Those with the lowest risk-i.e. buyers of the highest-rated bonds-are first

in line for payment should some of the receivables go into default. Then those at the next risk level have a right to payment, and so forth. Therefore there's an inherent tension among those various risk levels.

Still another factor is that the CMBS structure gives mezzanine debt holders

a level of control that's not concurrent with the size of their stake in the deal "You've got the B-note holders," who are often special servicers, "and you've got the A-note holders, who actually have the bigger piece of the deal," Transwestern's Steve Pumper said in a recent video interview on GlobeSt.com. "But the first loss position, being the B-note holders, is actually in a position to make the decision" in the event of a default.

The theory, says Edelstein, is that since B-piece holders "would be the first ones to lose value, they're going to fight to protect themselves and therefore indirectly protect everybody above them." Given the fiduciary role that the mezz debt holders play, "some people have thought that there's an inherent conflict of interest with B-piece holders in the first-loss position assuming fees from special servicing, doing asset management, dispositions, that kind of thing," says Pumper, Transwestern's Dallas-based executive managing director of investment services. "So it's been a bone of contention. But in my estimation, the special servicers have done a very good job."

It isn't as though intercreditor agreements make no provisions for crisis management. Yet when it comes down to it, the wording of the provisions frequently is open to interpretation, and, Edelstein says, many of these complicated deals are being settled outside the context of the documents, not inside.

"A lot of this stuff is not being resolved the way the documents had contemplated," he says. "They often require the more junior debt to buyout the senior debt or keep them current while they foreclose. A lot of these deals are not working out that way."

A case in point is the default on the John Hancock Tower in Boston in late 2008. Discussed elsewhere in this issue as an example of hedge fund activity (see page 15), it also illustrates one scenario for successfully waging tranche warfare. As senior debt holders sought immediate foreclosure on the 60-story office tower and junior debt holders sought more time to repay the loans, a joint venture of Normandy Real Estate and Five Mile Capital Partners acquired the mezz debt and forced foreclosure, buying the property for $660.6 million in early 2009.

The purchase price represented a deep discount on the $1.2 billion that Broadway Partners had paid for it two years earlier. "By bidding only approximately $20 million more than the existing mortgage debt, the joint venture was able to obtain greater-than-90%-plus financing at a top-of-the-bubble, below market interest rate," wrote Dechert LLP attorney Matthew Clark in an article this past summer.

Following their acquisition, the JV spent about $50 million on upgrades to the property and secured the market's largest lease thus far in 2010: a IS-year, 208,000-square- foot deal by locally based Bain Capital. With the tower's occupancy now at 95%, the JV in October sold the Hancock building to Boston Properties in a $930-million deal that includes the assumption of a $640-million securitized senior mortgage loan.

Although the Stuy- Town foreclosure on $3-billion of securitized debt has not yet been resolved, and certainly not in the way originally intended by a JV of Pershing Square Capital Management and Winthrop Realty Trust, Edelstein says it provides another example of how a mezz debt holder can come out a winner.

The possible agreement between the JV and senior lenders-still not finalized as of this writing-would mark a more successful outcome than an earlier attempt of waging tranche warfare on the 11,227 -unit multifamily complex.

In February of this year, a hedge fund controlling more than 25% of the $3-billion senior debt on Stuy- Town filed a motion challenging CW Capital Management. The hedge fund, Appaloosa Management, alleged in a court document that the special servicer violated its fiduciary duty to debt holders by seeking foreclosure "when other less hazardous avenues were available." Judge Alvin K. Hellerstein, the US District Court presiding over the Stuy- Town case, shot down Appaloosa's motion.

Six months later, the Pershing Square/ Winthrop JV sought to foreclose on the complex based on its acquisition of $300 million in senior mezz debt, which it had bought for 15 cents on the dollar. A New York State Supreme Court judge blocked the JV's efforts-but according to the Wall Street Journal, the partnership then met with CW Capital about a buyout of the mezz debt.

If the agreement pans out, Edelstein says, it would illustrate "how a mezz lender that is out of the money can play its hand with all of the intercreditor rights in the structures today to actually get paid something. Many people have been under the impression that in

these tranched deals, if you're out of the money you walk away or you get foreclosed. But you have a lot of folks looking to buy those positions because they have leverage, notwithstanding what the documents say."

He notes, however, that as tranche warfare goes, the battle lines were pretty clearly drawn in this instance. "When you talk about Stuy- Town, you're talking about senior versus junior," says Edelstein. "But within these structures, there are many juniors." A loan could be carved up into many more levels than simply A or B, for example. "So there are many fights that go on." For example, "when they do an appraisal and readjust the CMBS, the people who are getting cut out sue over that."

Such widespread litigation was a hallmark of the Extended Stay bankruptcy. Following the June 2009 filing, the largest in US hotel history, "You actually had two types of tranche warfare: between the senior and the mezz, and then you also had potential warfare between the different tranches of the CMBS stack," says Edelstein. Prior to the filing, there were additional squabbles between levels of mezz debt holders.

Although the Extended Stay restructuring was resolved, with a group led by Center bridge Partners prevailing in an auction with a $3.93-billion bid this past May and the company emerging from bankruptcy last month, the competition between the Center bridge group and a rival plan from Starwood Capital Group led to another round of warfare. Following that May auction, a group of unsecured creditors filed a motion in support of a new plan put forth by the Starwood-led group to acquire three-quarters of the Spartanburg, SC-based company and backstop a $ 140-million equity-rights offering that would enable the creditors to buy up to 20% of Extended Stay.

Although the volume of tranche warfare has kept workout attorneys busy, we may not have seen anything yet. New distress may have plateaued recently, yet Pumper points out, "If you look at 2005, 2006 and 2007 CMBS origination, the domestic numbers were $150 billion, $21 0 billion and $250 billion. That is coming due here. And a lot of that pertains to the office sector, which has been a lagging indicator."

As CMBS defaults increase, so will battles between debt holders, Edelstein predicts. "What might help is that as more of these cases play out in court, there will be more guidance as to what some of these agreements mean," he says.

In the Stuy- Town case, for instance, Supreme Court Judge Richard Lowe's interpretation of the intercreditor agreement "impacted many other deals. That established a precedent of record, although many lawyers think it's not much of a precedent, because the agreements vary in the way they're worded. But as more of these cases come up, hopefully they will be settled more quickly. A lot of the issues coming up now are issues of first impression," meaning that they haven't come before the court previously. A clear winner in tranche- to- tranche battles is often the beleaguered property owner, for whom the warfare can buy some time. "It gives rise to delay if the lenders fight among themselves," Edelstein says. "The borrower hangs around while the lenders duke it out."

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