4 Categories of Debt and Associated Remedies DIVE INTO THE FINE PRINT OF DEBT AND LENDING.

by Lawrence Fassler


ifferent investment positions in the “capital stack” of real estate financing have different remedies available to them if there are payment defaults or other problems with an investment. We’ll explore some of the different investment types and the related underlying remedies. FIRST-LIEN, SENIOR DEBT With senior (first-lien) debt investments, the underlying loan is usually secured by a first-position mortgage (or deed of trust), which gives the lender advantages even in a bankruptcy situation. Oftentimes, an additional guaranty of some sort will be secured from one of the principals or a controlling affiliate of the borrower. This guaranty may be limited to “bad acts” – outright fraud or other obvious examples of willful misconduct – but it can also extend to a full payment guaranty. With the security of a senior mortgage lien on the property, a lender can foreclose on the property in the event of pay- ment or other defaults by the borrower, then either sell the property to regain the lender’s principal or take over owner- ship of the property. Since the property had likely been valued at more than the loan amount at the time the loan was made, there will usually be enough “cushion”, the underlying equity interest of the borrower, so that the lender can ultimately regain invested principal. Events like the Great Recession, however, show that this initial cushion isn’t always enough to assure any principal return. SECOND LIEN, JUNIOR, OR SUBORDINATE DEBT Second-lien loans, while seen less frequently today than in pri- or decades (many senior lenders don’t want competing claims on the primary asset), still represent a way for many borrowers to increase their leverage on a project. These loans are riskier, and should be evaluated differently from first-lien loans. The overall loan-to-value ratio increases with second lien debt, providing less of an equity cushion for that loan; second-lien lenders are also subordinate to the first-lien lender when it comes to foreclo- sure or other workout situations, so that the property lien, while valuable, is no guarantee of full recovery. The interest rate on second lien loans is thus often significantly higher than for first


lien loans, to compensate for this risk. Being a secured lender (even if a junior one) does still have advantages over other creditors. Among other things, secured lenders enjoy: •  Priority vs. Unsecured Creditors. Secured claims are entitled to receive their full value in the collateral before any remaining proceeds are given to unsecured claims. Note, however, that this right is only of value where the collateral remains worth enough to cover the amount of the secured loan. •  Post-Petition Interest. Secured creditors are, under the bankruptcy code, entitled to post-petition interest on their claims; undersecured creditors are not. This can be significant, given that bankruptcy proceedings may run for several years. W hen you reach the point of foreclosure on a debt, you are not necessarily home free. Foreclosures can involve pitfalls of their own, including: • TAX LIENS AND MECHANICS’ LIENS, which usual- ly take precedence above everything else, including otherwise senior debt • THE “JUDICIAL” FORECLOSURE PROCESS, which can take a year or more in the courts • BAD APPRAISALS, which may mean your collater- al’s value was overestimated to begin with

•  Protection Against Decline in Value. Secured creditors can be protected against post-filing declines in value. This right is broad, and gives the creditor a say in collateral substitutions and debtor-in-possession financings, and may also include court-ordered grants of additional (or substitute) collateral or periodic cash payments. An extremely valuable right. •  Reduced “Cram-Down” Risk. Each class of creditors generally gets voting rights in any reorganization, but certain objections from certain classes of creditor may still be over- come (“crammed down”). It is generally much harder for a class of secured creditors to be crammed down, compared to a class of unsecured creditors. •  Intercreditor Agreement Considerations. When senior lenders do allow second liens on the property, they generally seek to make the second-lien lender “silent” – to have it agree that it won’t exercise some of its rights so as not to harm or inconvenience the first-lien lender. These agreements may limit enforcement actions, prevent second-lien lenders from opposing the first-lien lender’s seniority, and other waivers. MEZZANINE DEBT AND PREFERRED EQUITY Mezzanine debt and preferred equity do not have security interest in the property. Rather, the legal instruments general- ly provide, as their primary legal remedy, for taking over the manager’s control rights in the title-holding project company. This remedy can be quicker than a foreclosure proceeding on the real property asset, but the outcome of the action is less certain, particularly as holders of these instruments do not automatically get notice from county recorders when a foreclo- sure proceeding has commenced. Mezzanine debt requires a “pledge” of the sponsor’s (and sometimes all shareholders’) interest in the title-holding

entity. This security interest is recorded and, if necessary, can be “foreclosed on” by an agreed process under the Uniform Commercial Code. Preferred equity relies for its remedies not on pledged equity interests, but rather on contractual rights provided for in the operating agreement of the title-holding project company. Like mezzanine debt, preferred equity generally has as its remedy the take-over of the manager’s control rights in that project company. The remedy can potentially be exercised promptly; but lender approval to any change of control in the borrowing project company will generally still be required. Moreover, governmental-sponsored enterprises like Fannie Mae and, to a lesser extent, Freddie Mac are reluctant to let true preferred equity participate in transactions where they are involved; watered-down remedies for the preferred equity investor are sometimes agreed in order to appease these lenders. COMMON EQUITY A common equity position generally means that one is in- vesting alongside the sponsor, so there isn’t much in the way of remedies with common equity. There may be manager removal rights in the event of fraud, etc., but such instances arise only rarely and even those rights are sometimes restricted where Fannie Mae or Freddie Mac is involved as the property lender. There are reasons to take a common equity position, however. > Continued on :: PG 113 Lawrence Fassler, an attorney and real estate investor, is Corporate Counsel of RealtyShares, a leading real estate investment marketplace that places equity investments through North Capital Private Securities Corporation; a registered Securities broker-dealer, and member of FINRA/SIPC. RealtyShares as an institution does not advise on any legal issues, and this article is for general information only and does not represent professional legal advice. Contact the author at

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