By Jesse Sharf
The increasing popularity of mezzanine financing has led to changes in the practice of negotiating and drafting inter-creditor agreements. These agreements, which govern the relationship between the mortgage lender and mezzanine lender, differ in many respects from subordination agreements, which govern relationships between senior and subordinate mortgage lenders. Furthermore, as rating agencies and certain other participants in the securitization market maintain certain requirements regarding any debt affecting a securitized mortgage loan, these entities have become involved in determining the form and substance of intercreditor agreements as well.
The typical mezzanine loan, in which the mezzanine lender extends credit to a company that directly or indirectly owns some or all of the equity interests in the mortgage borrower and is given a pledge of the equity interests in the mortgage borrower as collateral, affords the mortgage lender some inherent protections absent in the old senior mortgage/subordinate mortgage scenario. For example, since the lenders have different collateral, the mortgage lender, whose collateral consists of real property, as opposed to the mezzanine lender's equity interests, does not have to worry about "subordination" of collateral.
These structural protections are generally not enough, however, to satisfy either the mortgage lender or the mezzanine lender. There is almost always a desire on the part of both lenders to reach an agreement between them as to a variety of additional subjects - hence the need for the intercreditor agreement. While the mortgage lender will typically start with a harsh form of intercreditor agreement, and leave it to the mezzanine lender to negotiate back from that starting point, many mezzanine lenders consider it better practice to have the mezzanine lender do the initial draft of the intercreditor agreement - after all, it is the mezzanine lender that typically has the most to gain from such an agreement.
Unfortunately, many mezzanine lenders' starting points are no more reasonable than the forms used by mortgage lenders. This is an area of practice that almost begs to have the parties start from a middle of the road form, perhaps utilizing negotiated samples from prior deals.
For a mortgage lender, some of the key issues to be addressed in the inter-creditor agreement, many of which are keyed off of the viewpoint that the mezzanine lender should have no greater rights than an equity partner in the deal, include the following:
Control. Where both mezzanine lender and mortgage lender have approval rights, the mortgage lender wants its approval to govern. This is one of the most significant issues for a mezzanine lender, because of the conflicting interests that the mezzanine and mortgage lender may have as a result of their different places in the capital structure. Terrorism insurance is an excellent example of why mezzanine lenders do not want to be subject to the control of mortgage lenders - the interests of the parties are not aligned in the arena of terrorism insurance, as the mortgage lender may be 100% protected, while the mezzanine lender is completely exposed.
Assignment/enforcement. A typical mortgage lender wants to restrict the ability of the mezzanine lender to assign its loan and to restrict the persons who can exercise mezzanine lender's enforcement rights and step into the borrower's shoes without triggering a default under the mortgage loan.
Bankruptcy. The mortgage lender wants the mezzanine lender to (a) assign its rights in a bankruptcy situation to the mortgage lender, (b) waive any rights it may have in a bankruptcy and (c) waive any subrogation rights it may have in a bankruptcy.
Payment subordination/priority. The mortgage lender wants the mezzanine lender to subordinate its payment rights, so that no payments are allowed to be made to the mezzanine lender after a default under the mortgage loan. The mortgage lender also wants the mezzanine lender to agree that (a) it will not acquire a tax or other senior lien and gain priority over the mortgage lender and (b) mortgage lender's protective advances enjoy the same "priority" (payment and lien) as the original advances.
Modifications. The mortgage lender wants the ability to modify the mortgage loan without limitation, while restricting the mezzanine lender's rights to do the same under the mezzanine loan.
Defenses. The mortgage lender wants to have the mezzanine lender waive both marshalling rights and rights to assert defenses to enforcement of the mortgage loan.
Future advances. If the mezzanine lender is advancing construction proceeds, the mortgage lender wants to ensure that these will always be available as provided in the mezzanine loan documents, that the mortgage lender can call for them and that the mezzanine lender's credit is sufficient. This same issue applies from the mezzanine lender's perspective if the senior loan has undisbursed proceeds.
Collateral subordination. The mezzanine lender's lien must be subordinate in any shared collateral, such as cash or letters of credit.
Refinancing. The mortgage lender wants to compel the mezzanine lender to accept a refinancing of the mortgage loan and agree to be similarly "subordinate" to such a loan.
Standstill. The mortgage lender may want the mezzanine lender to agree to a "standstill period," during which time the mezzanine lender will not exercise its rights in a default situation.
The mezzanine lender's key concerns include the following:
Consent. The mortgage lender must consent both to the mezzanine loan and to the exercise of remedies/assumption of the loan by the mezzanine lender. In addition, the mezzanine lender's affiliates and certain pre-approved categories of assignees (e.g., "institutional lenders") should be able to exercise the remedies. If there is a successor of the mezzanine lender that is not permitted to assume the mezzanine loan, such entity should be given more time to pay off the loan, with a waiver of any prepayment fees/lockout restrictions. This is also a bigger issue in the context of a securitization.
Transfer. The mezzanine lender wants the ability to pledge/transfer its mezzanine loan without consent and to clarify that any transfer of the mortgage loan is subject to the provisions of the intercreditor agreement.
Lien subordination/application of proceeds. The mezzanine lender wants to provide that the mortgage lender does not share in the mezzanine lender's equity collateral (or, if they do, that the mortgage lender's lien is subordinate to the interest of the mezzanine lender) and to agree on the application of casualty and condemnation proceeds/letters of credit/cash collateral.
Amendments. In contrast to the mortgage lender, the mezzanine lender wants to restrict or eliminate amendments that may be made to mortgage loan without mezzanine lender's consent (e.g., prohibit changes to the mortgage loan which increase principal, increase interest rate, accelerate mandatory principal payments (except upon default), add kickers/exit fees/otherwise increase obligations, shorten the loan term, spread collateral, cross default and/or cross collateralize, amend or modify transfer provisions, or amend or modify release price/provisions).
Rights to cure/buy mortgage loan. Two critical protections for the mezzanine lender are (a) its right to receive notice of defaults and an opportunity to cure and (b) its right to acquire the senior loan (typically upon default). Typical areas of contention include time periods and, in the purchase context, whether default interest, late charges and prepayment premiums/lockouts should apply.
The tension between the positions of the mortgage lender and mezzanine lender makes a "one size fits all" solution to negotiating intercreditor agreements impractical. Although some mortgage lenders are moving towards a "middle of the road" starting point, common practiceis still to start from a one-sided form that requires serious negotiation. The purposes of the parties would be better served by agreeing on the framework of a compromise up front.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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