As seen in the New York Law Journal: Using the Courts to Resolve Inter-Lender Disputes In Tiered Loan Transactions

Posted on March 11, 2012

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New York Law Journal

By: Benjamin M. Keller, Andrew H. Levy and Joshua A. Sohn

REAL ESTATE LOANS in the past few decades have often used multiple lender or "tiered" loan structures such as A/B loan participations and multi-tiered mezzanine loans to meet the financing needs of real estate borrowers.

The credit crisis that began in 2007, however, put tiered real estate financing transactions under special stress, and as the fallout from the credit crisis continues, lenders in these transactions find themselves in disputes with their fellow lenders regarding their respective rights and obligations under the loan documents. The most wellknown dispute of this nature is the Stuyvesant Town case, where the senior mortgage lender and one of the mezzanine lenders litigated the issue of whether, under the terms of the intercreditor agreement, the mezzanine lender could foreclose on the mezzanine collateral without first curing the default under the senior mortgage loan.

One generally overlooked option lenders have for resolving these disputes is filing a complaint in a court of proper jurisdiction seeking declaratory judgment as to the rights of the disputing lenders under the loan documents. Recent cases in New York's state and federal courts show that declaratory judgment can be an effective and efficient way for expediting the resolution of disputes in tiered real estate financings.

The use of declaratory judgment as a tool for clarifying the contract rights of the parties is well established under both New Yorkn2 and federal law.n3 Declaratory judgment actions can be brought in either state or federal court. According to courts faced with these issues, the purpose of declaratory judgment is to accomplish "the complete and final settlement of the rights and legal relations of the parties with respect to the matters in controversy"n4 and to permit "the court in one action to define the legal relationships and adjust the attendant rights and obligations at issue between the parties so as to avoid the dispute escalating into additional wrongful conduct."n5

In order for a court to hear a declaratory judgment action, the party seeking declaratory judgment must demonstrate that it has a legally protected interest in an actual controversy.n6 A party may not seek a judicial declaration of the rights and obligations under a contract until an actual controversy has arisen between the parties; however, this requirement can be met under many circumstances.n7

For example, an actual controversy existed where a tieredmezzanine loan went into default and the lenders disagreed as to whether the subordinate lender could sue the guarantors before the senior loan had been repaid in full.n8 On the other hand, a mortgagee's action for a judgment declaring that certain liens are subordinate to its mortgage was deemed premature where the mortgagee had not yet declared a default under the mortgage and commenced foreclosure proceedings or some other event had occurred demonstrating an actual controversy.n9

A cautionary note is in order for parties who bring declaratory judgment actions in federal district courts, particularly in instances where there are related actions pending in state court. The federal court may decline to hear the case. The Declaratory Judgment Act,n10 which makes the remedy of declaratory judgment available to federal courts, confers "on federal courts unique and substantial discretion" in deciding whether to hear declaratory judgment actions.n11 Although the Declaratory Judgment Act gives federal courts the discretion to abstain from exercising jurisdiction over declaratory judgment actions, they "cannot decline to entertain [a declaratory relief action] as a matter of whim or personal disinclination,"n12 and absent a related state court proceeding, they are unlikely to do so.n13

Earlier this year, the federal district court for the Southern District of New York granted a declaratory judgment and related injunctive relief in FCCD Ltd. v. State Street Bank and Trust Co,n14 a case where the senior lender in a participated real estate loan sought a declaration that certain control provisions in the loan participation agreement had been triggered. In FCCD Ltd., Lehman Brothers originated a loan in 2006 for up to $65 million that was secured by a first mortgage lien on 840 acres of raw land in Mexico on which the borrower intended to develop a hotel. The property was appraised at $58.8 million when the loan was originated, and shortly after origination, Lehman Brothers sold a senior interest in the loan to FCCD pursuant to a tiered-loan participation agreement. Subsequently, in 2008, Lehman Brothers assigned to State Street its subordinate interest in the loan, together with its legal title to the loan and its rights under the Loan Participation Agreement to administer and service the loan.

The relationship between FCCD, the holder of the senior interest in the loan, and State Street, the holder of the subordinate interest in the loan, was governed by the loan participation agreement, which set forth the rights and obligations of the two loan participants. As the senior interest holder, FCCD had first priority to reimbursements of principal and interest, and if the loan suffered a loss, then State Street, as the subordinate interest holder, would be the first to absorb that loss. As is typical for tiered-loan participations, the Loan Participation Agreement also provided that State Street had the right to appoint a "servicer" of the loan, meaning that State Street could control the collection and distribution of payments of principal and interest on the loan, and the enforcement of remedies in the event of a loan default. This arrangement is also common in tiered-loan participations, where the participant holding the most subordinate, and therefore riskiest, portion of the loan typically has certain control rights under the participation agreement.

State Street's right to service the loan, however, was not absolute, and the loan participation agreement provided that if the loan went into default, and the fair market value of the collateral had declined so much that the subordinate interest holder would not recover anything upon a sale of the collateral pursuant to the lenders' exercise of their remedies, then the right to service the loan would be transferred to the senior interest holder. A provision dealing with such an event (often called a "control appraisal event") is common in loan participation arrangements, and has the effect of removing control of servicing the loan from the interest holder otherwise in control once it is determined that the collateral has insufficient value for there to be any residual value for the subordinate interest holder if the property were sold.

The reason underlying this legal structure is that when the subordinate interest holder's prospect of recovery is so diminished that it can no longer be said to have any economic stake in the loan, then control of the loan should be transferred to the next most junior interest holder that still has an economic stake in the loan.

In FCCD Ltd. , determining whether a control appraisal event had occurred required calculating the "appraisal reduction amount" (i.e., how much less the property was worth than the total outstanding debt) in accordance with a formula provided in the loan participation agreement. The formula used in the agreement was typical for tieredloan structures of similar size. The loan went into default when the borrower failed to repay the outstanding principal and interest at maturity, and FCCD, as the holder of the senior interest in the loan, requested that the servicer commission an appraisal of the property to determine the Appraisal Reduction Amount. The Appraisal Reduction Amount was determined to be $25.6 million (i.e., the property was worth $25.6 million less than the total outstanding principal and interest on the loan) and the parties did not dispute this number.

What FCCD and State Street did dispute, however, was how the $25.6 million appraisal reduction amount should be allocated between the two loan participants. The issue was whether the loan participation agreement required the reduced value of the collateral to be first allocated totally to the subordinate interest holder. If the losses were not entirely allocated to the subordinate interest holder, then the subordinate interest holder's position would still have had value, meaning that a control appraisal event would not have occurred and control of the loan would not have been transferred. The servicer of the loan, who was still controlled by State Street (the subordinate interest holder), asserted that a control appraisal event had not occurred, and accordingly did not transfer control of the loan to FCCD.

The court interpreted the formula in the loan participation agreement, which determined how the appraisal reduction amount would be allocated between the participants, and granted declaratory judgment in favor of FCCD, the senior interest holder. In doing so, the court ruled that the appraisal reduction amount should be entirely allocated to State Street, that a control appraisal event had occurred, and that control of the loan should therefore be transferred from State Street to FCCD. In reaching the conclusion that the entire Appraisal Reduction Amount should be allocated to State Street, the subordinate interest holder, the court in FCCD Ltd. interpreted the applicable provisions of the loan purchase agreement with the aid of expert testimony as to the custom and usage of control appraisal events in tiered loan participation agreements.

A similar opportunity for using declaratory judgment arises in the securitized mortgage context, and in fact there is a recent Southern District of New York case where declaratory judgment was used to resolve a subordination dispute between different classes of certificate holders in a mortgage securitization trust. In Wells Fargo Bank v. ESM Fund I, LP , there was a dispute between the senior certificate holders and the insurer of the subordinate certificate holders in a mortgage securitization trust over the waterfall (i.e., the provision addressing the order of distributions of funds) in the pooling and servicing agreement. n15

The issue was how losses suffered by the mortgage securitization trust would be allocated under the Pooling and Servicing Agreement between the senior certificate holders and insurer of the subordinate certificate holders. The bank, as master servicer and custodian of the mortgage securitization trust, brought an interpleader action for declaratory relief on the interpretation of the Pooling and Service Agreement and the appropriate distributions from the trust. Similar to the result in FCCD Ltd. , the court in Wells Fargo determined that there was a dispute, interpreted the Pooling and Servicing Agreement, and granted declaratory judgment ruling that the losses suffered by the mortgage securitization trust should be allocated first to the insurer of the subordinate certificate holders. The court's interpretation of the pooling and servicing agreement rested on both the language of the waterfall provisions, which determined how funds coming into the mortgage securitization trust were to be distributed, and also the broader structure of the trust documents, which served as evidence of the parties' general intent that losses should be allocated first to the subordinate certificate holders.

Each of these cases illustrates how declaratory judgment can be a useful tool for resolving subordination and priority disputes under tiered-financing instruments. This conclusion, however, raises the question as to why, as the fallout from the credit crisis continues, more lenders have not filed declaratory judgment actions to resolve lender disputes in tiered loan transactions.

There are several plausible answers to this question. One is that the cases discussed here are very recent, which means that there could be more declaratory judgment actions of this nature pending or soon to be arriving in the courts, or alternatively, that lenders were not previously aware of the fact declaratory judgment can be an attractive dispute resolution tool. Another is that litigation is simply too costly as a dispute resolution tool unless the stakes are high enough and the parties cannot reach a settlement out of court.

An additional, and perhaps more important, cost of litigation, especially in the world of real estate finance, is the potential damage that litigation can cause to ongoing relationships that certain lenders and/or investors have with one another. A lender in one tiered-loan transaction may be reluctant to bring a declaratory judgment action against its co-lender if the two lenders will have to continue in an ongoing relationship as colenders, perhaps in the reverse positions, in another real estate financing transaction. Lenders may also be reluctant to bring declaratory judgment actions because they do not want to appear in the public records.

Since lender disputes in tiered loan transactions often center on a question of valuation (i.e., how much has the value of the underlying collateral diminished), another possible answer is that there is not a lot of predictive reliability in determining valuation due to the ongoing turmoil in the markets. Typically, the loan documents in a tiered-loan transaction provide for an appraisal upon the occurrence of certain trigger events (e.g., a payment default), and the loan documents often provide subordinate interest holders with re-appraisal rights after an initial appraisal has been triggered. If the initial appraisal is subject to being revised in the future when another (subordinate interest) holder requests one or more subsequent re-appraisals, then without some confidence that the value of the underlying collateral is not going to materially fluctuate from week to week or month to month, lenders may conclude that there is not enough clarity as to the outcome to warrant bringing a declaratory judgment action in the first place.

In closing, filing a declaratory judgment action can be an attractive option for a lender seeking to resolve an inter-lender dispute in a tiered real estate financing transaction, although the relatively small number of reported cases in this area suggests that other considerations may be keeping lenders from doing so or that lenders are not generally aware of the technique.

Benjamin M. Keller