CHAPTER 5.04. Secondary Financing

• Jurisdiction: United States

5.04. Secondary Financing

There are generally three approaches to secondary financing to supplement a senior mortgage loan. These approaches include subordinate mortgage financing, mezzanine financing, and preferred equity.¹⁵⁷

[1] Subordinate Mortgage Financing

Generally, senior lenders do not like subordinate mortgage debt for a host of reasons. A subordinate mortgage lender may have defenses to the foreclosure by the senior lender, such as marshaling requirements. A foreclosure of the subordinate mortgage risks termination of leases that form the value of the collateral for the senior lender or could force the borrower into bankruptcy, which would stay the right of the senior lender to foreclose. The subordinate lender can obtain a receiver for the property, which could interfere with the senior lender's desired actions for recovery of its loan. The senior lender will have the complications of having to deal with the subordinate mortgage lender in a foreclosure of a senior mortgage. The subordinate mortgage lender can interfere with such things as recovery of insurance proceeds or condemnation awards. The senior lender runs the risk of an equitable subordination of its status in the event of a borrower bankruptcy. And the senior lender runs the risk that a modification of its mortgage could result in a loss of priority. For these reasons, the second two means of subordinate financing, mezzanine debt and preferred equity, tend to be more prevalent than subordinate mortgage debt, other than subordinate debt with the senior mortgage lender.

[2] Mezzanine Financing

A mezzanine loan is one to an owner of the mortgage borrower secured by a pledge of that owner's interest in the mortgage borrower. The structure can vary, and the loan can be made to an upper tier of ownership, and often is; but the essential element is the pledge of the ownership interest in the entity that controls the real property. It is called a "mezzanine" loan because it is the layer of financing between the debt (the mortgage loan) and equity (the owner of the mortgage borrower).¹⁵⁸ Mezzanine lending blossomed after the dislocation of the credit markets in the wake of the 20082009 financial collapse, as borrowers needed additional sources of equity in the face of existing senior loans that prohibited secondary mortgage financing. Mezzanine lending found a particularly favorable home in CMBS financing, and was welcomed by borrowers because it was generally less expensive than the alternative of preferred equity.¹⁵⁹

The typical structure for a commercial real estate financing where mezzanine debt is involved is that the mortgage borrower—usually a single asset, single member Delaware limited liability company—is wholly owned by another Delaware limited liability company—also organized as a single asset, single member Delaware limited liability company—whose sole asset is its ownership interest in the mortgage borrower. That parent of the mortgage borrower might then be owned by one or more members. In a CMBS loan, it is likely that this parent of the mortgage borrower will itself be wholly owned by another special purpose entity, which is in turn owned by the "real" owners.¹⁶⁰ In either case, the mezzanine loan is made to the parent of the mortgage borrower, or its parent, and that mezzanine borrower pledges to the mezzanine lender all of its limited liability company interest in the mortgage borrower, or the parent of the mortgage borrower if the mezzanine borrower is the next higher tier of owner. Collateral for the mezzanine loan is therefore a security interest in limited liability company interests and governed by the Delaware U.C.C., specifically Articles 8 and 9. Accordingly, in structuring and documenting a mezzanine loan, consideration of creation, attachment, perfection, and priority of security interests is critical.¹⁶¹

The equity interests in a Delaware limited liability company (and in the occasional limited partnership used for a mezzanine loan) are typically "general intangibles" under Article 9 of the Delaware U.C.C. and are not generally "securities."¹⁶²However, the constituent documents of the company could elect to make those equity interests considered "securities" for purposes of the Delaware U.C.C. This is important because whether this election is made dictates, among other things, how the security interest in the mezzanine loan pledge can be perfected and the relative priority of that security interest. If the equity interests are merely those governed solely by Article 9, they are general intangibles and the security interest is perfected by filing a U.C.C. financing statement in the appropriate filing office,¹⁶³ which is the Delaware Secretary of State for a Delaware limited liability company.¹⁶⁴ If the equity interest is certificated—that is, the company issues a formal certificate representing the interest—the mezzanine lender might also take possession of the certificate representing that interest in order to insure first lien priority.¹⁶⁵ However, the mezzanine lender may be seeking an additional level of comfort beyond its rights as a secured creditor under Article 9. If the mezzanine borrower elects to be subject to Article 8 of the Delaware U.C.C. (so-called "opting in" to Article 8), the rights of the mezzanine lender are enhanced. By opting in, the equity interest is now a security¹⁶⁶ and can be controlled by the mezzanine lender through a control agreement, if the interest is not certificated, or the certificate itself is endorsed by the mezzanine borrower to the lender or its designee or in blank.¹⁶⁷ Opting in may also create challenges for the borrower and therefore is not to be taken lightly by those not experienced in the intricacies of the Delaware U.C.C.¹⁶⁸

For these reasons, a mezzanine lender will typically require certificated equity interests, election by the company to be subject to Article 8 of the Delaware U.C.C., mezzanine lender control of the certificated interests endorsed to the mezzanine lender or its designee or in blank, and a U.C.C. financing statement filed with the Delaware Secretary of State as a precaution in the event the mezzanine borrower elects to opt out of Article 8.¹⁶⁹ Additionally, the mezzanine loan documents will contain a negative covenant that the mezzanine borrower may not opt out of Article 8. One sometimes also sees requirements for an independent manager of the mezzanine borrower whose consent is required in order to opt out of Article 8. Mortgagee title insurance is not directly available to a mezzanine lender because the mezzanine borrower is an indirect owner of the underlying real property, and that interest is not an insurable interest. To address this, mezzanine lenders typically require title insurance to insure the pledge, whether by a stand-alone title insurance policy or by an endorsement to the owner's policy.¹⁷⁰ The latter consists of an endorsement to the mortgage borrower's owner's policy that provides the mezzanine lender with the rights to proceeds from any claims payable to the mortgage borrower under its owner's policy. As further insurance, mezzanine lenders also generally require a Uniform Commercial Code title insurance policy, which can only be issued if the pledged interests are certificated and classified as investment property under the applicable U.C.C. Such a policy insures the attachment, perfection, and priority of the secured party's lien on the pledged collateral. Just like a mortgage lender, the mezzanine lender will usually also require appropriate guarantors to guaranty the mezzanine loan, whether general guaranties or carve-out guaranties if the mezzanine loan is structured as a non-recourse loan, in order to deal with the risks to its collateral position, such as the mezzanine borrower allowing the mortgage borrower to encumber or sell the assets or by allowing the mortgage borrower or mezzanine borrower to file for bankruptcy.

Because the senior mortgage lender requires a guarantor, even if only for carve-out liability in a non-recourse loan, the guarantor will want to require a replacement guarantor should the mezzanine lender foreclose. In other words, if the mezzanine borrower is no longer in control of the mortgage borrower and the collateral, the guarantor of that mortgage loan will not want to remain potentially liable for the mortgage borrower's actions, as that mortgage borrower is now controlled by the mezzanine lender or a third-party purchaser at the mezzanine loan foreclosure. Moreover, the senior mortgage lender will likely want a guarantor who has a stake in influencing the mortgage borrower to comply with its covenants. Accordingly, the senior mortgage lender might require in its intercreditor agreement with the mezzanine lender that if a foreclosure of the mezzanine loan occurs, the mezzanine lender or its creditworthy parent must step into the shoes of the borrower-affiliated guarantor of the mortgage loan.¹⁷¹

[3] Preferred Equity

Preferred equity is a method of financing by which the financing is made through a capital contribution to an entity that holds, either directly or...