An intercreditor agreement (ICA) involving a construction loan raises a host of complicated and unique issues that are not addressed in the typical ICA.

As more fully described in our prior alert on Intercreditor Agreements (ICAs), and by way of a short introduction to mezzanine loans generally, the mezzanine lender in a single mezzanine loan structure makes a mezzanine loan to the mortgage borrower’s owner(s) (the “mezzanine borrower”) and the mezzanine loan is secured by the mezzanine borrower’s equity interest in the mortgage borrower (a single purpose entity that is not the property owner entity). Instead of a lien on the underlying real property, the mezzanine lender takes a pledge of equity interests in the mortgage borrower. This means that in the event of an enforcement action by the senior lender under a senior mortgage, a mezzanine lender’s loan is extinguished if the mortgage lender forecloses on its mortgage loan or accepts a deed in lieu. The mezzanine loan’s collateral only has value if the underlying property (or anticipated development potential) exceeds the amount of the mortgage debt. As a result, the mezzanine loan is vulnerable if there are intervening liens (such as real estate tax liens, mechanic’s liens or judgment liens) since its collateral is only an indirect interest in the property—and a foreclosing mezzanine lender indirectly becomes exposed to all such outstanding liens and liabilities without having the ability to foreclose any of them out. This puts the mezzanine lender at greater risk—and in exchange for this risk the mezzanine loan coupon is traditionally quite a bit higher than the mortgage loan coupon. Note that we have assumed in this article, for sake of simplicity, that there is a mortgage loan and a single mezzanine loan.

The mortgage lender and the mezzanine lender are typically parties to an intercreditor agreement designed to memorialize their relative priority (including confirmation of the subordination of the mezzanine loan to the mortgage loan) and respective rights and remedies.

When the mortgage loan is a construction loan, there are a number of issues that are particular to the situation—and not addressed in a typical ICA.

Prior to discussing the ICA-related issues that will arise, however, it is important to note that there are fundamental “structuring issues” that arise when originating (or considering) a mezzanine loan behind a construction loan. Specifically, the parties must first determine whether the mezzanine lender will fund its entire mezzanine loan (including construction loan advances) at origination or if, instead, the mezzanine lender will fund its mezzanine loan over time (for example, pari passu with construction loan advances being made by the construction lender). This will depend on various factors, such as (i) who, as between the lenders, is best equipped to handle construction draw requests, budget changes and other construction-related matters, (ii) whether the mezzanine borrower (together with the mortgage borrower) is willing to accept “two sets” of approvals, and (iii) whether the borrower is willing to accept the risk that differences in opinion between the lenders may arise with respect to each construction requisition and other construction-related matters (such as budget reallocations and change orders). Many construction lenders will prefer the mezzanine loan to be funded at closing and the mezzanine lender’s role with respect to construction-related matters to be minimized to the extent possible. Of course, in this case, the borrower will have to pay interest at the mezzanine loan rate on a fully funded mezzanine loan (which could well exceed a non-utilization fee should one be imposed in the case of construction loan advances made over time).

A description of some of the specific issues that may be addressed in ICAs between construction lenders and mezzanine lenders follows.  

1.  Approvals with Respect to Draw Requests, Changes to the Construction Budget and Other Construction-Related Matters. While both the mortgage loan documents and the mezzanine loan documents are likely to provide that each lender has the right to approve construction draws and changes to the construction budget (such as change orders or reallocations of line items), the ICA will often try to rationalize the process and minimize “dual” approvals thereby minimizing the risk of delay. Variations on the language and concept of course exist, but some ICAs require the mezzanine lender to not withhold its consent unreasonably or to limit the mezzanine lender’s approval to specific items or costs exceeding a certain dollar amount—while some ICAs altogether limit the mezzanine lender’s role to a non-binding consultation role. We also see agreements to jointly use certain construction consultants to reduce the risk of inefficiency or timing delays, and in the case of branded hotel deals, to coordinate decision‐making with requirements of the applicable hotel brand.

2.  Transfers and Foreclosure. ICAs typically provide that a mezzanine lender can transfer a controlling interest in the mezzanine loan (including in a foreclosure) without senior lender consent if the loan is transferred to (or the transferee in the UCC foreclosure is) a “Qualified Transferee” that satisfies certain “Eligibility Requirements.” And while the identity and financial wherewithal of the transferee or purchaser is significant in all cases (among other reasons, because the mezzanine lender may control and indirectly own the mortgage borrower following a UCC foreclosure), the construction lender will also be focused on the ability of the transferee to “step in” to an active construction project (and, in the case of a hotel, be acceptable to any applicable hotel brand). ICAs with construction loans therefore often require that, in addition to satisfying the “standard” conditions to a UCC foreclosure set forth in standard ICAs, transferees (and purchasers at a foreclosure sale) must be (or must retain) a qualified developer, construction manager or general contractor.

3.  Replacement Guaranties. Another condition to foreclosure of a mezzanine loan, also set forth in many ICAs, is that the foreclosing lender or the purchaser at the foreclosure sale must provide the construction lender with “replacement guarantees” from acceptable guarantors (i.e., persons meeting certain agreed-upon parameters or otherwise approved by the senior lender). At origination of a construction loan, the mortgage lender and the mezzanine lender will both require that a sponsor or other qualified entity which adequate financial wherewithal deliver to each lender a “non-recourse carveout” or “bad boy” guaranty, a completion guaranty, a carry guaranty and a payment guaranty.

The completion guaranty is a guaranty of the lien-free completion of the project and, also, of the obligation to keep the construction loan “in balance.” Certain mezzanine lenders may object to having to put up a replacement completion guaranty (or may simply object to the “balancing” obligation in any replacement completion guaranty) on the grounds that (i) the mortgage lender should instead pursue the original guarantor (who should remain liable even if a mezzanine foreclosure is completed), (ii) often, the mortgage loan completion guaranty includes a liquidated damages clause to defray the cost of completing the project and/or balancing calls and (iii) the mezzanine lender did not intend to complete construction. While this provision is often negotiated, the mortgage lender will typically agree to continue funding construction loan advances if the new mezzanine lender/developer undertakes to complete in accordance with the construction loan documentation.

A carry guaranty is a guaranty of the payment of debt service, real estate taxes, insurance premiums, utilities and any ground lease payments. Mezzanine lenders typically agree to provide these to mortgage lenders—but only for the period following the UCC foreclosure or assignment in lieu. Many carry guaranties contemplate termination if a deed in lieu is tendered.

A payment guaranty is not typically requested (or required) to be provided by a foreclosing mezzanine lender in ICAs between institutional lenders, but may arise in circumstances where the mezzanine lender is non-institutional and is expected to prosecute the development to completion. Furthermore, even if there is no payment guaranty, the mezzanine lender should expect that it will be required to fund loan balancing shortfalls in accordance with the terms of the senior loan documents.

These provisions clearly all need to be carefully reviewed when a mezzanine lender is considering its exercise of remedies.

4.  Rights to Cure; the Maturity Date. As mentioned above, an ICA will typically grant the mezzanine lender rights to cure both monetary and non-monetary defaults, with the right to cure non-monetary defaults being uncapped in duration provided that the mezzanine lender is keeping the mortgage loan current and the mezzanine lender is diligently pursuing the cure (or foreclosure, should possession be necessary). 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 and construction-related cures. (See our alert on UCC foreclosures and also see conditions to foreclosure described below.)

Clearly, when considering cures under a construction loan, any mezzanine lender evaluating whether to effect a non-monetary cure (and then possibly exercising a UCC foreclosure to “gain control”) will need to understand and evaluate, among other factors, the nature of the particular senior loan defaults to the extent they relate to construction, construction delays and budget overruns—as well as, ultimately, the mezzanine lender’s ability to complete and pay for the completion of the project. Also recall that, as noted above, the mezzanine loan is vulnerable if there are intervening liens (such as real estate tax liens, mechanic’s liens or judgment liens) as it does not have a mortgage lien on the underlying real property—and a “curing” mezzanine lender who may become a “foreclosing” mezzanine lender indirectly becomes liable for all such outstanding liens and liabilities without having the ability to foreclose any of them out. This will be of particular concern to a mezzanine lender in a construction loan situation—as the mechanic’s liens and other liabilities (such as unpaid contractors or suppliers) will diminish its value proposition.

The exercise of cure rights including retaining new contractors (and possibly new architects and engineers) and “re-mobilizing” will not only be costly but will take time to put in place. Accordingly, many mezzanine lenders negotiate for an extension of the dates set forth in the Construction Schedule and the date for achieving Substantial Completion in the ICA. This may require revisiting the ICA provisions regarding “curing non-monetary defaults” prior to a mezzanine lender’s foreclosure of its pledge.

5.  Purchase Options. A mezzanine lender is generally granted the right to buy the mortgage loan upon the occurrence and continuance of events of default under the mortgage loan documents. With a construction loan as the senior loan, however, the mezzanine lender who exercises such purchase option will need to consider that it is not only agreeing to pay the agreed-upon purchase price at the closing of the purchase—but also “stepping into” the senior lender’s future funding obligations.

6.  Mechanic’s Liens. As noted above, a foreclosing mezzanine lender does not have the ability, when it forecloses on its collateral, to foreclose subordinate liens on the real estate—and instead the mezzanine lender will step into control and indirect ownership of the real estate “subject to” such liens. Further, where there is construction there is also the risk of mechanics liens, which a foreclosing mezzanine lender will care a great deal about. Accordingly, the mezzanine lender will want to pay particular attention to the requirements of the loan documents (and the provisions in its ICA) regarding obtaining or waiving obtaining lien waivers.

The matters identified above are by no means an exhaustive list of all of the matters to be considered when negotiating or reviewing an intercreditor agreement with a senior construction loan—and by no means addresses all or every intercreditor agreement or all of the issues or concerns that may arise when considering actions to be taken under an ICA. These documents are complex. Also, note that the funding structures will vary from deal to deal and, likewise, each ICA will contain differently negotiated provisions. In addition, the market for these agreements (and therefore “market standard” 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. In moments of distress, clients are advised to seek experienced counsel—including counsel with “fresh eyes” to review these documents.

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