Jeffrey B. Steiner and David Broderick

This article will discuss three key topics in intercreditor agreements governing the relationship between mortgage and mezzanine lenders, and the evolving standards that are often taken into consideration when negotiating provisions addressing these topics. In particular, these three topics relate to (i) the evolving concept of mortgage lenders requiring either an actual supplemental guaranty or a joinder agreement with respect to the mezzanine lender's obligations under an intercreditor agreement, (ii) whether a mezzanine lender should be permitted to exercise limited voting/control rights on behalf of a mezzanine borrower in order to block certain material actions (such as a bankruptcy filing), and (iii) whether a mezzanine lender should be obligated to allow a mortgage borrower to deliver a deed-in-lieu of foreclosure, including waiving its right to full-recourse liability against a guarantor in connection with the delivery of a deed-in-lieu.

1. Requiring Supplemental Guaranties or Joinder Agreements

In some situations, a mezzanine lender will be a special-purpose entity with segregated liability, whose only asset is the mezzanine loan. When this is the case, the mezzanine lender will have limited assets (i.e., its interest in the mezzanine loan) with which to satisfy judgments against it (assuming for the sake of this article that there is no "veil piercing" or similar claim that would create liability for parties other than the mezzanine lender entity), and a mortgage lender may have concerns that it is not adequately protected against breaches of the terms of the applicable intercreditor agreement.

This is particularly the case with respect to a mezzanine lender's obligations to satisfy conditions precedent to a mezzanine foreclosure action, including causing a credit-worthy entity to deliver replacement guaranties in favor of the mortgage lender. If a mezzanine lender consummates a mezzanine foreclosure action without satisfying the applicable conditions precedent, a mortgage lender is typically left with two choices: (1) to commence a lawsuit nullifying the transfer of the mezzanine lender's collateral on the grounds that the conditions precedent were not satisfied prior to such transfer (the viability of which depends upon applicable state law) or (2) commencing a lawsuit for damages arising from the mezzanine lender's breach of the intercreditor agreement (which may be for naught if the mezzanine lender entity is a special-purpose entity without sufficient assets to satisfy a monetary judgment).

To protect against the risk described in scenario "2" above, a mortgage lender may require that a credit-worthy entity (usually a parent entity of the mezzanine lender) deliver a supplemental guaranty at the time the intercreditor agreement is entered into; however, this can raise authority issues due to the uncertainty of when or if the guarantor will be subject to liability under the supplemental guaranty, and a guarantor may also be reluctant to deliver a supplemental guaranty if it is required to satisfy ongoing financial covenants even when there is no present actual or contingent liability under the supplemental guaranty.

Another possibility is that a credit-worthy entity "backstop" some or all of the mezzanine lender's obligations under the intercreditor agreement. This can take the form of a joinder agreement signed by such credit-worthy entity whereby it agrees to be liable for all of the mezzanine lender's obligations and liabilities under the intercreditor agreement, thus giving the mortgage lender an entity with sufficient assets to satisfy a claim against the mezzanine lender if it breaches the intercreditor agreement.

Where a mezzanine lender is reluctant, however, to cause a credit-worthy entity to execute a joinder, mortgage lenders may accept an emerging concept of a "deemed replacement guarantor," whereby a credit-worthy entity will execute the intercreditor agreement for the sole purpose of being a deemed replacement guarantor with respect to replacement guaranties in favor of the mortgage lender, in a situation where the mezzanine lender consummates a mezzanine foreclosure without satisfying the conditions precedent set forth in the intercreditor agreement (including the obligation to deliver replacement guaranties). This structure can serve to give a mortgage lender comfort that it will not be left without a satisfactory guarantor under the mortgage loan following a mezzanine foreclosure (this is particularly important where the initial guarantor has negotiated for its liability to "cut off" upon a mezzanine foreclosure), while not creating broad potential liability to a mezzanine lender's parent entity for any mezzanine lender breaches of the intercreditor agreement.

2. Limited Voting/Control Rights on Behalf of a Mezzanine Borrower

Part and parcel to any mezzanine loan is the pledge of ownership interests (including control rights) in the mortgage borrower entity to the mezzanine lender as collateral for the mezzanine loan. Increasingly in intercreditor agreements, mortgage lenders are requiring that the mezzanine lender satisfy the conditions precedent that it would otherwise be required to satisfy prior to consummating a mezzanine foreclosure if it wishes to take "active control" over the mortgage borrower entity. The concept of "active control" will be defined in the intercreditor agreement and may be the subject of some negotiation, but typically requires a sustained level of engagement and control over the mortgage borrower, as opposed to taking more limited, intermittent actions in response to specific actions or risks that could harm the mezzanine lender.[1]

From the mezzanine lender's perspective, it may not desire to or practically be able to satisfy the conditions precedent to a mezzanine foreclosure action in limited instances where it wants to exercise control over the mortgage borrower (for example, to prevent a bankruptcy filing), and, therefore, will want to negotiate the right to take certain limited actions without it being deemed to have taken "active control." Furthermore, this structure may benefit the mortgage lender if it prevents the mortgage borrower from taking actions that would also be harmful to the mortgage lender.

The mortgage lender, however, must be careful not to permit sustained, active control over the mortgage borrower without requiring the mezzanine lender to satisfy certain conditions precedent, for fear of being without adequate protection under its loan. For example, the mortgage lender will want the mezzanine lender to delivery replacement guaranties (or, in the situations described in the first section of this article, above, be deemed to have delivered replacement guaranties) if it has taken "active control" over the mortgage borrower even if it has not consummated a mezzanine foreclosure action, because for practical purposes the mezzanine lender has assumed control over the mortgage borrower. This is particularly the case where the initial guarantor has negotiated for its liability to "cut off" when the mezzanine borrower no longer has control over the mortgage borrower or the property.

3. Mezzanine Lender Consent to a Deed-in-Lieu of Foreclosure and Waiver of Recourse Liability

Delivery of a deed-in-lieu of foreclosure is, as you would expect, a matter of greater concern to a mezzanine lender, because it will result in the mezzanine lender's collateral being virtually worthless. In most loan documents, a direct transfer of the property is prohibited and will often result in full-recourse liability to the guarantor (under both the mortgage loan and the mezzanine loan). Recourse liability can act as a deterrent to the mortgage borrower from delivering a deed-in-lieu without the mezzanine lender's express consent, but intercreditor agreements may also address this situation, typically by requiring notice to the mezzanine lender and the opportunity to purchase the mortgage loan prior to the mortgage lender's acceptance of a deed-in-lieu.

Most often, mezzanine lenders will not agree to waive recourse against the guarantor if the mortgage borrower delivers a deed-in-lieu without its consent. This can become a particularly contentious issue in states that have a long judicial foreclosure process, because the tendering of a deed-in-lieu of foreclosure is more appealing to a mortgage lender trying to avoid a drawn-out foreclosure. In an in increasing number of situations, another option is to first require that a mezzanine borrower offer an assignment-in-lieu of foreclosure (with respect to the mezzanine lender's collateral) to the mezzanine lender, which assignment-in-lieu must satisfy certain "tender" requirements set forth in the intercreditor agreement. If the mezzanine borrower tenders an assignment-in-lieu that satisfies such "tender" requirements and the mezzanine borrower does not accept such assignment-in-lieu, then thereafter the mortgage lender would be permitted to accept a deed-in-lieu and the mezzanine lender will waive recourse liability against the guarantor.

Jeffrey B. Steiner and David Broderick are partners at McDermott Will & Emery. David Brigleb, an associate at the firm, assisted in the preparation of this article.

[1] The following is a definition of the term "Active Control" used in a recent transaction: the exercise by [mezzanine lender] or its nominee or designee of (i) any control, (ii) any proxy rights, and/or (iii) any power of attorney granted pursuant to any of the [mezzanine loan documents] with respect to the [mezzanine collateral], or [mortgage borrower] (as to any such exercise by [mezzanine lender]), including, but not limited to, any action taken by [mezzanine lender] pursuant to any such exercise to direct or cause the direction of the management, policies or activities of [mortgage borrower] (as to any such exercise by [mezzanine lender]), including, without limitation, in connection with the commencement of any [bankruptcy proceeding] with respect to the [mezzanine collateral], or [mortgage borrower] (as to any such exercise by [mezzanine lender]) (it being acknowledged and agreed that (i) the mere grant of voting power in the [mezzanine loan documents] shall not constitute taking "Active Control", provided that, the continuing, affirmative exercise of such voting power to direct or cause the direction of the management or policies of [mortgage borrower] (as to any such exercise by [mezzanine lender]), by or on behalf of [mezzanine lender] shall, except as otherwise provided in the following clause (ii), constitute "Active Control" and (ii) the exercise of such voting power solely for the purpose of (x) vetoing or otherwise preventing an action by [mortgage borrower] (as to any such exercise by [mezzanine lender]), that would constitute a "Default" or "Event of Default" under the [mortgage loan documents] or the [mezzanine loan documents], or (y) taking limited, intermittent actions to protect [mezzanine lender's] interest in the [mezzanine loan or mezzanine collateral], in either case, shall not constitute "Active Control"); provided, further, however, that, for the avoidance of any doubt, the foregoing clause (ii) (y) shall not, and shall not be construed to, allow [mezzanine lender], pursuant to the exercise of "Active Control," to authorize or consent to the commencement of any [bankruptcy proceeding] with respect to [mortgage borrower] (as to any such exercise by [mezzanine lender]).