Borrower has a conduit type first mortgage loan that contains a prohibition on second mortgage grants, a prohibitively expensive prepayment penalty, and a lengthy remaining term. Borrower needs financing. Borrower has the right to or can secure a one-time approval from the mortgage lender to convey the property to a trust, corporation, partnership, llc, or other entity in which he has a continuing interest. Borrower’s potential “mezzanine lender” is concerned about securing its interest if it were to provide the needed financing, without being able to record a second mortgagee. Borrower suggests creating a new entity and transferring the property to it, with the mortgage lender’s consent, and pledging his interest in that entity to his mezzanine lender, or granting an initial interest therein that would give the mezzanine lender internal control over certain actions such as selling the property, pledging further interests in it or the property, right to unilateral control in the e vent of default under the first mortgage, etc. Mezzanine lender would also have the personal guaranty of the Borrower in the event Borrower violated the internal agreements regarding control of the new entity, applications of project proceeds to the first mortgage debt, etc. However, Borrower has little credit or asset strength beyond the project property.

Mezzanine lender wants to know how it is protected from Borrower’s acts in selling, mortgaging, or otherwise hypothecating interests in the entity or the underlying real estate in violation of their agreements and/or in violation of the prohibition on secondary mortgages. Much of the concern pivots on the possibility of the Mezzanine lender being stuck with an interest ahead of it as to the property, enforceable against it by the holder that interest, if that holder can make out a credible apparent authority claim supporting the Borrower’s grant of the interest to it. What protections against such a prospect can be built into the transaction and the documents, and are there better options for doing so dependent upon what entity is used, trust, corporation, partnership, llc, or other?

Remarks of Theodore H. Sprink, Senior Vice President, Fidelity National Financial, UCC Insurance Division

There are a number of methods for the lender to improve its position with regard to the Mezzanine Financing Transaction question. Here is an option for consideration:

If the entity is a Partnership or LLC it can "opt-in" to Article 8 of the Uniform Commercial Code and elect to have interests therein treated as securities (8-103(c)). An SPE/NEWCO could be formed for the purpose of acquiring the realty. Simultaneously SPE/NEWCO could issue a certificate representing a 100% membership interest to the borrower., and the borrower would then "endorse" the certificate to the lender (by executing a separate stock power) 8-102(a)(11). The lender would take possession, and would therefore have "control" (8-106).

The lender will have gained priority over any other "perfection by filing" (9-328). The lender should also consider requiring, in the LLC or Partnership Agreement, provisions prohibiting the SPE/NEWCO from "opting-out" of Article 8 at a subsequent date, without the lender's consent.

Attachment of the lender's security interest, perfection of same, and priority over other secured parties can be INSURED through the availability of UCC Insurance Protection. In practice, the underwriters of UCC insurance policies work closely with lenders and lender's counsel to suggest revisions to such documents in the event they are not adequately drafted. A very valuable "second set of eyes" to protect the lender.