Subordinate Financing in CMBS Transactions: Rating Agency,...
Transcript of 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
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.
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Knowing the Players: Securitization Parties
• Rating Agencies
• Investors
• Servicers
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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
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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
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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
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Different Worlds: CMBS vs. Portfolio
Lending
• Structural Differences and Major
Distinctions
• Administration
• Interfacing with the Borrower
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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
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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
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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
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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
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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
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Mezzanine FinancingAnd
Intercreditor Agreements
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• 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
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• 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
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• 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
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• 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
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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
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• 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.
CMBS Concerns Specific to Mezzanine Financing
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• 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.
CMBS Concerns Specific to Mezzanine Financing
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• 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.
CMBS Concerns Specific to Mezzanine Financing
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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.
CMBS Concerns Specific to Mezzanine Financing
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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.
CMBS Concerns Specific to Mezzanine Financing
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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.
CMBS Concerns Specific to Mezzanine Financing
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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.
CMBS Concerns Specific to Mezzanine Financing
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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.
CMBS Concerns Specific to Mezzanine Financing
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• 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.
Intercreditor Agreements
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• 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.
Intercreditor Agreements
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• 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.
Intercreditor Agreements
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• 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.
Intercreditor Agreements
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• 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.
Intercreditor Agreements
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• 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.
Intercreditor Agreements
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• 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.
Intercreditor Agreements
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.
Intercreditor Agreements
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• 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
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• 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
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Servicing and Control Rights
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• 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
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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
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
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
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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
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Preferred Equity Structure
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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.
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Preferred Equity, cont.
▪ 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
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Preferred Equity, cont.
▪ 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
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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.
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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.
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Structuring Preferred Equity Investments to
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.
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Structuring Preferred Equity Investments to
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.
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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
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Pari-Passu Structure
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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.
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A/B Structure
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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
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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
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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.
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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.
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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
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Servicing and Control Rights
▪ 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.
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Servicing and Control Rights
▪ 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.
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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.
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Servicing and Control Rights, cont.
▪ 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.
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Servicing and Control Rights, cont.
▪ 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.
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Servicing and Control Rights, cont.
▪ 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.
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