Stuy Town: Redux in the Desert

The decision in U.S. Bank National Association, Trustee v. RFC CDO 2006-1 Ltd. is important because it interprets the rights of a mezzanine lender pursuant to a widely used form of Intercreditor Agreement, virtually identical to the form of agreement in the Stuy Town Case. This appears to be the first such ruling by a federal court.

Background

Many, if not most, CMBS loans are structured with multiple layers of debt. A special purpose entity (SPE) that owns the real estate (Property Borrower) borrows money from a senior lender secured by its real estate assets. An upstream SPE borrows money from a mezzanine lender, secured by a pledge of the membership interests in the Property Borrower. The senior lender and the mezzanine lender enter into an Intercreditor Agreement, which usually specifies that the mezzanine lender is deemed subordinate to the senior lender.

In the Stuy Town Case, the court interpreted the Intercreditor Agreement to prohibit the mezzanine lender from exercising its remedies until it had paid off the senior debt. The decision blocked the mezzanine lender from taking control of the Property Borrower, thereby taking control of the underlying real estate asset.

The Arizona Case

The Arizona case involved Starr Pass Resort Developments, LLC (Starr Pass), which borrowed $145 million secured by, among other things, a first lien on the JW Marriott Starr Pass Resort in Tucson (Senior Loan). The owners of Starr Pass also borrowed $20 million dollars secured by a pledge of 100% of the ownership interest in Starr Pass (Mezzanine Loan). The Senior Loan matured and became due and payable in full and the Senior Lender scheduled a foreclosure sale.

The Mezzanine Lender subsequently scheduled a UCC sale prior to the date of the foreclosure sale. The expectation was that the Mezzanine Lender would gain control of Starr Pass and would put the property into a bankruptcy proceeding, blocking the Senior Loan foreclosure. The Senior Lender contended that this could potentially result in the loss of millions of dollars in value.

The Senior Lender, represented by a team of attorneys from Ballard Spahr LLP, argued that the Mezzanine Lender's attempt to force a sale of Starr Pass ownership interests without repayment of the matured Senior Loan would violate key provisions in the Intercreditor Agreement. U.S. District Court Judge David C. Bury found that the contract terms in the Intercreditor Agreement supported the Senior Lender's position, requiring the Mezzanine Lender to pay off the Senior Loan as a condition precedent to enforcing its remedies.

Judge Bury did not expressly rely on the holding in the Stuy Town Case. Rather, he engaged in an independent analysis, which led to the conclusion that the Intercreditor Agreement was clear and unambiguous in its relevant parts. The court held that the language of the Intercreditor Agreement, informed by its purpose, required the Mezzanine Lender to cure all outstanding defaults prior to the exercise of its remedies. Since the Senior Loan was a maturity default, a cure involved the payment of the entire $145 million. The court rejected arguments by the Mezzanine Lender that attempted to parse the language of the Intercreditor Agreement to assert that the cure obligation fell upon the transferee and was to occur “as of the date of the acquisition,” but not as a condition precedent to the acquisition.

It is significant that the court was guided by the overall subordination structure in the Intercreditor Agreement in reading and harmonizing the various requirements connected with the exercise of remedies by the Mezzanine Lender. The court rejected the attempt by the Mezzanine Lender to shift responsibility away from itself and onto the ultimate and unknown buyer at the sale. In a practical sense, the court determined that it was the responsibility of the Mezzanine Lender to fulfill these requirements as a condition precedent. This was consistent with the “bargained for first position and complete subordination” and the “strong and all encompassing subordination language” reflected in the Intercreditor Agreement, according to the court.

Interestingly, the court also noted that because the Senior Loan was part of a larger pool of securitized loans placed in a trust securing the investment of independent investors, the case involved the interests of multiple parties who relied upon and expected the court to enforce the actual terms of the Intercreditor Agreement. On this basis, the court held the public policy favors requiring commercial entities to act pursuant to their bargained-for rights. The court issued an injunction prohibiting the Mezzanine Lender from proceeding with the UCC sale and acquiring the equity collateral unless and until it cured the defaults under the Senior Lender.

Conclusion

The district court has now essentially affirmed, in principle and result, the Stuy Town Case. The court relied heavily on both the language and the purpose of the Intercreditor Agreement in making its decision. The court ruled that no amount of parsing of the contract language should produce a result that is contrary to the overall subordination scheme to which the Mezzanine Lender agreed and upon which numerous investors have relied. Thus, the Stuy Town Case has been reborn in the Arizona desert and its echo will continue to be heard in future cases involving CMBS-structured real estate loans.

The decision of the New York Supreme Court in Bank of America, N.A. v. PSW NYC LLC, 29 Misc.3d 1216A, 918 NYS3d 396, garnered national attention in 2010. The court ruled that, under the terms of an Intercreditor Agreement in common use in complex real estate loans across the United States, a mezzanine lender could not exercise its rights against its collateral without first paying off senior debt.

Commonly known among real estate lawyers as the “Stuy Town Case,” the decision caused a stir in real estate and legal circles since it implicated the potential value of mezzanine debt, a common component of real estate loans in a commercial mortgage-backed securities (CMBS) loan structure.

Now the issue is causing a stir in the Arizona desert. On Dec. 6, 2011, a federal judge in Arizona blocked the proposed sale of ownership interests in the entity that owns a Tucson resort until the matured first mortgage loan of the senior lender, in the amount of $145 million, is satisfied in full.

The decision in U.S. Bank National Association, Trustee v. RFC CDO 2006-1 Ltd. is important because it interprets the rights of a mezzanine lender pursuant to a widely used form of Intercreditor Agreement, virtually identical to the form of agreement in the Stuy Town Case. This appears to be the first such ruling by a federal court.

Background

Many, if not most, CMBS loans are structured with multiple layers of debt. A special purpose entity (SPE) that owns the real estate (Property Borrower) borrows money from a senior lender secured by its real estate assets. An upstream SPE borrows money from a mezzanine lender, secured by a pledge of the membership interests in the Property Borrower. The senior lender and the mezzanine lender enter into an Intercreditor Agreement, which usually specifies that the mezzanine lender is deemed subordinate to the senior lender.

In the Stuy Town Case, the court interpreted the Intercreditor Agreement to prohibit the mezzanine lender from exercising its remedies until it had paid off the senior debt. The decision blocked the mezzanine lender from taking control of the Property Borrower, thereby taking control of the underlying real estate asset.

The Arizona Case

The Arizona case involved Starr Pass Resort Developments, LLC (Starr Pass), which borrowed $145 million secured by, among other things, a first lien on the JW Marriott Starr Pass Resort in Tucson (Senior Loan). The owners of Starr Pass also borrowed $20 million dollars secured by a pledge of 100% of the ownership interest in Starr Pass (Mezzanine Loan). The Senior Loan matured and became due and payable in full and the Senior Lender scheduled a foreclosure sale.

The Mezzanine Lender subsequently scheduled a UCC sale prior to the date of the foreclosure sale. The expectation was that the Mezzanine Lender would gain control of Starr Pass and would put the property into a bankruptcy proceeding, blocking the Senior Loan foreclosure. The Senior Lender contended that this could potentially result in the loss of millions of dollars in value.

The Senior Lender, represented by a team of attorneys from Ballard Spahr LLP, argued that the Mezzanine Lender's attempt to force a sale of Starr Pass ownership interests without repayment of the matured Senior Loan would violate key provisions in the Intercreditor Agreement. U.S. District Court Judge David C. Bury found that the contract terms in the Intercreditor Agreement supported the Senior Lender's position, requiring the Mezzanine Lender to pay off the Senior Loan as a condition precedent to enforcing its remedies.

Judge Bury did not expressly rely on the holding in the Stuy Town Case. Rather, he engaged in an independent analysis, which led to the conclusion that the Intercreditor Agreement was clear and unambiguous in its relevant parts. The court held that the language of the Intercreditor Agreement, informed by its purpose, required the Mezzanine Lender to cure all outstanding defaults prior to the exercise of its remedies. Since the Senior Loan was a maturity default, a cure involved the payment of the entire $145 million. The court rejected arguments by the Mezzanine Lender that attempted to parse the language of the Intercreditor Agreement to assert that the cure obligation fell upon the transferee and was to occur “as of the date of the acquisition,” but not as a condition precedent to the acquisition.

It is significant that the court was guided by the overall subordination structure in the Intercreditor Agreement in reading and harmonizing the various requirements connected with the exercise of remedies by the Mezzanine Lender. The court rejected the attempt by the Mezzanine Lender to shift responsibility away from itself and onto the ultimate and unknown buyer at the sale. In a practical sense, the court determined that it was the responsibility of the Mezzanine Lender to fulfill these requirements as a condition precedent. This was consistent with the “bargained for first position and complete subordination” and the “strong and all encompassing subordination language” reflected in the Intercreditor Agreement, according to the court.

Interestingly, the court also noted that because the Senior Loan was part of a larger pool of securitized loans placed in a trust securing the investment of independent investors, the case involved the interests of multiple parties who relied upon and expected the court to enforce the actual terms of the Intercreditor Agreement. On this basis, the court held the public policy favors requiring commercial entities to act pursuant to their bargained-for rights. The court issued an injunction prohibiting the Mezzanine Lender from proceeding with the UCC sale and acquiring the equity collateral unless and until it cured the defaults under the Senior Lender.

Conclusion

The district court has now essentially affirmed, in principle and result, the Stuy Town Case. The court relied heavily on both the language and the purpose of the Intercreditor Agreement in making its decision. The court ruled that no amount of parsing of the contract language should produce a result that is contrary to the overall subordination scheme to which the Mezzanine Lender agreed and upon which numerous investors have relied. Thus, the Stuy Town Case has been reborn in the Arizona desert and its echo will continue to be heard in future cases involving CMBS-structured real estate loans.