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Real Estate Mezzanine and A/B Loans: Structuring and Enforcing Intercreditor and Co-Lender Agreements

Reconciling the Demands and Objectives of Senior and Junior Lenders

THURSDAY, SEPTEMBER 28, 2017 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

Today's faculty features: Bruce E. Prigoff, Partner, Cox Castle & Nicholson, San Francisco

Michael J. Waters, Of Counsel, Wachtel Missry, New York

The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.

Real Estate Mezzanine and A/B Loans: Structuring and Enforcing Intercreditor and Co-Lender Agreements

Reconciling the Demands and Objectives of Senior and Junior Lenders

Thursday, September 28, 2017

Bruce E. Prigoff, Partner, Cox Castle & Nicholson, San Francisco Michael J. Waters, Of Counsel, Wachtel Missry LLP, New York

KEY NEGOTIATION POINTS BETWEEN SENIOR LENDERS AND MEZZ LENDERS WHERE CONSENSUS HAS ERODED OR THE "BID-ASK SPREAD" HAS WIDENED

It appears that the general consensus regarding core intercreditor agreement terms that would be mutually acceptable to senior lenders and mezz lenders has eroded, due to several factors. Senior lenders encountered a variety of challenges when dealing with mezz lenders during the downturn in the economy and the real estate markets in the 2007 to 2013 period. Actions of certain "rogue" opportunistic distressed debt buyers and the lack of development and real estate management expertise of hedge-fund type foreclosing mezzanine lenders were perceived as harmful to the senior lenders interest in preserving their capital and in meeting their legitimate expectations in terms of exercising their default remedies. The high profile Stuyvesant case was a leading example of what can go wrong for a senior lender in dealing with a mezzanine lender. Hoping to learn from their past mistakes and to reduce their exposure to risk or loss stemming from the presence of mezzanine loans in their mortgage loan transactions, a number of the senior lenders set out to change their approach to the negotiation of intercreditor agreements on certain key points.

This trend has been more pronounced when the senior lenders are originating to hold the mortgage loan for their own portfolios (so-called "portfolio lenders"). Capital markets lenders looking to originate and sell mortgage loans through securitization of the mortgage loan and sale to third party mezz lenders (or retention of the mezz loans for their own account) have been less aggressive towards mezz lenders as they are in effect making a market for mezz loans and positions taken that impair the marketability of such mezz loans to potential mezz loan purchasers can adversely impair the business plan of such capital markets loan originators.

The thrust of the senior lenders on such key issues includes, without limitation, the following:

1. Disqualified Persons. (Slides 22-23) Senior lenders are seeking to prohibit all of the following persons from becoming a party to the transaction with the senior lender if such person or any of its affiliates falls within certain proscribed categories. Such prohibited persons consist of the mezz lenders or any successor or assign thereof (including a transferee of the mezz loan, any purchaser at a mezz loan foreclosure sale or any person acquiring the equity collateral

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in lieu of such a foreclosure), any property manager retained by such successor or assign, and any person who provides a replacement guaranty upon such foreclosure or assignment in lieu. Ostensibly the proscribed categories are aimed at weeding out the rogues or bad actors, but the senior lenders have expanded this concept in a number of ways to seek to limit such successors and assigns solely to persons who from an underwriting standpoint the senior lenders are comfortable doing business with. This concept is in effect attempting to import to a mezz loan foreclosure under the Uniform Commercial Code the kind of approval rights that a senior lender would have in a loan assumption transaction. In a nutshell, this approach creates a host of problems of mezz lenders, for reasons that can include: (a) exclusion of highly qualified bidders due to lack of senior lender approval thereof or some remote affiliate tripping some disqualification clause; (b) exposure of the mezz lender to liability to the borrower for conducting a commercially unreasonable foreclosure sale; (c) inability of the mezz lender to complete a foreclosure timely and to thereupon cure within deadlines imposed by senior lenders on mezz lender cures, due to the requirement of interactive procedures involving the senior lender review and approval of such persons (senior lender may demand approval rights and delivery to senior lender of open ended due diligence materials, but not commit to any finite timetable for issuance of senior lender approval); and (d) obstacles in terms of the mezz lender being able to conduct due diligence to confirm whether the potential bidders or other parties subject to such standards, together with all of their respective affiliates, comply with the objective criteria included in such requirements, as measured over periods that can reach back 25 years or more or even from the dawn of time (for a worldwide based real estate organization that may have a history of corporate mergers, the affiliates requirement can be an simply unmanageable).

To the extent that a mezz lender agrees to such a provision at all, such provision needs to contain solely objective criteria (not the senior lender smell test or reference to the senior lender's undisclosed proprietary criteria), that is readily verifiable by mezz lender, does not involve a web of companies (such sister or cousin affiliates, is limited to a short duration of time, such as 7 or 10 years, does not include "offenses" such as defaulting on any loan, doing a loan workout or, perhaps (given the tumultuous real estate markets since 2007) getting foreclosed upon or transferring a property to a lender pursuant to a deed in lieu. Suing a lender for lender liability or filing for voluntary bankruptcy or reorganization are of a different character and may be directly within the scope of the senior lenders' legitimate concerns. Given that senior lenders are loathe to publish a "bad actor list" for fear of exposure to liability or controversy for branding certain persons as unacceptable to do business with, some senior lenders who are looking to get beyond objective criteria seek to get a broad right of approval over the person taking title to and/or managing the mortgaged property through mezz foreclosure or over the person who will provide the replacement carveout guaranty. In certain cases regarding replacement carveout guarantors, a senior lender seeking this right will offer to qualify its approval rights with a reasonableness requirement in those cases where all of the objective criteria are met. From a mezz lender's standpoint, any such approval right, however qualified, is problematic, and mezz lender needs to limit the qualifications for each of the qualified transferee taking title, the replacement guarantor and the replacement property manager solely to objective criteria that is feasible for the mezz lender itself to diligence and satisfy without senior lender approval. Additionally, senior lenders sometimes demand that a mezz lender itself meet a Disqualified Person test at the time the intercreditor is signed and also at the time of mezz loan foreclosure.

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This in effect is a covenant for the mezz lender and its affiliates not to engage in any activity that would result in the mezz lender becoming a Disqualified Person for the duration of the loans, breach of which covenant would operate to prevent the mezz lender from making a credit bid in a mezz loan foreclosure. This should be resisted by mezz lenders, who once approved should be permanently qualified, and if at all allowed should exclude any potentially disqualifying litigation that relates to the intercreditor agreement of the loans themselves, so the mezz lender is not further handicapped in enforcing its rights under the intercreditor agreement or disputing matters between senior lender and mezz lender pertaining to the subject transaction.

An example of the definition of a Disqualified Person proposed by a senior lender recently reads as follows:

"Disqualified Person" means any Person if, at the time as of which a determination is required under the terms of this Agreement:

(i) such Person, or any Person that Controls such Person or is Controlled by such Person, is, or has been within the last seven (7) years, a debtor in a Proceeding in which such Person voluntarily filed a bankruptcy petition;

(ii) such Person, or any Person that Controls such Person or is Controlled by such Person, to the knowledge of the Person seeking the applicable approval or as determined by Senior Lender, has ever been convicted of, or pleaded guilty to, a felony involving dishonesty or fraud; or

(iii) such Person or any holder of direct or indirect legal or beneficial ownership interests in such Person, or any Person that Controls such Person or is Controlled by such Person (provided that for purposes of this clause (iii) the term "Controls" and "Controlled" shall not include clause (i) of the definition of "Control") is a Person that would not qualify, based on Senior Lender's then current proprietary criteria, to be an obligor on any financing originated, provided or acquired by Senior Lender.

2. Purchase Options. (Slides 19-20) Senior lenders are seeking to limit mezz lender purchase options in a number of ways.

One limitation sought to be imposed is to restrict the mezz lender's right to purchase the senior loan to a very short period that expires quickly after a senior loan event of default, after which mezz lender has no purchase right. Mezz lenders should oppose this strongly, as the purchase right is the ultimate fallback protection after all of the other possibilities have been exhausted ? senior loan default waiver or cure, senior loan workout, mezz foreclosure and cure. These processes take time to play out and the mezz lender should not lose its right to purchase until either the senior loan foreclosure is completed or, after senior lender negotiates with borrower and is in a position to accept a deed in lieu of foreclosure, adequate notice thereof is given to the mezz lender and a reasonable time is afforded for the mezz lender to purchase the senior loan is provided.

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A second aspect of a senior lender seeking to get the mezz lender out of the way so that the senior lender can exercise its remedies is the demand that mezz lender agree that if the senior lender negotiates a deed in lieu with the borrower and the mezz lender does not purchase the senior loan that the mortgage borrower can grant a deed in lieu to the senior lender without incurring full recourse personal liability under the mezz loan for a violative transfer. This forces the mezz lender to have to buy the senior loan or be at risk of a complete loss of its investment. The mezz lender would far prefer that the senior lender have to conduct a mortgage loan foreclosure in which the mezz lender would recover a portion of its investment if the winning bidder pays a purchase price in excess of the senior loan. It is typical for mezz loan documents to provide for full recourse in the event of a deed in lieu and many mezz lenders will not agree to a release of liability for a deed in lieu in favor of senior lender, but will agree that a senior loan foreclosure that goes through the bidding process does not give rise to recourse under the mezz loan.

3. Replacement Guarantors. (Slides 24-25) Senior lenders are seeking to assure that under all circumstances its mortgaged property collateral will be controlled directly or indirectly by a creditworthy person who has provided a carveout recourse guaranty to the senior lender. In the context of a foreclosure being run by a mezz lender and changes being made to ownership and control of the mortgaged property, it is difficult for a senior lender to cover every possibility in this regard. The senior lenders have sought to introduce some new concepts into intercreditor agreements in their effort to achieve this objective.

(a) One of these concepts is the "Deemed Replacement Guarantor", which requires a creditworthy entity (either the mezz lender or an entity that majority owns and controls the mezz lender) to undertake from the date of the intercreditor agreement to agree in writing that it shall be liable for the recourse carveouts in the event of a foreclosure or assignment in lieu (or exercise of voting control of the mortgage borrower) unless and until a replacement carveout guaranty is provided to senior lender by a person that meets the tests for a replacement guarantor. This will provide credit support for senior lender in the event of a mezz foreclosure and the occurrence of events that trigger carveout recourse, and will motivate the mezz lender to make sure it delivers to senior lender the required replacement guaranty from the winning bidder in the mezz foreclosure. However, it cannot assure senior lender that upon a mezz foreclosure the person in control of the mortgaged property will have signed and delivered the replacement carveout guaranty and will thus be more likely to be deterred from engaging in bad acts. For a similar reason, mezz lenders are resisting the Deemed Replacement Guarantor concept, because if it ever came into effect under circumstances where someone other than a mezz lender affiliate controlled the mortgaged property, the mezz lender would have exposure for that person's bad acts. Other examples of situations where the mezz lender would have concern are that the person delivering the replacement guaranty had a strong net worth but fell a little short of meeting the required financial strength for the replacement guarantor. In that case, a senior lender would have a hard time proving how it was damaged by that fact in a lawsuit against the mezz lender for failure to provide a qualifying replacement guaranty from a replacement guarantor. The outcome would be very different if the result was that the mezz lender was itself on the hook for bad acts as the Deemed Replacement Guarantor. A related requirement proposed by senior lenders is that if the mezz lender transfers its loan, the transferee would have to provide a

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replacement carveout guaranty from a Deemed Replacement Guarantor as a condition of such transfer.

(b) A second concept put forth by senior lenders is the requirement that the replacement guaranty not just be delivered to senior lender as a condition of the mezz loan foreclosure, but that it be delivered to senior lender by a specified number of days prior to the mezz loan foreclosure, to become effective upon such foreclosure. In the context of multiple bidders, this means that each bidders must sign and deliver is Replacement Carveout Guaranty prior to the foreclosure sale date. Provisions will state that only the winning foreclosure bidders affiliate's guaranty will become effective and all of the other guaranties will be returned by senior lender. This provision has not been particularly controversial as between senior lenders and mezz lenders.

(c) A more subtle angle taken by senior lenders is to have the replacement guarantor sign a replacement carveout guaranty under which the replacement guarantor agrees to full recourse for a violative transfer that occurs after (or on or after) the mezz foreclosure and to provide in the intercreditor agreement that failure to satisfy any and/or all of the mezz foreclosure conditions and requirements constitutes a transfer violation under the senior loan documents. It is essential for mezz loan counsel to pre-negotiate the form of replacement carveout guaranty to be signed by each of the potential mezz foreclosure bidders and to expressly provide therein that it does not cover the mezz loan foreclosure itself or the satisfaction of any of the conditions or requirements set forth in the intercreditor agreement with respect to such mezz loan foreclosure. Otherwise, the winning bidder at the mezz foreclosure sale faces the prospect that the senior lender will contend that the replacement guarantor is fully liable for the senior loan on a recourse basis for failure to satisfy the post-foreclosure requirements (and that senior lender will contend that such violative transfer occurred post-foreclosure during the period covered by the replacement guaranty).

4. Mezzanine Lender Experience and Creditworthiness. (Slide 22) Similar to the Deemed Replacement Guarantor concept, but broader in its intended scope, is the goal of senior lenders to have a creditworthy person be responsible for any breach of the intercreditor agreement by mezz lender. The genesis of this goal stems from a number of adverse experiences that senior lenders had with mezz lenders in the last real estate downturn. The presence of mezz lenders in a transaction, mezz lender approval rights, and sponsor recourse to mezz lenders for cooperating with senior lender remedies added complications and bogged down negotiations between senior lenders and senior loan borrowers. Mezz lenders in some cases took control of projects that such mezz lenders lacked the real estate expertise to properly develop and manage. Mezz lenders often were simply SPEs, whose sole asset was the mezz loan itself, such that the senior lender lacked a financially responsible party to look to for accountability for a breach of the intercreditor agreement. These experiences have motivated senior lenders to alter the previously common practice of deeming a mezz lender (in the definition of Qualified Transferee) to meet the requirements that were otherwise applicable to Qualified Transferees, which include itself having, or being majority owned and controlled by a parent that has, both a specified level of experience in the ownership of, or lending to, projects that are similar in use, scope and size as the subject property and a substantial net worth and liquidity of at least a specified amount. Some senior lenders are seeking to take this a step further, seeking to require that the mezz

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lender itself meet such financial criteria, or obtain a guaranty from a creditworthy parent of the mezz lender's obligations under the intercreditor agreement. Mezz lenders are pushing back on this demand, as this is a change from long-accepted market practice, it runs contrary to the goal of many mezz lenders to minimize liability in a transaction by using SPEs, and such mezz lenders may not have a creditworthy parent willing to provide such a guaranty. Mezz lenders need to carefully consider whether they meet the experience tests set forth in the Eligibility Requirements definition in the intercreditor agreement to make sure they or their parent qualify, and amend such provision as needed to assure it meets the qualification tests. For example, a mezz lender may have made many residential apartment loans but may be engaging in its first condo conversion loan and thus potentially not qualify under certain language unless it is modified to broaden the language pertaining to qualifying prior experiences.

5. Curing Senior Loan Defaults/Stuyvesant Case. (Slide 28) A key component of the court's decision to issue a temporary injunction barring mezz foreclosure in the Stuyvesant case was that the mezz lender had to cure the senior loan monetary default as a condition to such foreclosure, which in the case of the matured senior loan meant that the mezz lender would have to pay off the senior loan in full in order to foreclose. That interpretation was contradictory to what many experienced market participants understood the applicable intercreditor agreements to mean. It was particularly onerous in the case of Stuyvesant where the property value was $1 billion lower than the senior loan amount. However, as can be seen from the fact that after the court's ruling the senior lender bought out the mezz lender for the price the mezz lender paid for a mezz loan that was even more out of the money, the court's ruling stood a material chance of being overturned. The tack taken by a number of senior lenders in the ensuing years is to attempt to enshrine the court's holding in the Stuyvesant case by negotiating for intercreditor provisions that grant to the senior lender rights and impose on the mezz lender burdens that are consistent with the court's holding in Stuyvesant. These include the following:

(a) As a condition to mezz foreclosure, the mezz lender will be required to cure all monetary defaults, including payment of the senior loan at maturity. Sometimes the senior lenders will exclude amounts payable due to senior loan acceleration, but even in that case such a requirement puts a mezz lender in a very difficult position as regards senior loans at the time of their scheduled maturity ? where the mezz lender to foreclose and acquire ownership of the mortgage borrower and indirectly the mortgaged property, the mezz lender could arrange a refinance of the senior loan at market rates. If instead the mezz lender only has the option of paying off the senior lender as a means of curing such maturity default or buying the senior loan, then the mezz lender will need to find more expensive bridge capital to finance the purchase or payoff of a defaulted senior loan in a distress situation where the borrower remains in place. This type of distress investment capital is scarcer to obtain and more expensive, and will not be able to be replaced with standard property refinancing until the mezz lender forecloses out the mezz borrower.

(b) As a condition to mezz foreclosure, a number of senior lenders are seeking to condition mezz loan foreclosure on cure by the mezz lender of all senior loan defaults that can be cured without taking possession of the property. This can be problematic for a mezz lender with respect to any non-monetary default that does not require possession to cure. Normally the applicable notice and cure period in the intercreditor would afford to the mezz lender 30 days to

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cure after notice, or such longer time as would be reasonably necessary to effectuate such cure. Conditioning mezz loan foreclosure upon curing such non-monetary defaults in effects cuts off the mezz lender cure period on the date of its foreclosure, or bars such foreclosure until such cure is effectuated. Where a senior loan borrower has multiple defaults, some of which require the mezz lender to get possession of the property to cure, the mezz lender may be put in a possession where it cannot proceed timely to foreclose and get possession due to the existence of other defaults that do not require possession but are in the process of being cured. Mezz lenders should resist the requirement that senior loan non-monetary defaults be cured as a condition to mezz loan foreclosure.

6. Conditions Precedent and Conditions Subsequent to Mezz Loan Foreclosure. (Slide 15) There are only a couple of key conditions to mezz loan foreclosure that a mezz lender can endeavor to satisfy prior to or concurrently with a mezz loan foreclosure, namely making sure that the winning bidder is a Qualified Transferee, delivering to senior lender a replacement carveout guaranty from a replacement guarantor that meets the requisite tests, curing monetary defaults other than maturity defaults, and delivering to senior lender a certificate that such requirements have been complied with. Virtually all other requirements pertaining to mezz foreclosure set forth in intercreditor agreements can only be fulfilled post-mezz loan foreclosure and therefore should be set forth in an intercreditor agreement as covenants, or conditions to the senior loan continuing in place on a non-defaulted basis notwithstanding the mezz loan foreclosure. Such post-foreclosure requirements can generally only be satisfied by the winning bidder at the mezz foreclosure sale, rather than by the mezz lender (who, unless such mezz lender is the winning bidder, is out of the picture). Such post-foreclosure conditions often include, among other things, setting up a hard cash management if not already in place, delivering a non-consolidation opinion to senior lender regarding the qualified transferee, curing defaults any then uncured defaults including defaults that can only be cured upon taking possession of the property, and entering into a property management agreement with a qualified property manager. A typical deadline for achieving these requirements is 30 days after the mezz foreclosure sale. A number of senior lenders are pushing in intercreditor agreements for related provisions that pose material risks for mezz lenders. These include:

(a) Requiring the mezz lender as a condition to foreclosure to provide a certificate that all of the requirements relating to the mezz foreclosure set forth in the intercreditor agreement have been satisfied, or will be timely satisfied. For those requirements to be satisfied after the mezz loan foreclosure, mezz lender may have no control over satisfaction of such requirements and there is the potential that even with best efforts some requirements such as curing all senior loan defaults that require possession to cure will not be timely cured by the winning foreclosure bidder. Accordingly, this certification requirement should be divided into two parts: mezz lender certifies at the time of the mezz foreclosure sale as to the pre-foreclosure items, and the winning bidder is to provide a certification at the end of the 30 day period postforeclosure (assuming that it is in a position to confirm satisfaction as of that date). Failure to so certify by the mezz lender as to the limited number of pre-foreclosure requirements is an acceptable condition to foreclosure.

(b) As regards the failure of the winning bidder to satisfy the post-foreclosure requirements (including among such requirements failure to timely deliver the post-foreclosure

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