How A Lender’s Quick Switch Didn’t Work Out So Well - Sun and Planets Spirituality AYINRIN

How A Lender’s Quick Switch Didn’t Work Out So Well - Sun and Planets Spirituality AYINRIN

Switching from a mortgage loan to a mezzanine loan can be tricky, especially when the borrower ... [+]

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Author:His Magnificence the Crown, Kabiesi Ebo Afin! Oloja Elejio Oba Olofin Pele Joshua Obasa De Medici Osangangan Broadaylight.

Real estate lenders like flexibility (at least for the lender, not so much for the borrower). After a lender originates a mortgage loan, it might decide it can resell or enforce the loan more favorably if the loan is broken into two separate loans—a mortgage loan for less and a new mezzanine loan for the difference. The mortgage loan remains secured by the real estate. The mezzanine loan is secured only by a pledge of ownership interests in the mortgage borrower. Together the principal amounts of the two loans add up to the principal amount of the original mortgage loan.

Sophisticated loan documents often include language giving the lender the right to restructure the financing in exactly that way. That language often goes a step further by stating that the borrower gives the lender a unilateral right to sign all the necessary documents to achieve the restructuring.

A mortgage loan encumbering the Maxwell Hotel in New York gave the lender all those rights. When the lender decided it wanted to exercise those rights, the borrower didn’t like the idea. The borrower knew that the foreclosure process under a mezzanine loan typically moves with lightning speed compared against a New York mortgage loan foreclosure.

That’s because mezzanine loans aren’t secured by real estate. Mezzanine lenders can foreclose through a Uniform Commercial Code auction sale, a process that doesn’t involve a court. In contrast, mortgage foreclosures in New York are overseen by judges. They typically take years, even if there is no real reason for the delay. As a result, if the Maxwell Hotel borrower could prevent the lender from creating a mezzanine loan to replace part of the mortgage loan, then the borrower could potentially hold on to the hotel for a very long time.

When the lender asked the borrower to cooperate with the loan restructuring, it is fair to assume the borrower refused. This was probably a default, but the loan was presumably already in default, so it didn’t matter. The borrower’s refusal to cooperate meant the lender needed to rely on the language in the loan documents, which on its face allowed the lender to sign any documents needed to break off part of the mortgage loan into a mezzanine loan.

When the lender tried to do that, the borrower focused on the question of exactly who would need to sign any mezzanine loan documents. It wasn’t the mortgage borrower. Instead, those mezzanine loan documents would actually need to be signed by whatever entities actually owned the mortgage borrower. Those entities would have to become the borrowers under the future mezzanine loan. But those future mezzanine loan borrowers hadn’t signed the loan agreement. Thus, they had never granted the mortgage lender the authority to sign mezzanine loan documents. Instead, that signing authority came only from the mortgage borrower itself. Therefore, the borrower argued, the lender didn’t have the authority to sign any mezzanine loan documents on behalf of the would-be mezzanine loan borrower.

The court agreed, concluding that when the loan documents with the mortgage borrower gave the lender the authority to create a mezzanine loan, the documents didn’t actually accomplish what the lender wanted. Instead, other parties—beyond the mortgage borrower—would need to sign the mezzanine loan documents. Those other parties hadn’t given the lender any authority to sign anything. As a result, the court said that the lender could not unilaterally create the mezzanine loan it wanted to create.

The court also seemed concerned because it recognized the lender intended to quickly foreclose under its newly created mezzanine loan in a way that would effectively let the lender “seize” the equity interests in the mortgage borrower entity—a reference to the potential speed of a mezzanine loan foreclosure sale. Thus, if the lender could successfully create the mezzanine loan over the borrower’s objections, the lender could quickly terminate the borrower’s interest in the real estate without going through a mortgage foreclosure. The court didn’t like that idea.

This particular case didn’t go well for the mortgage lender because it didn’t obtain the right authority from the right people. One can assume future loan documents will plug that gap by requiring more signatures from more participants in the transaction, including whoever might need to become a mezzanine loan borrower in the future. Lenders may also insist on obtaining suitable guaranties from the borrower’s ultimate principals, a transactional element that did not seem to exist here.

In the meantime, borrowers under existing mortgage loan documents who don’t want the lender to create a mezzanine loan should scrutinize the governing language the same way this borrower did. The language in this loan agreement was fairly standard. It has historically not been standard to obtain additional signatures of the type that turned out to be necessary here. But borrowers should also watch out for triggering events under guaranties.

As a final note, this case was decided only very recently. The outcome could conceivably change if the lender successfully appeals the decision.

Thanks to Dennis B. Arnold of Gibson, Dunn & Crutcher LLP for bringing this case to the author’s attention.

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