Law & Policy: Foreclose and File? Buyers of Mezzanine Loans May Be Liable for Mortgage Debt
By Michael Hamilton
The purchase of a mezzanine loan in a loan-to-own strategy typically proceeds as follows:
Step 1: Acquire the mezzanine loan;
Step 2: Foreclose on the equity interests in the mortgage borrower; and
Step 3: Work out the mortgage loan.
If Step 3 is unsuccessful, the mezzanine lender might add:
Step 4: Put the mortgage borrower into bankruptcy (the “foreclose-and-file” variation).
The typical impediment to a bankruptcy is the nonrecourse carveout guaranty. A loan that would otherwise be nonrecourse to the guarantor becomes fully recourse if the borrower files for bankruptcy. However, when the mezzanine lender takes control of the mortgage borrower without also assuming the guaranty, that impediment (magically) disappears. Two recent judicial rulings are causing mezzanine debt investors to rethink this strategy.
In the 2010 case of Bank of America, N.A. v. PSW NYC L.L.C., an investor purchased the mezzanine debt relating to a high-profile apartment complex in New York City (at a discount of approximately 85 percent from the $300 million par value). The investor then sought to foreclose on the equity interests securing the mezzanine loan. Press reports also suggested that a foreclose-and-file strategy was afoot. The mortgage lender filed a lawsuit to enjoin the mezzanine lender. The mortgage lender asserted (in part) that the intercreditor agreement between the lenders required that all defaults under the mortgage loan (including the accelerated debt of $3 billion thereunder) must be cured before a foreclosure on the mezzanine loan.
The trial court agreed with the mortgage lender. The PSW ruling focused primarily on a specific provision of the intercreditor agreement stating that if the mezzanine lender acquires the interests in the mortgage borrower, the mortgage loan “shall not be accelerated by (the Mortgage) Lender solely due to such acqusition and shall remain in full force and effect; provided, however, that … all defaults under the Senior Loan … which remain uncured or unwaived as of the date of such acquisition have been cured by (the Mezzanine Lender).” The court interpreted this language as “unambiguous(ly)” requiring the mezzanine lender to pay the outstanding balance of the mortgage loan prior to foreclosing on the equity interests (even if the mortgage loan had been accelerated).
Distressed debt investors expressed disagreement. Mortgage lenders proclaimed it the “right outcome.” Others argued that the PSW court was policy driven—the underlying real estate asset is so important to the New York City community that a bankruptcy must be avoided if at all possible.
In December 2011, the same outcome was reached by a different court. The facts in U.S. Bank National Association et al. v. RFC CDO 2006-1, Ltd. were nearly identical to those in PSW. A mezzanine lender sought to foreclose on the equity interests in a mortgage borrower (in an alleged foreclose-and-file strategy). The mortgage lender sought to enjoin that action. The U.S. District Court concluded that the same language, also present in the intercreditor agreement of the RFC case, was again unambiguous and imposed a condition precedent to the mezzanine lender’s enforcement actions.
Up for Interpretation?
Without regard to whether or not the rulings in PSW and RFC are correct, the language is certainly not unambiguous (as demonstrated by the vigorous debate in the legal community on various listservs). One could interpret the intercreditor language to mean that the mortgage lender will not accelerate the mortgage loan solely as a result of the mezzanine lender taking over the mortgage borrower, as long as the mortgage loan defaults are cured.
In other words, the “cure condition” is not a condition to the foreclosure on the equity by the mezzanine lender but is a condition to the mortgage lender agreeing not to accelerate. Importantly (though not so much to the courts), other provisions of the intercreditor agreement explicitly stated the conditions to a mezzanine lender’s foreclosure action—with phrases such as “Mezzanine Lender shall not exercise any rights it may have … unless … .” The cited language on which the courts relied is not drafted with such conditional phraseology. Whether the outcome was the “right outcome” focuses less on language and more on what was intended and what the outcome “should be.” Mortgage lenders contend that if the mezzanine lender can effectively do an “end-and-around” in this manner, then an unintended weakness in the structure becomes apparent. Mezzanine lenders disagree as to whether such weakness was intended. We would expect a revision to the standard intercreditor agreement to address this issue.
Related Tip for Borrowers and Guarantors:
The foreclose-and-file strategy should prompt borrowers and guarantors to seek limitations on springing recourse provisions of the carveouts guaranty (for bankruptcy) to periods “when the Guarantor remains in control of the Borrower.”
Michael Hamilton is a real estate and finance attorney based in the Los Angeles office of DLA Piper L.L.P. (US).