Key Intercreditor Issues in the Mezzanine Loan

January 2003, The Mann Report, Jonathon K. Yormak

In the aftermath of the most recent real estate downturn, in which first mortgage lenders were regularly "held up" by the owners of second mortgages that were entitled to participate in the foreclosure process, mezzanine financing exploded in popularity. While not the only reason for its expanding use (another, for example, is the lower loan-to-value ratio now applied by most first mortgage lenders), mezzanine loans, which are secured by the pledge of ownership interests in the property-owning entity, do not require many lien to be recorded against the real property. As a result, first mortgage (or senior) lenders that are desirous of title devoid of other secured creditors, are amenable to such subordinate financing. Notwithstanding that a mezzanine loan does not cloud title, it is in the senior lender’s and the mezzanine lender’s best interest to agree upon their respective remedies in the event of a default by the borrower, as well as their respective rights with respect to the ownership and operation of the property during the term of the loans. These remedies and rights are typically set forth in an "intercreditor agreement."

The threshold issue in most intercreditor agreements relates to the mezzanine lender's ability to realize upon its collateral; in other words, the ability to take over the borrower's position and become the owner of the property. As most mortgages contain both direct and indirect transfer restrictions (e.g., due on sale provisions or prohibitions on a change in control), the enforcement of the mezzanine lender's collateral would be a default under the senior loan. Accordingly, the senior lender (and, possibly, in the case of a securitized loan, the applicable rating agencies) must agree that the enforcement of the pledge of the ownership interests in the event of a default under the mezzanine loan, whereupon the mezzanine lender shall become the direct or indirect owner of the asset, is not a violation of any transfer restrictions in the senior loan documents. Assuming the senior lender consents, the senior lender will also typically agree (either in the intercreditor agreement, or in a separate standstill agreement) to refrain from enforcing any of its remedies under the mortgage while the mezzanine lender exercises its remedies, provided that the mezzanine lender cures any defaults under the mortgage.

The lenders must also address who controls the various approval rights with respect to the borrower and the property. On the operational side, senior lenders almost always want to review and approve all significant leases and agreements (including all property management and leasing agreements), all annual and capital budgets, and all capital improvements. With respect to significant leases and agreements, both lenders want to make sure that only arms-length deals on market terms are entered into. The borrower, however, will want only one master in this instance, and request that either the senior or mezzanine lender have the exclusive right to approve a transaction. Accordingly, one or the other of the lenders usually ends up having the approval rights on these matters, and the other lender is merely notified.

The lenders' interests are not so aligned on issues related to budgets and capital improvements. As the senior lender's collateral is the property, it is in the senior lender's interest to maximize its value by re-investing (or establish reserves to later re-invest) in it.

The mezzanine lender, on the other hand, is in a riskier position, as it gets paid after the senior lender and, via its security interest in the borrower, has only a remainder or residual interest in the equity in the property. Furthermore, many mezzanine loans include an equity “kicker” or other participation feature, pursuant to which the mezzanine lender is entitled to all or a portion of the net cash flow after debt service. The mezzanine lender therefore wants to limit the amount re-invested (or reserved for re-investment) in the property, and to maximize the cash flow to the borrower. As a result, the lenders must strike a balance that satisfies each of their concerns. These are but a few of the issues that arise in the intercreditor agreement.

How these issues get resolved in each case is, of course, a function of the various factors surrounding each transaction. However, as complex as these issues and the

issues not discussed herein may appear, as Jay Anderson, COO of The Feil Organization and a partner in RCG Longview points out, "it is only when the intercreditor agreement is first being negotiated at the closing table that problems arise; as long as both lenders are willing to spend a little bit of time to reach an agreement at the outset, as is our practice, the intercreditor agreement is rarely a stumbling block."

Jonathon K. Yormak is a New York City real estate attorney with Fried, Frank, Harris, Shriver & Jacobson. Yormak can be reached at yormajo@ffhsj.com.