little effort, if any, is made to segregate communications at the developer/owner entity level, from communications at the borrower entity level.

But because the mezzanine lender generally becomes the owner of the mezzanine borrower entity after a UCC sale, the developer/owner may find that its pre-foreclosure communications with in-house counsel, as well as its communications with outside counsel—all of which it naturally presumed were privileged—are no longer privileged. This is because, under prevailing United States Supreme Court case law, when control of a corporate entity passes to new management, the right to assert or waive the corporation’s privilege passes with it. ⁵Commodity Futures Trading Com’n v. Weintraub, 471 U.S. 343, 348-349, 105 S. Ct. 1986, 1991, 85 L. Ed. 2d 372 (1985) (“[W]hen control of a corporation passes to new management, the authority to assert and waive the corporation’s attorney-client privilege passes as well. New managers installed as a result of a takeover, merger, loss of confidence by shareholders, or simply normal succession, may waive the attorney-client privilege with respect to communications made by former officers and directors. Displaced managers may not assert the privilege over the wishes of current managers, even as to statements that the former might have made to counsel concerning matters within the scope of their corporate duties.”). See also, e.g., In re In-Store Advertising Securities Litigation, 163 F.R.D. 452, 458 (S.D. N.Y. 1995) (“The former attorney of In-Store, Baer Marks, cannot claim the privilege that has been waived by the successor to its former client.”); Brown v. Car Ins. Co., 634 So. 2d 1163, 1166 (La. 1994) (quoting Commodity Futures Trading Comm’n and applying its reasoning under Louisiana law); In re Estate of Fedor, 356 N.J. Super. 218, 811 A.2d 970, 972 (Ch. Div. 2001) (same under New Jersey law). But cf. Favila v. Katten Muchin Rosenman LLP, 188 Cal. App. 4th 189, 115 Cal. Rptr. 3d 274, 297–98 (2d Dist. 2010), as modified on denial of reh’g, (Sept. 22, 2010) (sale of a corporation’s assets, without transfer of control of the corporation holding the privilege, does not also transfer the attorney-client privilege).

In short, the mezzanine lender becomes the owner of the attorney-client privilege after it takes over ownership of the mezzanine borrower and/or mortgage borrower. The same is likely true of attorney work-product prepared for the mezzanine borrower and/or mortgage borrower’s management, including research memorandum shared with the client, case evaluations, strategy letters, etc. ⁶See e.g. California Rules of Professional Conduct, Rule 3-700(D), providing that client owns papers in client’s case file. See also Eddy v. Fields, 121 Cal. App. 4th 1543, 1548-50 (2004) (producing work product to counsel for trustee effectively produced the material to the trustee and effected a waiver of the work product privilege with respect to the trustee and any successor-in-interest to the trustee); Weiss v. Marcus, 51 Cal. App. 3d 590, 599 (1975) (holding that attorney work product belongs to the client); Metro-Goldwyn-Mayer, Inc. v. Sup. Ct. (Tracinda Corp.), 25 Cal. App. 4th 242, 249 (1994) (where two formerly allied parties are now adverse to each other, counsel for one party may not refuse to supply work product to adverse party, where work product was created for the benefit of both parties and was closed to at least one party).

It is difficult to overstate how serious this loss of privilege can be for the developer/owner, should litigation with the mezzanine lender ensue. For example, frank evaluation letters or memoranda may identify weaknesses in the developer’s case. And once-thought-privileged communications with counsel might suddenly be turned against the developer, to disprove a subsequent position taken by the developer as to the meaning of disputed contract terms. Similarly, internal correspondence with counsel may provide the mezzanine borrower with valuable legal positions, damaging statements, and otherwise undiscoverable privileged facts, which can greatly assist the mezzanine lender in establishing liability against the developer.

Transfer of Ownership of the Privilege Can Create a Powerful Litigation Weapon for Mezzanine Lenders.

For mezzanine lenders who have taken ownership of the mezzanine borrower and mortgage borrower, competent litigation counsel should push to compel production of all of the borrower’s communications with its in-house and outside counsel, including all work product. This can be a game-changer in litigation, as it gives you direct insight into the developer’s thought processes and concerns, and may produce powerful evidence at trial.

The Developer/Owner Should Take Affirmative Steps to Preserve the Privilege by Maintaining Separation From the Mezzanine Borrower Entity.

On the developer/owner side, steps should be taken early on to attempt to institute protocol that will protect the developer’s attorney-client privilege. For example, a key argument that the developer might successfully make, in the event of subsequent litigation with the mezzanine borrower, is that the privileged information was solely shared at the developer/owner entity level, and was never disseminated to management of the mezzanine borrower/mortgage borrower.

It will probably be more difficult to avoid losing the privilege where the developer’s management is for all practical purposes identical to the mezzanine borrower/mortgage borrower’s management. So ensuring some level of separation between the developer’s management and the borrower entities’ management, if possible, is ideal.

Because the developer and/or its employees will often work for both the mezzanine borrower entity and the developer/owner, however, even simple precautions may prove valuable in subsequent litigation. For example, if a communication is sensitive or is intended to stay privileged at the developer level, ensure that email and letter subject lines refer to the information as privileged communications between attorney and the developer entity. Care should also be taken to use separate email and letter signature blocks, as well as separate letterhead, for the mezzanine borrower/mortgage borrower’s project-related communications, as contrasted from communications that are intended to be kept internal at the developer level. If practicable, setting up separate email addresses for mezzanine lender business will also be very valuable should a dispute arise later. Outside counsel should be kept informed of any protocol adopted, so they can be sure to protect the privilege by not disseminating information broadly across the borrower entities.

While many of these steps may exalt form over function, they could ultimately become invaluable in proving that the privileged communication was never disclosed to the mezzanine borrower/mortgage borrower. This is because, as a practical matter, a judge determining this issue will likely look to the communications themselves—mindful of the long tradition of American jurisprudence protecting the attorney-client privilege—to determine whether they were shared with the mezzanine borrower entity, or kept internal at the developer/owner level. In this regard, the litigator will be much better equipped to argue that the privilege was protected if the developer took demonstrated steps to guard the privilege.

Finally, another step that the developer may consider taking is negotiating to have a provision included in the mezzanine loan agreement providing that ownership of all attorney-work-product and attorney-client privileges will remain with the developer in the event of the mezzanine lender’s foreclosure on its security interest. Of course, the mezzanine lender may be unwilling to insert such a term into the loan agreement, and its enforceability may ultimately depend on the law of the specific jurisdiction which governs the mezzanine loan agreement, but it could prove especially helpful if later forced to argue against the compelled disclosure of privileged materials.

The Developer’s Standard Cash Management Policies May Trigger Litigation Under the Bad Boy Covenants Contained in Nonrecourse Carve-Out Guarantees

Another potential litigation pitfall associated with mezzanine loan transactions stems from the nonrecourse carve-out guarantee that the mezzanine borrower’s owner—the developer/owner parent entity and, in some cases, its principals—must generally give in order to obtain the mezzanine loan. A nonrecourse carve-out guarantee typically include “bad boy” covenants, under which the owner agrees that liability for the mezzanine debt, which is ordinarily nonrecourse to the owner, will become recourse to the owner in the event that the owner commits certain “bad boy” acts. ⁷“Bad boy” covenants contained in non-recourse carve-out guarantees are not unique to mezzanine loan transactions. See e.g. Wells Fargo Bank NA v. Cherryland Mall Ltd. Partnership, 295 Mich. App. 99, 103-105 (2011) (discussing use of bad boy covenants in non-recourse carve-out guarantees in standard non-recourse mortgage loan agreement) (decision subsequently abrogated by Michigan’s Nonrecourse Mortgage Loan Act, 2012 PA 67, MCL 445.1591 et seq.).

In the real estate development context, these “bad boy” acts typically include fraud, intentional misrepresentation, and misappropriation of the mezzanine borrower/mortgage borrower’s assets. ⁸See e.g. Aozora Bank, Ltd. v. 1333 N. California Blvd., 119 Cal. App. 4th 1291, 1295 (2004). For a general explanation of non-recourse carve-outs, and their role in the real estate lending, see Talcott J. Franklin & Thomas F. Nealon III, Mortgage and Asset Backed Securities Litigation Handbook §5:73 (West 2012) (“Nonrecourse loans and carve-outs to nonrecourse liability.”). Standard cash flow management practices widely used by developer/owners have the potential to run aground of these covenants, and may give rise to subsequent litigation claims.

For example, in order to keep the project moving, the developer/owner parent entity may periodically use its own cash to pay for the mortgage borrower/mezzanine lender’s project expenses, while waiting for construction loan draws to be funded. This is especially true where the property is not earning sufficient operating income to cover project expenses in advance of loan draws, which is often the case. As the loan draws are funded, the developer then reimburses itself from loan proceeds. This cash flow management procedure may be even more likely where the developer is a real estate investment trust or private equity fund, with immediate access to cash and multiple projects under management.

As long as the project remains adequately capitalized and project expenses are timely paid, the developer may feel there is nothing wrong with this procedure. That it’s just sound cash flow management. Perhaps even industry custom. But this practice can unwittingly create costly litigation claims against the developer/owner should the mezzanine lender subsequently take ownership of the mezzanine borrower and/or mortgage borrower entities through foreclosure.

What happens when the mezzanine lender claims that the developer has misappropriated the mezzanine borrower/mortgage borrower’s funds by repaying itself from the mortgage borrower’s senior loan proceeds, in violation of the bad boy covenants? ⁹See e.g. Blue Hills Office Park LLC v. J.P. Morgan Chase Bank, 477 F. Supp. 2d 366, 382 (D. Mass. 2007) (finding that borrowers’ commingling of loan proceeds with developer funds violated nonrecourse carve-out guarantees). See also Gregory M. Stein, The Scope of the Borrower’s Liability in A Nonrecourse Real Estate Loan, 55 Wash. & Lee L. Rev. 1207, 1280-81 (1998) (similarly identifying problems that may arise with cash-flow management procedures). Or argues that these cash contributions by the developer should be treated as additional equity contributions into the project, rather than cash advances that the developer intended to be paid back for, as the developer likely viewed them?

The Developer and Lender Should Agree to the Cash Flow Management Procedure Early and in Writing.

The most effective thing that both the developer and lender can do to avoid disputes in the future is to spell out the developer’s intended cash flow management practices during the contract drafting process. From the outset, the developer and the mezzanine lender should take steps to define what will be acceptable cash flow management procedure, including the use of loan proceeds and/or project revenues to reimburse developer cash advances, and put that understanding in writing. If it is impracticable to include this language in the mezzanine loan agreement and the nonrecourse carve-out guarantee, then the developer should be sure to obtain some written confirmation that the mezzanine lender does not object to the developer’s cash flow management procedure. Preferably, this should be done soon after the loan agreement is entered into, and before work on the project commences.

The Developer Should Ensure That the Lender Is Given Regular Written Reports of All Cash Flow Activity on the Project.

Another important step that the owner can take to protect itself during the life of the loan is to regularly update the mezzanine lender with written reports fully disclosing all cash flow activity on the project. This will begin to demonstrate a fully disclosed course-of-performance that will be powerful evidence should a dispute later arise, and may even arm the litigator with strong waiver and estoppel arguments. These reports may be required by the mezzanine lender, and/or the senior lender, anyway.

The key point here is that the developer should not just rely on “industry custom,” thinking that this will protect it in the event of any litigation. Although the developer may feel that it has strong arguments against the mezzanine lender’s “cash misappropriation” litigation claims—this will depend on the facts of each specific case—this is by no means a foregone conclusion. ¹⁰See e.g. Heller Fin., Inc. v. Whitemark at Fox Glen, Ltd., United States District Court for the Northern District of Illinois, Case No. 02 C 7708 (N.D. Ill. Sept. 21, 2004) (granting summary judgment against owner-guarantor after finding that guarantor “misappropriated” borrower funds, in violation of nonrecourse carve-out guarantees, by paying its affiliated entity’s project-related overhead costs with project revenue before applying revenues to outstanding loan balance). And, often, the harm to the developer/owner will be done by simply having to absorb the cost of litigation and/or any amounts paid in settlement. This harm can likely be avoided by paying attention to this issue at the negotiations and drafting phase or, at a minimum, during the early stages of the life of the project.

Conclusion

With the resurgence of the construction and real estate industries, and the concomitant loosening of the capital markets, mezzanine financing is returning as a viable form of junior real estate financing. But many of the standard mezzanine loan agreements used by practitioners have not changed. Potentially damaging litigation pitfalls were exposed in the typical mezzanine loan framework during the economic downturn. Moving forward, past litigation offers valuable lessons that practitioners, developers, and lenders alike can use if they wish to avoid future litigation, and protect themselves in the event litigation should ensue.