Hotel Mortgage Holder Barred from Converting Mortgage Loan In Part to Mezzanine Loan

In a case litigated in the New York Supreme Court[1], the Court recently ruled[2] that a private equity firm that acquired a mortgage loan made on the Maxwell Hotel in New York does not have the authority necessary to convert (without the borrower’s principal’s signature) a portion of its mortgage loan into a mezzanine loan under the Loan Agreement’s severance provision. That provision purported to grant a power of attorney in favor of the lender to sever the loan into a mortgage and mezzanine loan without execution by the borrower.

Pursuant to the Loan Agreement, the borrower received loans equal to approximately $170 million in the aggregate. The originating lender then sold the loans to the defendant lender. The borrower later failed to repay the loans, and the defendant lender attempted to convert the mortgage loan partly into a mezzanine loan in order to use the expedited foreclosure provisions available under the Uniform Commercial Code for mezzanine loans.

The plaintiffs, the borrower’s parent company, and guarantor, initially brought suit in Delaware Chancery Court, seeking an injunction to stop the defendant from using this power of attorney included in the Loan Agreement to pledge the plaintiff’s equity in the property owner/mortgage borrower. That court issued a stay of litigation and an injunction due to ongoing litigation in New York and the fact that the Loan Agreements provided for New York governing law.

The principal question before the New York Supreme Court was whether the defendant could use the Loan Agreement entered into by the borrower to execute documents on behalf of the lender non‑signatory plaintiffs and “divest them of their equity and prevent them from exercising their equity rights of redemption by circumventing foreclosure[.]”

The Court held that the relevant provisions of the Loan Agreement only gave the defendant lender limited power of attorney over the borrower and did not extend to the plaintiffs. The judge found that the language in the contract specifically stated, “Either the ‘constituent members’ of the [borrower] or the ‘guarantors’ may be needed to effectuate severance of the loans into a mezzanine structure.” The Court found this to be significant evidence the parties knew obligations would be imposed on outside parties. Thus, the defendant did not have the power necessary to convert the mortgage loan into a mezzanine loan on its own. Note that the Court’s ruling focused on the wording of the severance provision and did not directly address the equity of redemption (clogging) argument.

This type of severance provision is commonly found in commercial real estate loan documents but is typically used as a tool to “syndicate” or sell portions of a loan. In this case, an aggressive lender attempted to instead rely on this language to avoid the lengthy process of judicial foreclosure in New York. The Court refused to allow this step, ruling that the defendant would be “irrevocably harmed[.]” This may serve as a lesson to lenders that may now wish to broaden this severance language to provide a power of attorney not only for the borrower but also for its constituent members. If lenders in the future broaden this power of attorney language, it remains to be seen how future courts may rule on the equity of redemption argument, namely that this maneuver was intended to circumvent the owner’s protections under state foreclosure law to protect its equity of redemption. In the meantime, this ruling may serve to limit the use of this type of provision going forward where a mortgage lender seeks to gain an advantage by exercising the type of remedies typically available only to mezzanine lenders.

[1] New York “Supreme Court” is the trial level court of general jurisdiction in the New York State Court System.

[2] DCH LEX Propco GP LLC et al. v. YS 541 Lexington Holdings LLC, 2023 N.Y. Slip Op. 34296(U) (N.Y. Sup. Ct. 2023).