It has been a while since I have discussed the situation at Suyvesant Town, the huge residential housing complex on the far east side that has now been in foreclosure for some time. This property is a great example of the failure of the legal constructs put in place during the real estate boom (it is also clearly a failure of the business side of things, but that is almost too obvious to mention at this point).
Lenders were carved up into several different priority levels (this became very common) and the subordinate liens were referred to as mezzanine loans. While it might seem like the term mezzanine means only the middle portion, it actually refers to many layers of subordinate debt. Essentially, mezzanine debt is the equivalent of a second mortgage, but instead of directly placing a lien on the premises, lenders took a security interest in a different form of collateral: the shares of a special company set up to hold the real estate or even a company set up to hold another company that held real estate. This type of structure is repeatable, so you can have ten layers of debt on a property with different risk levels and therefore different interest rates.
The various lenders at each interest rate (even if initially it is all one lender, as we know from the residential bubble, these loans are sold off in all forms to many buyers), have to work together so that each gets paid, as long as the property is generating money to pay all of the lenders. They sign a document called an intercreditor agreement which is supposed to govern what happens while the loan is performing or when some piece of it goes into default. This document, particularly in the Stuy Town case, is complicated by the fact that with the mezzanine structure, if a junior lender forecloses it takes the place of the borrower on all loans senior to it. The Stuy Town agreement is not well drafted to deal with this situation, and apparently neither are many others.
Of course, there was a reason to replace a subordinate mortgage with a mezzanine loan. It is technically easier to foreclose as you can foreclose pursuant to Article 9 of the Uniform Commercial Code by auctioning the property without going to court. Theoretically, this should be simpler, and is actually similar to non-judicial foreclosure that is authorized in many states for real property. Lenders like non-judicial foreclosure because it allows for a much quicker sale of the collateral unless the debtor has reason to object. In Stuy Town, there is now a fight between a party foreclosing on the first mortgage, and a party that has invested in the junior debt and wants to foreclose on that junior debt. Thus, a fight. As it turns out, the intercreditor agreement should govern this situation, but the parties dispute its meaning, and whether a junior creditor must bring the mortgage current prior to foreclosing on a junior loan. It is hard to say in this case, as I have not seen the agreement, but it does make you wonder if all of the parties would have been better served by structure of subordinate mortgages, where the courts set out who can foreclose and who can collect on those amounts.