Commercial Real Estate Mezzanine Lending: Current Structural

Commercial Real Estate Mezzanine Lending:

Current Structural Features, Loan Document

Concepts and Intercreditor Issues

Jason S. Rozes, Esq.

Matthew B. Ginsburg, Esq.

Dechert LLP

TABLE OF CONTENTS

Page

18616279.2.BUSINESS

I. WHAT IS A MEZZANINE LOAN? ................................................................................. 2

II. CHARACTERISTICS OF A MEZZANINE LOAN ......................................................... 3

III. COLLATERAL FOR A MEZZANINE LOAN ................................................................ 4

IV. UNIQUE MEZZANINE LOAN DOCUMENT PROVISIONS ....................................... 8

V. MEZZANINE LOAN CONSIDERATIONS IN MORTGAGE LOAN

DOCUMENTS ................................................................................................................. 13

VI. INTERCREDITOR AGREEMENT ISSUES .................................................................. 14

authoritative statement of the law. You should obtain detailed and specific legal advice from a properly licensed attorney before

taking any legal action.

18616279.2.BUSINESS

I. WHAT IS A MEZZANINE LOAN

A. Generally, a mezzanine loan is a type of subordinate real estate financing that

is secured by a pledge of 100% of the equity ownership interests in the owner of

real property. The owner of the subject property will typically be a borrower

under a first mortgage financing whereby the mortgage lender will be granted a

first mortgage lien on the property. As reflected by the diagram below, the

borrower under the mezzanine loan will be the 100% owner of the mortgage

borrower/property owner:

B. To the extent a mortgage lender is willing to permit subordinate

financing, a mezzanine loan is an attractive structure for both the mortgage lender

and the mezzanine lender. As opposed to a second mortgage structure, the

mortgage lender gets comfort that the mezzanine lender does not have a second

lien on the property and the mezzanine lender is not a creditor of the mortgage

borrower. The structure is attractive to mezzanine lenders as they can indirectly

take title to the property from a foreclosure under the uniform commercial code

(“UCC”), rather than an often time-consuming and expensive real property

foreclosure.

C. Mezzanine lenders are typically lenders looking for a higher rate of return

and who are willing to take on more risk. They can include, among others,

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taking any legal action.

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specialty finance companies, REITs, investment banks and life insurance

companies.

D. It is becoming common to structure a loan with a mezzanine loan

component at closing or to include provisions in the loan documents that allow for

mezzanine financing at a future date after closing if certain economic tests and

other conditions are met by the borrower.

II. CHARACTERISTICS OF A MEZZANINE LOAN

A. As with other forms of subordinate financing, mezzanine loans tend to

have higher interest rates than mortgage loans. The increase in interest rate is due

to the higher risk profile of a mezzanine loan as compared to the mortgage

financing. One factor contributing to the higher rate of interest is that mezzanine

loans are not secured by the real property. Any liens recorded against the related

property, whether voluntary or involuntary, will have priority over the mezzanine

loan.

B. The mezzanine loan will have a higher loan to value ratio than the

mortgage loan. Generally, mortgage lenders will loan up to a certain percentage

of the appraised value of the property. Mezzanine loans are used by borrowers to

bridge the gap between the amount of proceeds advanced by the mortgage lender

and borrower’s equity in the property.

C. The mezzanine loan will typically mature on the same date as the related

mortgage loan.

D. The mezzanine loan will typically have the same payment date as the

related mortgage loan.

E. Mezzanine loans can have a fixed interest rate or a floating interest rate.

F. Mezzanine borrowers will typically be structured as single-purpose,

bankruptcy remote entities, in the same manner and subject to the same

requirements as the mortgage loan borrowers.

G. The mezzanine loan is serviced separately from the related mortgage loan

and will have its own servicer. For convenience, the mezzanine lender may

appoint the same servicer as the mortgage lender to process loan payments.

H. The key transaction documents for a mezzanine loan are:

1. Loan Agreement – the central agreement between the mezzanine

borrower and the mezzanine lender setting forth the basic terms of the

loan.

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taking any legal action.

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2. Pledge Agreement – the security agreement pursuant to which the

mezzanine borrower pledges its 100% direct equity interest in the

mortgage borrower as collateral security for the mezzanine loan.

3. Intercreditor Agreement – the governing agreement between the

mortgage lender and the mezzanine lender, setting forth their respective

rights and limitations. This agreement is not usually shared with the

mortgage borrower or the mezzanine borrower as neither borrower is a

party.

III. COLLATERAL FOR A MEZZANINE LOAN

A. A mezzanine loan is secured primarily by a pledge of 100% of the direct

equity interests in the owner of the property, who is the mortgage borrower.

Typically, the mortgage borrower will be structured as a limited partnership or

limited liability company. The creation, priority, perfection and enforcement of

the mezzanine lender’s security interest in such equity interests will be governed

by the UCC.

B. The Article 9 of the UCC provides that equity interests in partnerships and

limited liability companies are defined as “general intangibles”. The only method

to perfect a security interest in a “general intangible” is to file a UCC-1 in the

state of formation of the mezzanine borrower.

C. Generally, mezzanine lenders will require that the equity pledged as

security for the mezzanine loan be converted from an Article 9 general intangible

to a “certificated security” governed by Article 8 of the UCC. By requiring

Article 8 certificated securities, mezzanine lenders are able to take physical

possession of the collateral and their priority is protected against bona-fide

purchasers.

D. In order to effectuate the conversion into Article 8 certificated securities,

language similar to the following should be included in the mortgage borrower’s

operating agreement or limited partnership agreement, as applicable:

“Member’s limited liability company interest in the Company shall be

represented by the Shares (defined below) issued to Member by the

Company. Member's Shares represent Member's entire limited liability

company interest in the Company. Member hereby agrees that its interest

in the Company and in the Shares shall for all purposes be personal

property. Member has no interest in specific Company property.

“Shares” means the limited liability company interest in the Company

held by Member. The limited liability company interest in the Company

shall constitute a "security" within the meaning of, and governed by, (i)

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taking any legal action.

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Article 8 of the Uniform Commercial Code (including Section 8-

102(a)(15) thereof) as in effect from time to time in the State of New York

and (ii) Article 8 of the Uniform Commercial Code of any other applicable

jurisdiction that now or hereafter substantially includes the 1994 revisions

to Article 8 thereof as adopted by the American Law Institute and the

National Conference of Commissioners on Uniform State Laws and

approved by the American Bar Association on February 14, 1995.

Notwithstanding any provision of this Agreement to the contrary, to the

extent that any provision of this Agreement is inconsistent with any non-

waivable provision of Article 8 of the Uniform Commercial Code as in

effect in the State of New York (the “UCC”), such provision of Article 8

of the UCC shall control.”

E. Each such certificate is denominated in terms of the percentage of the

limited liability company interests in the mortgage borrower evidenced by such

certificate and must be signed by a member or an officer on behalf of the

mortgage borrower. A transfer of limited liability company interests in the

mortgage borrower is effected by the mortgage borrower's registering the transfer

upon delivery of an endorsed certificate representing the limited liability company

or limited partnership interests being transferred. At closing, the certificate

should be signed and endorsed in blank. A sample certificate is included below.

Sample Certificated Interest

“CERTIFICATE FOR

_________________ LLC

THIS CERTIFICATE HAS NOT BEEN AND WILL NOT BE

REGISTERED UNDER THE SECURITIES ACT OF 1933 OR UNDER THE

SECURITIES OR BLUE SKY LAWS OF ANY STATE. THE HOLDER OF THIS

CERTIFICATE, BY ITS ACCEPTANCE HEREOF, REPRESENTS THAT IT IS

ACQUIRING THIS SECURITY FOR INVESTMENT AND NOT WITH A VIEW

TO ANY SALE OR DISTRIBUTION HEREOF. ANY TRANSFER OF THIS

CERTIFICATE OR ANY LIMITED LIABILITY COMPANY INTEREST

REPRESENTED HEREBY IS SUBJECT TO THE TERMS AND CONDITIONS

OF THE LIMITED LIABILITY COMPANY AGREEMENT (AS DEFINED

BELOW).

Certificate Number _____ _____% of Interests

________________________ LLC, a Delaware limited liability company (the

"Company"), hereby certifies that ______________________ (the "Holder") is the

registered owner of ______ % of the limited liability company interests in the Company

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taking any legal action.

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(the "Interests"). THE RIGHTS, POWERS, PREFERENCES, RESTRICTIONS

(INCLUDING TRANSFER RESTRICTIONS) AND LIMITATIONS OF THE

INTERESTS ARE SET FORTH IN, AND THIS CERTIFICATE AND THE

INTERESTS REPRESENTED HEREBY ARE ISSUED AND SHALL IN ALL

RESPECTS BE SUBJECT TO THE TERMS AND PROVISIONS OF, THE LIMITED

LIABILITY COMPANY AGREEMENT OF THE COMPANY, DATED AS OF

___________ __, 20__, AS THE SAME MAY BE AMENDED OR RESTATED FROM

TIME TO TIME (THE "AGREEMENT"). THE TRANSFER OF THIS CERTIFICATE

AND THE INTERESTS REPRESENTED HEREBY IS RESTRICTED AS

DESCRIBED IN THE AGREEMENT. By acceptance of this Certificate, and as a

condition to being entitled to any rights and/or benefits with respect to the Interests

evidenced hereby, the Holder is deemed to have agreed to comply with and be bound by

all the terms and conditions of the Agreement. The Company will furnish a copy of the

Agreement to the Holder without charge upon written request to the Company at its

principal place of business. The Company maintains books for the purpose of registering

the transfer of Interests.

Each limited liability company interest in the Company shall constitute a

"security" within the meaning of, and governed by, (i) Article 8 of the Uniform

Commercial Code (including Section 8-102(a)(15) thereof) as in effect from time to time

in the State of Delaware, and (ii) Article 8 of the Uniform Commercial Code of any other

applicable jurisdiction that now or hereafter substantially includes the 1994 revisions to

Article 8 thereof as adopted by the American Law Institute and the National Conference

of Commissioners on Uniform State Laws and approved by the American Bar

Association on February 14, 1995.

This Certificate shall be governed by and construed in accordance with the laws

of the State of Delaware without regard to principles of conflicts of laws.

IN WITNESS WHEREOF, the Company has caused this Certificate to be

executed by [__________________] as of the date set forth below.

Dated: _____________________

________________________________

Name:

Title:

(REVERSE SIDE OF CERTIFICATE

FOR INTERESTS OF _________ LLC)

FOR VALUE RECEIVED, the undersigned hereby sells, assigns and

transfers unto _____________________________________________________ (print or

typewrite name of Transferee), __________________ (insert Social Security or other

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taking any legal action.

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taxpayer identification number of Transferee), the following specified percentage of

Interests: ______________ (identify the percentage of Interests being transferred), and

irrevocably constitutes and appoints __________________________, as attorney-in-fact,

to transfer the same on the books and records of the Company, with full power of

substitution in the premises.

Dated: ______________________ Signature:_______________________

(Transferor)

Address:”

F. Mezzanine lenders should also be cognizant to include a provision in the

mortgage borrower’s operating agreement or limited partnership agreement, as

applicable, which provides that upon the foreclosure of the mezzanine lender’s

pledge of mortgage borrower’s equity, the mezzanine lender will be automatically

admitted as a member of the mortgage borrower. Without this provision, the

foreclosing mezzanine lender could be exposed to an argument that even though

the mezzanine lender owns 100% of the equity in the mortgage borrower, the

mezzanine lender would not be able to direct the actions of the mortgage

borrower without the consent of the mezzanine borrower. See below for a sample

provision which should be included:

“Upon a foreclosure, sale or other transfer of the limited liability company

interests of the LLC pursuant to that certain Pledge and Security

Agreement (the “Mezzanine Pledge Agreement”), between Member and

Mezzanine Lender, the holder of such membership interests shall

automatically be admitted as the sole Member of the LLC upon such

foreclosure, sale or other transfer, with all of the rights and obligations of

all of the Members hereunder, at which time [Manager]

shall, at the

option of such sole Member, be immediately terminated and have no

further rights whatsoever with respect to the LLC or the Property. The

LLC acknowledges that the pledge of the membership interest in the LLC

made by the Member in connection with the Mezzanine Pledge Agreement

shall be a pledge not only of profits and losses of the LLC, but also a

pledge of all rights and obligations of all of the Members. Upon a

foreclosure, sale or other transfer of the membership interests of the LLC

pursuant to the Mezzanine Pledge Agreement, the successor Member may

transfer its interests in the LLC as it deems necessary or desirable. The

pledge of a membership interest in the LLC by the Member is,

notwithstanding anything contained herein, permitted hereby and shall not

cause the Member to cease to be a member of the LLC.”

In the event the mortgage borrower is “manager managed”, the foreclosing mezzanine lender should have

an explicit right to terminate the manager upon a foreclosure.

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taking any legal action.

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IV. UNIQUE MEZZANINE LOAN DOCUMENT PROVISIONS

In connection with the origination of a mezzanine loan, the common practice is to

draft the mezzanine loan documents based closely on the related mortgage loan

documents. Many of the negotiated deal terms, including representations and

warranties, covenants, insurance provisions, events of default, and payment terms

should be the same in the mortgage and mezzanine loans, so it is efficient and

practical to base the mezzanine loan documents on the related mortgage loan

documents. In addition to reflecting the specific deal terms related to the mezzanine

loan, there are several unique provisions that should be added to the mezzanine loan

documents.

A. Representations and Warranties Relating to Mortgage Loan. In addition to

the customary representations and warranties regarding the property, the equity

collateral and the borrower parties, the mezzanine borrower should make certain

representations and warranties relating to the mortgage loan, including the

following:

1. “All of the representations and warranties contained in the

Mortgage Loan Documents are (i) true and correct in all material respects

and (ii) hereby incorporated into this Agreement and deemed made

hereunder as and when made thereunder and shall remain incorporated

without regard to any waiver, amendment or other modification thereof by

the Mortgage Lender or to whether the related Mortgage Loan Document

has been repaid or otherwise terminated, unless otherwise consented to in

writing by Lender.”

2. “No Mortgage Loan Event of Default or an event of circumstance

has occurred which with the giving of notice or the passage of time, or

both, would constitute a Mortgage Loan Event of Default exists as of the

date hereof.”

B. Specific Covenants.

1. Liquidation Events. It is critical that the mezzanine loan

documents contain a covenant that the mezzanine borrower be obligated to

pay to Lender all amounts received by the mortgage borrower in

connection with a casualty, condemnation, foreclosure of the mortgage

loan or refinancing of the mortgage loan, net of certain approved

deductions. As a result of the subordinate nature of a mezzanine loan, the

mortgage lender will be entitled to recieve proceeds from any of the

foregoing first and prior to the mezzanine lender. In the event that there

are excess proceeds after repayment of the mortgage loan, such amounts

should be paid to the mezzanine lender rather than being distributed to the

mortgage borrower’s equity owners. Below is a sample provision:

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taking any legal action.

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“(a) In the event of (i) any Casualty, (ii) any Condemnation, (iii) a

foreclosure or deed-in-lieu of foreclosure of the property (a

“Mortgage Loan Foreclosure Transfer”) or (iv) any refinancing

of the Mortgage Loan (each, a “Liquidation Event”), Borrower

shall cause Mortgage Borrower to cause the related Net

Liquidation Proceeds After Debt Service to be deposited directly

into an account designated by Lender (to be treated as a

distribution by the Mortgage Borrower). On each date on which

Lender actually receives a distribution of Net Liquidation Proceeds

After Debt Service, such distribution shall be applied in the same

manner as repayments under Section [__] hereof, and such

prepayment shall include any [Short Interest] and [Breakage

Costs]. Notwithstanding anything to the contrary contained herein,

each prepayment under this Section shall be applied in inverse

order of maturity and shall not extend or postpone the due dates of

the monthly installments due under the Note or this Agreement, or

change the amounts of such installments.

(b) Borrower shall notify Lender of any Liquidation Event not

later than three (3) Business Days following the first date on which

Borrower has knowledge of such event. Borrower shall be deemed

to have knowledge of a Mortgage Loan Foreclosure Transfer on

the date notice of such Mortgage Loan Foreclosure Transfer is

given to Mortgage Borrower and a refinancing of the Mortgage

Loan on the date on which a commitment for such refinancing has

been entered into by Mortgage Borrower. The provisions of this

Section shall not be construed to contravene or modify in any

manner the restrictions and other provisions regarding refinancing

of the Mortgage Loan or Transfers set forth in this Agreement.”

“Net Liquidation Proceeds After Debt Service” mean with

respect to any Liquidation Event, all amounts paid to or received

by or on behalf of Mortgage Borrower in connection with such

Liquidation Event, including, without limitation, proceeds of any

sale, refinancing or other disposition or liquidation, less (i) in the

event of a Liquidation Event consisting of a Casualty or

Condemnation, Lender’s, Mortgage Borrower’s and/or Mortgage

Lender’s reasonable costs incurred in connection with the recovery

thereof, (ii) in the event of a Liquidation Event consisting of a

Casualty or Condemnation, the costs incurred by Mortgage

Borrower in connection with a Restoration in accordance with the

Mortgage Loan Documents, (iii) in the event of a Liquidation

Event consisting of a Casualty, Condemnation or Mortgage Loan

Foreclosure Transfer, amounts required or permitted to be

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taking any legal action.

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deducted therefrom and amounts paid pursuant to the Mortgage

Loan Documents to Mortgage Lender, (iv) in the event of a

Liquidation Event consisting of a Casualty or Condemnation, those

proceeds paid to Mortgage Borrower pursuant to Section [__] of

the Mortgage Loan Agreement as a surplus that remains out of the

Net Proceeds, (v) in the case of a Mortgage Loan Foreclosure

Transfer, such reasonable and customary costs and expenses of

sale or other disposition (including attorneys’ fees and brokerage

commissions), (vi) in the case of a Mortgage Loan Foreclosure

Transfer, such costs and expenses incurred by Mortgage Lender

under the Mortgage Loan Documents as Mortgage Lender shall be

entitled to receive reimbursement for under the terms of the

Mortgage Loan Documents, (vii) in the case of a refinancing of the

Mortgage Loan, such costs and expenses (including attorneys’

fees) of such refinancing, and (viii) the amount of any prepayments

required pursuant to the Mortgage Loan Documents in connection

with any such Liquidation Event.”

2. Mortgage Borrower Covenants. The mezzanine loan documents

should require the mezzanine borrower to cause the mortgage borrower to

comply with the provisions of the mortgage loan documents. This is

possible because the mezzanine borrower is the 100% owner of the

mortgage borrower and can cause the mortgage borrower to take actions

(i.e. comply with the mortgage loan documents). It is important that the

mezzanine lender require compliance with the mortgage loan documents,

because an event of default under the mortgage loan could result in a

mortgage loan foreclosure which would render the equity collateral

securing the mezzanine loan worthless. The mezzanine loan documents

should also include covenants prohibiting the amendment of the mortgage

loan or purchase of the mortgage loan without the mezzanine lender’s

consent. Examples of these covenants include the following:

“(a) Borrower shall cause Mortgage Borrower, in a timely manner,

subject to any applicable cure periods under the Mortgage Loan

Documents, to observe, perform and fulfill each and every

covenant, term and provision of each Mortgage Loan Document

whether the Mortgage Loan has been repaid or the applicable

Mortgage Loan Document has been terminated, unless otherwise

consented to in writing by Lender.”

“(b) Borrower shall not cause or permit Mortgage Borrower to (i)

enter into any document evidencing or securing the Mortgage Loan

that is not a Mortgage Loan Document on the Closing Date, (ii)

enter into any amendment, material modification, consolidation,

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taking any legal action.

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restatement, supplement, waiver or termination of any Mortgage

Loan Document (other than any such termination that is effected

pursuant to the terms of the Mortgage Loan Agreement as in effect

on the Closing Date) shall be subject to Lender’s approval, which

approval shall not be unreasonably withheld or conditioned.

Notwithstanding anything to the contrary in this Section [__],

provided an Event of Default shall not have occurred and be

continuing, whenever Lender’s approval or consent is required

pursuant to the provisions of this Section [__], Lender shall use

good faith efforts to respond within ten (10) Business Days after

Lender’s receipt of Borrower’s or Mortgage Borrower's written

request for such approval or consent. If Lender fails to respond to

such request within ten (10) Business Days, and Borrower or

Mortgage Borrower sends a second written request containing a

legend in bold letters stating that Lender’s failure to respond within

an additional five (5) Business Days shall be deemed consent or

approval, Lender shall be deemed to have approved or consented

to the matter for which Lender’s consent or approval was sought if

Lender fails to respond to such second written request before the

expiration of such five (5) Business Day period.”

“(c) None of Borrower, Mortgage Borrower, Guarantor or any

Affiliate of any of the foregoing shall acquire or agree to acquire

the Mortgage Loan, or any portion thereof or any interest therein,

via purchase, transfer, exchange, operation of law or otherwise. If

Borrower, Mortgage Borrower, Guarantor or any Affiliate of any

of the foregoing shall have failed to comply with the foregoing,

then Borrower shall (i) immediately notify Lender of such failure

and (ii) cause any and all such Persons acquiring any interest in the

Mortgage Loan Documents (A) not to enforce the Mortgage Loan

Documents, and (B) upon the request of Lender, to the extent any

of such Persons has or have the power or authority to do so, to

promptly (1) cancel the promissory note evidencing the Mortgage

Loan, (2) reconvey and release the liens securing the Mortgage

Loan and any other collateral under the Mortgage Loan

Documents, and (3) discontinue and terminate any enforcement

proceeding(s) under the Mortgage Loan Documents.

Notwithstanding the foregoing, it shall not constitute a breach of

the foregoing covenants if Guarantor acquires any subrogation

claim in respect of the Mortgage Loan solely by operation of law

as a result of a payment under the guaranty executed in connection

with the Mortgage Loan, provided that, promptly after acquiring

any such subrogation claim, Guarantor agrees in writing that it

shall not enforce the same until payment in full of the Debt.”

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taking any legal action.

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3. Prepayment of Mortgage Loan. Prepayments of the mortgage loan

and mezzanine loans are often a source of contention amongst the deal

parties. The mortgage lender would prefer that all prepayments go to the

mortgage loan first as it is senior in priority to the mezzanine loan, while

the borrower would prefer to prepay the mezzanine loan first as it accrues

at a higher interest rate. Often a comprise is reached where to the extent

there is a prepayment the mortgage loan and mezzanine loan are prepaid

simultaneously on a pro-rata basis.

4. Cross Default. The mezzanine loan documents must provide that

that the occurrence of an event of default under the mortgage loan

documents is an immediate event of default under the mezzanine loan

documents. As a foreclosure of the mortgage loan would be devastating to

the mezzanine loan (i.e., (i.e., loss of complete value of the mezzanine

loan), the cross default allows the mezzanine lender to protect its

investment by foreclosing on the equity collateral and exercising its rights

to cure the mortgage loan under the related intercreditor agreement.

Typically, a mezzanine loan foreclosure can be successfully completed in

less time than it takes to complete a mortgage loan foreclosure.

5. Irrevocable Article 8 Proxy. In addition to requiring that the

mortgage borrower governing documents contain certain language

regarding Article 8 of the UCC as previously discussed above

, the

mezzanine loan documents should also contain a voting proxy from the

mezzanine borrower relating to all of the mezzanine borrower’s rights to

vote as a member of the mortgage borrower.

“Solely with respect to Article 8 Matters (as hereinafter defined),

Pledgor hereby irrevocably grants and appoints Lender, from the

date of this Agreement until the termination of this Agreement in

accordance with its terms, as Pledgor’s true and lawful proxy, for

and in Pledgor’s name, place and stead to vote the Pledged

Securities, whether directly or indirectly, beneficially or of record,

now owned or hereafter acquired, with respect to such Article 8

Matters. The proxy granted and appointed in this Section shall

include the right to sign Pledgor’s name (as a member of Mortgage

Borrower) to any consent, certificate or other document relating to

an Article 8 Matter that applicable law may permit or require, to

cause the Pledged Securities to be voted in accordance with the

preceding sentence. Pledgor hereby represents and warrants that

there are no other proxies and powers of attorney with respect to an

Article 8 Matter that Pledgor has granted or appointed. Pledgor

This language is commonly referred to as the “Article 8 opt-in” language.

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taking any legal action.

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will not give a subsequent proxy or power of attorney or enter into

any other voting agreement with respect to the Pledged Securities

with respect to any Article 8 Matter and any attempt to do so with

respect to an Article 8 Matter shall be void and of no effect. The

proxies and powers granted by Pledgor pursuant to this Agreement

are coupled with an interest and are given to secure the

performance of Pledgor’s obligations under the Loan Documents.

As used herein, “Article 8 Matter” means any action, decision,

determination or election by Mortgage Borrower or its member(s)

that its limited liability company interests be, or cease to be, a

“security” as defined in and governed by Article 8 of the Code, and

all other matters related to any such action, decision, determination

or election.”

V. MEZZANINE LOAN CONSIDERATIONS IN MORTGAGE LOAN

DOCUMENTS

In addition to the specific provisions discussed above which are to be included in the

mezzanine loan documents, it is also important when representing a mezzanine lender

that the mortgage loan documents are reviewed carefully to confirm that they function

properly with a mezzanine loan. The following issues should be considered:

A. Cross Default. The mortgage loan must not be cross-defaulted with the

mezzanine loan. A default under the mezzanine loan should not create a default

under the mortgage loan documents. This would allow the mortgage lender to

exercise remedies against the property while the mezzanine lender is either

foreclosing or attempting to workout the mezzanine loan and while the mortgage

loan may otherwise be performing and not suffering any independent default.

B. Pledge and Foreclosure. The mortgage loan documents must expressly

permit the pledge of any direct or indirect interest in the mortgage borrower in

connection with the mezzanine loan and the exercise of any rights or remedies

that the mezzanine lender may have under the mezzanine loan documents.

Mortgage loan document transfer restrictions typically restrict pledges and

transfers of the equity interest in the mortgage borrower. Without these

exceptions, the making of the mezzanine loan would cause a default under the

mortgage loan documents and not allow a mezzanine lender to protect its interest

by exercising its remedies under the mezzanine loan documents.

C. Recourse. The pledge of equity interest in connection with the mezzanine

loan and any foreclosure of the mezzanine loan must not be a recourse event

under the mortgage loan. Without this exception, the sponsorship of the mortgage

and mezzanine borrowers would be motivated to fight a foreclosure of the

mezzanine loan, even if the value of the property was less than the total amount of

the mortgage loan and mezzanine loan, because the transfer of 100% of the equity

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taking any legal action.

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interests in the mortgage borrower would likely result in a full recourse event

under the mortgage loan. Also, as stated above in B., mezzanine lenders insist on

this drafting point so they can successfully foreclose their mezzanine loan without

causing further financial stress and complexity to the property and the borrower.

D. Insurance/Condemnation Proceeds. In the event the mortgage borrower is

entitled to any insurance and/or condemnation proceeds after completion of

restoration, the mortgage lender should agree to provide those amounts to the

mezzanine lender. As discussed with respect to Liquidation Events above, this

provision is additional protection to the mezzanine lender to ensure that excess

proceeds are paid to the mezzanine lender rather than to the mortgage borrower’s

equity ownership.

E. Reserves. In the event the mortgage loan is repaid and the mezzanine loan

remains outstanding, the mortgage lender should agree to transfer all amounts

held in any mortgage loan reserve accounts to the mezzanine lender. This gives

the mezzanine lender the right to obtain the benefit of any additional collateral

held by the mortgage lender, rather than such amounts going back to the mortgage

borrower. Typically, a mezzanine lender will not hold reserve funds as additional

collateral for the mezzanine loan because they are being reserved for by the

mortgage lender.

VI. INTERCREDITOR AGREEMENT ISSUES

A. In connection with the origination of a mezzanine loan, the related

mortgage lender will often require the mezzanine lender to enter into an

intercreditor agreement. The intercreditor agreement generally benefits both the

mortgage lender and mezzanine lender. The mortgage lender gains comfort that

(1) the mezzanine loan is subordinate in structure and payment to the mortgage

loan and (2) mezzanine loan transfers are generally restricted. The mezzanine

lender often gains the right to: obtain notice of, and the right to cure, mortgage

loan defaults, purchase the mortgage loan and foreclose on the mezzanine loan

collateral. The mortgage lender and mezzanine lender also exchange various

representations and warranties relating to the ownership and status of the

mortgage and mezzanine loans respectively.

B. In the real estate capital markets industry, most mezzanine loan

intercreditor agreements are based upon the CREFC

form intercreditor

agreement, though the market has adopted a number of modifications since it was

originally published. Also, lenders have modified the form agreement in certain

ways that are unique to their lending requirements. In short, although these

CRE Finance Council (CREFC) is a trade organization in the commercial real estate finance space. More

information can be found at http://www.crefc.org/.

authoritative statement of the law. You should obtain detailed and specific legal advice from a properly licensed attorney before

taking any legal action.

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agreements are typically based on the same form, they can vary dramatically from

deal to deal and from lender to lender.

C. Mezzanine Lender Rights:

1. Foreclosure/Exercise of Control Rights. Generally, intercreditor

agreements provide that the mezzanine lender can realize on its separate

collateral other than equity collateral (e.g., cash reserves or accounts) at

any time. To exercise any remedies with respect to the equity collateral

certain conditions must be met:

a. The transferee taking title to the equity collateral is a

“Qualified Transferee”. This is usually a person that meets certain

eligibility requirements (i.e. meeting a specified asset test). The

mezzanine lender and its affiliates are often pre-approved in the

agreement as Qualified Transferees.

b. Within thirty days after the foreclosure, a “Qualified

Manager” is required to manage the underlying property. This is

usually a person that meets a specified experience test (i.e.

manages a certain number of properties that are similar to the

underlying property, has a certain number of years of experience

etc.).

c. A party meeting specified net worth and liquidity tests

provides to the mortgage lender supplemental recourse carve-out

guaranties. It is important to the mortgage lender that a party with

assets will stand behind the replacement guaranty as it gives the

mortgage lender comfort that the replacement guarantor will be

unwilling to take bad acts and put its assets at risk.

In addition to the forgoing, some mortgage lenders require that certain

defaults under the mortgage loan be cured prior to the mezzanine lender’s

foreclosure on the equity collateral. Mortgage lenders generally fall into

three camps on this issue:

a. All mortgage loan defaults must be cured as a condition

precedent to mezzanine lender’s foreclosure on the equity

collateral (excluding those defaults that cannot be cured without

taking title to the equity collateral). This is the most difficult

scenario for the mezzanine lender. If the mortgage loan has been

accelerated, for a mezzanine lender to successfully cure all defaults

under the mortgage loan, the mortgage loan must be paid in full by

the mezzanine lender as a condition precedent to a foreclosure.

authoritative statement of the law. You should obtain detailed and specific legal advice from a properly licensed attorney before

taking any legal action.

18616279.2.BUSINESS

b. All monetary mortgage loan defaults must be cured as a

condition precedent to mezzanine lender’s foreclosure on the

equity collateral (excluding the payment of full of the loan).

c. No cure of mortgage loan defaults as condition precedent to

equity foreclosure. This is the most favorable case for the

mezzanine lender and the standard that is generally found in the

capital markets. The mortgage lender gains comfort because as a

condition precedent to foreclosure the mezzanine lender must

provide an additional recourse carve out guaranty and if the

mezzanine lender does not cure outstanding defaults after

foreclosure, the mortgage lender will have the right to foreclose on

the mortgage loan.

In nearly all cases, mortgage lenders will not require the cure of mortgage

loan defaults that are not curable by the foreclosing mezzanine lender and

do not have a material adverse affect on the use, value or operation of the

property. An example would be the failure of the mortgage borrower to

deliver to the mortgage lender financial statements of its parent. This

default is personal to the borrower and a third party mezzanine lender

would be hard pressed to be able to cure this default.

2. Cure Rights. Generally mortgage lenders grant mezzanine lenders

monetary and non-monetary cure rights under an intercreditor agreement.

Prior to exercising remedies under the mortgage loan documents, the

mortgage lender will provide the mezzanine lender with written notice of

the underlying default and provide an opportunity to cure such default.

a. Monetary Cures. In the event of a monetary event of

default, mortgage lenders will provide mezzanine lenders the right

to cure monetary defaults within five (5) to ten (10) business days

after mezzanine lender’s receipt of notice of such default.

Generally, mezzanine lenders only have a limited number of

monetary cures. They can range from as few as four (4) cures for

the life of the mortgage loan to as many as six (6) consecutive

cures. Notwithstanding the cap on cures, mezzanine lenders will

generally be able to continue curing monetary defaults so long as

they are diligently and continuously exercising remedies against

the equity collateral (i.e., foreclosing on the equity collateral under

the mezzanine loan documents).

b. Non-Monetary Cures. In the event of a non-monetary

event of default, mortgage lender will provide mezzanine lender

the right to cure such monetary default within the later of (i) the

same period the mortgage borrower has to cure such default, plus

authoritative statement of the law. You should obtain detailed and specific legal advice from a properly licensed attorney before

taking any legal action.

18616279.2.BUSINESS

ten (10) business days and (ii) 30 days after mezzanine lender’s

receipt of notice of such default. Such period is often extended for

the period necessary for mezzanine lender to effectuate such cure

for so long as the default does not materially impact the use, value

or operation of the property or the mezzanine lender is diligently

and continuously exercising remedies against the equity collateral.

Typically, a mezzanine lender’s right to cure defaults will expire

upon a bankruptcy of the mortgage borrower.

3. Purchase Option. Under the intercreditor agreement, the mortgage

lender typically grants the mezzanine lender the right to purchase the

mortgage loan upon the occurrence of certain conditions, usually the

acceleration of the mortgage loan or in the event the mortgage lender has

commenced exercising remedies. The purchase option will expire upon

the earlier of the cessation of the event that triggered the purchase option

or the foreclosure of the mortgage loan.

Generally, the mortgage lender must provide the mezzanine lender

notice of the occurrence of any of the foregoing triggers. Upon receipt of

such notice the mezzanine lender may elect to purchase the mortgage loan

by delivering a purchase election notice and closing within ten (10)

business days. The mortgage loan option purchase price is generally the

sum of the outstanding principal balance of the mortgage loan, plus

accrued interest, plus any other costs incurred by the mortgage lender

(including any workout fees or liquidation fees due to the mortgage

lender’s special servicer). Generally, default interest, exit fees,

prepayment premiums and other such fees are excluded from the purchase

price. These fees are often excluded because the mortgage lender is eager

to be paid off when the loan is in default and is willing to accept only the

outstanding principal balance of the mortgage loan, plus accrued interest,

and any costs it actually incurred.

In connection with negotiating the purchase option right, the

mezzanine lender will typically want to build deed-in-lieu protection in to

the intercreditor. A deed-in-lieu of the mortgage loan is as devastating to

the mezzanine loan as a mortgage foreclosure (i.e., loss of complete value

of the mezzanine loan), the only difference is it can happen much faster.

As a backstop to any agreement in the intercreditor agreement relating to a

deed in lieu, the mezzanine lender will want the mezzanine loan

documents to restrict the mezzanine borrower from causing the mortgage

borrower to grant a deed-in-lieu to the mortgage lender. In the event the

mortgage lender intends to take a deed-in-lieu from the mortgage borrower

it should be required to provide the mezzanine lender notice and a chance

to purchase the loan at the mortgage loan purchase price. Some

authoritative statement of the law. You should obtain detailed and specific legal advice from a properly licensed attorney before

taking any legal action.

18616279.2.BUSINESS

mezzanine lenders are able to gain further protection by having the

purchase option right continue for a period even after the mortgage lender

has taken title to the property through a deed-in-lieu. In this event, the

mezzanine lender also has to pay the costs that the mortgage lender

incurred to take title to the property through a deed-in-lieu, such as

transfer taxes.

4. Mortgage Loan Modifications. Under a typical intercreditor

agreement, mezzanine lenders are often granted consent rights over certain

mortgage loan modifications, which include:

a. increasing the interest rate, principal balance or any other

material monetary obligation;

b. obtaining any contingent interest or equity kicker or

imposing new fees;

c. extending the prepayment lockout period or increasing

prepayment fees;

d. imposing financial covenants or making existing ones more

restrictive;

e. shortening or extending the maturity date;

f. changing the transfer restrictions of the mezzanine loan;

g. changing the cash management provisions of the

mezzanine loan; or

h. cross-defaulting the mezzanine loan with any other debt.

Note that a mezzanine lender will lose its consent rights to many of these

modifications if the mortgage loan is in default and the mezzanine lender’s

cure period has expired. If the mezzanine lender is not curing defaults

under the mortgage loan, the mortgage lender will see this as a sign that

the mezzanine lender is not interested in protecting its investment,

therefore the mortgage lender should be free to work out the mortgage

loan as it sees fit without having to wait for the mezzanine lender’s cure

period(s) to expire.

5. Affiliated Borrower Mezzanine Lender. Intercreditor agreements

will generally restrict the mezzanine lender’s right to transfer the

mezzanine loan to the mortgage borrower, the mezzanine borrower or any

affiliate thereof. This is an important issue for mortgage lenders as

authoritative statement of the law. You should obtain detailed and specific legal advice from a properly licensed attorney before

taking any legal action.

18616279.2.BUSINESS

borrower affiliated mezzanine lenders can use their rights as mezzanine

lender as a “second bite at the apple”. For example, if the mortgage

borrower defaults in making a mortgage loan payment, the affiliated

mezzanine lender would have the right, under the intercreditor agreement,

to cure that payment, effectively granting the borrower a notice and cure

period for all defaults.

The issue is generally addressed in two ways. First, there could be an

outright prohibition on transfers of the mezzanine loan to affiliates of

borrower. The other method is to permit such transfers, but, upon such

transfer, the affiliated mezzanine lender would no longer be permitted to

exercise any rights under the intercreditor agreement (i.e. no right to

foreclose, cure, purchase the mortgage loan or have consent rights over

mortgage loan modifications).

A sample disability provision from a capital markets intercreditor

agreement is as follows:

“Section [__]. Affiliated Mezzanine Lender. Notwithstanding

anything in this Agreement to the contrary, in the event that at any

time the Mezzanine Loan (or any portion thereof or interest

therein) is held by an Affiliated Mezzanine Lender, such Person

shall have no rights under Sections 5, 6, 8, 10, 12, 13, 14, 15 or 16

hereof, may not take an Equity Collateral Enforcement Action and

may not engage in a Mezzanine Loan Modification without Senior

Lender’s prior written consent, which may be withheld in its sole

discretion.

“Affiliated Mezzanine Lender” shall mean an owner of all or any

portion of the Mezzanine Loan (or any interest therein) who (i)

owns, directly or indirectly, more than twenty-five percent (25%)

of the direct or indirect ownership interests in Borrower or

Mezzanine Borrower or (ii) has the power, directly or indirectly, to

direct or cause the direction of the management or policies of

Borrower or Mezzanine Borrower, whether through the ability to

exercise voting power, by contract or otherwise (but excluding any

such ability arising solely through operation of the Mezzanine

Loan Documents).”

A corollary issue often negotiated by mortgage and mezzanine lenders is

how a “borrower affiliated mezzanine lender” is defined in the

intercreditor agreement. For certain mortgage lenders, a person will not

be deemed to be a “borrower affiliated mezzanine lender” unless it owns

at least 25% of the direct or indirect interest of the mortgage borrower or

authoritative statement of the law. You should obtain detailed and specific legal advice from a properly licensed attorney before

taking any legal action.

18616279.2.BUSINESS

controls the mortgage borrower. More conservative mortgage lenders are

often more restrictive, and will deem a person to be a “borrower affiliated

mezzanine lender” if it owns any interest in the mortgage borrower.