An investor bought an apartment building in San Jose and the broker wanted to send flowers for the occasion. A large bouquet was delivered to the buyer's office with a note that read, "Rest in Peace."
The buyer was irritated and called the florist to complain. After he had told the florist of the obvious mistake and that he was not pleased, the florist said: "Sir, I'm really sorry for the mistake, but what I'm more concerned about is . . . there is a funeral taking place today, and they have flowers with a note saying, "Congratulations on Your New Apartment!"This amusing joke is a good way of reminding us that both real estate and business deals continue to be closed in the Bay Area. As a banking, real estate and business lawyer representing parties to these transactions, I am very aware, and I expect most readers are as well, that financing continues to be a critical part of making a successful deal. During the robust period prior to 2008, one way parties garnered additional leverage in structuring real estate transactions was to utilize so-called mezzanine financing, in which the collateral securing a junior layer of debt consisted of the ownership interests in the borrower rather than the real estate. When the borrower was a limited liability company, this junior loan collateral could be secured through a pledge of the membership interests the owners held in the borrowing LLC.
The concept of using mezzanine debt to enhance leverage has not gone away. However, recent cases looking at transactions structured several years ago have curtailed the latitude of mezzanine lenders ("Mezz Lender") and improved the position of the senior secured lender ("Mortgage Lender") in the event problems arise after loan closings. If you are a Mortgage Lender holding real estate collateral, this may make it more attractive for you to enter into a transaction involving mezzanine financing. If you are a Mezz Lender or a borrower seeking to obtain and use mezzanine financing, obstacles now exist that were not there - or at least not believed to exist - before the markets collapsed in 2008.
The most significant point to take away from the recent case law is the enormous importance of the intercreditor agreement in multi-party transactions. This includes mezzanine financing discussed here, as well as other arrangements involving multiple creditors. In the cases mentioned below, the courts specifically analyzed the language and terms of the intercreditor agreements executed by the parties in reaching their rulings and, therefore, the exact language drafted into the intercreditor agreement will significantly affect the rights of the parties. If you become involved in a financing using mezzanine debt or a transaction with multiple creditors, close attention should be paid to the intercreditor agreement regardless of your position in the transaction.
Now, we discuss some basics about mezzanine financing and then assess the recent case law. Mezzanine financing provides an opportunity to apply an additional layer of secured debt to a real estate transaction by using the equity in the borrower itself, which are held by the owners. This debt is in addition to the Mortgage Lender's loan, which is secured by a first deed of trust against the subject property. For example, assume an entity acquiring real estate is an LLC, and the Mortgage Lender will loan 65% of appraised value based on its underwriting policies. This amount, however, is insufficient to close the transaction. A layer of mezzanine financing might be obtained by having the owners of the LLC, i.e., its members, pledge their interests in the borrowing LLC to secure additional loans. This financing, secured by entirely separate collateral and often provided by an entirely different lender - the Mezz Lender, reduces the owner/investor funds required to complete the purchase.
The Mortgage Lender, holding real property collateral, and the Mezz Lender typically enter into an intercreditor agreement as well, whereby the mezzanine financing is, among other things, subordinated to the loan held by the Mortgage Lender. But other terms and conditions are also rounded up and placed in the intercreditor agreement, including provisions limiting the remedies of the Mezz Lender while the senior secured loan is in default. One common term in many intercreditor agreements requires the Mezz Lender to cure defaults in the senior secured loan prior to transferring its interest in the borrower through a UCC foreclosure sale of its collateral to a "qualified transferee."
In the event problems develop with the project and defaults occur in the senior secured loan, the ultimate remedy for the Mortgage Lender, at some point, is to commence foreclosure proceedings. When this occurs, and particularly if values have declined, the junior Mezz Lender's strategy for protecting its interest frequently involves taking control of the borrower through a foreclosure sale of the ownership interests, and then placing the borrower in bankruptcy to maintain control and buy time to work out a liquidation that, to the extent possible, increases value at sale and protects the Mezz Lender's interests.
Recent court decisions, including Bank of America, N.A. v. PSW NYC LLC, 918 N.Y.S.2d 396, 2010 N.Y Slip O-p. 51848(U) (N.Y. Sup. Ct. Sept. 16, 2010), and U.S. Bank National Association v. RFC CDO 2006-1 Ltd., Case No. 4:11-cv-664, Doc. No. 41 (D.Ariz Dec. 6, 2011), changed the playing field for these strategies by reaching the conclusion that the Mezz Lender is required to cure all defaults, including repaying the entire senior secured loan if that loan has been accelerated or matured, prior to conducting its UCC foreclosure sale. The Mezz Lender also may have to replace guarantors supporting recourse carve outs prior to a foreclosure. The bottom line is that these court decisions, which seem to be generating persuasive force, shift negotiating power in a workout or problem situation to the Mortgage Lender at the expense of the Mezz Lender.
As mentioned, these cases carefully scrutinized the intercreditor agreements, and therefore it will be worthwhile for a party to the transaction to pay close attention to that agreement.
The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.