Issues in Structuring a Mezzanine Finance Transaction
Given the significant amount of debt that must be refinanced or otherwise dealt with over the 2009-2012 time period, mezzanine finance and its variants are likely to have continued relevance.  This environment is likely to force transactions as property owners are forced to sell or refinance under distress conditions. Pension funds and other buyers will seek to take advantage of this environment.  It is anticipated that banks will continue to reduce the size of their loan portfolios and apply very conservative underwriting standards, with perhaps much lower loan to value ratios than had become customary, and display continued resistance to second mortgages and insistence on bankruptcy remote structures. This creates an opportunity for non-bank lending institutions to fill the gap in the capital structure in the acquisition or refinancing of real estate and other assets.
The essence of mezzanine finance is a loan secured by a pledge of the equity interests in a business entity. The equity interests pledged are most commonly interests in an entity which owns a real estate project or, somewhat less commonly, an operating business. The mezzanine borrower is the owner of these equity interests. That is, the mezzanine borrower is the owner of the entity which owns the real estate. Mezzanine finance transactions may also take the form of preferred equity investments in a special purpose real estate entity, an operating business entity, or a parent of such entities. Additionally, the mezzanine loan may be coupled with conversion rights which permit the lender to convert some portion of the loan into equity interests. Mezzanine capital fills the space between the funds provided by the true common equity type investors and the mortgage lender.
This article discusses various issues in structuring mezzanine finance transactions and dealing with defaults by a mezzanine borrower through foreclosure of the pledged equity interests.
Mezzanine finance took on increasing prominence over the past twenty years for a number of reasons. First mortgage lenders on large real estate projects increasingly saw the granting of second mortgages on projects as creating an elevated risk of legal complications in the event the first mortgage lender foreclosed on its real estate collateral. These legal complications included the risk of the second mortgage lender involving the borrower in a bankruptcy proceeding in which it could act aggressively in a cram down scenario to the detriment of the first mortgage lender. 
In addition, the loan to value ratios for commercial mortgage backed securities has typically been capped at approximately 60 percent in order for the securities to obtain an investment grade rating from a rating agency.  Equity investors in significant commercial real estate projects will usually provide no more than 20 percent of the value in a particular acquisition or development.
A mezzanine loan secured by the equity interests in the real estate owner as opposed to the underlying real estate presented one solution to this problem.
The Mezzanine Lender-Borrower Relationship
The parties in a mezzanine loan transaction will typically include the mezzanine borrower, the entity which owns the real estate or operating business directly, the mortgage lender, and the mezzanine lender. In addition, it is common to require guarantees from the controlling persons of the indirect owner as additional security and to make bankruptcy less attractive.
These parties are tied together through the mortgage loan agreement, the mezzanine loan agreement, the inter-creditor agreement, the security and pledge agreement, and guarantees. There will often be ancillary agreements related to cash management matters which provide the lenders with rights to control funds generated by the property as they travel through its bank accounts under certain circumstances. The inter-creditor agreement and pledge and security agreement are discussed below.
The mezzanine loan agreement includes many of the same provisions included in any sophisticated loan agreement. These include provisions related to prepayments, cash management, cash allocation and reserves, provisions relating to casualty, insurance, and condemnation proceeds, and provisions relating to the inter-creditor arrangement and compliance with the mortgage loan agreement.
Key representations and warranties include those regarding title to the underlying real estate of its corporate owner and the title of the mezzanine borrower to the equity interests in such corporate owner. The value of the pledged equity interests in the real estate owner depends on the title of the owner to the real estate and the title of the mezzanine borrower to those equity interests. For this reason many of the representations and warranties as well as the covenants address issues related to the value of and the security of rights in the underlying real estate asset.
Covenants will also typically restrict transfers, in whole or in part, of the mezzanine borrower, the real estate owner, guarantors, or their affiliates in an effort to maintain bankruptcy remoteness. The mezzanine lender will be particularly interested in maintaining bankruptcy remoteness of the mezzanine borrower and the real estate owner if the mezzanine lender desires to market the mezzanine loan by securitization or sale of participations.
With respect to securitization there may also be extensive covenants related to the cooperation of the mezzanine borrower and the real estate owner in the securitization process. This includes covenants relating to assistance with the preparation of offering documents and in compliance with securities laws relating to the offering. In this context the lender may also require permission to divide the mezzanine loan in various ways including creating various senior and subordinate interests in the loan.
Another important provision deals with the liability of the borrower and its affiliates. Typically this provision will provide, with certain exceptions, that the lender’s only recourse is to the collateral, that is, the equity interests in the owner or the real estate. The exceptions are the non-recourse carve-outs which permit the lender to make claims for money judgments against the borrower and any guarantors upon the occurrence of certain events. The business concept here is that if the loan fails to perform for purely economic reasons, the lender may only recover against the pledged equity collateral. However, if losses exist due to bad acts of the borrower (such as wasting of the asset or misrepresentations), then the lender should have rights against the borrower, guarantors, and affiliates to recover its losses. This is an area where mezzanine lenders may be more aggressive in the future, requiring more matters to create recourse liability and, from an underwriting perspective, requiring additional guarantors.
The mezzanine lender will also have specific rights which permit it to cure defaults under the mortgage loan. The mezzanine lender’s underlying security is the real estate, and it will not want to lose that in a foreclosure of the mortgage loan unless the real estate’s value has fallen with a low probability of recovery. The mezzanine lender will also require prohibitions on any consensual foreclosure or deed in lieu of foreclosure of the real estate collateral.
The pledge and security agreement will provide the lender with a security interest in the equity interests in the owner of the real estate project (see Wis. Stat. Â§ 409.203 and Â§ 409.102(1)(s)). The pledge and security agreement will describe in detail the rights provided to the lender with respect to the collateral in the event of a default including the foreclosure rights under Article 9 of the Uniform Commercial Code (“UCC”). The foreclosure process is discussed in more detail below.
The Pledge as Security
Article 9 of the UCC provides the requirements for the perfection of a security interest in the equity interests of the real estate owner. Perfection is the event which establishes the priority of the lender’s rights in the collateral. The lender with the most senior priority is first in line to recover against the collateral.
Under Article 9 there are various means of perfection of equity interests in a business entity:
- Filing with the applicable state agency
These provide differing levels of priority when they come into conflict.
Since equity interests in the borrower provide collateral for the mezzanine lender, possession and control may be used to perfect a security interest both of which provide senior priority compared to perfection by filing. For perfection by possession or control, the equity interests in the borrower must be governed by Article 8 of the Uniform Commercial Code.
If the equity interests are governed by Article 8, they may be perfected by possession or control by the mezzanine lender. Either of these forms of perfection take priority over perfection by filing, however, perfection by control takes priority over a conflicting lien perfected by possession (see Wis. Stat Â§ 409.328(1) and 409.328(5)).
Equity interests that are not traded on a securities exchange or securities markets may become subject to Article 8 by expressly adopting its provisions in the operating or partnership agreement of the real estate owner. In addition to the additional protection provided in terms of priority, possession or control of the equity interests of the borrower provides the mezzanine lender with additional leverage against the borrower since the lender will not have to sue the borrower to obtain possession of the membership or partnership interests.
Article 8 also provides a lender who takes a security interest in the equity interests as collateral with protected purchaser status where the lender provides value (the loan) and is unaware of any adverse claims to the equity interests (see Wis. Stat. Â§ 408.303 and Â§ 401.201(44)). Protected purchaser status means that upon obtaining control of the equity interest (when the lender acquires possession) the mezzanine lender’s rights pursuant to its security interest are free of any adverse claims of which it is unaware.
A lender who has taken possession of the certificates evidencing equity interests has certain obligations under Wis. Stat Â§ 409.207 to protect and maintain the collateral using reasonable means.
The borrower may object to providing the lender with possession or control of its equity interests as Article 8 imposes additional formalities and compliance obligations upon the issuer. If the borrower cannot be persuaded, the security interests may be perfected by filing a UCC financing statement with the relevant state office. The risk with perfection by filing, however, is that another lender may be able to acquire senior priority in the equity interests by perfecting by possession or control provided that the equity interests are or become subject to Article 8 of the UCC.
The mezzanine lender will require an agreement with the mortgage lender which addresses a number of issues. Where the mezzanine lender enters the capital structure after the mortgage loan is in place, a mezzanine loan may implicate prohibitions on additional borrowing by the borrower or a due on encumbrance clause included in the mortgage loan documents such as the loan or credit agreement. These provisions may reach beyond the actual mezzanine borrower and its subsidiary to its corporate parent or certain of the borrower’s affiliates, depending on the structure of the original transaction, to prevent end runs around such provisions relating directly to the borrower. The borrower and mezzanine lender will also require the consent of the mortgage lender to the mezzanine loan arrangement.
The mezzanine lender will also require assurances from the mortgage lender to protect the mezzanine borrower’s interest in the underlying real estate asset as the mezzanine lender’s security is the borrower’s equity interest in the owner of the underlying asset. These assurances include the recreation via contract of rights that would exist by law for a second mortgage lender, such as prohibitions or limitations on the acceptance of a deed in lieu of foreclosure by the mortgage lender or consenting to a sale of the underlying asset, which would not result in the full payment of the outstanding balance on the mezzanine loan. A properly recorded second mortgage encumbrance would survive a deed in lieu of foreclosure transaction or other transfer or sale transaction.
The mezzanine lender also will want to obtain the right to purchase the lien of the mortgage lender. This right is triggered typically once the mortgage loan has been accelerated. The lien must be purchased in whole and not in part with the price equal to the principal balance, plus accrued interest and other amounts due under the mortgage loan documents. This allows the mezzanine lender to protect the underlying real estate collateral in the event a mortgage lender will or has commenced foreclosure proceedings. The mezzanine lender will have to determine whether or not acquiring the lien is worth the additional expenditure of funds or whether it is throwing good money after bad. The mezzanine lender will typically also have the right to cure defaults of the borrower under the mortgage loan.
In return the mortgage lender will typically require agreements from the mezzanine lender that the mezzanine lender’s rights against the mezzanine borrower and the real estate owner, including the right to payment, are subordinate to the mortgage lender’s rights. The right to accept payment in the ordinary course will be carved out to the extent there is no default under the mortgage loan. The mortgage lender may also require an acknowledgement that the mezzanine borrower has no liens in the underlying real estate asset. If the mortgage loan is rated (such as a CMBS loan), the mortgage lender may require the consent of a rating agency to a transfer of control of the mezzanine loan.
The mortgage lender may also place certain limitations or restrictions on the exercise of the mezzanine lender’s rights to foreclose on the equity interests in the real estate owner. These include restrictions on the transferee of the equity interests, the identity of the manager of the property after foreclosure of the pledged collateral and the establishment of certain reserve accounts.
Both the mortgage lender and the mezzanine lender may require standstill covenants of each other with respect to the business or financial terms of their respective loans. For example such covenants would prohibit amendments to the relevant loan documents of either lender which increase interest rates, increase the principal balance of the loan, extend or shorten the maturity dates, cross default the loan with other loans, and similar matters.
Title Insurance and Uniform Commercial Code Perfection Insurance
nsurance similar to real estate title insurance is available to mezzanine lenders. However, mezzanine lenders generally are considered to have too distant a connection with the underlying real estate collateral to obtain an owner’s policy of title insurance or a loan policy of title insurance with respect to the real estate. They may however have an “insurable interest” in the underlying real estate as defined and required under Wisconsin law to access property insurance coverage. 
However, mezzanine lenders can obtain policies of insurance from title insurers which insure the creation, perfection, and priority of their security interest in the equity interests of the real estate owner. The lender may also obtain coverage insuring that the mezzanine borrower in fact owns the equity interests being pledged and that the lender has protected purchased status under UCC Article 8.
Foreclosure and Sale of Pledged Equity Interests
In the event of a default under the mezzanine loan, the mezzanine lender may exercise its rights under Article 9 of the UCC to take possession of the pledged collateral (if it has not perfected by possession or control), and may sell, license, lease or otherwise dispose of the collateral by commercially reasonable means (Wis. Stat Â§ 409.610(1); Wis. Stat. Â§ 409.609(1)).
This may take the form of a public or private sale, provided such sale is commercially reasonable. The secured party may purchase at a public sale or a private sale, provided that with respect to a private sale the secured party may purchase only if the collateral is of a kind that is sold on a recognized market or subject to widely distributed price quotations (Wis. Stat Â§ 406.610(3)). This means that a mezzanine lender will generally only be able to purchase the pledged equity interests at a public sale. This is significant for a party who acquires a troubled mezzanine loan to take control of the real estate because a public sale requires a certain amount of marketing effort be expended so that multiple bids are generated at auction.
Strict compliance with the disposition procedures is important to avoid a challenge from the borrower under Wis. Stat. Â§ 409.626 especially where collection of a deficiency will be sought against guarantors and the borrower. Under that statutory provision the amount of the deficiency may be reduced to zero as the statute establishes a presumption that the proceeds from disposition are equal to the debt and collection costs (Wis. Stat. Â§ 409.626(1)(d)). Moreover, a secured party may be liable for damages for failure to comply with the statutory disposition requirements including commercial reasonableness (Wis. Stat. Â§ 409.625(2)).
In conducting either a public or private sale of the collateral, a mezzanine lender must be cognizant of the fact that the equity interests in the real estate will in most cases be considered securities, and are therefore subject to state and federal securities laws. The commentary to UCC Article 9 indicates that a commercially reasonable public sale for purposes of the UCC may be a sale conducted in accordance with one of the transaction exemptions established under federal and, by implication, state securities regulations. 
Strict foreclosure is also available to a secured party in a mezzanine loan transaction. This may be of interests to a distressed debt investor acquiring the mezzanine debt to obtain control of the property. Strict foreclosure means that the mezzanine lender may accept the collateral as full or partial satisfaction of the debt owed it (Wis. Stat Â§ 409.620). With respect to full satisfaction, the secured party may retain the collateral in full satisfaction of the debt provided the debtor does not object to the proposal within twenty (20) days after it is sent to the borrower. Strict foreclosure thus requires the cooperation or at least indifference of the mezzanine borrower.
Finally, under Wis. Stat. Â§ 409.623 the borrower, a guarantor, or any other secured party or lien holder may redeem the pledged collateral anytime before the collateral is accepted in strict foreclosure, sold, or otherwise disposed of pursuant to Article 9 of the UCC.
Jonathan L. Schuster and Edward J. Lawton are both members of Axley Brynelson, LLP’s Business Law Practice Group. For more information on mezzanine finance transaction structuring, please contact Mr. Schuster at 608.283.6769 or firstname.lastname@example.org, or Mr. Lawton at 608.283.6717 or email@example.com.
 Page C6, June 10, 2009, Relief for Commercial Real Estate Debt? It Seems Possible, Lingling Wei, Kris Hudson, Wall Street Journal, U.S. Edition.
 Page C6, August 5, 2009, As Values Decline, Pension Funds Jump Into Real Estate, Anton Troianovski, Wall Street Journal, U.S. Edition.
 Real Estate Transactions – Structure and Analysis with Forms, Â§ 4:21, Alvin L. Arnold, 2009.
 Real Estate Transactions – Structure and Analysis with Forms, Â§ 4.19, Alvin L. Arnold, April, 2009.
 “A person has an insurable interest in property when the relationship between him and the property is such that he has a reasonable expectation, based upon a real or legal right, of benefit to be derived from the continued existence of the property and of loss or liability from its destruction.” Stebane Nash Co. v. Campbellsport Mut. Ins. Co., 27 Wis.2d 112, 118, 133 N.W.2d 737, 742 (Wis. 1965). Neither a legal nor equitable interest in property is necessary. Id.
 “Dispositions of investment property may be regulated by the federal securities laws. Although a “public” disposition of securities under this Article may implicate the registration requirements of the Securities Act of 1933, it need not do so. A disposition that qualifies for a “private placement” exemption under the Securities Act of 1933 nevertheless may constitute a “public” disposition within the meaning of this section. Moreover, the “commercially reasonable” requirements of subsection (b) need not prevent a secured party from conducting a foreclosure sale without the issuer’s compliance with federal registration requirements.” Comment 8 to UCC Â§ 9-610.