Distressed Real Estate During COVID-19: The Role of Intercreditor Agreements between Mortgage Lenders and Mezzanine Lenders

Pillsbury Winthrop Shaw Pittman LLP

Pillsbury Winthrop Shaw Pittman LLP

Mortgage lenders and mezzanine lenders considering amendments to loan documents, forbearance, loan transfers, the exercise of remedies or deeds in lieu of foreclosure, and other loan-related fact patterns will need to revisit and comply with the provisions of their respective ICAs. The current distressed real estate environment will put many of these arrangements to the test.


  • ICAs allow for the existence of subordinate financing by defining the key features of the relationship between mortgage and mezzanine lenders.
  • ICAs are key documents to consider when dealing with distressed real estate and considering amending loan documents, exercising remedies, curing defaults or taking other actions. Mezzanine lenders in particular need to pay close attention to the ICA requirements when considering UCC foreclosures.
  • ICAs are complex and can present both challenges and opportunities.

With the passage of time since the first COVID-related lockdowns, many real estate lenders are no longer willing to forbear from collections and modify repayment terms and instead are pivoting to considering, or in fact exercising, their remedies. At this juncture, some borrowers are also asking to “turn in the keys”—particularly in the hardest hit sectors of hospitality and retail. For mortgage lenders, this may mean accelerating the debt and proceeding to a real estate foreclosure of the mortgaged property. For mezzanine lenders, this may mean conducting a UCC foreclosure of the pledged equity. Besides confirming subordination of the mezzanine loan to the mortgage loan, intercreditor agreements (ICAs) address many of the fact patterns described above, along with granting cure rights and purchase rights to the mezzanine lender. These provisions can present both challenges and opportunities.

Background—Mezzanine Loans and ICAs
In a mezzanine loan, the mezzanine lender makes a loan to the mortgage borrower’s owner(s) (the “mezzanine borrower”), secured by a pledge of the mezzanine borrower’s equity interest in the mortgage borrower. The mezzanine lender does not have a lien on the mortgaged property. Upon a foreclosure of the mezzanine loan, the mezzanine lender (or, potentially, a higher bidder at the foreclosure sale) will become the owner of the mortgage borrower (and it will then indirectly own and control the mortgaged property). The mezzanine lender’s loan is extinguished if the mortgage lender forecloses on its mortgage loan or accepts a deed in lieu. The collateral for a mezzanine loan has value only to the extent that the value of the underlying property exceeds the amount of the mortgage debt. In this regard, the mezzanine loan is vulnerable if there are intervening liens (such as real estate tax liens, mechanic’s liens or judgment liens) as the mezzanine lender does not have a lien on the underlying real property—and a foreclosing mezzanine lender becomes indirectly liable for all such outstanding liens and liabilities without having the ability to foreclose any of them out.

Nevertheless, mezzanine loan documents contain many of the same representations and covenants as the mortgage loan, and grant to the mezzanine lender many of the same approval rights as are set forth in mortgage loan documents. One important difference is that most mezzanine loans are cross-defaulted with the mortgage loan—so that a default under the mortgage loan triggers a default under the mezzanine loan but that a default under the mezzanine loan does not, typically, trigger a default under the mortgage loan.

The mortgage lender and the mezzanine lender are often parties to an ICA designed to set forth their respective rights and remedies, including confirmation of the subordination of the mezzanine loan to the mortgage loan. More particularly, the ICA provides that the mezzanine lender may receive payments of interest and fees so long as no event of default has occurred and is continuing under the mortgage loan documents. However, if the mezzanine lender cures the mortgage borrower’s defaults (pursuant to the cure provisions set forth in the ICA, see below), generally the mezzanine lender may receive debt service payments under its mezzanine loan documents. Simply put, if an event of default has occurred and is continuing under the mortgage loan documents, the mezzanine lender will no longer be entitled to receive payments in the ordinary course. While certain ICAs allow the mezzanine lender in such a case to pursue enforcement of its “separate collateral,” which could include reserves funded under the mezzanine loan, this will differ from ICA to ICA.

An ICA is not limited to agreements just between a single mezzanine lender and a mortgage lender. There can be debt stacks involving multiple mezzanine loans—in which case the second mezzanine lender (up the ladder in the debt stack) will make a loan to the second mezzanine borrower (the owner of the first mezzanine borrower in the stack) and the second mezzanine loan will be secured by the second mezzanine borrower’s equity interest in the first mezzanine borrower—and so forth such that “multi-tier” ICAs are required. We have assumed in this article, for sake of simplicity, that there is a mortgage loan and a single mezzanine loan.

A simple visual of a mortgage loan and a mezzanine loan, with an ICA, is included here:

This client alert addresses some of the more common provisions in ICAs—and by no means addresses all or every ICA or all of the issues or concerns that may arise when considering actions to be taken under an ICA. Also, note that each ICA contains differently negotiated provisions—and, in addition, that the provisions in these agreements evolve over time, taking into account case law, litigation, changing markets (such as the one we are now in) and other developments.

Finally, note that this client alert does not address issues surrounding bankruptcy provisions in (or the bankruptcy of a lender a party to) an ICA—or the issues that are raised when a mezzanine loan is junior to a construction loan. These topics will be addressed in forthcoming client alerts.

Mezzanine Loan Transfers and Foreclosures
As a general matter, most ICAs do not impose any restrictions on a mortgage lender’s transfer of the mortgage loan other than limiting transfers to a borrower or borrower affiliate. On the other hand, the ICA will typically provide that transfers of controlling or majority interests in mezzanine loans and foreclosures (and related transfers) of mezzanine loans may only occur without rating agency approval or mortgage lender approval (if the mortgage loan has not been securitized) if they involve transfers to certain predefined “Qualified Transferees” that meet certain largely financial (and usually negotiated) “Eligibility Requirements.”

Note that definitions of Qualified Transferees often allow an entity to be a Qualified Transferee if it is controlled by another Qualified Transferee, even if the controlled entity does not comply with the Eligibility Requirements. The result is that a mezzanine loan can be owned by a special purpose entity whose only asset is the mezzanine loan (and who is otherwise not capitalized or credit supported). If the mortgage lender has assets and a significant balance sheet, this can create an imbalanced situation—and the reputational risk to the mezzanine lender may be the main (perhaps the only) reason that the mezzanine lender upholds its obligations under the ICA. This misalignment will most certainly affect the analysis of any default situation.

ICAs generally restrict a lender from selling its loan to the borrower or affiliates of the borrower and contain “neutering” provisions such that a loan held by a borrower or borrower affiliate is not entitled to the many protections afforded mezzanine lenders in the ICAs.

Mezzanine Lender’s Cure Rights
Another important right negotiated by mezzanine lenders in ICAs is the right to receive notices of a mortgage borrower’s default(s) and the right to cure defaults under the mortgage loan for some period of time. This provision is often referred to as the standstill provision because the mortgage lender is agreeing that, for so long as the mezzanine lender is curing the default(s) of the mortgage borrower, the mortgage lender will not exercise remedies. For example, the mortgage lender will not accelerate the mortgage loan or pursue a foreclosure during this period.

While the specific time periods and conditions to cure are often negotiated, the general standard is usually a short period of time within which to cure monetary defaults coupled with a cap on the number of cures that are available—with longer often uncapped periods of time within which to cure non-monetary defaults. The mezzanine lender’s right to cure non-monetary defaults is contingent on the mezzanine lender keeping the mortgage loan current and diligently pursuing the cure (or foreclosure, should possession be necessary) and, also, on the delay not materially impairing “the value, use or operation” of the property. Rights to cure will terminate if there is a bankruptcy of the mortgage borrower. As a practical matter, many mezzanine lenders will need to foreclose in order to be in a position to effect certain non-monetary cures.

Conditions to Foreclosure by the Mezzanine Lender
ICAs often contain requirements relating to a mezzanine loan foreclosure or acceptance of an assignment in lieu of foreclosure by the mezzanine lender—including requiring that the transferee of the collateral be the mezzanine lender or a predefined Qualified Transferee, requiring that the mezzanine lender cure the mortgage loan defaults (with most ICAs now making clear that such obligation does not include the obligation to pay the mortgage loan off in full), the requirement that the property be managed by a pre-qualified or mortgage lender approved property manager, the requirement that the property be subject to a cash management system (with reserves funded, as required) within some number of days following consummation of the transfer, the requirement to deliver certain opinions and organizational documents and the requirement to retain new independent directors. (In the much publicized Stuyvesant Town decision, involving a senior lender who had accelerated its senior loan and obtained a judgment of foreclosure and a mezzanine lender who had elected not to cure the defaults under the senior loan, the court enjoined the mezzanine lender from consummating its UCC foreclosure and confirmed the senior lender’s view that the ICA required the mezzanine lender to cure all senior loan defaults, including paying off the accelerated senior loan, prior to consummating its UCC foreclosure. This decision has resulted in certain revisions to most ICAs.)

In addition, importantly, the transferee or an affiliate of the transferee meeting certain pre-agreed financial parameters or otherwise approved by the mortgage lender must provide substitute guaranties and indemnities to the mortgage lender (covering actions taken following the date on which the foreclosure occurs) regardless of whether the original guarantors and indemnitors are released. This is particularly important for the mortgage lender whose borrower sponsor is being replaced and, in addition, because many mortgage loan guaranties provide that they terminate, or that continuing liability under such guaranties will end, from and after the date on which there occurs a mezzanine loan foreclosure.

Replacement guaranties should be delivered by the transferee prior to or concurrently with the mezzanine lender foreclosing on its collateral—and, given the issues identified above regarding the credit-worthiness of certain Qualified Transferees, should specify a minimum net worth and liquidity for the replacement guarantor/indemnitor. Because most mortgage “due on sale” clauses specify that a change in control of the mortgage borrower is a transfer of the property requiring consent, a mezzanine lender’s compliance with the above conditions to foreclosure protects the mezzanine lender’s foreclosure from triggering the due-on-sale provision in the mortgage loan documents.

Note that many ICAs require that the above conditions to foreclosure also apply if the mezzanine lender exercises voting powers with respect to or controls the mortgage borrower. These provisions are sometimes the subject of negotiation or careful revision.

Loan Document Modifications
ICAs provide that modifications to the senior loan documents are subject to mezzanine lender approval unless a mortgage loan default has occurred and is continuing. These include:

  • increasing the principal amount of or interest rate on the mortgage loan;
  • increasing material monetary obligations of the mortgage borrower under the mortgage loan documents;
  • extending or shortening the scheduled maturity date of the mortgage loan (unless provided in the mortgage loan documents);
  • converting the mortgage loan into or exchanging the mortgage loan for any other indebtedness; or
  • extending the period during which voluntary prepayments are prohibited or during which prepayments require the payment of a fee (or modifying the amount of such fees).

Typically, the funding by the mortgage lender of protective advances and interest accruals are not modifications requiring mezzanine lender consent. Often, the scope and number of such approvals may be reduced (to cover a small handful of key concerns such as increasing the principal amount of the loan, shortening the maturity and granting the mortgage lender a “kicker”) in the context of a workout or following the occurrence and continuance of events of default. Intercreditor agreements also often include substantially mirror provisions, granting the senior lender substantially mirror approval rights with respect to modifications of the mezzanine loan documents.

Early in the pandemic and still in the current environment, practitioners are revisiting these provisions to determine whether mortgage lenders are required to obtain the consents of mezzanine lenders (and vice versa) in order to grant forbearance (with practitioners paying special attention to the relevant waiver provisions, in this context), to enforce remedies or to impose obligations.

Given the near mirror modification provisions—and the fact that many mezzanine loan documents contain many of the same provisions as are contained in the mortgage loan documents—it is likely that, if a modification of the senior loan documents is needed which requires mezzanine lender approval, then a mirror modification of the mezzanine loan which requires mortgage lender approval will also be needed. In this regard, note that implementing these mirrored provisions can result in one lender approving modifications which another lender does not. In turn, borrowers may not be willing to proceed with a modification unless all lenders approve the modification.

Purchase Options and the Deed in Lieu
A mezzanine lender is generally granted the right to buy the mortgage loan upon the occurrence of certain triggers including the occurrence and continuance of events of default under the mortgage loan documents or the mortgage loan becoming a “specially serviced” loan in the context of a securitized mortgage loan. Certain ICAs require the posting of a deposit upon the exercise of the option and a timeline for the exercise of the option. Some are more open-ended so that, for example, the purchase option continues in effect until there is a mortgage loan foreclosure or deed in lieu of foreclosure and can be exercised even if the mezzanine lender is not exercising its rights (otherwise) to cure mortgage loan defaults. Some may require that the purchase option ceases upon the delivery of a deed in lieu of foreclosure or some specified period.

The purchase price payable by the mezzanine lender upon the consummation of the option includes the outstanding principal balance of the mortgage loan, unpaid interest on the mortgage loan and all other amounts due on the mortgage loan (including protective advances and expenses incurred by the mortgage lender)—with some discussion around whether the mezzanine lender should pay for workout fees, special servicing fees or liquidation fees in the case of securitized mortgage loans—and with certain mortgage lenders waiving the receipt of certain sums such as default interest, late fees or prepayment fees or premiums.

A related but separate provision in ICAs usually involves the mortgage borrower’s decision to deliver a deed in lieu of foreclosure to the mortgage lender. Absent protections drafted into an ICA, the delivery by a mortgage borrower to its lender of a deed in lieu will extinguish all value in a mezzanine loan. While certain “bad boy” guaranties delivered to mezzanine lenders may make clear that a transfer of the underlying property without the mezzanine lender’s consent triggers recourse (likely full recourse) to the guarantor, many ICAs (i) obligate the mortgage lender to notify the mezzanine lender that it intends to accept the deed in lieu within a certain number of days prior to such acceptance and (ii) grant to the mezzanine lender a purchase option, or a first right to accept an assignment in lieu, in such case.

Financing of Mezzanine Loan.
A mezzanine lender will often be granted the right to finance its position under a repurchase facility or similar arrangement without mortgage lender consent provided that the entity providing such financing meets certain parameters (and is not a mortgage borrower affiliate). Such financing providers also will then usually be provided with notice and opportunities to cure.

With COVID-19 and the resulting economic disruption, we can expect various of these provisions to come under scrutiny and be tested—even possibly in court. Certainly, given the likely increase in foreclosures and workouts, mortgage and mezzanine lenders are advised to review their ICAs to understand their relative rights and obligations. These provisions and agreements are quite complex and evolving. In moments of distress, clients are advised to seek experienced counsel—including counsel with “fresh eyes” to review these documents.

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Pillsbury Winthrop Shaw Pittman LLP

Pillsbury Winthrop Shaw Pittman LLP on:

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