Mezzanine Intercreditor Agreements: How Should We Deal With Stuyvesant Town?

On Sept. 16, 2010, a state trial court in New York surprised the mezzanine loan industry with a written decision that is continuing to reverberate through the community. The court issued an injunction that prevented a mezzanine lender from foreclosing its lien on its equity collateral unless it first cured all defaults on the mortgage loan. The case (referred to here as the “Stuyvesant Town case”) ¹Bank of Am.
, N.A. v. PSW NYC LLC, 651293/10, 2010 WL 4243437 (N.Y. Sup. Sept. 16, 2010), also cited as 98 NYS 396. related to the giant Peter Cooper Village and Stuyvesant Town apartment complex in Manhattan. Many in the industry considered the case wrongly decided — an aberration, not likely to be repeated or sustained on appeal. Some speculated that the unexpected outcome resulted not from the merits, but rather, from the prominence of this particular project and its importance to the New York economy.

However, on Dec. 6, 2011, the United States District Court for the District of Arizona (in a case referred to here as the “Arizona case”) issued a similar injunction — preventing a mezzanine lender from foreclosing its lien on the equity collateral unless it first cured all defaults on the mortgage loan. ²Order, U.S. Bank Nat’l Ass’nv. RFC CDO 2006-1, Ltd., No. CV 11-664 TUC DCB (D. Ariz. Dec. 6, 2011), ECF No. 41. The two trial courts based their rulings on interpretations of essentially identical terms in the intercreditor agreements, and utilized essentially identical reasoning.

As a result of the Arizona case, the mezzanine loan industry can no longer afford to regard the Stuyvesant Town case as an aberration. Lawyers representing mezzanine lenders now need to face up to the implications of these two cases and must seriously consider negotiating changes to the intercreditor agreement in future deals to reduce the risk of a recurrence. When mezzanine lenders propose changes in order to avoid a recurrence of these cases, lawyers representing mortgage lenders will need to decide whether to entertain them.

This article explores the impact of the Stuyvesant Town and Arizona cases, examines the competing interests of the mortgage lender and the mezzanine lender with regard to the issue raised by these cases, and proposes a modification to the standard form of intercreditor agreement in future deals to protect the mezzanine lender from a recurrence of the result in these two cases while still protecting the legitimate expectations of the mortgage lender. ³The author of this article agrees with the many published and unpublished commentators who believe that the two cases were wrongly decided. See, for example, James D. Pendergast, Foreclosure Becomes More Difficult for Mezzanine Lenders, Practical Real Estate Lawyer (March 2012), in which the author characterized the Stuyvesant Town case as a “wild misreading,” that was “argued backwards to get to the right result.” However, the focus of this article is not on whether the courts were correct, but rather, on changes that should be made to the most commonly used form of intercreditor agreement to prevent a recurrence of these unexpected court decisions while still preserving the legitimate interests of the parties.

The CMBS Form of Intercreditor Agreement.

Both cases interpreted contractual terms that have probably been used in thousands of transactions. The terms are found in a suggested form of intercreditor agreement between the mortgage lender and the mezzanine lender, often called the “Dechert Form,” because it was first published in 2002 on the website of the law firm Dechert, LLP. The form can still be found on Dechert’s web site. ⁴David W. Forti and Timothy A. Stafford, Mezzanine Debt: Suggested Standard Form of Intercreditor Agreement Feb. 2002,
http://www.dechert.com/Mezzanine_Debt__Suggested_Standard_Form_of_Intercreditor_Agreement_03-01-2002/ (last visited April 2, 2012). The form was also published on May 1, 2003, by Standard & Poors in its U.S. CMBS Legal and Structured Finance Criteria. Since then, the form has been used as a template for intercreditor agreements in almost all transactions involving a mezzanine loan where the mortgage loan was originated for the securitization market. Many banks, insurance companies, and other institutional mortgage lenders adopted the form, or a version of it, for their deals. Most lawyers active in the mezzanine loan industry are intimately familiar with this form. We will call this recommended form of intercreditor agreement the “CMBS Form.”

According to its authors, the CMBS Form was based on “significant input from rating agencies, mezzanine lenders and first mortgage lenders.” The goal was to develop a form that was “balanced,” and would represent a “middle ground” between the conflicting interests of mortgage and mezzanine lenders, and “could be accepted by all participants as an appropriate starting point to reduce the amount of negotiation and variation in these agreements.” ⁵Id. This goal was certainly achieved for a decade or so. However, in the opinion of this commentator, these two new cases undermine that goal and reduce the efficacy of the CMBS Form.

The Issue Raised by These Cases.

The issue raised by these cases is whether, in a situation where both the mortgage loan and mezzanine loan are in default, the mezzanine lender must cure all of the defaults under the mortgage loan before it can foreclose on its own collateral and take control of the property. This is an important question because the situation arises frequently. It most often arises at the maturity of these loans. Usually the mortgage loan and mezzanine loan are scheduled to mature concurrently. If they mature, and if the owner of the underlying real estate cannot sell or refinance the property, then both loans will be in default. Under the CMBS Form, as interpreted by these two courts, the mezzanine lender is precluded from enforcing the rights in its own loan documents unless it first cures the defaults under the mortgage loan. Since, in these situations the mortgage loan has matured and the entire amount has become due, this term, as interpreted by the recent court decisions, precludes the mezzanine lender from foreclosing its own loan and gaining control of the real estate unless it first pays off the mortgage loan in full.

Do the terms in the CMBS Form, as recently interpreted by the Stuyvesant Town and Arizona cases, make business sense? Or should the parties to new transactions negotiate changes to these terms in order to avoid a recurrence of the Stuyvesant Town and Arizona cases?

The Mezzanine Lender’s Interests.

The mezzanine lender has a strong interest in being allowed to foreclose its lien on the equity collateral before curing mortgage loan defaults, especially if the mortgage loan has matured or has been accelerated.

From the mezzanine lender’s perspective, if the underlying real estate investment is stressed but there is still enough value in the real estate to cover the mortgage loan and some or all of the mezzanine loan, then a properly drafted intercreditor agreement would allow the mezzanine lender to invest the time and fresh capital necessary to rescue its investment. If an agreement does not encourage such a rescue, then at least it should not prevent or discourage it.

But the mezzanine lender’s motivation to invest rescue capital will be constrained unless it first gains control of the real estate. Until the mezzanine lender has control of the real estate, it is often difficult for it to evaluate whether additional investment in the deal would be productive, or just “throwing good money after bad.” Until the mezzanine lender steps into the shoes of the real estate owner, it will be difficult for the mezzanine lender to understand the nature of the opportunity and the risks, in order to underwrite the additional investment. Until then, there is risk that actions taken by other parties over which the mezzanine lender has no control, such as a borrower bankruptcy, additional borrower debt, unauthorized transfers, or senior lender foreclosure, could impair the mezzanine lender’s ability to recoup any of the new money it may invest in the deal. Frequently, it will make no economic sense for a mezzanine lender to invest fresh capital in the deal unless the mortgage lender makes some accommodations, such as agreeing to write off or subordinate a portion of the mortgage loan; but, absent control of the property, it can be difficult for a mezzanine lender to get a mortgage lender to negotiate seriously about providing such accommodations.

Therefore, from the mezzanine lender’s perspective, the intercreditor agreement should have as few impediments as possible with regard to foreclosing on the mezzanine collateral. Absent a consensual arrangement between the mezzanine lender and the borrower (who is often unmotivated to cooperate), foreclosure on the equity collateral is the only means available to the mezzanine lender to gain control of the real estate. ⁶Technically, by foreclosing on the equity collateral, the mezzanine lender becomes only an indirect owner of the real estate. It becomes the owner of an entity that owns the owner of the real estate. By this means, the foreclosing mezzanine lender achieves practical control of the real estate.

But, under the CMBS Form as recently interpreted in the Stuyvesant Town and Arizona cases, foreclosures of a mezzanine loan at maturity or after acceleration of the mortgage loan will become rare. In order to cure all defaults under a mortgage loan after maturity or acceleration, the mortgage loan must be paid in full. If, as held in these cases, the mezzanine lender is required to cure all mortgage loan defaults before foreclosing, then the mezzanine lender will be caught in an impossible dilemma. Since mortgage loans are typically much larger than mezzanine loans, the mezzanine lender would not be able to foreclose at maturity or after acceleration of the mortgage loan unless it first doubled or tripled its investment in the property. But it will rarely make economic sense for the mezzanine lender to increase its investment in the property until after it forecloses. From the mezzanine lender’s perspective, the only economically defensible course is first foreclose, then invest. But under the CMBS Form, as interpreted by the Stuyvesant Town and Arizona courts, the required order is exactly backwards: First invest (and invest a lot!), then foreclose.

The Mortgage Lender’s Interests.

The mortgage lender’s interests in this situation are in direct conflict with the interests of the mezzanine lender.

The mortgage lender, of course, would like to be repaid. So, at the simplest level, any contractual term that gives someone (in this case, the mezzanine lender) a motivation to pay off the mortgage loan is desirable. The CMBS Form, as interpreted by these two courts, requires the mezzanine lender to pay off the mortgage loan in full just to get to the negotiation table. On the surface, that additional leverage sounds good to the mortgage lender.

But the mortgage lender has a more fundamental interest: Avoidance of a mortgage borrower bankruptcy.

During the recession of the 1990s, it was routine for mortgage borrowers to try to gain leverage in workout negotiations by threatening a bankruptcy. The threat usually carried some weight, because mortgage borrowers who did file a bankruptcy case were sometimes able to use (or, in the view of the lending community, abuse) the court process to achieve a better outcome than would have been obtained if the loan documents had been enforced in accordance with the original intentions of the parties.

Since the recession of the early 1990s, real estate lenders and their counsel have devoted substantial efforts to reduce the likelihood of a borrower bankruptcy, and to reduce the adverse effects on the lender if the borrower actually files a bankruptcy. A variety of tools have been employed, including special purpose entities, bankruptcy remote entities, and independent directors. New case law has helped to reduce the borrower’s leverage in some bankruptcies. ⁷See especially Bank of Am. Nat’l Trust & Sav. A
ss’n v.
203 N. LaSalle St. P’ship, 526 U.S. 434 (1999). However, the most effective tool to deter bankruptcies has been springing recourse to a creditworthy guarantor. Since the recession of the 1990s, real estate lenders have routinely required, as a condition to making the loan, that a “warm body” or a well-capitalized entity (i.e., someone who would have a lot to lose in a bankruptcy) agree, in a guaranty document, that it will become liable, on a full recourse basis, for repayment of the entire loan if the borrower files a bankruptcy case. It is impossible to track the frequency of events that did not happen – i.e., how often people elected not to file a bankruptcy. However, most real estate finance practitioners are familiar with numerous instances in which the threat of personal liability was an effective deterrent to a bankruptcy filing. Most would probably agree that, in the world of commercial real estate, bankruptcy and threats of bankruptcy have played a much smaller role in the current recession than in the previous recession, and that much of the credit (or blame) for this change goes to springing recourse terms.

This change, however, could be undermined by a mezzanine lender willing to “play the bankruptcy card.” If a mezzanine lender forecloses its lien on the equity collateral, then the mezzanine lender will replace the original mortgage borrower as the party with the power to file a bankruptcy case. But the springing recourse guaranty – the device that creates the strongest deterrent to a borrower bankruptcy, was signed by an affiliate of the original mortgage borrower, not by the mezzanine lender. Suddenly, as soon as the mezzanine lender completes its foreclosure, the loaded gun that had effectively deterred the borrower from filing a bankruptcy will be pointed at the wrong person – at the guarantor provided by the former borrower, who is no longer in control of the bankruptcy decision. Thus, from the mortgage lender’s perspective, a mezzanine loan foreclosure substantially increases the mortgage lender’s risk of suffering a bankruptcy or threats of a bankruptcy.

The Stuyvesant Town and Arizona cases neatly eliminate this concern. A mezzanine lender cannot use bankruptcy as leverage in its negotiations with the mortgage lender unless it is in a position to cause the mortgage borrower to file bankruptcy. The decision whether to file bankruptcy belongs to whomever owns the mortgage borrower. If the intercreditor agreement requires the mezzanine lender to pay off a matured or accelerated mortgage loan before foreclosing the mezzanine loan, then there will never be a time, prior to payment in full of the mortgage loan, when the mezzanine lender can cause a borrower bankruptcy.

Concern about bankruptcy may have impacted both the Stuyvesant Town and Arizona cases. The courts’ analysis, on its face, relied entirely on contractual interpretation, without regard to bankruptcy concerns. But both courts included “dicta” in their written orders observing or speculating that the mezzanine lender, in each case, intended to throw the mortgage borrower entity into bankruptcy as soon as it gained control of the mortgage borrower by foreclosing the mezzanine loan. ⁸“Dicta” means “a statement, comment, or observation in a judicial opinion that is unnecessary to the decision in the case.” Dicta definition, USLegal.com, http://definitions.uslegal.com/d/dictum/ (last visited April 2, 2012). According to the unofficial chatter in the legal community following the Stuyvesant Town case, the fear of bankruptcy of an important New York property, rather than an analysis of the terms of the contract, was the real driver of the outcome. ⁹This chatter, of course, is mere speculation.

Were the Courts Right?

This commentator believes that the two courts did not correctly interpret the intercreditor agreement. However, if the chatter and speculation in the legal community is correct, then this commentator has some respect for the courts’ motivation for reaching the incorrect result.

In the view of this commentator, both courts misconstrued the underlying intention of the relevant language in the intercreditor agreements. The language in the S&P Form is reproduced in the footnote below. ¹⁰Both courts focused primarily on the following language, which appears in Section 11(b) of the CMBS Form: “To the extent that any Qualified Transferee acquires the Equity Collateral in accordance with the provisions and conditions of this Agreement, such Qualified Transferee shall acquire the same subject to the Senior Loan and the terms, conditions and provisions of the Senior Loan Documents for the balance of the term thereof, which shall not be accelerated by Senior Lender solely due to such acquisition and shall remain in full force and effect; provided, however, that (i) such Qualified Transferee shall have caused Borrower to reaffirm in writing, subject to such exculpatory provisions as shall be set forth in the Senior Loan Documents, all of the terms, conditions and provisions of the Senior Loan Documents on Borrower’s part to be performed and (ii) all defaults under the Senior Loan which remain uncured as of the date of such acquisition have been cured by such Qualified Transferee or waived by Senior Lender except for defaults that are not susceptible of being cured by such Qualified Transferee; provided, that such defaults which are not susceptible of being cured do not materially impair the value, use or operation of the Premises. [Optional: Notwithstanding any contrary or inconsistent provision of this Agreement, the Senior Loan Documents or the Mezzanine Loan Documents, no acquisition or other fee or similar charge shall be due in connection with such Qualified Transferee’s acquisition of any interest in Borrower or the Premises as the result of a Equity Collateral Enforcement Action or assignment in lieu of foreclosure or other negotiated settlement in lieu of any of the foregoing.]” The two courts interpreted this language to require the mezzanine lender to cure all defaults under the mortgage loan before foreclosing the mezzanine loan. But the S&P Form, at a completely different place, specifically lists the conditions that must be satisfied in order for the mezzanine lender to foreclose. This commentator believes that the language cited by the two courts was placed in the agreement for an entirely different purpose. While not artfully drafted, the intent of that language is to approve a mezzanine foreclosure, not to prohibit or restrict it. The language is, in effect, a pre-approved assumption. Correctly interpreted, it means that if the mezzanine lender forecloses in accordance with the agreement, then notwithstanding the “due-on-sale” clause in the mortgage or any other terms in the mortgage loan documents restricting transfers of interest in the mortgage borrower, the mortgage lender agrees to recognize the mezzanine lender as the new owner of the mortgage borrower, and agrees not to accelerate or enforce the mortgage loan solely on account of the foreclosure of the mezzanine loan.

Granted, this section of the agreement has a “proviso.” However, as succinctly summarized by another commentator, the “proviso,” properly interpreted, “is not a condition to the foreclosure on the equity by the mezzanine lender but is a condition to the mortgage lender agreeing not to accelerate.” ¹¹Michael Hamilton, Law & Policy: Foreclose and file? Buyers of Mezzanine Loans May be Liable for Mortgage Debt, Commercial Property Executive, March 1, 2012. It means that the mezzanine lender still needs to cure any other defaults under the mortgage loan after it forecloses the mezzanine loan if, in the long term, it wants to hold on to the property (except that defaults that cannot be cured by the mezzanine lender and that do not impair the value, use or, operation of the property, such as guarantor financial covenants, will be excused). If the mezzanine lender fails to cure those other defaults, then the mortgage lender will be free to accelerate the mortgage loan and proceed to a mortgage foreclosure, which would extinguish the mezzanine lender’s interest in the property.

While disagreeing with the courts’ interpretation of the intercreditor agreement, this commentator respects the courts’ motives (assuming, for the sake of this discussion, that the chatter in the community regarding the Stuyvesant Town case was correct — that the courts’ real motives were revealed by the dicta concerning bankruptcy). In both cases, if the mezzanine lenders had been allowed to foreclose, it appeared that they intended to use their powers as the new owners of the mortgage borrowers to throw the mortgage borrowers into bankruptcy. While bankruptcy has social utility in many situations (such as saving jobs and providing fresh starts to individuals and operating businesses), it has little justification in typical real estate finance. Society at large usually does not have a meaningful stake in whether a particular commercial real estate asset is owned by one investor or another. Foreclosure of an commercial property is not likely to result in a net job loss. Also, in a typical real estate financing, informed and sophisticated investors agreed to utilize tools designed to deter bankruptcies, and it would be unfair to upset the expectations of those parties by allowing a third party, in this case the mezzanine lender, to take control of the asset and use that control to file a bankruptcy case.

What Is to Be Done About These Two Cases?

In due course the courts will need to sort out the rights of the parties under existing deals. But looking forward, the CMBS Form is not a law or statute binding on future deals. It is only a recommended form of contract, and the parties are free to negotiate changes. Until these two cases, most practitioners, if they thought about it at all, would likely have said that the “real deal” is that the mezzanine lender is not required to pay off a mortgage loan before foreclosing the mezzanine loan – but if the mezzanine lender does not cure the mortgage loan defaults, then the mortgage lender remains free to foreclose its own loan. The question now faced by practitioners is whether to negotiate changes to the CMBS Form in order to increase the likelihood of court decisions that are consistent with that “real deal,” or stick with the CMBS Form and accept that the “real deal” may have changed.

This commentator recommends that the interests of the industry will be best served by negotiating changes to the CMBS Form; but those changes should take into consideration the interests of both the mortgage lender and the mezzanine lender.

Specifically, for all the reasons described above, the mezzanine lender should be allowed to foreclose its loan without curing defaults under the mortgage loan (with the clear understanding that the mortgage lender remains empowered to foreclose its own loan if the mezzanine lender does not cure those defaults). The CMBS Form should be amended to make this clear.

But, in return for this, the list of conditions that the mezzanine lender must satisfy before foreclosing its loan should be increased by adding the following: The mezzanine lender or an affiliate, with substantial credit, must first deliver a replacement non-recourse carve-out guaranty that includes springing recourse for the entire mortgage loan that would be triggered if the mezzanine lender places the borrower into bankruptcy.

This would not be a major change from current practice. The CMBS Form, at Section 5(a), already requires such a replacement guaranty. But the requirement is triggered only if the mezzanine foreclosure “results in the removal” of the original guarantor. There has been much debate in the community as to what is meant by “results in the removal,” since a mezzanine foreclosure, in itself, would not impact the liability of the original guarantor. ¹²For a recent discussion of this ambiguous term, see Thomas R. Fileti, The CMBS Form of Intercreditor Agreement – Time for a Fresh Look?, 598 Practicing Law Institute Real Estate Law and Practice 29 (2012). Mr. Fileti makes numerous cogent arguments for negotiating changes to the CMBS Form, but primarily from the perspective of the Senior Lender. Mortgage lenders should seek to amend the CMBS Form to remove this ambiguity and require, in exchange for allowing the mezzanine lender to foreclose, that a creditworthy party deliver a replacement guaranty whether or not the mezzanine foreclosure results in the removal of the original guarantor.

This change should answer the mortgage lender’s legitimate bankruptcy concern. The mezzanine lender would be allowed to foreclose and step into the shoes of the borrower, but only if it agrees to replicate the protections against bankruptcy that were a key part of the original bargain between the mortgage lender and the borrower.

Many mortgage lenders, including most mortgage lenders originating loans for securitization, began insisting on this change to the CMBS Form several years ago, long before the Stuyvesant Town and Arizona cases, even before the 2008 recession. In the view of this commentator, this is a reasonable request; but mezzanine lenders who agree to this change have a legitimate basis for arguing that they should also be allowed, as a quid pro quo, to amend the CMBS Form to avoid a recurrence of the Stuyvesant Town and Arizona cases. Some drafting suggestions for implementing this change are set forth in the margin. ¹³The following is one drafting suggestion to avoid a recurrence of the result in the Stuyvesant Town and Arizona cases (new text is boldfaced, deleted text indicated by strike-through font):

• First, rewrite Section 11(b) as follows: “To the extent that any Qualified Transferee acquires the Equity Collateral in accordance with the provisions and conditions of this Agreement, such Qualified Transferee shall acquire the same subject to the Senior Loan and the terms, conditions and provisions of the Senior Loan Documents for the balance of the term thereof, which shall not be accelerated or otherwise enforced by Senior Lender solely due to such acquisition and shall remain in full force and effect; provided, however, that (i) such Qualified Transferee shall have caused Borrower to reaffirm in writing, subject to such exculpatory provisions as shall be set forth in the Senior Loan Documents, all of the terms, conditions and provisions of the Senior Loan Documents on Borrower’s part to be performed and (ii) all following such acquisition, Senior Lender shall be entitled to enforce all of its rights and remedies under the Senior Loan Documents unless all other defaults under the Senior Loan which remain uncured as of the date of such acquisition have been cured by such Qualified Transferee within the applicable cure periods described herein or waived by Senior Lender except for defaults that are not susceptible of being cured by such Qualified Transferee; provided, that such defaults which are not susceptible of being cured do not materially impair the value, use or operation of the Premises.
• Second, as “belts and suspenders,” add the following to the beginning of Section 9(c): Notwithstanding anything to the contrary contained in this Agreement, including, without limitation, Section 11(b), …

By amending the CMBS Form to ensure, contrary to the Stuyvesant Town and Arizona cases, that the mezzanine lender can foreclose its loan without first curing mortgage loan defaults, but by coupling that with amendments to the CMBS Form to ensure that after the mezzanine foreclosure the mortgage lender continues to enjoy the benefit of springing recourse to a creditworthy guarantor to deter bankruptcies, the industry will get back to the “middle ground” and restore the “balance” that the original authors of the CMBS Form sought to achieve.