United States: Intercreditor Issues: Impact Of Select Recent Decisions On Intercreditor Rights

The explosive growth of mezzanine and other types of subordinate commercial real estate lending during the last two decades was enabled, in part, by the relative standardization of the intercreditor arrangements that governed the rights and obligations of senior and junior lenders. A sustained rise in real estate values prior to 2007 generally enabled borrowers to re-finance maturing debt. As a result, the universe of case law interpreting common provisions in the common forms of intercreditor agreements used in these transactions is quite limited. However, in the aftermath of the liquidity crises, a number of recent decisions have contributed to the body of case law in this area, with important repercus-sions for senior and junior lenders alike.

In December 2011, two courts, following Bank of America, N.A. v. PSW NYC LLC¹ (commonly known as the "Stuy Town" case), each held that language in the applicable intercreditor agreement required a foreclosing mezzanine lender, as a condition to completing its UCC foreclosure, to cure existing defaults under the related mortgage loan. When a mortgage loan has been accelerated or is in maturity default, these holdings require the mezzanine lender to repay the mortgage loan in full before complet-ing a UCC foreclosure.

Separately, in a transaction involving separate senior and subordinate mortgage loans, the United States Bankruptcy Court for the District of Massachusetts also considered the applicable intercreditor agreement in confirming a debtor's plan of reorganization over the objection of a senior mortgage lender. In this case, which was decided in favor of the junior mortgage lender, the Court followed the rationale laid out in Bank of America, N.A. v. North LaSalle Limited Partnership (In re 203 North LaSalle Street Partnership),² in holding that the assignment of a junior mortgage lender's voting rights contained in an intercreditor agreement is unenforceable in a bankruptcy case.

This DechertOnPoint discusses the holdings of these important recent cases.

The Stuy Town Decision and Its Progeny

In the highly publicized Stuy Town decision, a New York state judge blocked a mezzanine lender's proposed UCC foreclosure sale on the grounds that the intercreditor agreement required the mezzanine lender to first "cure all Senior Loan defaults."³ Because the senior loan was in maturity default, the mezzanine lender was effectively required to repay the mortgage loan in full as a condition precedent to the UCC foreclosure.

Following the Stuy Town decision, it was unclear whether other courts would adopt the holding. Several potentially distinguishing facts at issue in Stuy Town made the case seemingly unique. The mezzanine lender had purchased a piece of the mezzanine debt at a steep discount imme-diately prior to commencing its mezzanine loan foreclosure.⁴ The principal of the mezzanine lender was also quoted in the press as stating his intention to file the mortgage borrower into bankruptcy following the comple-tion of the mezzanine foreclosure. The disposition of the property at issue in Stuy Town would also affect the housing of tens of thousands of middle class New Yorkers. Two recent cases, however, from the United States District Court for the District of Arizona and from a New York State court, have shown that at least some courts are following the Stuy Town precedent.

The emerging trend in these cases has been to determine whether to grant the mortgage lender a preliminary injunction, blocking the mezzanine lender's UCC foreclosure, by focusing primarily on three sections of the intercreditor agreement addressing, respectively, express conditions to a UCC foreclosure, implied conditions to a UCC foreclosure, and the mortgage lender's right to injunctive relief.

Express Conditions to a UCC Foreclosure

Each of the intercreditor agreements in the subject cases included a similar provision laying out express conditions precedent to the mezzanine lender's UCC foreclosure. In U.S. Bank National Association v. RFC CDO 2006-1, Ltd., ⁵ the U.S. District Court for the District of Arizona noted that Section 5(a) of the intercreditor agreement provided, in relevant part, that the transferee of the equity collateral being sold in a UCC foreclosure receive prior rating agency confirmation unless (i) the transferee is a "Qualified Transferee," (ii) the property will be managed by a "Qualified Manager" promptly after the mezzanine foreclosure and (iii) hard cash management will be implemented, if not already in place. The satisfaction of these conditions precedent to a UCC foreclosure was not disputed in any of the subject cases described here.

Implied Conditions to a UCC Foreclosure

Similarly, each of the intercreditor agreements in the subject cases included a similar provision that the courts interpreted as an implied condition precedent to the mezzanine lender's UCC foreclosure. Section 6(d) of the intercreditor agreement in Stuy Town provided, in relevant part:

The mezzanine lender in Stuy Town argued that Section 6(d) was intended to protect the mezzanine lender and that it limited the circumstances in which the mortgage lender could accelerate the mortgage loan solely by reason of a mezzanine foreclosure. Under this interpretation, in cases where the mortgage loan was in maturity default or had already been accelerated, the language in 6(d) would be moot. The mezzanine lender also noted that Section 6(a) of the intercreditor agreement, which contained the express conditions precedent to a UCC foreclosure similar to those in U.S. Bank, recognized the right of a mezzanine lender to foreclose on its equity collateral and specifically listed the conditions precedent to realizing upon such collateral. If curing the mortgage loan was a precondition to a mezzanine foreclosure, according to the mezzanine lender, it would have been listed in Section 6(a) rather than 6(d). The failure of the mezzanine lender to cure defaults under the related mortgage loan would not, according to the mezzanine lender, prevent the mezzanine lender from completing its UCC foreclosure but would merely permit the mortgage lender to pursue its remedies under the related mortgage loan documents. The Stuy Town court and the U.S. Bank court each found these arguments unpersuasive, holding that the mezzanine lender was required to cure existing mortgage loan defaults as a condition precedent to its UCC foreclosure, effectively requiring repayment of the mortgage loans in full where the mortgage loans had matured or had been accelerated.

Injunctive Relief

In CSMSC 2007-C2 Broadway Portfolio II, LLC v. OREP/Oxford HY Venture Funding 4, L.P., ⁷ as in Stuy Town and U.S. Bank, the courts upheld the enforceability of provisions in the applicable intercreditor agreements in which the parties agreed that monetary damages would be insufficient to remedy a breach of the intercreditor and that injunctive relief should be granted. In each case, the mortgage lender filed suit seeking a preliminary injunction to enjoin the acquisition or sale of the mezzanine collateral until all amounts due under the mortgage loan were paid off in full.

In Broadway Portfolio II, the court discussed balancing the equities among the parties, but found little sympathy for the mezzanine lender. The court noted that, if the mezzanine lender were prevented from proceeding with its foreclosure, the mezzanine lender's only real asset would remain subordinated to the mortgage lender's security interest, but the court emphasized that this risk was contemplated by the terms of the intercreditor agreement. The court further noted that any excess proceeds remain-ing following the mortgage loan foreclosure would inure to the benefit of the mezzanine lender and, as such, the equities did not tip in favor of the mezzanine lender. As in U.S. Bank, the court declined to distinguish between the concepts of subordination and standstill, relying on the intercreditor agreement provisions providing for subordi-nation to support its interpretation that the intercreditor agreement implicitly required a full standstill of the mezzanine lender's right to foreclose unless the mortgage loan defaults were cured.

In each of Stuy Town, U.S. Bank and Broadway Portfolio II, the court cited the alleged intent of each mezzanine lender to orchestrate the related mortgage borrower's bankruptcy following the mezzanine lender's UCC foreclosure. In U.S. Bank, the court also recognized that the intercreditor agreement expired pursuant to its terms on the completion of a mezzanine loan foreclosure and, therefore, intercredi-tor provisions prohibiting the mezzanine lender from filing the mortgage borrower into bankruptcy would be inapplic-able following the mezzanine foreclosure.

In each of U.S. Bank and Broadway Portfolio II, the court enjoined the mezzanine lender's UCC foreclosure action unless the mezzanine lender cured the mortgage loan default in full at the time of the acquisition of the equity collateral.

Assignment of Rights in Bankruptcy

In another case, involving a senior mortgage loan and subordinate mortgage loan structure (and not a mezzanine loan) which went in favor of the junior mortgage lender, a Bankruptcy Court held an intercreditor provision assigning a junior mortgage lender's rights in bankruptcy to the senior mortgage lender to be unenforceable. In In re SW Boston Hotel Venture, LLC,⁸ the United States Bankruptcy Court for the District of Massachusetts ruled that a junior mortgage lender's right to vote its claim in a bankruptcy proceeding is a substantive right that cannot be waived.

SW Boston Hotel Venture, LLC ("SW Boston") owned the Boston W Hotel and a related condominium project and obtained construction financing from a senior mortgage lender. In order to complete construction of the project, SW Boston also obtained a junior mortgage loan. The junior mortgage lender entered into an intercreditor and subordination agreement with the senior mortgage lender pursuant to which the junior mortgage lender agreed to subordinate its rights of payment to those of the senior mortgage lender under its senior loan. Pursuant to the terms of the intercreditor agreement, the junior mortgage lender also assigned to the senior mortgage lender its voting rights in the event of any bankruptcy case involving SW Boston.

In April 2010, SW Boston and its related entities filed a Chapter 11 petition for bankruptcy. In June 2011, the debtors filed a modified and amended plan of reorganiza-tion (the "Plan") that they sought to confirm over the objection of the senior mortgage lender. All of the other classes of creditors, including the junior mortgage lender, voted in favor of the Plan. The senior mortgage lender submitted a ballot rejecting the Plan on behalf of itself and a ballot on behalf of the junior mortgage lender, despite the junior mortgage lender having filed its own vote in favor of the Plan. The senior mortgage lender requested that the bankruptcy court strike the junior mortgage lender's vote and rule that the junior mortgage lender had rejected the Plan. SW Boston and the junior mortgage lender opposed the senior mortgage lender's exercise of the junior mortgage lender's voting rights, and further argued that as the senior mortgage lender was the only objecting creditor, the Plan should be confirmed as a "cramdown" plan.

The bankruptcy court held that the assignment of the junior mortgage lender's voting rights was unenforceable. Acknowledging that 11 U.S.C. § 510(b) provides for the enforceability of subordination agreements, the bankrupt-cy court went on to explain that a subordination agreement may not nullify or alter substantial rights under the Bankruptcy Code. Citing North LaSalle, the bankruptcy court reasoned that an assignment of voting rights in a future Chapter 11 case to a senior lender was contrary to the substantive rights conferred upon creditors under 11 U.S.C. § 1126(a) of the Bankruptcy Code and thus unenforceable. The bankruptcy court emphasized North LaSalle's holding that, because Congress did not intend to permit creditors to alter substantive provisions of bank-ruptcy law, a creditor cannot waive its rights to vote on a bankruptcy plan. The junior mortgage lender's vote accepting the Plan was therefore upheld as valid.

The bankruptcy court went on to confirm the Plan, holding that it satisfied the requirements of a "cramdown" under 11 U.S.C. 1129(a) of the Bankruptcy Code.

Significance of the Decisions

The decisions in Stuy Town, U.S. Bank, and Broadway Portfolio II suggest that courts have little patience with mezzanine lenders, or at least mezzanine lenders that the courts believe will file mortgage borrowers into bankruptcy upon completing a UCC foreclosure. However, the decision in SW Boston indicates that there are some limits to how far bankruptcy courts will go to serve senior lenders, particularly where a senior lender seeks to block confirma-tion of a plan otherwise approved by the debtor and other creditors.

Footnotes

1 Bank of America N.A. v. PSW NYC LLC, 2010 WL 4243437 (N.Y. Sup. Ct. Sept. 15, 2010) (unre-ported).

2 246 B.R. 325 (Bankr. N.D. Ill. 2000).

3 PSW, 2010 WL 4243437 at *5.

4 PSW, 2010 WL 4243437 at *4.

5 Case No. 4:2011cv00664 (D. Ariz. Dec. 6, 2011) (unreported

6 PSW, 2010 WL 4243437 at *5.

7 Index No. 652809/2011 (N.Y. Sup. Ct. Dec. 15, 2011) (unreported).

8 2011 WL 5520928 (Bank. D. Mass. Nov. 14, 2011).

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