Tough Times for Lenders : Financial Services Lawyer & Attorney : Winstead Law Firm : Finance, Banking, Bankruptcy

One trend in the market at this moment: borrowers that want to utilize a mezzanine loan (as part of the debt structure) are having difficulty in obtaining the approval of their first lien (mortgage) lender to the mezzanine loan.

What is a mezzanine loan?

Here is a definition used by Standard and Poors:  a mezzanine loan is a loan "to equity holders of the borrower (including situations where the equity is pledged to secure reimbursement obligations under letters of credit or other contingent obligations). Frequently these loans are secured by a pledge of equity interests in the senior mortgage debt borrower."

Let’s explore an example of how it can play out when the project is in distress, the borrower fails to make a payment on the first lien loan, and a mezzanine loan is in place.

Let’s assume that the following:

• borrower fails to make a monthly payment on the first lien loan (this loan encumbers improved commercial real estate)
• the loan documents do NOT require the first lien lender to give borrower notice of the failure
• the loan documents state that such failure shall constitute a default (or an event of default) under the first lien loan
• a mezzanine loan is in place, secured NOT by the improved commercial real estate but by a pledge of ownership interests in the borrower 

Step One: review the first lien loan documents for the basis for a default, and the notices required to be given to the borrower.

Step Two: review any agreements between the first lien lender and the mezzanine lender, looking for any notice and cure rights on the part of the mezzanine lender relating to a borrower default under the first lien loan.  (This agreement typically is called an "intercreditor agreement.")

In the absence of a mezzanine loan, the first lien lender would take step #1 and go forward with exercising its rights under the loan documents.

However, the existence of the mezzanine loan requires the first lien lender to take step #2, which means that:

• prior to giving any notice or taking any action under the first lien loan, the first lien lender (or the servicer) should review the intercreditor agreement between the first lien lender and the mezzanine lender
• the intercreditor agreement typically will give notice and cure rights to the mezzanine lender for certain events, and on the exercise of certain rights and remedies of the first lien lender

A close reading of the intercreditor agreement might show the following (the following is fairly typical – but you’ll need to closely read your documents):

• before the first lien lender can take an “Enforcement Action” against the borrower, the first lien lender must give the mezzanine lender notice and opportunity to cure any default by borrower under the first lien loan
• the intercreditor agreement gives this definition: “’Enforcement Action’ shall mean . . . . acceleration of, or demand or action taken in order to collect, all or any indebtedness secured by the Premises (other than giving of notices of default and statements of overdue amounts) . . . . ”

So, based upon all of this information, what notices must be given by the first lien lender (or loan servicer)?

PICK THE CORRECT STATEMENT(S)

1: First lien lender must give borrower notice of borrower’s failure to make the monthly payment

2: First lien lender must give the mezzanine lender notice of borrower’s failure to make the monthly payment in order for a default to exist

3: First lien lender does NOT need to give default notice to borrower nor to mezzanine lender in order for a default to exist        

4: If or when first lien lender makes demand to the borrower for payment, then it must give mezzanine lender notice and opportunity to cure

#3 and #4 are correct (although the first lien lender might decide to give the notice of the default [under #3] merely as a business practice - if for no other reason that it would like to be paid - and to be able to show a court that it did give parties an opportunity to pay).

The lesson is read, read and read the documents; and then follow them.

Finally, don’t forget to give any notices required by local law or statutes.

Any questions or comments on this topic?

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Guest Writer: Brenda Brown, Winstead PC

This is a special series of blog entries in which we provide some quick answers tolenders' frequently asked questions (FAQ).  Two things should be kept in mind. First, none of these questions can be answered in a vacuum. Questions should be considered with a thorough review of the file and an interview with appropriate loan officers. And secondly, many of the questions are worth revisiting from time to time because subsequent events will impact the answers.

Without further ado:

FAQ #1 -  The Borrower is how far behind – now what?

• Analyze the entire situation: the collateral, the loan documents, the file, any co-lender or intercreditor agreements, financials on the parties, the market - in other words, the entire picture. Act like you're about to own it.
• Consider restructuring – But send a "Discussion Letter" – to help avoid waiver of lender's rights under the loan documents
• Determine whether a default – as defined in the loan documents – has occurred. If so, consider sending Notice of Default and Notice of Acceleration.
• Generally Borrower has "terminal euphoria" and no reason to change unless it is in default.

FAQ #2 -  What if the default was not a monetary default?

• "Default" vs. "Event of Default" – check defined terms in the loan documents.
• Look for Grace / Cure Periods to see if expired.

FAQ #3 -  What can I do besides calling a default?

• Alternatives to calling a default include à Restructure (i.e., amend the loan documents so the borrower is no longer in default – if the borrower's financial deterioration is not too great)
• Simple Notice of Default à Just to create a written record that it exists and is continuing.

To read the entire Tough Times FAQ series, please click here.

Please post comments or questions below.
 

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