Control provisions in mezzanine loans - by Thomas Kearns and Sari Kreutzer

 

 

Mezzanine loans are loans secured by a pledge of the membership interests in the property owner or its 100% owner. Over the last couple of decades mezzanine loans have revolutionized the lending market by permitting a property owner to obtain both a mortgage on the real estate and a separate mezzanine loan secured by the membership interests. The pledge agreements securing the mezzanine loans sometimes include a provision permitting the mezzanine lender to take full management and voting control of the property owner before a formal foreclosure of the lien on the membership interests. The enforceability of such a drastic remedy has been questioned by some practitioners since it does an end around the statutory requirements in the Uniform Commercial Code that govern foreclosures of membership interests. In addition, counsel to mezzanine lenders have been taking the position that transfer taxes that would be payable on a foreclosure are not payable when control is taken by the lender since no transfer of the interest has yet occurred.

Two recent cases at the trial court level, however, have held that such control provisions in pledge agreements may be generally enforceable. In a bankruptcy court decision WorkCentric LLC v. Sunz Insurance Solutions, LLC a parent company pledged its membership interests in its subsidiary to an insurance company during a forbearance period. The parent company subsequently did not meet its obligations under the forbearance agreement, and thus, the court held that even though the insurance company had not yet foreclosed on the pledged membership interests, the insurance company had the right to take control of the company, replace the company’s management and exercise membership rights. In an unreported decision affecting a Times Square hotel, a New York Supreme Court held that similar moves to replace management by an opportunistic investor which purchased a mezzanine loan was permissible in the circumstances.

Among other issues, these control provisions complicate the typical bad act recourse guarantees that often accompany both mortgage and mezzanine loans. For example, if the guaranty says there is liability to the guarantor for acts taken by the borrower, what if those acts were done by the borrower after control has shifted to the mezzanine lender? Of course, the exact facts and circumstances of each situation might impact on the enforceability. For example, will a court exercising equitable powers permit such a drastic interim remedy for a mere technical default? Mezzanine lenders also may want to be careful since some laws which apply to operators of a property such as environmental laws might apply to a mezzanine lender once it’s in control of a borrower.

While we await appellate court decisions, borrowers should be aware of these provisions and the recent case law and consider their impact on the guarantees being signed as part of the loan.

Thomas Kearns is a partner, and Sari Kreutzer is an associate with Olshan Frome Wolosky LLP, Manhattan, N.Y.