Mezzanine Loans to Developers and Owners of Real Estate Projects: 10 Ways to Improve the Quality of the Equity Pledge
Grant Puleo and Michael Lyon
The authors discuss the ways to improve the quality of an equity pledge.
As interest rates rise and real estate sales soften, the 1. Require the Borrower to Opt-In to Article 8 quality and enforceability of the equity pledge becomes Mezzanine lenders typically rely on ling a nanc- more important to mezzanine lenders. The use of the ing statement under revised Article 9 of the Uniform equity pledge as collateral is an important feature of Commercial Code (‘‘UCC’’) to perfect their interest in mezzanine lending to developers and owners of real the equity collateral. This, however, is not the preferred estate projects. The collateral for mezzanine nancing, method of perfecting the lender's security interest in being a hybrid of debt and equity nancing, generally the pledged equity under the UCC. Under the UCC, an consists of pledges of the equity interests of the bor- equity interest in a limited liability company or limited rower by the member(s) of the borrowing entity and partnership is initially considered a general intangible not a deed of trust, mortgage or other security interest and not a ‘‘security.’’ A lender can perfect a security in real property. As a result, mezzanine nancing is interest in a general intangible only by ling a nanc- seen as riskier than real estate-secured nancing, ing statement. The priority among security interests is justifying mezzanine lenders' higher rates of return (in determined under the ‘‘ rst to le’’ rules of Article 9 some cases 20 percent or higher). What if, on the other of the UCC. In order to enhance the lender's security hand, the mezzanine lender could dramatically improve interest in the pledged equity and turn this ‘‘general the quality of its equity pledge and still achieve returns intangible’’ into a ‘‘security’’ under Article 8 and of 20 percent or higher? This article focuses on 10 ‘‘investment property’’ under Article 9, the lender important ways in which a mezzanine lender can (and should require the issuer to ‘‘opt-in’’ to Article 8 of the UCC. In order to ‘‘opt-in’’ to Article 8, all the is- should) attempt to improve the quality of its equity col- suer must do is amend the operating agreement or lateral when providing nancing to owners and devel- partnership agreement to add language to the e ect that opers of real estate projects. the equity interests in the issuer are governed by Article 8 of the UCC. The equity interest should also Grant Puleo and Michael Lyon are both members of the Real Estate be certi cated and the certi cate should carry a legend and Financing, Restructuring and Bankruptcy practice groups at the to that e ect to permit perfection in the certi ed securi- law rm of Procopio, Cory, Hargreaves & Savitch LLP. Mr. Puleo works ties by ‘‘control.’’ Once the entity has opted-in to out of Procopio's San Diego o ce and can be reached at [email protected]. Mr. Lyon is located in Procopio's Carlsbad o ce Article 8, a lender should include provisions in the and can be reached [email protected]. operating agreement, partnership agreement, the
46 THE REAL ESTATE FINANCE JOURNAL/SPRING 2007 pledge agreement, and consent documentation to oped this specialized endorsement which insures that ensure that the entity cannot later opt-out of Article 8. (i) all payments for loss under the title policy will go There are several bene ts to the mezzanine lender directly to the mezzanine lender until the mezzanine perfecting a security interest in investment property as loan has been paid in full, (ii) there will not be a denial opposed to a general intangible under Article 9. For of coverage as a result of the transfer of any of the example, obtaining exclusive control over the certi - ownership interest to the mezzanine lender, and (iii) cate provides protection against all subsequent the title company waives its right of subrogation and purchasers. Unlike an Article 9 general intangible, a indemnity against any of the policyholder's equity security interest in investment property can be per- owners until the loan is paid in full. The mezzanine fected by either (1) ling, (2) possession or (3) control. nancing endorsement can also include a ‘‘non- Control should, in most cases, have priority over all imputation’’ endorsement whereby the lender is as- other security interests previously perfected by ling. sured that the title company will not deny coverage If the secured party obtains control or possession of based on matters known to the borrowing entity or its the certi cated security, no other party can obtain equity interest owners and such matters will not be control. Thus, the mezzanine lender should require the imputed to the lender. entity in which it will have a pledged equity interest to Finally, the mezzanine lender should make sure that ‘‘opt-in’’ to Article 8, agree not to ‘‘opt-out’’ and is- the borrower or fee-owner of the project has adequate sue appropriate certi cates to the lender which lender title insurance in the form of an owner's title insurance should take possession of at the closing. policy as of the closing of the mezzanine loan. If the lender is required to enforce its rights under the pledge, the lender will succeed to the fee ownership of the bor- 2. Obtain UCC Insurance and a Land Title rower's real property (either directly or through the Policy Mezzanine Financing Endorsement owners of the borrower). As a result, the mezzanine UCC insurance is a title insurance product issued lender will have the bene t of whatever title insurance by national title insurance companies such as First policy the borrower has obtained at closing. American Title Company, Fidelity Title and others. The policy e ectively shifts the risk of proper attach- 3. Negotiate Subordination/Intercreditor ment, perfection, and priority of lender's security interests to the title company. UCC policies ensure the Agreement With Senior Lender security interest for enforceability, validity, priority, The relationship between the senior lender and the perfection, and attachment of the equity collateral and mezzanine lender is governed by a written (and often include a pre-closing UCC search and ling of a recorded) agreement commonly called an intercreditor UCC-1 Financing Statement. agreement. The rst step to e ectively negotiating the UCC insurance also covers fraud, forgery, insures intercreditor agreement with the senior lender is the gap between the loan closing and ling of the identifying what's important. There are several UCC-1 and provides cost of defense coverage in the provisions/concessions in the intercreditor agreement event of a challenge to the lender's security interest. that the mezzanine lender should attempt to obtain The policy will also cover future advances, or advances from the senior lender. They include the following: made by the insured subsequent to date of the policy. (1) Obtain senior lender's consent to the pledge of Therefore, advances made in a revolving credit are the equity interests and other mezzanine loan covered by the policy even though they are made after documents. the date on which the policy is issued. The policy can (2) Ensure that the security interest in the pledged also cover after-acquired property. equity is superior to any lien of senior lender. The title company will also serve as a second set of (3) Obtain the right to purchase or prepay senior eyes in the transaction and will provide the UCC search debt at par (i.e., principal and interest only without functions, thus assuming the responsibility for search- late charges, default interest, prepayment penalties, ing the proper jurisdiction's public records for the cor- etc.). rect entity and collateral. The UCC insurance can also replace or supplement a costly legal opinion given by (4) Ensure that senior lender consent is not needed borrower's counsel (discussed below) and pay the cost to enforce rights under the equity pledge and that of defense in the event something goes wrong. such enforcement will not trigger a default under In mezzanine loans where the mezzanine lender is the senior loan. not obtaining a subordinate deed of trust or other inter- (5) Obtain the right to payments of net cash ow est in real property owned by the borrower but is only (i.e., after payment of closing costs and applicable receiving a pledge of the equity interest, it is still use- senior loan release prices and reserves) absent ful to obtain ‘‘title insurance’’ in the form of a ‘‘mez- default under the senior loan. zanine nancing endorsement’’ to the standard owner's (6) Senior lender should agree to ‘‘stand still’’ if title insurance policy. The title companies have devel- borrower is in default under the mezzanine loan
THE REAL ESTATE FINANCE JOURNAL/SPRING 2007 47 Mezzanine Loans to Developers and Owners: 10 Ways to Improve the Quality of the Equity Pledge
(i.e., no cross-default provision in senior loan docu- or person. The bankruptcy-remote nature of an SPE ments tied to a default under the mezzanine loan). should be enhanced by requiring lender approval (7) Senior lender must provide notice of default before commencing a voluntary bankruptcy under the senior loan and provide junior lender with proceeding. Finally, the organizational documents of an opportunity to cure following expiration of the entity should grant the lender the ability to remove senior borrower's cure period. the manager in the event the entity violates any of the provisions of its organizational documents or any of (8) No amendments to senior loan documents with- the mezzanine loan documents. This will allow the out mezzanine lender's consent. lender to quickly succeed to the ownership and control (9) Mezzanine lender should have right to assign its of the equity interest in the event of such a default. This interest in mezzanine loan without senior lender's will allow the lender to prevent bankruptcy lings and consent. gain control over the cash ow without having to resort to a foreclosure. Additionally, the mezzanine lender should obtain written consents from all members 4. Carefully Review Senior Loan Documents authorizing the entire mezzanine loan transaction, Notwithstanding the importance of the intercreditor including an acknowledgment of lender's pledge and agreement, the mezzanine lender (and its legal counsel) security interest in the equity interests and con rma- should also carefully review the senior loan documents. tion that the operating agreement or partnership agree- There are several key provisions that must be consid- ment has not been amended and is in full force and ered and often negotiated with the senior lender. First, e ect. the senior loan documents must permit the mezzanine loan including the pledge of equity interests that is the 6. Draft Pledge and Security Agreement to security for the mezzanine loan. Additionally, there must be no restrictions on transfer of control to the Comply With UCC Requirements mezzanine lender in the event the mezzanine lender The Pledge and Security Agreement (the ‘‘Pledge’’) exercises its rights in the collateral. The senior loan is the document that grants the mezzanine lender its documents should be scrutinized with respect to the security interest in the equity collateral. There should maturity date, loan amount, release prices, reserves, be language in the Pledge making it clear that the entity default/cross-default or cross-collateralization lan- has opted-in to Article 8 of the UCC and which pre- guage and other key provisions to make sure they cor- vents it from opting-out. One way to ensure that there relate with the business terms underwritten by the mez- is not an ‘‘opt-out’’ of Article 8 is to grant lender an ir- zanine lender. revocable proxy in the Pledge, although, as discussed above, this can also be accomplished by a prohibition 5. Tailor Borrower's Organizational Docu- of amendment to the ‘‘opt in’’ language in the operat- ing agreement. ments In many states (including California) sureties and Make sure the operating agreement and/or other guarantors have certain statutory and common law organizational documents of the borrower entity, and rights. In one respect, pledging the equity interest in any entity that will have its equity interest pledged to the borrower could be seen as a guaranty or suretyship the mezzanine lender, contain several important relationship in which case, the mezzanine lender provisions. These include the appropriate UCC Article should be careful to include language in the Pledge 8 ‘‘opt-in’’ provision, and no ‘‘opt-out’’ amendment whereby the pledgor waives any such rights. without consent of mezzanine lender, special purpose entity (‘‘SPE’’) provisions and language allowing the 7. Make Sure All Mezzanine Loan Documents lender to remove the manager following a default. The operating agreement for the borrower and the manager are Consistent of the borrower should also contain standard restric- Each of the mezzanine loan documents should be tions on bankruptcy, dissolution and liquidation of the carefully drafted to ensure internal consistency. There company, merger, consolidation, or reorganization and should be restrictions on all transfers of ownership disposing of all or any substantial part of the compa- interests. Not only should such transfers be deemed an ny's business or property without lender's consent. ‘‘Event of Default’’ under the loan document but there As explained above, the organizational documents should be a ‘‘springing’’ or limited indemnity/guaranty should contain language stating that the entity has if there is any violation of the restrictions on transfer. ‘‘opted-in’’ to Article 8 of the UCC and that it cannot Standard ‘‘mortgage covenants’’ should be required ‘‘opt-out.’’ Additionally, the entity should be an inde- by the mezzanine lender in the mezzanine loan docu- pendent bankruptcy-remote special-purpose entity that ments with respect to issues such as the establishment is unlikely to be the subject of a bankruptcy or to be of tax, improvements, real estate broker fee and insur- consolidated if there is a bankruptcy of a related entity ance escrows, the approval of the property manager,
48 THE REAL ESTATE FINANCE JOURNAL/SPRING 2007 lease forms (and in some cases the leases themselves) lien, UCC and litigation searches in the state of organi- and full access to the borrower's books and records. zation as well as the State(s) in which the borrower's principal place of business and real property are located. 8. Require Borrower's Counsel to Provide Ideally, the lender will also have an adequate op- Opinion Letter portunity to review a preliminary title report or title commitment, underlying title documents, survey, Many mezzanine lenders insist that borrower's purchase documents (if the borrower or its a liate is counsel provide a legal opinion regarding all legal is- acquiring the project) and other similar project sues which could a ect the rights of the lender, includ- documents. For example, a purchase agreement may ing the legal status (due formation, valid existence and contain provisions regarding seller-carryback nanc- good standing) of the debtor(s), the perfection, attach- ing or retention of a pro t participation interest, or ment and priority of a security interest and the due au- requiring the seller to perform certain post-closing thorization, delivery and performance of the loan docu- obligations such as completion of site improvements ments and the loan transaction. In some cases, it may or obtaining entitlements. The results of this investiga- be necessary to also obtain a ‘‘non-consolidation’’ tion are very important and will likely be the subject of opinion to make clear the separate nature of the enti- negotiations between the lender, borrower, seller, and ties involved. other third-parties. As discussed above, UCC insurance is based upon the same due diligence which must be done to issue a 10. Followup on Items That Need to be legal opinion and in some cases can (and should) be used to supplement or replace certain portions of the Obtained After the Closing legal opinion. For example, in certain transactions, Once the frenzy of activity ends and the mezzanine opinions regarding perfection, attachment and priority loan closes, there are still several things the lender of the lender's security interest in the pledged equity should do to ensure the attachment, perfection, and can be eliminated since these matters are covered under priority of the collateral. First, where the pledge is the UCC insurance policy. The advantage of the UCC secured under the UCC, the lender should make sure it insurance is that it does not have the exceptions, obtains physical custody of ownership certi cates at quali cations, and assumptions which can weaken the closing with endorsement. The lender should also assurances contained in legal opinions. Under a UCC con rm with the title company that the UCC Financing insurance policy, the title company is an indemnitor of Statements have been led. While the title company the accuracy of the underlying due diligence, whereas technically is on the hook for any ‘‘gap’’ between clos- a legal opinion assumes such accuracy. In those in- ing and the title company ling the Financing State- stances where cost is an issue, the UCC insurance is a ments, it is good practice to follow up to make sure l- cost e ective alternative. ing takes place as soon after the closing as possible. Similarly, the lender should make sure the title com- pany delivers the nal title insurance policy and 9. Establish Comprehensive Checklist for Due endorsements based on the pro-forma policy the title Diligence Items company issued prior to closing. Since mezzanine nancing is usually provided to the borrower very quickly, there is often little due dili- Conclusion gence conducted on borrower by the mezzanine lender. The mezzanine lender can take steps before, during, This is a mistake. You must ‘‘know your borrower’’ and after the closing to improve the attachment, prior- and the project. Getting to know your borrower and the ity, and perfection of the collateral and the remedies project can often be done quickly and cost e ectively available it in the event of a default by borrower. The with the help of the title insurance company, lender's mezzanine lender can (and should) also improve its counsel and the borrower itself providing the requisite position relative to the senior lender. The mezzanine information to get the lender comfortable with the bor- lender should utilize the title company and borrower's rower and project. When conducting its due diligence counsel to further shift risk away from the mezzanine on the borrower entity or entities, the mezzanine lender lender. These steps will mitigate the risks associated must scrutinize the organizational documents to make with mezzanine nancing and improve the quality of sure the loan and pledge are allowed under the operat- the equity collateral. If however, notwithstanding ing documents and that the parties signing the loan lender's e orts to mitigate risk and improve the quality documents have the requisite authority to do so. Fol- of the collateral, the borrower defaults, there are vari- low up to make sure that the entity or entities are duly ous steps that the lender should (or must) take to formed, validly existing and in good standing. Conduct enforce its security interest.
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