One of the more material provisions in an intercreditor agreement between a mortgage lender and a mezzanine lender is the “payment subordination” provision. A typical payment subordination provision provides that, after the occurrence of a mortgage loan default, senior lender (i.e., mortgage) will have the right to be repaid under its senior loan prior to junior lender (i.e., mezzanine) being repaid any portion of the junior loan with respect to payments from the borrower or any proceeds from the loan collateral.
Lien Subordination Distinguished
Payment subordination should not be confused with lien subordination. Lien subordination establishes the rights between senior and junior secured parties to the same collateral, whereby proceeds from the collateral are first paid to the senior lienholder and any remaining proceeds will be paid to the junior lienholder only after the senior lienholder has been paid in full. Lien subordination is not paramount in the mezzanine loan context because mortgage lenders and mezzanine lenders hold security interests in separate collateral, but payment subordination is a central component of any mortgage-mezzanine intercreditor arrangement. As such, mezzanine lenders and their counsel should be mindful to avoid overbroad payment subordination provisions while negotiating their intercreditor agreements.
A recent case, In Re MPM Silicones, 15-CV-2280(NSR), 2019 WL 121003, highlights the distinction between lien subordination and payment subordination. In that case, the court affirmed the Bankruptcy Court for the Southern District of New York’s order granting defendant second lien noteholders’ (the juniors) motion to dismiss, holding that the juniors did not violate their intercreditor agreement (ICA) when they accepted shares of the reorganized debtor’s new common stock and certain fees from debtor’s cash collateral before the senior secured note holders (the seniors) were paid in full.
This holding hinged on the court’s determination that (i) the new equity was not proceeds of the common collateral and (ii) the juniors, which held both secured and unsecured notes, acted as unsecured (but not secured) creditors when they voted in favor of the reorganization plan and accepted these benefits. The court held that the ICA provided the juniors with “unfettered reign” to act against the debtor when doing so in their capacity as unsecured creditors.
Although the court ultimately decided that the juniors did not violate the ICA, in its discussion of the various tranches of debt, the court stated that “[g]enerally speaking, the first lien noteholders have first priority… [and] the second lien noteholders may [not] exercise remedies as secured lenders to reach the common collateral or its proceeds before the first lien noteholders are paid in full.” The court went on to explain, in its interpretation of specific ICA provisions, that “the seniors’ liens have complete priority over the [juniors’] liens,” and “the [juniors] will not take or receive any part of the common collateral, including its proceeds, until the Seniors’ claims are fully discharged.”
The court’s conclusion essentially restated the proposition that payment subordination is inextricably linked to lien subordination. That is, any payments that were subject to the lien subordination were also covered by the payment subordination.
Typically, a mortgage-mezzanine intercreditor agreement will allow a mezzanine lender to receive payments prior to a mortgage loan default, but, after a mortgage loan default, mezzanine lender must hold any payments or distributions received in trust and turn them over to senior lender until senior lender is paid in full. Accordingly, as discussed below, there are three situations in which mezzanine lenders and their counsel must limit the scope of the payment subordination provision.
The first such situation occurs when reserves are established for the benefit of the mezzanine lender from the proceeds of the mezzanine loan. A broad construction of the payment subordination provision would preclude mezzanine lender, after a mortgage loan default, from applying funds held in such reserves prior to the senior loan being paid in full (e.g., applying interest reserve funds to the payment of interest under the mezzanine loan). Thus, mezzanine lenders must negotiate to have payments from reserves expressly carved out of any payment subordination.
Secondly, mezzanine lenders must have the right, after a mortgage loan default, subject to the other applicable provisions of the intercreditor agreement (including, the mezzanine lender’s obligation to cure the mortgage loan default) to effectuate a UCC foreclosure sale. The mezzanine lender must also be permitted to credit bid at the auction in addition to accepting third party bids, and to apply the proceeds of such sale (in the event of a sale to a third party) to the outstanding mezzanine debt. The mortgage lender should not object to this provision because, even though the mezzanine loan will (at least partially) be paid off prior to the mortgage loan, the mortgage loan default would have been cured and, with the mezzanine loan out of the debt stack, the mortgage lender will be free to negotiate any restructuring of the mortgage loan solely with the mortgage borrower.
The third carve out to payment subordination that mezzanine lenders must succeed in negotiating into the intercreditor agreement is the right to sell the mezzanine loan, even after a mortgage loan default, to a third party investor. Such investor would likely purchase the mezzanine loan at a discount with a view towards curing the mortgage loan default and exercising remedies under the mezzanine loan. In such a scenario, the mortgage lender benefits by having its loan made current again without needing to foreclose on the mortgage collateral or otherwise engage in a workout with the mortgage borrower.
Often, it should be noted, after the occurrence of a mortgage loan default, which in turn would place the mezzanine loan in default, mezzanine lenders are incapable of exercising remedies because they may not have the funds to cure the mortgage loan default, which cure is commonly a condition precedent to permitting a UCC foreclosure. If a mezzanine lender cannot cure the mortgage loan default and exercise remedies, the mortgage lender then is usually left with no alternative but to foreclose on the real estate due to the fact that the continuing existence of the mezzanine loan is a barrier to restructuring the mortgage loan.
Most intercreditor agreements between mortgage and mezzanine lenders follow the Commercial Mortgage Securities Organization (CMSA) form, which can be found on the Commercial Real Estate Finance Counsel website. The language from Section 9 of the CMSA form provides that “mezzanine lender shall not accept or receive payments…from borrower and/or from the premises prior to the date that all obligations…under the senior loan documents are paid.”
Once a mortgage loan default occurs, “senior lender shall…receive payment and performance in full of all amounts due…to senior lender before mezzanine lender is entitled to receive any payment on account of the mezzanine loan. All payments or distributions…received by mezzanine lender contrary to the provisions of this agreement shall be received and held in trust by the mezzanine lender for the benefit of senior lender and shall be paid over to senior lender…” “[P]rovided that no event of default shall then exist under the senior loan documents, mezzanine lender may accept payments of any amounts…which mezzanine borrower is obligated to pay mezzanine lender…and mezzanine lender shall have no obligation to pay over to senior lender any such amounts.”
An additional right the mezzanine lender would want to have is the ability to accept a discounted payoff of the mezzanine loan. However, the general payment subordination provision set forth in the paragraph above is, at best, ambiguous as to whether the mezzanine lender has such a right. Mezzanine lenders should attempt to clarify this ambiguity directly with the mortgage lender by negotiating an express right to receive a discounted payoff.
If, however, the mortgage lender is not willing to agree to this clarification, mezzanine lenders should, alternatively, negotiate the right to sell the mezzanine loan to a borrower affiliate, subject to no guarantor financial covenants being breached as a consequence and the terms of the intercreditor agreement relating to sales of loans otherwise being satisfied. As discussed above, mezzanine lenders typically do not have the ability to cure a mortgage loan default, and, due to the existence of the mezzanine loan, mortgage lenders cannot negotiate a workout with the mortgage borrower without the consent of the mezzanine lender.
Given these potential pitfalls inherent in overbroad intercreditor payment subordination provisions, it behooves mezzanine lenders and their counsel to limit the impact of such provisions wherever possible in order to retain as much freedom and flexibility as possible during a mortgage loan default, which will often benefit all parties throughout the debt stack rather than just mezzanine lenders themselves.
Specifically, after a mortgage loan default, the mezzanine lender should have the right to (i) apply funds held in a mezzanine loan interest reserve to the payment of mezzanine loan interest, (ii) provided all of the other applicable provisions of the intercreditor agreement are complied with, foreclose on the UCC collateral, credit bid at the auction and apply the proceeds of any sale of the collateral to a third party to the mezzanine debt and (iii) sell the loan to a third party investor.
Additionally, mezzanine lenders should try to clarify the payment subordination provision in order to expressly permit them to accept a discounted payoff from the mezzanine borrower or, alternatively, sell the mezzanine loan to a borrower affiliate.
Jeffrey B. Steiner and David Broderick are partners at McDermott Will & Emery LLP. John Bauco and Sean Thorsen, associates at the firm, assisted in the preparation of this article.