subordinate financing in cmbs transactions: rating agency,...

Subordinate Financing in CMBS Transactions:

Rating Agency, Investor and Servicing ConcernsStructuring A/B, Pari Passu, Mezzanine, Preferred Equity,

and Intercreditor Arrangements for Securitization

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THURSDAY, FEBRUARY 21, 2019

Presenting a live 90-minute webinar with interactive Q&A

Steven Coury, Partner, White and Williams, New York

Allen J. Dickey, Shareholder, Polsinelli, Dallas

Siobhan M. O'Donnell, Of Counsel, Ballard Spahr, Los Angeles

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Subordinate Financing in CMBS

Transactions: Rating Agency, Investor and

Servicing Concerns

Siobhan M. O'Donnell

Of Counsel

424.204.4341

[email protected]

Structuring A/B, Pari Passu, Mezzanine, Preferred Equity,

and Intercreditor Arrangements for Securitization

Setting the Table: CMBS

General Overview

• Commercial mortgage-backed securities

(CMBS) or conduit loans

• Participants in the CMBS process

6

Brief Overview of CMBS and

Historical Context

• CMBS structure relatively recent creation; modern market came out of Resolution

Trust Corporation (RTC) following the savings and loan crisis.

• CMBS pools large numbers of mortgages into a single bond issue. CMBS

securitizations began as pools of seasoned and troubled balance sheet loans and

eventually became source of financing for new CRE loans.

• Most deals are multi-borrower transactions; can have single borrower or single asset

securitizations (trophy properties)

• The “REMIC” (Real Estate Mortgage Investment Conduit) → essential to the CMBS

structure

– Created by the Tax Reform Act of 1986

– Multiclass, mortgage-backed securities; cash flow from underlying mortgage assets are

allocated to individual bonds (“tranches”)

– Provides pass-through tax structure for bondholders

– The REMIC trust is tax-exempt

• Still smallish percentage of overall CRE finance volume.

7

Knowing the Players: Securitization Parties

• Rating Agencies

• Investors

• Servicers

8

Rating Agencies

• Nationally recognized statistical rating agencies – registered with the SEC

• Typically see Standard & Poor’s (S&P), Moody’s, Fitch, Kroll, Morningstar and DBRS.

• Assess credit risk of CMBS bonds

– Key roll in process: Investors purchase bonds based on ratings

• Assign ratings to each tranche of bonds in a CMBS transaction; ratings are based on

the underlying collateral and loss protection for each class/tranche of bonds

– From AAA to Unrated

– Objective opinion as to quality and credit of bonds

• Monitor performance following securitization and may issue modified ratings based

upon change in circumstances

• Loan documents may require as a condition to certain matters (transfers, defeasance,

release of collateral, replacement of a property manager etc...) that Rating Agency

Confirmation (“RAC”) is obtained ➔ rating agencies confirm that action item will not

result in a downgrade of the bonds

Source: U.S. Securities and Exchange Commission; CREFC9

Rating Agencies, cont...

• Each rating agency has own internal ratings criteria, used to evaluate loans

– Look at cash flow, loan structure, terms of the loans, quality of property and asset

type, tenants, quality of sponsor

– Review of loan structure will include review of any subordinate debt and its

impact on risk profile

– If mezzanine debt, will include a review of the intercreditor agreement

• Mezzanine lender and mortgage lender negotiate rights vis a vis each other:

mortgage lender protections and mezzanine lender rights

• The “S&P” or CREFC form

– developed with input from market participants

– generally accepted by rating agencies

– became widely accepted as industry standard (including in non-CMBS transactions)

– evolution has continued, particularly as a result of the 2008 financial crisis

Source: S&P; Moody’s Investors Service

10

Investors

• After CMBS bonds are rated by the rating agencies the bonds are offered to

investors

• Investors are typically money managers and insurance companies (to lesser

extent, opportunity funds, pension funds, and banks)

• Disbursements from the trust are made to each class of investors per the

“waterfall”; highest rated bonds are paid first and lowest rated bonds are paid

last. Riskier, lower rated bonds have a higher yield.

• Losses accrue to holders of the lowest rated bonds first.

• Investors like the call protection and low extension risk to protect yield that

CMBS securities afford.

• Investors can select CMBS bonds based on desired risk, term and yield to

match needs and tolerance

Source: CREFC11

The Most Important Investor: The B-Piece

Holder

• The B-piece is the bottom or most junior tranche in a

securitization transaction

• Holds the riskiest tranche of bonds (and gets the

highest yield)

• Has the ability to appoint and replace the special

servicer at will (sometimes is the special servicer)

• Because of risk – evaluate underlying collateral carefully

unlike other investors

12

Servicers

• Once the loan is made to the borrower and securitization closes, all future dealings take place with

the servicer for the securitization trust.

• Servicer acts on behalf of bondholders and the trust.

• The Pooling and Servicing Agreement (the “PSA”) sets out the duties of the servicer and special

servicer.

• Master Servicer:

– Collect loan payments and ensure taxes and insurance premiums are paid; reporting; remit funds to the

trustee; advance delinquent principal and interest payments and make protective advances; oversee

primary servicers’ loan servicing

– Refers defaulted loans to the Special Servicer

• Primary or Sub Servicer: Responsible for day-to-day servicing and performance monitoring

• Special Servicer: Resolve distressed and defaulted mortgage loans; review borrower requests

– B piece holder (holder of the most junior tranche of bonds) has ability to be or select Special Servicer

• Bound by the “servicing standard”: maximize net present value of collateral on behalf of

bondholders

• In addition to the PSA, servicers must also operate within four corners of the loan documents

governing the individual loans

13

Different Worlds: CMBS vs. Portfolio

Lending

• Structural Differences and Major

Distinctions

• Administration

• Interfacing with the Borrower

14

CMBS

• Typically fixed rate

• Stabilized, income-producing properties

• Predicable cash flow for investors

• Difficult to customize

• Loans deposited into collateral are “true

sales”; allows originators to clear balance

sheets (but see Dodd-Frank risk retention

rules implemented at the end of 2016; 5%

must be held)

• Subject to REMIC rules (no significant

changes to the underlying loans/collateral)

• Call protection: prepayments are restricted

(defeasance or yield maintenance)

• Second lien mortgages are NOT permitted

Portfolio

• Floating or fixed rate

• Construction and/or “transitional”

properties

• Remain on lenders’ balance sheets – all

risk is retained

• Flexibility on prepayment ability and

extensions

• Lenders may allow second lien

mortgages

– Often subject to a subordination and

standstill agreement, which makes the

second lien mortgage a “soft second”

Structural Differences

15

Structural Differences cont... – A Side Note on

CRE CLOs

CRE CLOs: another form of securitization of CRE loans, but distinct from CMBS in a number of

respects:

• Similar to CMBS structure, also a pass-through vehicle but different structure allows for greater

flexibility

• Means to securitize floating rate, shorter-term bridge loans

– Collateral pool can also include mezzanine loans and participations

• Reinvestment rights; collateral manager can buy or sell assets in and out of the collateral pool

(CMBS pools are “static”)

• Loans deposited into the CLO pool are not “true sales” and remain “on balance sheet”

• Loan intended for CLO often has characteristics of a portfolio loan:

– Loans can be restructured or extended while remaining in the collateral pool

– Servicing generally performed by the lender that made the original loan

– Often highly structured, including large renovation budgets and future funding; requires intensive

servicing, but more flexibility for servicers to make decisions (still subject to restrictions on significant

modifications, which can trigger tax implications)

• Since CLOs issue securities – need rating agencies to rate the bonds ➔ no second lien mortgage

financing allowed

Source: The Real Estate Finance Journal, Winter 2017,

Wharton Real Estate Review Spring 2012

16

No Second Lien Mortgages Allowed

• Concern about the power of an additional secured creditor of

the mortgage borrower in a bankruptcy context

– Bankruptcy remoteness is everything in CMBS

• Since second lien mortgages are not acceptable in CMBS –

market participants devised creative ways to increase leverage

with subordinate debt

– Mezzanine loans

– Preferred equity (“soft” or “hard”)

Creative structure is not enough: Rating agencies and B-Piece Buyers view

subordinate debt as putting additional stress on mortgaged property – more debt

means less equity

17

Loan Administration

CMBS

• Servicing is run through the PSA structure: master servicer, special servicer, primary

servicer

• Bound by the applicable servicing standard and the four corners of the loan

documents = rigid structure in terms of what can be approved

• Loans must be administered in manner that complies with REMIC rules

Portfolio

• Lender applies its own individualized standards in addressing loan defaults,

restructurings and borrower consent requests

• Lenders often engage a third-party servicer; third-party servicer will administer the

loan in accordance with the servicing standard articulated in its servicing agreement

with the lender

18

Relationship with Borrower

CMBS• Split obligations, responsibilities, and liabilities for the loan between multiple

parties (primary, master and special servicers).

• No “relationship lending”

Portfolio• Continuity in the origination, servicing, and workout of the loan.

• Portfolio lenders typically have closer relationship with borrowers;

relationship lending.

• Borrowers often wary of CMBS structure because of rigidity and lack of

attention/flexibility

19

Mezzanine FinancingAnd

Intercreditor Agreements

20

• Structural Subordination– Mezzanine borrower is the owner of 100% of equity interests of the mortgage borrower/property owner;

mortgage borrower is the owner of the property– Bankruptcy remote SPEsas the mortgage borrower and mezzanine borrower – Equity pledges as collateral, not a mortgage or deed of trust– Mezzanine loans are structurally subordinate to the mortgage loan

• Equity Pledge Features – Different collateral compared to mortgage loan

• No mortgage lien priority• Upon foreclosure mezzanine lender takes subject to all liabilities and obligations of the property owner

absent contractual subordination or termination rights• UCC foreclosure, not a foreclosure of a mortgage

– Voting rights– UCCArticle 8 vs. Article 9 perfection

• Article 9: file UCC-1.• Opt in to Article 8: certificated securities with irrevocable proxy

Mezzanine Financing

21

• An “Intercreditor Agreement” governs the relationship between the mortgage lender and the mezzanine lender.

• The Intercreditor Agreement sets forth various rights, remedies and obligations with respect to the real estate collateral, the borrowers and the guarantors, for example:– The permitted collateral for a mezzanine loan.– When a mezzanine lender may accept payments from the mezzanine

borrower.– Modification of mortgage and mezzanine loan documents.– The remedies that may be exercised upon a default of either loan.– The right of the mezzanine lender to purchase the mortgage loan.– The right of the mezzanine lender to receive notice of mortgage loan

borrower defaults and an opportunity to cure.

Mezzanine Financing

22

• Special provisions relating to mortgage loan documents– Expressly permit the pledge and foreclosure of the equity interests in mortgage

borrower; foreclosure of equity collateral would not be a recourse event to guarantors– Inclusion of Article 8 “opt-in” and other provisions in favor of mezzanine lender in

property owner’s operating agreement– Grant of cure rights and powers of attorney in favor of mezzanine

lender upon any default under the mortgage loan– Cross default to mortgage loan event of default– Prohibition against modification of mortgage loan documents– Insurance/condemnation proceeds and mortgage loan reserves– Restrict the right of a mezzanine lender to exercise remedies against a common

guarantor if the mortgage loan is pursuing a claim against the common guarantor or has notified the common guarantor of an outstanding claim

Mezzanine Financing

23

• Recourse carveoutsthat are unique to mezzanine loans, as distinguished from mortgage loans– Full recourse on bankruptcy or reorganization to cover mezzanine borrower and any

intervening entities, as well as mortgage borrower and guarantor– Expansion of full recourse on due-on-sale or due-on-encumbrance provisions to

include deeds-in-lieu and consensual foreclosure or sale agreements of the mortgage loan

– Increased exposure of carveoutsguarantors to recourse damage claims for violation of SPEprovisions due to structural subordination

– Mortgage loan modifications not approved by mezzanine lender– Purchase of mortgage loan by mortgage borrower related party– Real property transfer taxes upon foreclosure– Compensating for lack of mortgage priority and risk of mechanics’ liens, unapproved

contracts and agreements, claims/liabilities, borrower indemnity obligations, judgments and tenant breach claims

Mezzanine Financing

24

How does the existence of subordinate debt affect a securitization?

• Rating agencies, certificate buyers, B-Piece buyers (CMBSparties) assume that any subordinate debt puts additional stress on the mortgaged property.

• Less equity reduces the Borrower’s incentive to build property value or preserve the property.

CMBS Concerns Specific to Mezzanine Financing

25

• It is believed that the existence of subordinate debt increases the likelihood of default, a disruption in operating the real property post-default, and the severity of loss with respect to a defaulted mortgage loan, and, therefore, will result in a higher default rating.

• However, subordinate debt provides a “deep pocket” to cure senior loan defaults and purchase the senior loan.


26

• The loan documents and ICA will be analyzed to determine the subordinate lender’s ability to:

– Transfer debt;

– Control the mortgaged property, the mortgage borrower, loan servicing and enforcement, and property management;

– Receive payments and enforce its rights, before or after default, under the mortgage loan.


27

• Mezzanine and mortgage lenders rely on provisions in their loan documents requiring borrowers to cooperate in restructuring their loans.

• Lenders want broad restructuring rights; Borrowers want to ensure that their obligations are not increased, no additional costs, loan economics do not change, non-recourse carveoutsare not affected, and material non-economic rights are not changed.


28

Structure of the Mezzanine Loan: • CMBSrequires mezzanine loans to be secured by a 100% pledge

of the equity interests in the mortgage borrower/property so that the mezzanine lender can quickly take control of the mortgage borrower upon a default.

• Require that a mezzanine loan be coterminous with mortgage loans so as to limit refinance risk.

• Mezzanine loans cannot be secured by a subordinate lien on the real estate, a guaranty by the mortgage borrower, or any other credit enhancement that would reduce the likelihood of repayment of the mortgage loan or violate the SPE covenants.


29

The Mezzanine Lender:• Because of the mezzanine lender’s ability to take control of

the mortgage borrower, the mezzanine lender must be a Qualified Institutional Lender or a Qualified Transferee, having experience in the real estate investments of this type and that satisfies certain financial requirements.


30

The Mezzanine Borrower:• The Mezzanine Borrower will be required to be a bankruptcy

remote SPE and to provide a non-consolidation opinion concluding that the assets of the mezzanine borrower would not be consolidated into the bankruptcy estate of any affiliated persons or entities that collectively own, directly or indirectly, more than 49% of the mezzanine borrower.


31

Cash Management:• A cash management agreement with standard “waterfalls” in

place after a “trigger” event will be required.• In general, following a trigger event based on an event of

default, any subordinate debt will not be paid.• Mezzanine lenders must be careful about trigger events and

cash flow controlled by the mortgage loan servicer.


32

Intercreditor Agreements:• CMBS requires that intercreditor agreements address such

issues as default and cure, prepayment, loan transfers, and control and approval rights over leases, property management, and other operational issues.


33

• Mezzanine Loan Foreclosure:– The ICA requires that a foreclosing mezzanine lender is financially strong and

experienced. – The ICA requires that a mezzanine lender, as a condition to foreclosure, (a) obtain a

rating agency confirmation, or (b) that the mezzanine lender be a qualified transferee (satisfying certain net worth and liquidity requirements), post a replacement guarantor, appoint an acceptable property manager, provide a new non-consolidation opinion, and impose hard cash management.

– In many recent ICAs, the mezzanine lender or its successor would no longer automatically qualify as a Qualified Transferee, and must meet the same financial criteria that a third party would need to satisfy, and cannot be a “Disqualified Person”

– This is in effect attempting to import to a mezzanine loan foreclosure the kind of approval rights that a mortgage lender would have in a loan assumption transaction.


34

• Replacement Guarantor:

– ICAsalmost universally require that, as a condition to foreclosure, the mezzanine lender posts a replacement guarantor acceptable to the mortgage lender or that satisfied certain financial and other objective tests.

– The original CMBSrequired a replacement guarantor only if the original guarantor was removed. Now, the ICA has evolved to require a replacement guarantor as both a condition to foreclosure and taking any control over the mezzanine borrower.

– Deemed replacement guarantor.


35

• Replacement Guarantor Requirement to Exercise Control Rights– Mezzloan pledge agreements typically provide the mezzanine lender with the right

upon a borrower default to exercise all voting rights with respect to the mortgage borrower, without the need to foreclose.

– In addition, in mezzanine loans secured under UCC Article 8, the mezzanine lender holds as collateral the equity certificate, so that the mezzanine lender can immediately take voting control over the mortgage borrower.

– However, there is risk of lender liability once mezzanine lender has taken control of the mortgage borrower.

– Upon assuming control, a mezzanine lender can vote to cause the mortgage borrower to voluntarily file for bankruptcy.

– Mortgage lenders now attempt to include the exercise of voting control rights by the mezzlender along with UCC foreclosure in requiring mezzlender to provide a replacement carve-outs guarantor, materially reducing the value of mezzlender obtaining a pledge of voting rights as a remedy.


36

• Stuy Town:

– The ICA required that the Mezzanine Lender cure all mortgage loan defaults as a condition precedent to foreclosure. As the mortgage loan had been accelerated, this was $3.5 billion. The court issued an injunction stopping the mezzanine lender’s foreclosure. Mezzanine Lender had no obligation to post a replacement guarantor.

– New ICAsprovide that the mezzanine lender take subject to all outstanding mortgage loan defaults.

– Mezzanine Lenders are prevented from filing a mortgage borrower bankruptcy by posting the replacement guarantor.


37

• Bankruptcy:– Most ICAsrestrict the mezzanine lender’s rights in a bankruptcy of the

mortgage borrower. – The ICA requires:

• The mortgage lender’s claims are paid first;• The mezzanine lender will not commence or conspire to commence a bankruptcy

against the mortgage borrower• If the mezzanine lender is deemed a creditor of the mortgage borrower, (a) the

mortgage lender may vote the mezzanine lender’s claim and (b) the mezzanine lender will not challenge any good faith claims of the mortgage lender, dispute any valuation of the mortgaged property, or take any other action adverse to the mortgage lender’s ability to enforce its rights.

• Mezzanine lender required to assign any rights to vote on a bankruptcy claim.• CMBSis hostile to second mortgages as would give the subordinate lender rights in

bankruptcy.


38

• Transfers of the Mezzanine Loan by the Mezzanine Lender:

– Most ICAsrestrict the mezzanine lender from selling, transferring, or pledging more than 49% of the mezzanine loan unless to a Qualified Transferee.

– Mezzanine lenders sometimes are successful in negotiating exceptions to prequalify them, their affiliates, and certain other specifically identified entities with investment and management experience.

– Many ICAshave a hole in the language that would allow a transfer of the equity interests in the mezzanine lender entity providing a back door to transfer the loan.


39

• Mezzanine Lender Cure Rights:

– Mezzanine lenders want extended mortgage loan cure rights to protect their investment.

– ICAs generally provide a set number of monetary cures (usually 4-6 in any year or over the term of the loan).

– Non-Monetary defaults can be extended by the mezzanine lender as reasonably necessary, provided that the mezzanine lender has kept the mortgage loan current, no bankruptcy, and no material impairment to the value, use, or operation of the mortgaged property.


40

• Purchase Option Event Triggers– After the occurrence of certain “triggering events”, including acceleration of the maturity date, scheduled

interest or principal payments being delinquent for 90 days, maturity default, borrower’s bankruptcy or becoming a specially serviced mortgage loan, mezzanine borrower has the right to buy out the mortgage loan.

• The use of purchase options has been severely limited due to:– Capital restrictions of mezzlenders.– Deteriorating collateral values resulting in the mezzanine loan being “out of the money” and having little

value.– Closing as little as 10 days after exercising the option, which would be of little value to a mezzlender

• Purchase Price: Par plus accrued interest plus expenses. Prepayment fees, exit fees, late charges, default interest are negotiated.

• Mezzlender should seek to not lose its right to purchase until either (i) the mortgage loan foreclosure is completed or (ii) after mortgage lender is in a position to accept a deed-in-lieu of foreclosure, adequate notice is given to mezzlender and a reasonable time is provided for mezzlender to purchase the mortgage loan.

• The mezzanine lender should try to expand the triggers for a purchase option to include events such as a bankruptcy of the mortgage borrower, deed in lieu of foreclosure, and a failure of the mortgage borrower to pay the mortgage loan on the maturity date.


41

• Mortgage Loan Deed-in-Lieu Restrictions

– Customarily, the granting of a deed-in-lieu to the mortgage lender would be full recourse to guarantor, while a mortgage foreclosure would not be full recourse.

– However, mortgage lenders may demand that if the mortgage lender negotiates a deed-in-lieu with the mortgage borrower, and the mezzanine lender declines to purchase the mortgage loan, the granting of a deed-in-lieu will not result in full recourse liability under the mezzanine loan’s guaranty.

– This forces the mezzanine lender to either buy the mortgage loan or be at risk of a complete loss of its investment.

– The mezzanine lender would far prefer that the mortgage lender conduct a mortgage foreclosure, as the mezzanine lender would recover a portion of its investment if the winning bidder pays a purchase price in excess of the mortgage loan.

Mezzanine Lender Purchase Rights

42

• Relief for foreclosing Mezzanine Lenders on financial covenants, interest rate cap strike price, required reserves, extension conditions, and other provisions.

• Agreement to provide copies of notices and financial statements.• Joint determination/consultation regarding trigger periods.• Mezzanine Endorsement to Owner’s Title Policies• Ground Lease Defaults.• Resizing of the Mortgage Loan; Mortgage Lender’s ability to crease

additional mezzanine loans prior to securitization.• Mortgage Lender’s ability to uncross properties and require separate

mezzanine loans.• Affiliated Junior Lenders.• Mortgage Loan Standstill Provisions in rapid foreclosure states.• Disqualified Persons

Additional Provisions

43

Servicing and Control Rights

44

• Tension between senior and junior debt as to how much control each will have over the borrower’s decisions.

• Where there is no subordinate debt, the mortgage lender will have all control rights.

• Subordinate lenders, who are the first risk of loss, are arguably more closely involved in property operation and have more risk.

Servicing and Control Rights –Mezzanine Loans

45

Control and Approval Rights • Handled in three ways: (1) the mortgage lender has the approval right,

(2) mezzanine lender has approval until a trigger event, or (3) mortgage lender has approval right subject to mezzanine lender consultation rights.

• Customary Approval Rights:– Leases– Property Management– Annual Operating Budget– Books and Records– Alterations– Insurance– Transfers

Servicing and Control Rights –Mezzanine Loans

46

Steven E. CouryWhite and Williams LLP

7 Times SquareNew York, New York 10036

[email protected](212) 631-4412

Thank You

47

mailto:[email protected]

Polsinelli PC. In California, Polsinelli LLP

Subordinate Financing in CMBS Transactions: Rating Agency,

Investor and Servicing Concerns

Structuring A/B, Pari Passu, Mezzanine, Preferred Equity, and

Intercreditor Arrangements for Securitization

Allen Dickey

[email protected]

real challenges. real answers. sm

Background and Basics

▪ Current State of Mortgage / Mezzanine Finance

– limited liability companies have become the preferred

vehicle for creating bankruptcy remote entities in

many financing transactions

– may feature mezzanine / preferred equity / A/B loans,

and pari passu financing arrangements

– imperative that commercial finance attorneys

understand the consequences of these structures in

the CMBS market

49


Preferred Equity

▪ Preferred equity—like the name implies—is an equity

investment into a joint venture that owns a 100 percent

interest in a property. The investment is typically made into a

newly formed entity so that the equity investor does not need

to conduct entity-level diligence or analyze any entity-level

liabilities.

▪ If the asset is encumbered by senior debt, the preferred equity

investor will want to ensure that the investment is made in

compliance with the loan documents. One of the biggest

misconceptions about preferred equity is that its legal

structure is the same as a mezzanine loan. To be clear – a

preferred equity investment is not a loan, and it is typically not

secured.

50


Preferred Equity Structure

51


Preferred Equity, cont.

▪ A preferred equity investor is entitled to a “preferred return” on

its investment, which can be structured to either accrue or to

have periodic payments, irrespective of cash flow. The

payments to the preferred equity investor will be set forth in

the distribution provisions of the joint venture/operating

agreement in order to ensure that the preferred return is paid

first.

▪ Any preferred equity investment will have an end date or a

mandatory redemption date on which the equity investment is

required to be redeemed. Extensions of the mandatory

redemption date can be negotiated, but generally it is co-

terminous with the senior loan maturity date or, in some

instances, it is a date that immediately follows the loan

maturity.

52



▪ To repeat - preferred equity is typically not secured. Pledges of ownership

interests are not unheard of, but they are not typical in the same way that

they are for mezzanine loans. If there is no pledge, the concern is what

remedies can be made available to the preferred equity investor if the

investment, together with the preferred return, if a default occurs. Since

there is no loan, pledge or loan agreement, all remedies available to the

preferred equity investor are set forth in the operating agreement with the

other partners or members.

▪ These remedies typically include a lockdown on cash flow and the ability to

“take over” the deal (becoming the sole manager of the asset and make all

property related decisions, including the determination of whether to sell the

property and at what price). The investor will want to be in complete control

with no interference from the other partners. To have control, there is no

foreclosure action or Uniform Commercial Code process that the preferred

equity investor has to commence and complete. The right to “take over” is

contractual.

53



▪ The other partners who now no longer have control of the deal will generally retain

their economic interests in the deal, but they will be deeply subordinated in terms of

payment. In certain instances, the other partners or members completely forfeit

rights and economic interests. And some deals are structured in a manner so that

the other partners (or credit-worthy persons or entities acceptable to the preferred

equity investor) indemnify the preferred equity investor against any claims or losses

that the investor may suffer if the other partners interfere with this “take over.” This is

akin to a “bad-boy” guaranty in the mezzanine loan space.

▪ Like mezzanine loans, any remedies that investors may have negotiated in their joint

venture agreement must take into consideration any senior loan restrictions or

requirements. If the senior loan documents do not allow the preferred equity investor

to exercise its remedies in a timely manner, the investor will need to pursue certain

amendments to the loan documents or negotiate a separate recognition agreement

with the senior lender. The form and substance of recognition agreements are rapidly

evolving.

54


Preferred Equity “Recognition” [i.e.

Intercreditor] Agreements

The term was historically quite apt for two reasons—preferred equity holders were not

deemed to be “creditors,” at least in the usual sense, and the rights under the agreement

were essentially limited to a “recognition” of certain of the holder’s rights under the

Operating Agreement, including the right of removal of the property manager or general

partner or managing member under various conditions acceptable to the senior lender in

a given case, so that exercise of those rights will not result in a “prohibited transfer”

default under the senior loan documents. As preferred equity has continued to evolve

and incorporate mezzanine-like terms and conditions, making it more and more debt-like

(“hard” preferred equity), the “recognition” agreement has become more and more like

the mezzanine intercreditor agreement and seems likely to continue to do so.

55


Structuring Preferred Equity Investments to

comply with CMBS Prerequisites▪ Virtually every CMBS prospectus will indicate that B-Notes, mezzanine

loans, preferred equity and other investments that are subordinated or

otherwise junior in an issuer's capital structure and that involve privately

negotiated structures expose the investor to greater risk of loss.

▪ A preferred equity arrangement, especially of the “soft” variety, is likely to

have the least negative effect on the rating of a mortgage loan. Some

senior lenders who will not tolerate secondary “debt” on their mortgaged

property will consider preferred equity to be essentially equity rather than

debt for the purpose of interpreting such covenants even if the preferred

equity has extensive debt indicia and would be treated as equity under

income tax and accounting rules. This has been true recently in construction

lending where some bank lenders governed by the HVCRE regulation

requirement that their borrower must have a certain level of equity capital in

the project have been willing to consider preferred equity as appropriate

equity to be included in calculating the borrower’s contribution.

56



comply with CMBS Prerequisites

▪ Senior lenders want to examine the level of control that the preferred equity

holder can exert over the mortgage borrower. It is not uncommon for the

preferred equity holder to have removal and replacement rights regarding

property management or the entity itself, or even the ability to sell the property in

compliance with the mortgage loan documents (in the case of CMBS, either of

them likely subject to a “Rating Agency Confirmation” that the action will not

cause a downgrade, qualification or withdrawal of the applicable rating of

securitized debt), but Securitization Parties look skeptically at a preferred equity

holder’s ability to affect the daily operations of the mortgage borrower or exercise

other controls over the mortgage borrower.

▪ Additionally, senior lenders will examine the identity of the preferred equity holder

and its ability to transfer its interest in the mortgage borrower. As the preferred

equity holder demands and gains more potential control over the mortgage

borrower and the mortgaged property, the identity of the preferred equity holder

becomes paramount. Senior lenders and Securitization Parties will expect the

preferred equity holder to meet certain “Qualified Transferee” standards as to

financial strength and experience in real estate investment and management. A

preferred equity holder with solid credentials and a properly structured

investment could even enhance the credit rating of the mortgage loan.

57



comply with CMBS Prerequisites

▪ As with mezzanine lenders transferring mezzanine debt, the

preferred equity holder's ability to transfer its interest in the

mortgage borrower would generally be subject to the

transferee meeting the same standards or obtaining a Rating

Agency Confirmation as to transferee's acceptability, or both.

▪ As noted above, preferred equity has increasingly mimicked

mezzanine financing, an evolution that is likely to continue in

the same direction, which will mean that inevitably the

concerns of the senior lenders will be the same as in the

mezzanine financing context.

58


Pari-Passu Loans

▪ A pari passu loan is one in which the participants share the upside and downside of the loan equally.

Except for certain fees and other payments sometimes paid exclusively to the lead lender to reward it for

originating and administering the loan, all payments are paid first to the lender but then distributed pro

rata to the participants in accordance with their participation amount.

▪ The pari passu participation itself has evolved into a structure, usually called a “syndicated” loan, where

there is a lead lender that administers the loan, but there are separate promissory notes for each lender

so that each lender is a direct creditor of the borrower rather than a co-owner of the loan. Terms of

advancing, expense sharing, loan administration, lender consent requirements, defaulting lender

provisions, and so on are either built directly into the loan documents with the borrower or are contained

in a separate co-lender agreement among the participants.

▪ The CMBS version of the syndicated loan is commonly evidenced by multiple, separate promissory notes

of equal priority secured by the same real property collateral. The notes are equal in priority for payments

of principal and interest and suffer losses pro rata. The agreement among the lenders is called a co-

lender agreement. Such notes may end up in the same securitization, or different ones, or some in and

some out of securitizations; if they not all in the same securitization, the servicers of the first note

securitized (called the “A-1 Note”) service the entire loan although holders of A-2 et seq. loans have

limited control and consultation rights

59


Pari-Passu Structure

60


A/B Loans

▪ The A/B note structure is essentially a subordinated loan participation structure that

allows multiple mortgage lenders to classify and spread the risk among the note

holders but with separate notes rather than as owners of a single note. There are

variations in the way A and B note loans are structured, but the most common

version is a loan evidenced by two promissory notes, generally referred to as the A

Note and the B Note. Both notes are secured by the same mortgage and other loan

documents, with the rights and obligations of the respective note holders governed by

an intercreditor agreement that typically is called a co-lender agreement or similar

name, and although containing many similar provisions, it is significantly different in

certain respects from the intercreditor agreement used in connection with mezzanine

lending.

▪ The A/B loan structure is a subordinated loan participation but with separate

promissory notes. The A Note represents the lower risk portion of the debt. The B

Note represents the higher leverage, higher risk portion of the debt, and furnishes

credit support for the A Note.

61


A/B Structure

62


A/B Loans, cont.

▪ The A Note is senior to the B Note in rights of payment and receives principal and

interest payments first. Conversely, the B Note holder suffers all losses, until the B

Note is wiped out, and only then does the A Note holder realize any loss. A/B loans

usually allow principal and interest payments on a pari passu basis until a default

occurs, at which point the structure reverts to restore the A Note holder to its senior

payment position. Because of the credit support structure, and the increased risk of

first loss, the B Note often carries a higher interest rate.

▪ Given that the aggregate amount of the component notes will be secured by the

same first mortgage lien, it might seem at first blush that the maximum size of the

loan would be the same, based on loan-to-value (“LTV”) analysis and debt service

coverage ratio (“DSCR”) standards, whether the loan is represented, for example, by

one $50 million note or by a $35 million A Note and a $15 million B Note. In either

case, the probability of a default under the loan will be the same. But the

senior/subordinate aspect of the A/B Note structure may allow the senior lender to

securitize the A Note on a disproportionately profitable basis. If the A/B Note

structure gives the B Note fewer rights on a default than a holder of a similarly sized,

undifferentiated pari passu interest in the whole loan, rating agencies are, not

surprisingly, likely to treat the A Note markedly better than they would an

undifferentiated pari passu interest in the whole loan. Ideally, the lender could also

63


A/B Loans, cont.

find a B Note investor that, not being bound to as conservative an underwriting

approach as the B Note holder, believes that the chance of default on the B Note is

not as great as the A Note holder or rating agency analysis would suggest, making

the entire A-B package materially more valuable than it would be standing alone.

▪ The creeping expansion of the control rights accorded to B Notes has caused at least

one rating agency to express concern over the continued efficacy of the A/B Note

structure to provide subordination benefits to the A Note. In early A/B Note

transactions, the B Note was a very passive investment, able to collect its pro rata

share of payments when no default existed and to protect its interest by buying out

the A Note in the case of a default, but having no real input on the administration or

servicing of the mortgage loan. Rating agencies particularly liked to see A Notes in

CMBS pools with the B Note left outside the pool, because the loans in the pool were

typically serviced by a third party servicer pursuant to an agreement with a servicing

standard that required the servicer to act in furtherance of the best interests of the

investors in the pool. With the B Note outside the pool, the servicer would be free to

make decisions to maximize the return to the CMBS investors with no concern for

the effects of its decisions on subordinate lenders. Over time, however, many B Note

64


A/B Loans, cont.

holders have obtained greater protections with respect to the servicing of the loans,

such as the right to consult with the servicer regarding decisions, the right to have the

best interests of the B Note included in the servicing standard, or certain rights to

appoint the special servicer, provided that the B Note has not lost most of its value.

When the rights afforded to B Notes are so expanded, the rating agencies will no

longer view the B Note as essentially another source of possible repayment, but

instead, as a competing interest that might compel a high-risk and time consuming

workout strategy that may be the B Note’s only hope of repayment at the cost of

exposing an over-secured A Note to the risk of litigation and deterioration of the

collateral.

▪ Before the financial crisis of 2009-2012, B notes vied with mezzanine loans in

popularity and may have even been more popular in CMBS transactions. But post-

crisis the B notes have lost some of their luster, although that is likely a result of other

factors than a response to any evidence that B notes suffered greater losses during

the crisis than mezzanine loans. In fact, given the havoc wrought on mezzanine

loans in those years, one might successfully wager that a thorough study would show

that mezzanine debt suffered disproportionate losses compared to B Notes, which at

least had a lien on the real estate and substantially more consent rights regarding

senior lender actions than mezzanine lenders.

65


A/B Loans, cont.

▪ One reason for their declining popularity is likely that, as previously discussed, rating

agencies tend to assign greater value to the mortgage note in a mezzanine structure

than to the A Note in an A/B structure. A likely stronger reason for the decline in use

of the A/B structure is that the mezzanine structure has become far more popular with

junior lenders, who perceive that they have far more control of their destiny as

mezzanine lenders. In the CMBS context the B note is truly the tail on the dog,

required to wag or droop along with the A-Note and the heightened discretion of the

senior lender post-default. The only mechanism for the B Note holder to exercise

control is to exercise its right to purchase the A Note, which can be a very risky and

expensive proposition, while the mezzanine lender can exercise its cure rights and

foreclose and take over ownership of the borrower. The trade-off for this possibly

illusory belief in more control over its destiny is the loss of a direct security interest in

the real estate, making the mezzanine lender vulnerable to intervening secured and

unsecured creditors of the mortgage borrower. The rating agencies’ tendency toward

lower valuation of A Notes in the A-B structure than in the mezzanine situation, as

discussed above, may evidence that the junior mortgage position has more value by

virtue of its combination of property lien and consent rights than the mezzanine

lender’s mere security interest in the equity. The next significant downturn in the real

estate market may reveal whether the mezzanine lenders’ “wager” was justified.

66


A/B Loans, cont.

▪ Another reason B notes may have fallen somewhat out of favor is that the co-lender

agreement subjects them to loss of consent, consultation, cure, and other rights if

they become “out of the money” or “appraised out,” which will occur if the property

declines in value so that the virtual principal amount of the B note, based on the re-

determined value of the property, is less than 25% of its original amount.

▪ In the A/B structure, since two notes are secured by the same mortgage, the holder

of the A Note is vulnerable to a determination, in the event of a bankruptcy of the

borrower, that the A Note is undersecured (i.e. the value of the collateral is less than

the amount of the debt) because the A Note and B Note indebtedness may be

deemed to be a single indebtedness in that circumstance. (►In re Ionosphere Clubs,

Inc., 134 B.R. 528, 22 Bankr. Ct. Dec. (CRR) 651, 26 Collier Bankr. Cas. 2d (MB) 955

(Bankr. S.D. N.Y. 1991)) If, on the other hand, the B Note were secured by a different

instrument, i.e. a subordinate mortgage, the holder of the A Note would be less

vulnerable to a claim that it is undersecured because only the A Note indebtedness

would be counted in determining the amount of the claim secured by the A mortgage.

If undersecured, the holder of the A Note’s post-petition interest and attorneys’ fees

(which can be substantial) are not entitled to be included in its secured claim,

whereas they may be included if the holder of the A Note is fully secured. It should be

emphasized that this would not happen to the A holder if the B was secured by a

second mortgage rather than a subordinated slice of the first.67



▪ In each structure, there will be a tension between senior and junior debt as to how

much control each will have over the borrower's decisions. Where there is no

subordinate debt, the mortgage lender can have all of the control rights. But in each

instance where a subordinate lender has the right to participate in a control decision,

the mortgage lender's freedom to act to protect its own interests is constrained to

some degree. A mortgage lender that approves a capital improvement or a lease

proposed by the mortgage borrower, which they both agree would benefit the

property, could be frustrated by a subordinate lender that disapproves of the

proposed action. The subordinate lender, on the other hand, exposed first to the risk

of loss on the property, can make a credible case that it has more reason to be

intimately involved in the details of the property's operation than the mortgage lender

sitting comfortably atop an equity cushion stuffed extra full with funds provided by the

subordinate lender.

▪ The balance struck with respect to these operational consents will vary from loan to

loan and from lender to lender.

68



▪ Issues Common to all Subordinate Debt. When considering how the existence of subordinate debt might

affect a securitization, it is important to note some considerations that apply to all types of subordinate

debt. Rating agencies, certificate purchasers (especially the most subordinate B-piece buyers) and other

parties to the securitization transaction (“Securitization Parties”) assume that any subordinate debt puts

additional stress on the mortgaged property because a property owner will have less equity and a

correspondingly reduced incentive to build property value or, when trouble arrives, even to preserve it.

▪ It is believed that the existence of subordinate debt increases the likelihood of default, a disruption in

operating the real property post-default, and the severity of loss with respect to a defaulted mortgage

loan and, therefore, will result in a higher default rating. Securitization Parties will analyze the mortgaged

property’s overall DSCR, LTV, and securitized pool fundamentals such as loan concentration to affiliated

borrowers and geographic and property type diversity to determine the potential impact of subordinate

debt on the rating. They will also analyze the various loan and intercreditor documents to determine the

subordinate lender’s ability to (a) transfer debt, (b) control the mortgaged property, the mortgage

borrower, loan servicing and enforcement, and property management, and (c) receive payments and

enforce its rights, before or after default, under the mortgage loan. In response to evolving market

standards, mezzanine and mortgage lenders may increasingly rely on provisions in their loan

agreements requiring borrowers to cooperate in restructuring their loans for flexibility in securitizing the

loans. Lenders want the broadest possible restructuring rights, while borrowers want to ensure that any

restructuring does not modify material economic or non-recourse provisions, materially increase borrower

obligations or decrease borrower rights, or cause them to incur any, or at least excessive, additional

costs.

69


Servicing and Control Rights, cont.

▪ Issues Specific to Mezzanine Financing. Securitization Parties will have several concerns about

mezzanine financing:

▪ ►Structure of the Loan. Securitization Parties normally require mezzanine loans to be secured by

a 100% equity pledge so that the mezzanine lender can quickly take control of the mortgage

borrower upon a default, and prefer mezzanine loans to be coterminous with mortgage loans so

as to limit refinance risk. Mezzanine loans should not be secured by a subordinate lien on the real

property, a guaranty by the mortgage borrower, or any other credit enhancement that would

reduce the likelihood of repayment of the mortgage loan or violate the single/special purpose

entity (“SPE”) restrictions of the mortgage loan.

▪ ►Structure and Identity of the Mezzanine Lender. Because of the mezzanine lender’s ability to

take control of the mortgage borrower, Securitization Parties examine the mezzanine lender

closely, including its structure and experience in the real estate investment community (thus, as

discussed below, the requirement that mezzanine debt may be transferred only to a “Qualified

Institutional Lender” or “Qualified Transferee”). If there is more than one mezzanine lender, they

will expect an agreement among the mezzanine lenders clearly specifying workout and

enforcement details and preferably designating one mezzanine lender to negotiate all issues with

the mortgage lender.

70



▪ Structure of the Mezzanine Borrower. The mezzanine borrower will be required to be

a bankruptcy remote SPE and to provide a substantive non-consolidation opinion

concluding that the assets of the mezzanine borrower would not be consolidated into

the bankruptcy estate of any affiliated persons or entities that collectively own,

directly or indirectly, more than a 49% of the mezzanine borrower.

▪ ►Cash Management. A cash management arrangement with appropriate

“waterfalls” in place is a standard requirement.

▪ ►Intercreditor Agreement. Although intercreditor agreements will be covered in

detail later in this chapter, it should be noted here that Securitization Parties will

require the agreement to address such issues as default and cure, prepayment, loan

transfers, and control and approval rights over leases, property management, and

other operational issues.

71



▪ Issues Specific to Preferred Equity. A preferred equity arrangement, especially of the “soft”

variety, is likely to have the least negative effect on the rating of a mortgage loan. Some senior

lenders who will not tolerate secondary “debt” on their mortgaged property will consider preferred

equity to be essentially equity rather than debt for the purpose of interpreting such covenants even

if the preferred equity has extensive debt indicia and would be treated as equity under income tax

and accounting rules. This has been true recently in construction lending where some bank

lenders governed by the HVCRE regulation requirement that their borrower must have a certain

level of equity capital in the project have been willing to consider preferred equity as appropriate

equity to be included in calculating the borrower’s contribution.

▪ Senior lenders want to examine the level of control that the preferred equity holder can exert over

the mortgage borrower. It is not uncommon for the preferred equity holder to have removal and

replacement rights regarding property management or the entity itself, or even the ability to sell

the property in compliance with the mortgage loan documents (in the case of CMBS, either of

them likely subject to a “Rating Agency Confirmation” that the action will not cause a downgrade,

qualification or withdrawal of the applicable rating of securitized debt), but Securitization Parties

look skeptically at a preferred equity holder’s ability to affect the daily operations of the mortgage

borrower or exercise other controls over the mortgage borrower.

72



▪ Additionally, senior lenders will examine the identity of the preferred equity holder and

its ability to transfer its interest in the mortgage borrower. As the preferred equity

holder demands and gains more potential control over the mortgage borrower and

the mortgaged property, the identity of the preferred equity holder becomes

paramount. Senior lenders and Securitization Parties will expect the preferred equity

holder to meet certain “Qualified Transferee” standards as to financial strength and

experience in real estate investment and management. A preferred equity holder

with solid credentials and a properly structured investment could even enhance the

credit rating of the mortgage loan. As with mezzanine lenders transferring mezzanine

debt, the preferred equity holder’s ability to transfer its interest in the mortgage

borrower would generally be subject to the transferee meeting the same standards or

obtaining a Rating Agency Confirmation as to transferee’s acceptability, or both.

▪ As noted above, preferred equity has increasingly mimicked mezzanine financing, an

evolution that is likely to continue in the same direction, which will mean that

inevitably the concerns of the senior lenders will be the same as in the mezzanine

financing context.

73

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