Mezz Lenders and Intercreditor Agreements

Subordinate financing for real estate has been around for as long as borrowers have desired to increase their leverage. Historically, such funding was secured in the same way as senior financing with a mortgage that was similar but junior to the senior mortgage. However, with the advent of structured finance, lenders became sensitized to the perils that second mortgages posed to the secured senior position.

During the past decade, borrowers accessed subordinate debt by obtaining mezzanine loans-financing secured by pledges of the ownership interests in an entity that owned real property, rather than by the real property itself. The relationship of the mezzanine lender to the mortgage provider, and the mezz lender's rights in that relationship, are governed by an intercreditor agreement. This is often a major factor in the potential success or failure of the loan. The greater the array of rights granted by the senior lender to the mezzanine lender, the greater the value of the mezzanine loan. As we will see, the position of a mezzanine provider under an intercreditor agreement often is not a winning one.

If senior lenders had their choice, they would not enter into an intercreditor agreement with the mezzanine lender. However, in 2002, what is now the Commercial Real Estate Finance Council introduced a form of mezzanine intercreditor agreement for use in all securitized mortgage loans. While the standard intercreditor agreement attempts to reach a middle ground, it often results in a the mezzanine lender not having any significant or practical rights.

Transfer Restrictions. The mezzanine lender is usually prohibited from transferring a controlling interest in its loan unless the transferee is a "qualified transferee" (or the rating agencies otherwise provide a no-downgrade letter with respect to such transfer). A qualified transferee has many definitions, but it is generally an entity that is a sophisticated real estate investor with total assets and net worth meeting or exceeding a certain threshold. Often, a proposed transferee of the mezzanine loan has difficulty meeting the thresholds and, as a result, the mezzanine lender cannot transfer the mezzanine loan.

Conditions Impacting Collateral Foreclosure. Generally, the foreclosing mezzanine lender is required to satisfy certain requirements to become the holder of all of the equity interests in the mortgage borrower pursuant to a UCC foreclosure. This may include: posting adequate reserves (e.g.: taxes, insurance, TI), providing recourse carve-out guaranties to the mortgage lender from a creditworthy guarantor similar to the guaranties that the original equity owners provided, retaining a qualified property manager, instituting a hard lockbox for all property revenues, and providing a litany of other items, such as non-consolidation opinions. Subsequent to a foreclosure by the mezzanine lender, that lender will be obligated to comply with the terms and provisions of the senior mortgage loan and cure all defaults under the senior mortgage loan. This could create a huge financial burden and cause the lender not to foreclose.

Amendment to Loan Documents. The intercreditor agreement may provide that a mortgage lender may not be permitted to modify the terms of its mortgage loan without the mezzanine lender's consent (e.g.: increase interest rate, amount of principal, etc). Without the right to change the terms of the mezzanine loan, a mezzanine lender's hands may be tied in any restructuring.

Purchase of Mortgage Loan. If the mortgage loan goes into default, the mezzanine lender usually has the right to purchase it at par (plus accrued interest), plus all other sums then due under it. The right of the mezzanine lender to purchase the mortgage loan is often illusory since the mezzanine lender rarely has the financial wherewithal to purchase the senior mortgage debt.

Control Rights. In some cases, the mezzanine and mortgage lenders have overlapping approval rights under their loan documents. In those instances, the intercreditor agreement will often provide that the mezzanine lender's approval, and then the mortgage lender's approval, will be obtained.

However, many intercreditor agreements do not give the mezzanine lender the right to exercise its approval rights prior to the senior lender. Therefore, the mezz lender is unable to exercise any rights or control over the operation of the property.

If a mezzanine lender does not have the financial ability to cure a senior mortgage default, purchase the senior mortgage loan or, at maturity, payoff the mortgage loan, many of the benefits and rights granted to a mezzanine lender in an intercreditor agreement will be of no value. Even if the mezzanine lender does have sufficient funds to take advantage of any of the rights or remedies granted to it, the mezzanine lender's position after the foreclosure of its collateral will be subject to whatever the borrowers may have done to the real estate asset, i.e., the mezzanine lender takes the property as-is. We have seen mezzanine lenders that were unaware that the mortgage borrower had placed subordinate debt on the mortgaged property, that the mortgage property was subject to tax liens, and that there existed claims of tenants, judgment creditors and mechanic lienors, all of which would have priority over the interest of the mezzanine lender.As the economy begins to recover, it is important that mezzanine lenders reassess their situation and make sure that they understand the very subordinate nature of their position.

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