best practices in commercial real estate financing: essential issues in negotiating a/b note...

Best practices in commercialreal estate financing: Essentialissues in negotiating A/B noteintercreditor agreementsDavid M. StewartReceived: 12 September, 2002

AbstractIn this quarterly feature the nuts and bolts of loan documentstructuring and negotiations are investigated, as well as theclosing process and loan administration. This issue’s paperexamines the most hotly negotiated legal issues between thesenior and junior lenders in the context of A/B notes originated forthe REMIC securitisation market, where both the senior (A) andjunior (B) note share a mortgage interest in the same real property.The paper outlines the ways in which the holder of the B note mayattempt to protect its interest in the face of actions by the A noteholder that could otherwise modify or reduce the borrower’sobligations to the B note holder, or eliminate the collateral for theB note. In each case, the author suggests typical compromisepositions that should satisfy both the B note holder and theholders of all tranches of the securities backed by the A note.

Over the last two years, US lenders originating loans for inclusion inmortgage-backed securities (REMIC) transactions have markedlyincreased the use of subordinated debt, which the lenders originatein addition to the main securitised debt with respect to a particularborrower or asset. Often this subordinated debt is sold privately andnot securitised. The increased use of subordinated debt isattributable to several factors, including:

. the desire of originating lenders to balance origination volumeand securitisation execution;

. the existence of greater numbers of loan investors willing topurchase the subordinate loan interest;

. for the borrower, the ability to obtain a higher loan-to-value ratio(and similarly for the lender, the ability to originate and securitiseloans backed by a lower grade of asset) than would be available ifthe entire loan were included in a securitisation without asubordinated piece;

. the perceived need to break into smaller pieces the largest loans inany given REMIC pool (which would otherwise constitute toolarge a portion of the collateral pool); and

The section editor is Joshua

Stein, a real estate and finance

partner in the New York office

of the international law firm of

Latham & Watkins. His

articles and books on

commercial lending and

commercial leasing have been

extensively published in

Briefings in Real Estate

Finance and elsewhere. He can

be contacted at

[email protected] or

+1 212 906 1342.

David M. Stewart

is a real estate finance

attorney with the international

law firm of Latham &

Watkins, based in New York

City. He previously practised

law in London and in Central

Europe.

Keywords:

REMIC, CMBS, A/B notes, intercreditor

agreements

David M. StewartLatham & Watkins885 Third AvenueNew YorkNY 10022-4802, USATel: +1 212 906 1200Fax: +1 212 751 4864E-mail: [email protected]

HENRY S T EWART PUB L I C A T I ONS 1473 ^ 189 4 B r i e f i n g s i n R e a l E s t a t e F i n a n c e VOL . 2 NO . 3 P P 2 5 6 – 2 6 1256

. favourable changes in the way that rating agencies treat theseforms of additional debt.

The additional debt ordinarily takes the form of a bifurcation of thefinancing: the originating lender includes the first-priority mortgageloan in the immediate securitisation, while simultaneously creating asubordinate loan, which the lender holds or sells outside of thesecuritisation. The purchaser of this junior loan typically buys itsinterest at a moderate discount and may, itself, include thatsubordinate piece in a subsequent securitisation.Previously, mezzanine loans were the most common form of

additional debt, but the relatively new A/B structure is increasinglypopular. While a mezzanine loan is generally made to the equityowners of the property-owning entity, and is secured by a pledge ofthe borrower’s equity interests in the property owner, an A/B loan ismade to the property-owning entity, itself: the ‘A’ (senior) and ‘B’(junior) loans are evidenced by separate promissory notes, but thesame entity is the borrower under both loans, and a single mortgagetypically secures both of the A and B loans. In that way, the A andB lenders effectively share the mortgage lien. The B note may havethe effect of providing credit support to the A note, while giving theB note holder a direct first mortgage lien, which is generallyconsidered stronger collateral than a pledge of equity. Additional,but rarely seen, alternatives to this A/B structure would be aseparate, subordinated B loan or the creation of a juniorparticipation interest that is held outside of the securitisation.

THE ROLE OF THE INTERCREDITOR AGREEMENTSince the A note holder and the B note holder in an A/B structureshare the mortgage lien in the collateral, their relationship must begoverned by an intercreditor agreement — also called an agreementamong note holders — that confirms the subordination of the Bnote holder’s interest and that limits certain of the B note holder’srights under the loan documents. The purchasers of B notes hotlynegotiate these intercreditor agreements, because the B note holderis the last to be repaid and the first to lose, if the loans do notperform and the value of the collateral diminishes.Therefore, the B note holder has the greatest immediate need to

interact directly with the borrower and to control the loanadministration in default cases. On the other hand, the purchasers ofthe A note holder’s interest in the securitisation pay ‘top dollar’ forthat senior stake, and both the rating agencies and the purchasers ofcertificates in lower tranches of the A securitisation will expect tolimit the ability of the B note holder to meddle with the loan andwith the realisation process after borrower default.The nature of the negotiation between the A note holder, whose

interest is about to become securitised, and the B note holder, whomay intend to hold the loan, to participate in it or to securitise it,depends largely on the clout and sophistication of the B note

Rise of A/B structures

The holders’ stakes

Essential issues in negotiating A/B note intercreditor agreements

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purchaser — its size and institutional goals, as well as its exitstrategy for the loan. The historic relationship, including previousdeal history, among the A note holder, as the originator of thewhole loan, its ‘B piece’ buyer within the A note securitisation andthe B note holder also frames the intercreditor deal issues. Typically,the A note holder drafts the intercreditor agreement with the interestat heart of the lowest grade securities in the A securitisation, and theB note holder, as purchaser, sets the agenda of issues it wishes tonegotiate. Nonetheless, the B note holder inevitably may beexpected to raise the following ‘hot button’ intercreditor issues, inorder to reduce the risk that the A note holder will jeopardise thesecurity for the junior loan or adversely modify its effectivemonetary terms.

Free exercise of the A note holder’s loan remediesAs a starting point, the A note holder expects the ability to pursue(or to elect not to pursue) any available remedies against theborrower without the consent of the B note holder. For instance, thetypical intercreditor agreement grants the A note holder the abilityto restructure both the A note and the B note as a whole (subject tothe servicing standard of the A note securitisation’s pooling andservicing agreement), including the ability to forgive a portion of thedebt or to reduce the interest rate. As a non-negotiable point, the Bnote holder must bear the entire economic burden of any write-down, principal or interest reduction, waiver or deferral under therestructuring; that is, all borrower payments made after the date ofthe workout agreement are credited to the A note as though theworkout had not occurred, with the payment terms of the A noteremaining as they were prior to the workout, and the B note holderbearing the full effect of such reductions or deferrals, up to theentire amount of the B note.

Limitation on the B note holder’s loan remediesAs a related and inverse function to giving the A note holder fullfreedom to protect its interest and deal with the borrower, theintercreditor agreement will typically prohibit the B note holderfrom enforcing its loan remedies against the borrower. The B noteholder is specifically prohibited from calling the loan, from filing abankruptcy petition against the borrower and from voting anyclaims in a bankruptcy of the borrower, while all of these rights arespecifically granted to the A note holder or a servicer operating onits behalf, which servicer must act merely in accordance with theservicing standard identified in the A note securitisation. Theintercreditor agreement may grant the A note holder the exclusiveauthority to make all decisions, consents, waivers, approvals andmodifications with respect to the loan. The collective effect of theserestrictions would put the B note holder into a largely passive role.As a consequence, the B note holder will typically demand some

consultation right, consisting of notice, at a minimum, or approval

Restructure risk

Consultation rights

Stewart


rights, at a maximum, with respect to any actions that would modifya monetary term of the B note or could potentially reduce thelikelihood that the borrower will repay the B note in full or that thevalue of the collateral will be sufficient to cover the outstandingamount of the B note. The parties may wish to negotiate whichspecific actions and circumstances would trigger the consultation orapproval right, but they must be aware that the rating agencies’position papers have taken a dim view of B note holder approvalrights after the loan has gone into default: the agencies would like tosee the B note holder’s rights limited to consultation only, with adrop dead date (perhaps 60 days) after which, if there is noagreement between the A note holder’s special servicer and the Bnote holder’s agent (often called an operating adviser), then thespecial servicer would have sole authority to act in the best interestof the A securitisation certificates.

Termination of the B note holder’s rightsAn ambitious and aggressive B note holder may even demand theright to deal directly with the borrower in administering the loan, assubservicer or as special servicer in the context of default, since theB note holder takes the first ‘hit’ if the value of the collateral isinsufficient to fully pay the A note and the B note. Of course, thisrole is so significant that it must be agreed upon as a fundamentaldeal term of the sale of the B note to the B note holder.Even if the B note holder is granted this right, however,

conceivably the value of the loan collateral could decline to thepoint that there would be no equity remaining in excess of theamount of the A note. In that situation, the B note holder’scollateral has effectively been wiped out — it no longer has asubstantial security interest in the property and any furtherdiminution in collateral value hurts the A note holder. At that point,the B note holder should lose its right to interact directly with theborrower, or to direct the enforcement of remedies. The A noteholder and the B note holder can establish a regime that wouldcontemplate this administrative authority transfer, by creating adefinition of ‘controlling note holder’, who would be empowered tonominate a sub-servicer for the loan, or to instruct that servicer orthe special servicer after a borrower default. While the B note holderwould be the initial controlling note holder, it would lose thatdesignation if an appraisal of the collateral (under the terms of theA securitisation pooling and servicing agreement) showed that thetotal value of the collateral had fallen below a negotiated threshold.

Ability of the B note holder to cure borrower defaultsSeparately, the B note holder may wish to safeguard its interest (andprevent the A note holder from reducing the borrower’s paymentsor wiping out the B note holder’s interest in a workout orenforcement proceeding) by intervening on the borrower’s behalf, tocure any missed payment or other borrower default under the terms

The equity-controlrelationship

Intervention



of the A note, and thereby denying the A note holder or its servicerthe opportunity to pursue remedies or to revisit the loan terms withthe borrower. The A note holder should generally be amenable tothis B note holder cure opportunity, since it effectively functions ascredit support for the A loan. In these circumstances, however, theA note holder would want to make sure that any cure by the B noteholder would not cause a delay or postponement of the A noteholder’s remedies against the borrower, especially where the delaycould impair the cash flow to the A note holder, damage the valueof the collateral or interfere with its ultimate realisation. The A noteholder may also want to limit the total number of times that the Bnote holder may cure borrower defaults.

Ability of the B note holder to purchase the loanAs a fall-back position in the various scenarios where the borroweris unable to keep both the A loan and the B loan current, the B noteholder must plan an exit strategy that maintains its interest. Afterthe loan has gone into default, where the B note holder is facing theloss of its control rights, as described above, or a restructuring orworkout engineered by the A note holder that would have thepractical effect of reducing the B note holder’s right to interest,principal or its intended collateral, the B note holder’s bestalternative may be to purchase the A note holder’s interest. Theintercreditor agreement should contemplate that if the B note holderexercises this purchase option, the A note will be purchased fromthe securitisation trust. The A note holder would typically allowsuch a purchase only after a borrower default (or when the loan isotherwise ‘specially serviced’). In this case, the purchase price for theA note should be the outstanding principal and accrued interestunder the A note, plus reimbursement to the A note servicer of allits advances, together with interest on those advances, plus the costsof the transfer. The parties may wish to negotiate whether thepurchase price should include default interest; from the B noteholder’s perspective, it should almost certainly exclude anyprepayment premium or yield maintenance fee, although the A noteholder may have a contrary view. The sale to the B note holdershould be without recourse, representation or warranty.

Ability of the B note holder to transfer its interestin the loanAs important to the B note holder as the right to buy the A note isits ability to resell the B note. Even at the time of the origination ofthe loan, the B note holder must be mindful of a way to end itsinvolvement in the loan, especially in the event of a borrowerdefault. The B note holder may have neither the appetite nor thecapital to purchase the A loan, and it may determine thatforeclosure or other remedies are not permitted or are too slow orimpractical; therefore the B note holder should obtain in theintercreditor agreement the right to sell its interest in the loan at any

Purchase price

Stewart


time. Additionally, even apart from the default context, if the B noteholder intends to include its B note interest in a future securitisation,it will need to get that transfer right pre-approved in theintercreditor agreement. The A note holder will want to restrict thepotential transferees of the B interest to qualified institutionallenders or to investment funds managed by institutions with at leastthe experience and strength of the initial B note holder. Agreeing onthat definition may be difficult.

ECONOMIC ISSUESThis paper has discussed only the intercreditor issues that directlyaffect the ways that B note holders can attempt to protect theirjunior interest in the face of either an underlying borrower defaultor actions by the A note holder that could otherwise have the effectof modifying or reducing the borrower’s obligations to the B noteholder, or eliminate or put at risk the collateral for the B note.These issues are fundamental protections for the B note holder, butthey are completely apart from certain economic issues that areinherent in the intercreditor relationship (and that are reflected inthe intercreditor agreement), but that are beyond the scope of thispaper. Briefly stated, the economic issue most critical to each noteholder is the ‘waterfall’ of the borrower’s payments to each of the Anote holder and the B note holder. The fundamental nature of theA/B relationship is that the A note holder should be fully paidbefore any moneys go to pay the B note holder. The parties willwant to negotiate, however, when funds are applied to the paymentof default interest on either of the loans, or how unscheduledprincipal reductions, including prepayments and prepaymentpremiums, should be handled. The parties may agree on separatewaterfall regimes for payments before and after default (or after thetime that the loan becomes specially serviced under the terms of thepooling and servicing agreement).Assuming that the intercreditor agreement accurately reflects the

waterfall and other economic terms that define the A/B relationship,to protect its investment, the B note holder should start with theforegoing issues of control and security. It should focus on ancillarypoints, such as the mechanics of loan administration and the abilityof the B note holder to pledge or otherwise finance its interest in theB note, only after reducing to its satisfaction the risk that the seniorlender could weaken the economic terms and collateral support theB note holder expects from the borrower.

# David M. Stewart 2002.

B note securitisation

‘Waterfall’



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