Intercreditor Agreements: Too Cool for School?

Where there are multiple layers of financing in a real estate project, there is (or should be) an "intercreditor agreement" that attempts to sort out the potential conflicts between a senior lender -- typically, the lender with a mortgage on the real estate -- and the junior lender, who may have a second priority mortgage on the property but more typically is a mezzanine lender with a lien on the borrower’s stock. These agreements are attempts to pre-negotiate the dance steps, if both parties are trying to enforce against a defaulting borrower, to help bring about an orderly workout. The hope is to keep them from stepping on each other’s feet, when there’s panic on the dance floor later.

This is tougher than it sounds. Both lenders have a variety of rights directly against the borrower, by contract and by law as lienholders, to which the other may not be a party. Often, for example, the senior lender wants assurance that, if the junior takes over the borrower, the junior will assume (not repudiate) the mortgages and the debt. The junior wants to know that if it does that, and takes over the property and owner to preserve it as a going concern, then the senior won’t accelerate, call the loan or otherwise freak out just because of the change in control. Writing a good intercreditor agreement can be a work of craftsmanship: there are a host of little notice, consent and forbearance steps that must be nailed down, in order for such an agreement to work.

And there’s the rub. Like any pre-nuptial agreement, the problem is that these things often are written in haste, when romance is still in the air – but by the time they’re enforced, everyone hates everyone else.  That summarizes the state of play in a recent case that illustrates some practical risks of intercreditor arrangements and mortgage lenders-mezzanine lender wars.

The Stuyvesant Town-Peter Cooper Village development is Manhattan's biggest apartment project. If you've ever driven or cabbed around the Lower East Side, you've seen it. Its financing is in default: Welcome to the new millenium.

In August, some funds tried to get control of the project, by buying its deeply discounted mezzanine debt, and then foreclosing quickly on the collateral for that junior debt: the equity of the property owners.  Their thinking apparently was if you control the owner, you control the property, right?  The senior lenders with mortgages on the defaulted $3 billion or so of secured debt wanted to foreclose too.  The senior lenders’ foreclosure was already underway in court in June:  so they sued in New York state court, to stop the new junior lenders' UCC foreclosure on the control equity interest.  The senior lenders’ argument was that the intercreditor agreement required the junior mezzanine debt to cure all the defaults under the senior lenders’ mortgages before pulling the trigger on their UCC foreclosure of the control equity interest.

Confused yet? Pause to have some sympathy for Stuy Town's residential tenants, watching all these legal missiles fly overhead among various courts and Wall Street behemoths, just trying to make sense of where to send their rent checks and who's in charge in any given week. See the valiant attempts of the residents association to keep up with all this, in plain English.  They even wrote a FAQ for the tenants.  Hats off to that office, for trying to keep the residents informed without burying them in legalese.

Speaking of legalese, that was what the injunction hearing focused on.  The state court judge reached his determination carefully parsed the text of the intercreditor agreement, where the key clauses about who goes first, and who is subject to what from who, is liberally larded with "provided, howevers", and myriad run-on sentences with lots of little nested (1)s, (2)s, (a)s, (b)s and (ii)s.  Ever read one of those and wonder if the lawyer is being a little too clever?  That was apparently the case here: the two parties literally placed their legal bets on opposite arguments about the meaning and antecedent of one of the "provided, however"s.

On September 16th, the judge ruled for the senior lenders, finding that the intercreditor agreement's intent was on their side. The state court issued a preliminary injunction against the mezzanine lenders' UCC foreclosure, to let the senior debt do what it wanted, which apparently was to foreclose on the land.

So, of course, the mezzanine lender sued to get an injunction against THAT.  On September 28th, the court denied the mezzanine lender’s request for a second injunction, so the senior lender's servicer was able to proceed with the mortgage foreclosures.

This is high-stakes poker. If the courts had gone the other way, it’s likely that the next move of the distressed-mezzanine-loan purchasers would have been to take over the landowner -- and then take the entire underlying real estate project immediately into bankruptcy:  very possibly freezing the senior lenders' rights for a year or more while Stuy Town slogged through a Chapter 11 case.

There are a couple of lessons for real estate professionals from this interesting high-stakes duel among senior mortgage lenders and junior mezzanine lenders.

1. Clean, clear drafting matters.

If you're arguing in court about who has to stand down first, under an intercreditor agreement, and the other party has a shot at winning, then the drafting wasn't that spiffy in the first place.

We don't have data about the Stuy Town players specifically. But in the go-go days of the last boom, a lot of intercreditor agreements .. and other real estate loan documents ... were written in great haste. Now in 2010 we are seeing some of the results of hasty documentation.

Also, in the era of securitization, it's possible that some intercreditor agreements were written by originating lenders who planned to sell off their interests separately and immediately: as a result, those deals might tend to favor the lenders in junior positions (to make it easier for the loan originators to sell the junior debt on a given project), at the cost of not having as much motive to make it bulletproof for the purchaser of senior debt (who also buys its debt from the originator).

This is a problem with securitizations, highly routinized transactions that aren't very carefully thought through and sheepish following of rating agency criteria generally. As with the "mortgage robo-signer" problems this year, some of the bankers, lawyers and others who were involved in originating loan paper during the boom seem to acted in a rather cursory way:

 "Have a piece of paper signed in the file that says "intercreditor agreement"?"

"Check."

"What's it say?"

"Who cares?"    (For now.)

Here’s the problem with such vague and fuzzy drafting: while it is great fun for litigators to try to convince judges who may or may not have much experience with interpreting intercreditor agreements (and makes for great press, especially in big cases like the Stuy Town matter), it’s both really expensive for the clients – the lenders (and investors) paying the bills – and it yields unpredictable results. Instead, if it’s humanly possible to get to an agreement on terms, it makes much more sense to have a written agreement that is so clear that the other side doesn't even want to litigate the point. You want to avoid judges and courts altogether, by having rights that can be worked out without ever going to court.

Realistically, for 3 billion dollars, in the Stuy Town matter, the various lenders were all going to go to court and take a shot anyway. But it's clear from the court record that the judge and the parties had to agonize over the meaning of the primary "provided", the third "therefore," the fourth "forthwith", and so on.

As a non-lawyer, if you are buying a sheaf of paper that is so thick with long clauses that it blinds lab rats, don't be afraid to push back on your drafters. Make them explain it to you in English. Then make them write it that way. When you need to collect, you don't want to be in New York State Court (or any court), paying retail by the hour for the privilege of arguing about the real meaning of the fifth "forsooth."

2. You have to think carefully about junior debt in a real estate deal; and the distressed sales going on in this economy make it much trickier.

Generally, as in the Stuy Town situation, senior lenders do not want a junior or mezzanine lender to take control of the borrower prior to curing any defaults under the senior loan.  This is because the senior debt doesn't want to face the prospect of a loan that continues not to perform -- but now, further delayed by tough workout or bankruptcy fight, negotiated and funded by a junior or mezzanine lender who now has become "the borrower", having bought in for a cheap price, and with plenty of cash to defend.

Not that a junior lender or borrower with money is always a bad thing.  Obviously, if there's real rescue financing that makes a rescue possible without cramming the senior debt out of existence, that's potentially a good thing for everyone.  Also, in the case of a construction loans or an incomplete project, a senior might actively want junior interests to foreclose the borrower’s position, come in with some new money and finish the project, so that the senior lender’s collateral increases in value without the senior lender having to take it over, or advance more itself.

3. Bankruptcy really is all that: a bankruptcy court can completely gut and change the deals lenders make.

The senior debt in the Stuy Town case justifiably feared a bankruptcy and the attendant stay of its foreclosure.  The gist of an intercreditor agreement is a contract that any remedies exercised by anyone, and any money received from the borrower entity, all should be handled in a "waterfall" fashion, where creditors line up to get their return in the order of their previously-negotiated priority.

Theoretically, a well-crafted intercreditor agreement entered into well in advance of a borrower's defaults should have a lot of weight in determining the respective creditors' interests after a bankruptcy filing.   But anecdotally, there's some indication that some bankruptcy courts lean more towards "split the baby" answers -- for example, requiring that any payouts of interest made by the borrower are made to all tranches on an equal or near equal footing -- a very different result from that bargained for by the different lenders.  There are some pretty good legal arguments that this is the wrong legal outcome: but that's litigation fodder.  So, all lenders should walk into workouts with a clear understanding that the assumed order of priority may get re-examined by a court, whether rightly or wrongly, once insolvency looms.

As a practical matter, that means that when you or your experts crack the wax seal on the vault to look at a loan's documentation, to see if the signed note is in the file and so on, preparing for a sale or workout, you might want to glance – carefully -- at that intercreditor agreement too.