Second-lien loans differ from mezzanine debt and preferred equity in several respects; each has different sets of rights.
Preferred equity, for example, should not be subject to bankruptcy concerns, as it is not debt. And both preferred equity and mezzanine debt generally take over the manager’s control rights as a primary remedy, which can be quicker than a foreclosure proceeding on the real property asset. They do not, though, have a hard security interest in that asset and do not automatically get notice from county recorders when a foreclosure proceeding has commenced.
Second-lien loans are less frequently seen than in prior decades, since they are now generally not allowed on transactions primarily financed by CMBS-securitized or insurance company-backed first-lien loans. Those buyers simply don’t want any competing claims on the primary asset. Other primary lenders, however, are more forgiving.
Different Lending Metrics
Second-lien debt investments must be evaluated differently than those involving first-lien debt. The overall loan-to-value ratio increases with second-lien debt, providing less of an equity cushion for that layer of the capital stack. Second-lien creditors are also subordinate to the first-lien creditor, so the debt is therefore relatively riskier than first-lien debt and the interest rate is often higher.
Second-lien loans have a hard security interest in the primary asset; which confers several rights, most importantly against declines in value that occur after a bankruptcy filing has occurred. A second-lien creditor also automatically gets notified by county recorders when a first-lien creditor files for foreclosure. This is different from preferred equity or mezzanine debt in which instruments generally take over the manager’s control rights as a primary remedy. This can be quicker than a foreclosure proceeding on the real property asset, but less certain in outcome.
Bankruptcy Positioning — The fact that a second-lien loan does have a mortgage or trust deed on the property – i.e., that it is secured – does set it apart from other creditors.
Priority vis-à-vis unsecured creditors — Secured claims are entitled to receive their full value in the collateral before anything is given to unsecured claims. But to the extent that a secured creditor is undersecured, it shares ratably with other general unsecured creditors (including trade creditors).
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.
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. It is an extremely valuable right.
Reduced “Cram-Down” Risk — Each class of creditors generally gets voting rights in any reorganization, but a class’s objections may still be overcome (“crammed down”). It is generally much harder for a class of secured creditors to be crammed down, compared to a class of unsecured creditors.
As earlier noted, however, the second-lien loan still needs to “share” its interest in the collateral with that of the first-lien lender – and those primary lenders are not always willing to do that. The CMBS market and insurance companies generally don’t allow second-lien loans on their collateral properties, because they are considered to (i) slow down the process of foreclosure for that first-lien holder, (ii) make it more difficult for a first-lien holder to agree to a favorable reorganization in bankruptcy, since other secured lenders can vote against their proposed plan and thus increase the risk of some “cram-down” loss of principal, and (iii) thus push the first-lien holder to foreclose on the property (which is somewhat expensive and time-consuming) earlier than it might otherwise do.
Other lenders can accept these risks as long as an agreement is reached defining each others’ rights in certain situations. These are generally called “intercreditor agreements.”
Intercreditor Agreement Considerations
As earlier noted, many first-lien lenders avoid second-lien loans on the property because they don’t want to have to deal with competing claims on the asset. When they do allow it, most first-lien lenders generally seek to make “silent” the second-lien holder – 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 usually involve four key elements:
- Prohibitions (or limitations, sometimes time-related) on the right of second-lien holders to take enforcement actions.
- No-challenge covenants (again, sometimes time-related) as to the 1st-lien lender’s exercise of its foreclosure actions.
- No-challenge covenants as to the validity or priority of the first lien.
- Waivers of certain other secured creditor rights.
The first-lien lender seeks the enforcement delay to make sure that it mitigates the risk of not being “first in time” in filing a lien. Instead of being fully “silent,” second-lien creditors generally just agree to be “quiet” for a while by establishing “fish-or-cut-bait” or “standstill” periods (usually 90 to180 days) as to refraining from exercising their rights. Aggressive second-lien holders even seek “use-it-or-lose-it” provisions, forcing the first-lien holders to make a timely election of remedies, or else forfeit their right to take future remedial action.
Intercreditor agreements also often clarify the right of the second-lien creditor to purchase the first-lien obligations, for an agreed period after a default or bankruptcy event. Some consider these rights to be valuable because, once exercised, a second-lien creditor steps into the first-lien holder’s shoes and will be free to exercise all of the rights of a secured creditor, which will provide more leverage in negotiating a reorganization plan. Other observers place less importance on them, since a first-lien lender will often agree anyway to sell the loan if an at-par offer is made.
On the other hand, preferred equity should generally not be subject to bankruptcy concerns, as it is not debt. Thus, each of the possible means of subordinate or mezzanine financing instruments should be well understood – both on their own terms and in the context of the available alternatives.
About the Author
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 lawrence@realtyshares.com.
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