This month’s eTips was contributed by Peter Korda and Joshua Kurtz, with the firm
Seyfarth Shaw LLP.
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For a real estate mortgage lender, it is unthinkable to close a mortgage loan transaction without obtaining title insurance, insuring the priority and enforceability of its security interest in real property. As real estate mezzanine loan issuance has increased dramatically in recent years, [FN 1] mezzanine lenders have sought comparable protection with respect to the priority and enforceability of their security interests in non-realty loan collateral.
Mezzanine loans differ from mortgage loans in that mezzanine loans are secured by a pledge of direct or indirect ownership interests in an entity that holds title to real property, such as a limited liability company (“LLC”) or a limited partnership (“LP”); whereas, mortgage loans are secured by the real property itself. Since a mezzanine lender’s collateral (the ownership interests) is characterized as personal property, rather than as real property, and attachment, perfection and priority of its security interest in the collateral is governed by the Uniform Commercial Code (“UCC”), rather than local mortgage laws, [FN 2] typical lender’s title insurance is not available to mezzanine lenders. As an alternative, title insurance companies offer mezzanine lenders insurance for their security interests in the applicable personal property, in addition to augmenting property owners’ policies for the benefit of the mezzanine lenders.
One can identify four categories of mezzanine loan-related coverage, namely,
1. UCC insurance protection (a “UCC Policy”); [FN 3]
2. a mezzanine endorsement (a “UCC Mezzanine Endorsement”), [FN 4] which invariably accompanies a UCC Policy;
3. an ALTA 16 Mezzanine Endorsement (a “Title Mezzanine Endorsement”); [FN 5]
4. additional affirmative title coverage to a mezzanine lender, insuring over certain title defects excepted or excluded from coverage under an owner’s title insurance policy (“Affirmative Coverage”).
A. The UCC Policy. A UCC Policy insures the attachment, perfection, and priority of a lender’s interest in personal property. [FN 6] In addition to the basic lien-priority coverage, the UCC insurance will cover many of the risks associated with the perfection of a security interest through the central state filing system, such as mis-indexed filings, unauthorized termination statements filed against the record, the correctness of the debtor name and filing in the appropriate jurisdiction. [FN 7] In addition, the basic coverage will also insure the “gap” period between the most recent search report conducted by the title company and the date of filing the new UCC statement. [FN 8]
B. The UCC Mezzanine Endorsement. A UCC Mezzanine Endorsement expands the basic coverage afforded under a UCC Policy by deleting certain exclusions from coverage under that policy, including, among other things, an assumption of mezzanine borrower’s rights in the pledged collateral, [FN 9] loss resulting from certain adverse matters created by a prior owner of the pledged collateral, and loss in priority to a purchaser that qualifies as a “Protected Purchaser” (as defined in Article 8 of the UCC). [FN 10]
To issue the expanded coverage afforded under a UCC Mezzanine Endorsement, title companies will require that a mezzanine lender perfect its security interest in the equity interests in the LLC or LP by control, [FN 11] as set forth in Article 8 and 9 of the UCC, which requires the real property owning entity, to “opt in” to Article 8 [FN 12] and the mezzanine lender to take control of the equity collateral. [FN 13]
C. The Title Mezzanine Endorsement. A Title Mezzanine Endorsement is an endorsement to a real property owner’s title insurance policy that expands certain rights and protections under the policy solely for the benefit of a mezzanine lender, and, if so stated in the endorsement (as it currently states in the 2006 ALTA 16 Mezzanine Endorsement), its successors and assigns. [FN 14] Specifically, a Title Mezzanine Endorsement provides for the assignment to a mezzanine lender of certain insurance proceeds otherwise payable to the real property owner [FN 15] and, in addition to other matters, provides the mezzanine lender with “non-imputation,” coverage [FN 16] and “fairway” coverage. [FN 17]
Non-imputation coverage deletes certain portions of an exclusion from the policy which would otherwise enable the title company to deny coverage to the mezzanine lender based on certain acts and knowledge of the real property owner being imputed to the mezzanine lender. [FN 18]
Fairway coverage waives the title company’s right to deny coverage to the insured on the ground that any or all of the ownership interests (direct or indirect) in the real property owner were transferred to or acquired by the mezzanine lender (applicable, for example, where local law may be read to provide that the transfer of the direct or indirect ownership interests in an entity will result in its dissolution, termination or creation of a new entity, thereby, terminating its coverage under an owner’s title insurance policy).[FN 19]
In certain circumstances (e.g. non acquisition transfers, such as a refinancing), obtaining a Title Mezzanine Endorsement can be viewed as too costly for a given transaction. [FN 20] As an alternative, a mezzanine lender may get comfortable without purchasing the endorsement if recourse for the risks that a Title Mezzanine Endorsement addresses is covered by a “deep pocket” guarantee or indemnity, and the real property owner assigns to mezzanine lender all of its rights in any insurance proceeds payable under the owner’s policy. [FN 21] Of course, foregoing a Title Mezzanine Endorsement is ultimately a business decision.
D. Affirmative Coverage to an Owner’s Policy. In addition to the coverage provided in a Title Mezzanine Endorsement, title insurers can provide Affirmative Coverage protection to a mezzanine lender through the real property owner’s title insurance policy. Affirmative Coverage includes the insuring over certain title defects excepted or excluded from coverage. [FN 22] As an illustration, if a current title survey discloses that a building located on the real property encroaches onto an adjoining lot by three inches, a title insurer may not provide affirmative coverage to the real property owner against said encroachment. However, the title insurance company may provide affirmative coverage in the owner’s policy for the benefit of the mezzanine lender to the affect that, upon the acquisition by the mezzanine lender of any interest in the insured owner, the policy would insure against monetary loss from the enforced removal of the encroachment, subject to the terms and conditions of a Title Mezzanine Endorsement.
In Conclusion. Although mezzanine lending is inherently more risky than mortgage lending (e.g., the risk of post-closing liens on the real property diminishing the value of the pledged ownership interests), obtaining appropriate mezzanine loan-related title insurance (a) offers the mezzanine lender enhanced confidence at the time of closing, at least as to its position vis-a-vis competing claims on the pledged ownership interest collateral; and (b) affords the mezzanine lender the right under certain circumstances to benefit from the real property owner’s title insurance coverage.
Peter J. Korda is co-head of the Structured and Real Estate Finance Group of Seyfarth Shaw LLP and is a partner in the Firm’s New York Office. Joshua A. Kurtz is an associate in the Real Estate Practice Group of the firm’s New York Office. The authors thank Joseph B. Manello, of counsel in the Firm’s Boston Office, Daniel J. Evans, an associate in the Firm’s New York Office, James D. Prendergast, general counsel of the UCC Division of The First American Corporation; Gary Zimmerman, senior vice president of the UCC Plus Division of the Fidelity National Financing Family of Companies; and David L. Wanetik, vice president of the UCC Insurance Division of LandAmerica National Commercial Services, for their assistance in preparing this article.
Trigild was appointed receiver for 59 units of a 104 unit condo conversion project in San Bernardino, CA. Trigild was also appointed receiver for two additional projects – A 118 unit development in Fresno, CA and a 10 unit apartment complex in Las Vegas.
Trigild closed the receivership estate for three apartment complexes in Florida, one which is Section 8 Housing. All three properties were overseen by Trigild’s Florida regional office.
* This article does not constitute legal advice and legal counsel should be consulted as to the appropriate coverage for each transaction.
[FN 1] As an example, (although recognizing that we are currently in a cyclical downturn) within the last few years, mezzanine loan issuance included in commercial real estate collateralized debt obligations skyrocketed to over $3 billion per year. See Daniel A. Rubock, U.S. CMBS and CRE CDO: Moody’s Approach to Rating Commercial Real Estate Mezzanine Loans, Moody’s Investor’s Service, Rating Methodology, Mar. 29, 2007, at 1.
[FN 2] The attachment, perfection and priority of a security interest in the equity interests of an LLC or LP are governed by Article 9 of the UCC, and as to certain methods of perfection, Article 8 must be consulted. See generally, UCC § 9-313.
[FN 3] Note, however, that unlike the standard title insurance forms promulgated by the American Land Title Association (“ALTA”), there is no uniform UCC Policy or UCC Mezzanine Endorsement promulgated by the title insurance industry.
[FN 4] As with the UCC Policy, there is no uniform UCC Mezzanine Endorsement promulgated by the title industry.
[FN 5] The current Title Mezzanine Endorsement was adopted by the ALTA on June 17, 2006; note, however, a Title Mezzanine Endorsement is not currently available in all jurisdictions (e.g., not available in Texas), and in certain jurisdictions, the state insurance departments have promulgated or approved modified versions of a Title Mezzanine Endorsement (e.g., New York State).
[FN 6] See, e.g., Eagle 9 UCC Insurance Policy Jacket, form 8100 (3/01) issued by First American Title Insurance Company; UCC Plus Insurance Policy Jacket issued by Fidelity National Title Insurance Company and Chicago Title Insurance Company; UCC 9 Loan Insurance Policy Jacket issued by Commonwealth Land Title Insurance Company, (each on file with author).
[FN 7] James D. Prendergast, The Utility of UCC Insurance, The Secured lender, Nov./Dec. 2003, vol. 59, num. 6 at 96.
[FN 8] Id.
[FN 9] Note that some UCC policies do not contain an exclusion assuming mezzanine borrower’s rights in the pledged equity. However, certain underwriting requirements must be satisfied to provide this coverage.
[FN 10] See, e.g., Policy Jackets supra note 6.
[FN 11] See e.g., Eagle 9 UCC Insurance Policies Pamphlet, available at http://www.eagle9.com/downloads/LMK.pdf. The relative advantages of perfection by control is beyond the scope of this article.
[FN 12] U.C.C. § 8-103(c).
[FN 13] See U.C.C. §§ 9-106(a), 8-106.
[FN 14] See generally Endorsement 16-06 (Mezzanine Financing) supra note 5.
[FN 15] Id. ¶ 2(a).
[FN 16] Id. ¶ 4.
[FN 17] Id. ¶ 5.
[FN 18] Id. ¶ 4.
[FN 19] Id. ¶ 5.
[FN 20] Since a Title Mezzanine Endorsement can only be attached to an owner’s title policy of title insurance, in non-acquisition financings, the property owner may be reluctant to purchase an increased amount of (or new) owner’s title insurance. See Rubock, supra note 1, at 5 n. 15.
[FN 21] See id. The title company should agree to the terms of the assignment of insurance proceeds.
[FN 22] In all cases, granting Affirmative Coverage is subject to the applicable state insurance regulations.
Reprinted and excerpted with permission from the March 17, 2008 edition of the New York Law Journal © 2008 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited.