zanine lenders are now tasked with figuring out how to best protect their[/b] interests as the economy works its way through a recession, and the credit markets and housing market continue to be in shambles. The softening of residential real estate, which led to the problems in the credit markets, poses a particularly daunting challenge for commercial mortgage lenders involved in financing the development of new condominium projects. The situation for mezzanine providers is even more troublesome. Although most of the financing provided for condominium development made sense several years ago, when the loan commitments were executed and construction commenced, lenders must now decide whether to continue funding such projects and what to do with the completed properties until the market recovers. The holders of the mezzanine piece are now in a tenuous position, but they are not alone. Even senior debt is no longer secure, simply because so much equity has been lost so quickly. To review, mezzanine financing is a form of junior debt that is not secured by a lien on the real estate, but rather, it is an assignment of the borrower's interest in the single-purpose entity that owns the property. In many recent loans, mezzanine debt provided the owner with the ability to improve the loan-to-value (LTV) ratio of the property without being required to place a subordinate mortgage on the property. This arrangement, is turn, afforded an added level of protection to the holder of the mortgage on the property. Moreover, because the mezzanine debt would be eliminated in a foreclosure of the senior debt or a bankruptcy filing by the property owner, the holder of the senior debt assumed that mezzanine financing provided an incentive for the mezzanine lenders to assist in solving any problems the property or the borrower might face. For the senior lender, mezzanine financing was also attractive, as it improved the LTV of the mortgage while providing another lender who would assist if a problem were to develop. Because the subordinate lender does not have a mortgage on the property, it could preclude the senior lender from foreclosing. But of course, as we have seen, if a problem develops, the various layers of debt make a workout all the more difficult. [b][i]Pledge of equity[/i][/b] Unfortunately, an already difficult workout is further complicated by the different tranches of mezzanine debt, which means that the mezzanine lenders holding lower positions in the debt stack are at greater risk. Because the lower tranches have higher interest rates, it is less likely that the holder of that tranche of mezzanine debt will ultimately be paid in the event of a default. This, of course, is the reason the interest rates on the lower tranches of debt are so much higher. As a result, when the borrower has financial problems and either defaults or is at risk of defaulting, one or more of the mezzanine lenders may be at risk of losing their investments, while other holders of the senior debt are more secure. The relationship among the mezzanine lenders is governed by the terms of their intercreditor agreement, which is the first document that should be considered prior to commencing a workout in order to determine who has the authority to act. Furthermore, in situations where the senior debt and the mezzanine debt are held by separate institutions and require multiple levels of consents, workouts for properties with both securitized and mezzanine debt become even more complicated. Workouts involving securitized loans are even more problematic, because the securitized mortgage debt will be subject to a pooling and servicing agreement, which limits the likely cooperation of the servicers in a workout. It must be noted that the mezzanine lenders are only protected if they have priority, and in order to have a priority security interest in the pledged collateral, they would need to have perfected their security interests in the collateral. By doing so, they can enable their claim to prevail over those of purchasers, other lenders and creditors trying to obtain a lien on the collateral. It is, therefore, incumbent on the mezzanine lender to have perfected its security interests in the collateral for the loan, or the mezzanine lender could be at risk of losing its collateral, even though such an action could make the debt fully recourse against the borrower. The advantage of mezzanine financing is that its collateral is a pledge of the equity in the property. This specification enables the lender to take control of the asset through a Uniform Commercial Code auction of the interests in the Special Purpose Entity that is the owner, without the time and expense of a real property auction. Though the mezzanine lender can acquire the property, it is still subject to the senior debt, which remains as a lien on the property. The disadvantage of this action is that the mezzanine lender acquires the ownership interests in the asset and, as a result, also becomes responsible for the entity that owns the property. [b][i]Reviewing condo docs[/i][/b] Workouts of mezzanine loans add another challenge for the lenders: Every state regulates the sale of condominium units differently. Consequently, the lender must be aware of the state's laws and the power that prior purchasers have in the process. Unlike the workout of a typical commercial loan, where the only entities involved are the lender, borrower, and perhaps a tenant and/or guarantor, a workout of a condominium loan could also involve state regulators, existing contract vendees and any existing unit owners. It is imperative that mezzanine lenders review all of the condominium documents and state filings prior to any workout decision, due to the potential liability to the purchasers if the offering documents fail to fully and adequately disclose the material facts of the condominium. In addition, the lender must examine the borrowers' offering documents and state filings to determine the lender's obligations under the law have been met. The lenders must also determine whether the project has been constructed in accordance with the legal plans before modifying the documents to either sell or withdraw the offering plans and rent until the market improves. However, if some of the units are subject to a contract or have already closed, then the lender's options are limited, and it is now obligated to comply with the initial offering documents. In the event that the lender determines that its exposure is too great, it might want to consider bringing in someone else to complete the project, selling the loan at a discount or terminating the offering. Conversely, if the borrower has acted in accordance with the loan and offering documents, then it is logical for the lender to permit the borrower to complete the project and not become involved with the offering. The advantage of leaving the borrower in control of the project prevents the purchasers from having grounds to file a failure-to-comply suit against the lender. It should be noted that if the lender does take control of the project and there are significant deficiencies, then its exposure could be significantly more than the unpaid balance of the loan. Another important step for lenders taking over a troubled project is to review existing contracts to make certain the developer has not promised purchasers amenities that the developer cannot deliver at the time of closing. When a major delay in the completion of a project is expected, the lender must also review the Federal Interstate Land Sales Act, which permits purchasers to rescind their contracts if a project does not open within two years, as well as the state law governing sales of condominiums. Also, lenders should be aware of whether the sold units were purchased for use or resale and if there are any resale restrictions in the offering documents. In the event that the units are investor-purchased, marketing them would be in direct competition with the lender and thereby further depress valuations of the property. Furthermore, the lender should also be aware of the status of the purchasers' deposits. Some states, such as New York, hold deposits in escrow, pending the issuance of a Temporary or Permanent Certificate of Occupancy and the recording of the Condominium Declaration. The law varies in each state, with some allowing the use of deposits in advance of occupancy. In the event that deposits have been used and the planned project is not completed, purchasers have the right to rescind their contracts, and the lender is liable for the return of the deposits. [b][i]Liability claims[/i][/b] One of the primary reasons for the mezzanine lenders to act as expeditiously as possible when a condominium development begins to experience financial problems is to limit the exposure to the purchasers. The longer a troubled project continues, the more purchasers will be involved in the negotiations. Although now rarely raised, lender liability claims are a major concern in instances where there were prior unresolved disputes between the borrower and the lender. For that reason, lenders should not even contemplate a workout prior to the borrower's signing a letter waiving any claims against them. This pre-workout letter should not only waive any claims, but also indicate an understanding that there is no assurance that the negotiations will succeed or that there will be a result. Additionally, lenders should be particularly aware of any correspondence from the borrower that is self-serving, establishes a basis for a subsequent claims of meddling or bad faith, or gives the impression that the lender exercised control over the borrower or the project. If the negotiations suddenly end without warning after good-faith discussions and the lender, without notice, commences the lien foreclosure, the borrower could claim that it did not act in bad faith. It should be noted that in a lender liability claim, the issue is not whether the borrower will ultimately win or lose, but that delays could cause the project to lose more of its value. The purpose of reviewing all the pertinent documents is to provide the lender with the ability to incorporate a waiver of those claims in workout documents so that the borrower cannot haunt the lender later. Given the current market dynamics, it is in the best interest of all lenders involved in a workout to unify and act as a single entity. Any disputes among the lenders will only serve to either hurt the project or help the borrower – neither of which is in any of the lenders' best interests. Needless to say, negotiations for workouts are always complicated, given the fact that the project is in turmoil. Further, when multiple mezzanine lenders are involved and are required to make majority or unanimous agreements, the challenges are even greater. This requirement could cause problems for the holders of the junior mezzanine pieces, because they have the most to lose if the holder of the senior debt on the property decides to foreclose its mortgage on the asset, ultimately eliminating the mezzanine lender's collateral. [i] Stuart M. Saft is a partner at Dewey & LeBoeuf LLP, based in New York. He can be contacted at (212) 424-8245
