In this era of troubled real estate investments, it is critical to understand the relative rights of the senior lender and the mezzanine lender in a loan default situation, particularly with respect to the separate recourse guaranties provided to each lender by the borrower. The lenders’ respective rights (including subordination) are spelled out in the intercreditor agreement between the two lenders; however, the treatment of the recourse guaranty rights against the sponsor is often unclear or not fully thought through. Most importantly, the rights of the mezzanine lender under its separate guaranty may be blocked or curtailed at the point when having the recourse guaranty is most crucial to the mezzanine lender.

The Recourse Guaranty

One of the most important documents in a typical mezzanine lending transaction is the recourse guaranty from the sponsor (the ultimate owner of the borrowing entities) to each lender. The mezzanine lender and the senior mortgage lender will have their own separate guaranty from the sponsor. The terms of the guaranties will be identical, except that the mezzanine lender’s guaranty will cover not only the mezzanine borrower’s “recourse acts,” but also those of the senior borrower, while the senior lender’s guaranty will cover only the recourse acts of the senior borrower.

The recourse guaranty is, of course, primarily a deterrent sanction against specific, deliberate borrower actions that mirror the exculpation exceptions in the underlying non-recourse loan agreement. The events covered by recourse guaranties fall into two basic categories: (a) “bad boy” acts, such as fraud, waste, misappropriation of rents or insurance proceeds, breach of single-purpose entity provisions, etc., and (b) certain major events, such as non-permitted transfers, voluntary bankruptcy and collusive involuntary bankruptcy (which I will refer to as “breaking the thread” events). The “bad boy” acts give the lender a claim to the extent of its losses caused by the covered event, while the “breaking the thread” events make the entire loan immediately recourse to the sponsor.

Mezzanine Loan Architecture

The architecture of mezzanine lending is built on the principle of separate collateral and rights: the mezzanine lender is not the beneficiary of the senior lender’s mortgage and has no claim against the senior borrower (including the right to participate as a creditor in a bankruptcy of the senior borrower). Similarly, the mezzanine lender’s equity collateral is normally defined in the intercreditor agreement as “separate collateral” against which the senior lender has no claim, and the mezzanine lender can exercise unsubordinated remedies against its equity collateral and receive and retain the proceeds thereof irrespective of whether there is a senior loan default, including senior borrower bankruptcy. To the extent of any cash flowing from the property, the rights of the mezzanine lender are fully subordinate to the claims of the senior lender, and in the event of a senior borrower default, the senior lender is entitled to payment in full before any property cash is released to the mezzanine lender. A senior borrower default thus gives the senior lender the right to block the payment of property-derived cash flow to the mezzanine lender until the default is cured. Under the intercreditor agreement, the mezzanine lender has the right to cure any senior borrower default and restore its ability to receive the cash flow from the property once the senior lender is current. Thus, in exchange for the agreement not to compete with the senior lender for the property or claim against the senior borrower, the mezzanine lender receives the unfettered right to proceed against its separate borrower and collateral (as distinct from taking a subordinate mortgage and subordinate claim against the common property owner/borrower).

Competing Rights of the Lenders to Recourse Guaranty Claims

Because recourse guaranties have a common debtor in the sponsor, questions invariably arise as to how each lender's rights should be construed with respect to claims against the sponsor under such guaranties. Are such claims "common collateral" since there is a common obligor, or are they "separate collateral" protecting separate lender interests? Should the mezzanine lender’s recourse claims against the sponsor be stayed or subordinated to any pending or potential senior lender recourse claims? What if only the mezzanine lender’s recourse guaranty is triggered, such as in the event of a mezzanine borrower bankruptcy, which is neither a senior lender default nor a senior lender recourse event?

The proper approach should be to look at the specific recourse events for guidance, and to allocate (and where appropriate, subordinate) those rights based on the interests that the guaranty aims to protect. Where the primary effect of the recourse event is on one lender’s collateral and the collateral already has applicable subordination provisions in effect under the intercreditor agreement, then the subordination of the recourse claim should follow the subordination that applies to the affected collateral. For example, stealing rents or committing waste on the property primarily affects the real estate and cash flow from it, for which the subordination priorities are clearly in favor of the senior lender. Even though such events are also recourse events for the mezzanine lender, it would be appropriate to require the mezzanine lender to stand still while the senior lender pursues its recourse claim, or to turn over any recoveries on such mezzanine recourse claims to the senior lender for application to the senior debt.

In contrast, in the event of a mezzanine borrower-only bankruptcy (when there is no senior borrower bankruptcy), the mezzanine lender should not be restricted in pursuit of its mezzanine claim as (a) there is no comparable claim triggered under the senior recourse guaranty, and (b) the mezzanine recourse guaranty is customarily part of the mezzanine lender’s “separate collateral.”

Similarly, a non-permitted transfer of the property (or of the equity in the senior borrower) by the mezzanine lender is disastrous for the mezzanine borrower as its equity collateral is unhinged from the property and it is left with the then-empty shell mezzanine borrower. (Or, as Shakespeare said in Sonnet LXXIII, “bare ruined choirs, where late the sweet birds sang.”) In such event, the mezzanine lender has nothing left but its recourse guaranty claim, and ought to be allowed to pursue it.

A senior borrower bankruptcy, however, raises somewhat different and more complex issues.

Effect of Senior Borrower Bankruptcy

Consistent with the mezzanine architecture of separate loans and borrowers, in a bankruptcy of the property owner, the mezzanine lender does not even have a seat at the table, and is at risk of recovering nothing whatsoever if the equity is wiped out, as is often the result in a bankruptcy. The mezzanine recourse guaranty thus bridges that gap by providing alternate recourse to the sponsor and, in that circumstance, is much more vital to the mezzanine lender than to the senior lender. The senior lender still would have access to the mortgaged property for its recovery, with a bankruptcy functioning essentially as delay for the senior lender in getting to its collateral, whereas the mezzanine lender risks being left with nothing in a senior borrower bankruptcy. This makes it important for the mezzanine lender to have an unsubordinated right under the intercreditor agreement to pursue the recourse guaranty in the event of a senior borrower bankruptcy. Indeed, most mezzanine lenders take the view that they are not underwriting a senior borrower bankruptcy and are certainly not compensated for taking that risk in the mezzanine loan pricing. While a mezzanine borrower bankruptcy could be viewed for the mezzanine lender as analogous to a senior bankruptcy for the senior lender (simply as a delay in the ability to access the collateral), in a senior borrower bankruptcy, the mezzanine lender is at risk of being cut off from its collateral entirely unless it can foreclose on its equity collateral and step into the position of the owner of the senior borrower.

Interestingly, in some recent major deals the trend in intercreditor agreements is to treat the recourse guaranty exactly opposite of what would be logically expected. The mezzanine lender is given the unsubordinated right to pursue the guaranty when it is only delayed in reaching its equity collateral (mezzanine-only bankruptcy when the senior lender does not itself have a recourse claim), but has to turn over recourse guaranty proceeds in the event of a senior bankruptcy. As discussed above, a senior borrower bankruptcy is precisely the event where the structure breaks down for the mezzanine lender, and the recourse guaranty becomes its primary collateral. If the mezzanine lender had the benefit of a perfected junior mortgage, so that it would have a continued (though subordinated) claim against the underlying property, subordination of the recourse guaranty would then be inconsequential.

Accordingly, the better result would be for the mezzanine lender to be able to pursue its recourse claim when it has nothing else left (or is at risk of losing its connection to the property), and to subordinate such recourse claims when they relate to damage to the senior lender’s property collateral.