Two new cases concerning disputes between senior lenders and mezzanine lenders suggest that the general principle that New York courts will strictly enforce arms-length commercial real estate agreements may not be quite the hard-and-fast rule that many expect it to be. These cases involve loan structures that are substantively similar to the now well-known Bank of America v. PSW NYC (Stuyvesant Town) case concerning the Stuyvesant Town apartment complex.1 The cases indicate that in light of the current state of the real estate market, the strategy of purchasing mezzanine loans at a deep discount with the intention to quickly foreclose those positions carries with it real litigation risk.

‘Stuyvesant Town’

The leading case dealing with mezzanine lenders’ rights to foreclose on equity collateral while the senior loan is in default is Stuyvesant Town. In that decision, the New York Supreme Court conducted a thorough analysis of the relevant intercreditor agreement that purported to define the relative rights of the senior lender and the mezzanine lender.2 The case arose after the most junior mezzanine lender, who had recently purchased the mezzanine loan in a private transaction, initiated a foreclosure proceeding, seeking to take control of the borrower entity.3 The senior lender, however, sought to stop that foreclosure by seeking a preliminary injunction.4 The Stuyvesant Town court granted the injunction and stopped the mezzanine foreclosure.5 According to the court, the central issue was whether the intercreditor agreement permitted a transferee at the foreclosure sale of the borrower’s equity collateral to take the collateral without first curing a senior loan default.6 Section 6(d) of that intercreditor agreement provided:

To the extent that any Qualified Transferee acquires the Equity Collateral pledged to a Junior Lender pursuant to the Junior Loan Documents in accordance with the provisions and conditions of this agreement…such Qualified Transferee shall acquire the same subject to (i) the Senior Loan and the terms, conditions and provisions the Senior Loan Documents and (ii)…all defaults under (1) the Senior Loan and the applicable Senior Junior Loans, in each case which remain uncured or unwaived as of the date of such acquisition have been cured by such Qualified Transferee[.]7

The foreclosing mezzanine lender argued that this contract provision, Section 6(d), “does not impose a pre-condition to the acquisition of equity collateral, but rather, applies only after the acquisition[.]“8 Instead, the mezzanine lender argued that it had no obligation to cure the default under the senior loan and that if it did not do so the only consequence would be that the senior lender could accelerate the loan (which had already occurred).9 Failure to cure the senior default, it argued, would not invalidate the transfer occasioned by the mezzanine foreclosure.10 The court disagreed. Finding that the foreclosing mezzanine lender was “cherry-pick[ing] the acceleration language,” the court found the agreement unambiguous, since its “plain language obligates [the mezzanine lender] to cure all Senior Loan defaults if [the mezzanine lender] acquires the Equity Collateral.”11 Without curing the senior loan default, the Stuyvesant Town court found, the mezzanine foreclosure could not proceed.12

The lengthy Stuyvesant Town decision, which explored other relevant intercreditor provisions to support its decision, also noted concern about the possibility of the mezzanine lender, who had purchased $300 million face-amount debt for approximately $45 million, effectively taking control of the $5 billion property.13

‘U.S. Bank v. LH Hospitality’

In contrast to the Stuyvesant Town case, in October 2012, the New York Supreme Court denied a preliminary injunction sought by a senior mortgage lender under a similar intercreditor agreement.14 The mezzanine loan was for $35 million and came behind a $165 million senior loan secured by 42 hotel properties. The mezzanine lender sought to foreclose and the senior lender objected. In U.S. Bank, several of the same issues resolved in the Stuyvesant Town decision were raised again during oral argument.

First, as in Stuyvesant Town, the applicable intercreditor agreement provided that only a “Qualified Transferee” would be permitted to foreclose on the mezzanine collateral after: (1) reaffirming in writing that it would be bound by the senior loan documents, and (2) curing any defaults existing under the senior loan.15 Like Stuyvesant Town, the mezzanine lender argued that these two requirements were not preconditions to completing the foreclosure and taking title to the collateral, rather, the transferee could satisfy them after a transfer.16 The mezzanine lender also contended that, in any event, failure to satisfy those conditions only caused an acceleration of the senior loan and would not prevent the mezzanine lender from taking title to the mezzanine collateral.17

Importantly, at oral argument, the mezzanine lender’s counsel conceded that he believed the language in this intercreditor agreement was the same as in the Stuyvesant Town case, but argued that Stuyvesant Town was wrongly decided.18 Making the same argument that the Stuyvesant Town court adopted, senior lender’s counsel attempted to explain that the language obligated the mezzanine lender to cure the senior loan or not be a qualified transferee.19 In this instance, however, the U.S. Bank court was unpersuaded and it denied the preliminary injunction. Significantly, the U.S. Bank court did not explain its ruling on the record or in a written opinion.20

This result, however, may be explained by the following factors. In contrast to Stuyvesant Town, there was no indication during the preliminary injunction hearing that the mezzanine lender purchased the loan at a significant discount from face value or that the mezzanine lender was engaged in behavior intended to do anything other than cut its losses from a loan that it planned to hold to maturity. Thus, the court did not question whether the mezzanine lender had a legitimate interest at stake. Perhaps because the mezzanine lender’s motives were not in question, the court did not conduct an exhaustive balancing-of-the-equities analysis as the court did in Stuyvesant Town.

‘AMR v. Midtown’

Approximately one month later, in November 2012, the New York Supreme Court in AMR v. Midtown went the opposite way and granted a preliminary injunction, staying a foreclosure proceeding initiated by a mezzanine lender.21 There, the senior lender held a $125 million loan secured by a mortgage interest in a ground lease in an Aruban hotel.22 The mezzanine lender had recently purchased the $35 million face value mezzanine loan for an undisclosed amount and scheduled a foreclosure which was to take place two days after the preliminary injunction hearing.23 The purchaser at the foreclosure sale would have controlling rights over the hotel.24 Instead of analyzing the specific terms of the relevant intercreditor agreement, as in Stuyvesant Town, the parties focused on the commercial reasonableness of the proposed sale.25

The court, however, was concerned with the equities of the situation, and the effect a potential bankruptcy filing initiated by the foreclosing mezzanine lender would have.26 Like Stuyvesant Town, a primary concern for the court was that the junior lender seeking to foreclose had only recently purchased the debt, most likely for an amount well below its initial price.27 Thus, the court analyzed the details of the underlying transaction to determine an equitable outcome.

The junior mezzanine lender contended that the proposed sale was commercially reasonable, and that was the only issue contested in the trial documents.28 The senior lender, who was seeking to enjoin the sale, argued that the foreclosure sale was not commercially reasonable because the defendant’s foreclosure bidding process was misleading the market of potential bidders and placed excessive demands on bidders, including a 25 percent deposit on any bids submitted.29 The court, however, focused on the equities of the situation stating, “I’m not disputing your commercial reasonableness…there’s a bigger picture here that I am involved with. I’m not involved with the piece of property in a blighted areas that nobody wants. I’m dealing with…a gorgeous hotel…not[]some sort of brown field property that nobody wants[.]“30

Moreover, the court went on to voice concerns over the potentially opportunistic behavior of the junior lender and particularly, how that would affect the other lenders’ interests. In particular, the court mentioned the potentially disastrous effect a bankruptcy filing would have on all lenders, even nonparty lenders, “[i]f there’s a bankruptcy filing tomorrow or if there’s some other loan that we all don’t know about all of a sudden somebody is now coming in an swooping up the ground lease, what am I going to do to protect their interest[?]“31

As in Stuyvesant Town, the court was troubled by the fact that the foreclosing mezzanine lender had purchased the $35 million loan at significantly below par. It stated concerns that the mezzanine lender had initiated the foreclosure in order to wipe out other non-party junior mezzanine lenders and take control of the equity in the hotel, which a recent appraisal valued in excess of $100 million.32 The court, addressing defendant, stated “you have $35 million loan that I don’t know how much you paid for, first of all. You could have paid a million dollars for it, I don’t know. Now I’m going to let you foreclose on a $35 million when you invested $1 million on a piece of property that’s worth $300 million?”33 In fact, the court went so far as to ask the mezzanine lender’s counsel to call his client to ask how much it purchased the mezzanine loan for, however, the counsel was unable to find an answer.34 In light of this potential unfairness, and certain unresolved discovery issues, the court stayed the foreclosure proceeding.

Conclusion

These cases make plain that, in the context of the current real estate market and sales of commercial loans at steep discounts, courts may be reluctant to strictly enforce intercreditor agreements. Stuyvesant Town, U.S. Bank, and AMR suggest that courts are becoming interested in knowing whether a foreclosing lender is seeking to protect a long-standing position or is using foreclosure as part of an investment or negotiation strategy intended to maximize the return on a recent investment. These cases indicate that counsel in similar cases need to pay particular attention to equitable considerations when advising clients and formulating litigation strategy as foreclosure of mezzanine positions appears to be an area of jurisprudence in New York courts.

Joshua Sohn and Jason Goldstein are members of DLA Piper. Matthew S. McElroy, a law clerk at the firm, assisted in the preparation of this article.

Endnotes:

1. Bank of America v. PSW NYC, 29 Misc.3d 1216(A), 2010 WL 4243437 (N.Y. Sup. Ct. 2010).

2. Id. at *5-6.

3. Id. at *4.

4. Id. at *5-6.

5. Id. at *13-14.

6. Id. at *1.

7. Id. at *2.

8. Id. at *4.

9. Id.

10. Id.

11. Id. at *5.

12. Id. at *13-14.

13. Id. at *4.

14. See U.S. Bank Nat’l Ass’n v. LH Hospitality, Docket No. 653351/2012, Prelim. Inj. Hr’g, 30 (Oct. 17, 2012 N.Y. Sup. Ct.).

15. Id. at 17.

16. Id. at 26.

17. Id. at 27.

18. Id. at 28.

19. Id. at 29.

20. Id. at 30. An interesting distinction between U.S. Bank and Stuyvesant Town was the basis for foreclosure. In Stuyvesant Town the foreclosure occurred after an event of default followed by an acceleration, while the borrower in U.S. Bank was in maturity default. Although the distinction was not discussed by the court, and no opinion was issued, it could help explain why the court was more sympathetic to the mezzanine lender in U.S. Bank than in Stuyvesant Town.

21. See AMR Ventures II v. Midtown Acquisitions, Docket No. 653814/2012, Prelim. Inj. Hr’g, (Nov. 20, 2012 N.Y. Sup. Ct.).

22. Id. at 19.

23. Id. at 16. In addition, there were two junior subordinated loans in the collective principal amount of $70 million.

24. Id. at 17.

25. Id. at 18, 26, 33-36.

26. Id. at 37-40.

27. Id. at 28.

28. Id. at 18, 26, 33-36.

29. Id. at 13-15.

30. Id. at 27.

31. Id. at 37-38.

32. Id. at 9.

33. Id. at 28. Interestingly, the court suggested the idea of giving defendant a court order giving rights and ownership of the LLC at issue pending “[senior lender] paying [junior lender] the $35 million that [it is] owed, and at that point [the junior loan] reverts back to [senior lender.]” And with regards to the $35 million owed to junior lender, the court stated “ [junior lender] shouldn’t get a penny more than that[.]“

34. Id. at 8.