Doug Cornelius .com

Fran Mastroianni of Goodwin Procter LLP, published a story in Real Estate Investment & Finance: The Case for Exotic Notes in Commercial Real Estate Transactions.

“PIK (payment-in-kind) Notes and Toggle Notes, which began as alternative debt instruments with safety valve features attractive to the real estate industry, became a life jacket keeping overly aggressive financially engineered deals afloat. Their use has temporarily retreated but their intrinsic value as sophisticated real estate finance tools almost guarantees that they will reemerge as the debt crisis subsides.”

The Wall Street Journal has an article in the C Section by Jennifer S. Forsyth and Kemba J. Dunham on real estate mezzanine loans: Real-Estate Investors Like View From Mezzanine Section.

If mezzanine investors think that it is a “no-lose bet” they are getting themselves in trouble. There is a higher return on mezzanine debt because it is riskier.

The senior mortgage lender will often set limitations on the ability of the mezzanine lender to foreclose on the borrower and take over control of the borrower. Typically this will include the mezzanine lender stepping into the guarantees of the now-wiped out guarantors.

Since the collateral is the equity ownership, the mezzanine lender steps into all of the liabilities of the borrower. This may mean that trade debt has piled up and other obligations may be outstanding.

Lastly, the mezzanine borrower is not going to default on the loan unless they think the value is gone. Inevitably, this means the mezzanine lender is not going to be made whole if they have to foreclose and take over the borrower.

I ran across two articles on usury and expect we will see more as the debt markets and foreclosures continue to sort themselves out and more borrowers are faced with foreclosure.

Usury is the charging of excessive interest on a loan. Most states have a law prohibiting usury and defining what is meant by usury. Usury laws were originally targeted at loan sharks. As a result, most usury statutes make the charging of usurious interest a criminal act. They also generally allow the borrower to escape from making the excessive interest payments.

Massachusetts defines interest in excess of 20% to be the interest rate that triggers usury. M.G.L. Chapter 271, Section 49. The 20% threshold also includes any brokerage fees, recording fees, commissions, forbearance or any other amounts the borrower has to pay to the lender.

The 20% rate is prorated for shorter periods of time. Upfront fees can push an otherwise legal loan into a usury loan if it is maid off early. For example, if you have ten year loan at 18%, plus a 3% commission payable at closing, that loan is usurious if the borrower pays it off at the end of the first year.

M.G.L. Chapter 271, Section 49(a) provides for a criminal sentence of up to ten years and a fine of up to $10,000. Also, M.G.L. Chapter 271, Section 4(c) allows the court to void a usurious loan.

Massachusetts has two exceptions to usury. The first is the regulated lender exception in M.G.L. Chapter 271, Section 49(e). Under this exception, the usury statute does not apply to “any lender subject to control, regulation or examination by any state or federal regulatory agency” or to “any loan the rate of interest for which is regulated under any other provision of general or special law or regulations.” This means that banks, credit unions and most conventional lenders are not subject to usury in Massachusetts. However, CMBS originators and investment funds may not fall under this exception.

The second exception is by use of a “leg-breaker letter.” Under M.G.L. Chapter 271, Section 49(d), you can charge usurious interest as long as you send a letter to the Attorney General with the lender’s and borrower’s name and accurate address. This notification is good for two years.

The leg-breaker exception is very easy to comply with. I was surprised to see stories about usury in Massachusetts.

Both stories are about a loan for the development of a 186 home community and godf course in Dracut. Massachusetts Lawyers weekly reported the story: Release Won’t Shield Lender from Usury Claim of Borrower subscription). It reports a story about LR5-A Limited Partnership v. Meadow Creek, LLC, et al. (Massachusetts Lawyers Weekly subscription), with a decision coming out of the Business Litigation Session of the Superior Court. The decision found that a release or waiver of claims for usury is not effective. Usury is a public policy law and cannot be waived by the parties. The case was also reported in the Boston Globe: Usury lawsuit names Harvard, Princeton, and Yale Endowments.

The borrower made notes with an interest rate in excess of 20%. The decision from the Superior Court says it was a 21% interest rate. The Boston Globe story says one of the loans was 42%. The lender was an investment fund set up by Realty Financial Partners. The lender was a non-conventional lender and therefore could not benefit from the regulated lender exception to the usury law. They should have filed a leg-breaker letter. The decision was silent on whether the filed a letter. The Boston Globe story reports that two notices were filed, but that one was filed too early (before the lending partnership was formed) and the second filed too late (after the loan was made).

The borrower goes on to charge the limited partners of the lender violated usury and is trying to bring a claim against them directly. This seems foolhardy from a legal perspective. But it apparently worked from a public relations perspective because he got his name in the paper

The problem I have with the application of the usury laws in commercial financing is that they merely give the borrower an opportunity to wiggle out from their bargain. According to the story, the borrower thought they could quickly obtain development rights and then refinance the loan with a conventional lender at a lesser interest rate. He failed and the lender had to foreclose on the property. The borrower must have thought the interest rate was acceptable at closing. Now that the deal went south, he is trying to apply the law retroactively to get himself out of his bargain.

Disclosure: Realty Financial Partners is a client of my firm.

Parke Chapman wrote a primer in the National Real Estate Investor on CMBS, CDO and the commercial debt markets.

Some highlights:

Q: What led to the formation of the first commercial real estate CDO in 1999?

A: Commercial real estate CDOs were a major innovation in part driven by the need to diversify risk after the 1998 Russian financial crisis sparked a global liquidity crunch. Unlike CMBS, which adhere to strict rules on the type and quality of collateral, the commercial real estate CDO market allowed lenders and investors to introduce a debt vehicle with more flexibility. What this means is that commercial real estate CDO managers can swap collateral out of the pool, making these highly managed pools of debt.

Q: What types of loans back CMBS and commercial real estate CDOs?

A: Two key differences center on the fixed- and floating-rate nature of the collateral. Commercial real estate CDOs are typically backed by floating-rate loans whereas CMBS collateral is backed by first-mortgage loans. A commercial real estate CDO can be backed by all sorts of collateral. CMBS, preferred equity and construction loans are commonly held by commercial real estate CDOs. REIT bonds and various other types of exotic debt such as second-lien loans and unsecured debt can get lumped into these pools.

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With mezzanine financing, there is a potential guarantee liability to the principals of the developer that they may not foresee. The issue arises in a financing that has a mortgage loan with springing guarantees combined with a mezzanine loan secured by a pledge of interests in the mortgage borrower.

Generally, the principals of a mortgage borrower give a bad boy springing guarantee to the mortgage lender. The principals agree to be personally liable for the mortgage loan if the borrower declares bankruptcy or does other “bad” things. Principals of the borrower give these guarantees because they control the borrower and have an economic interest in the borrower. They are essentially agreeing that in exchange for a non-recourse loan, they will not fight the lender’s efforts to take the collateral if the loan defaults.

The problem arises when the mezzanine lender forecloses on the pledge of interests in the mortgage borrower. After foreclosure, the mezzanine lender controls the mortgage borrower. Meanwhile, the springing guarantor has lost its economic interest in and management control of the mortgage borrower, but still has the liability under the guarantee for “bad acts” of the mortgage borrower.

If there is a mezzanine loan that goes into default, followed by a foreclosure by the mezzanine lender, the mezzanine lender controls the borrower, not the guarantor. The mezzanine lender can then threaten to bankrupt the mortgage borrower and trigger the personal liability for the mortgage debt. In the end, the guarantor may be forced to repay the mezzanine lender on its loan; in effect, the mezzanine loan had become a recourse obligation.

Mezzanine borrowers/bad boy guarantors should require the mezzanine lenders to obtain either (i) a release of the bad boy guarantor from the mortgage lender (usually by replacing the bad boy guarantee with one from the mezzanine lender) or (ii) an appropriate indemnity from the mezzanine lender for liability under the bad boy guarantee that the mezzanine lender creates post foreclosure. In each case, this should be a condition to permitting the foreclosure of the mezzanine position.

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I will speaking as part of the seminar: Real Estate Development From Beginning to End in Massachusetts in Dedham on November 16, 2007.

Agenda

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I just received a copy of an article by James D. Pendergast, Senior Vice President and the General Counsel of the U.C.C. Division of the First American Corporation: Secured Real Estate Mezzanine Lending (with Form).

Mr. Pendergast proposes that a mezzanine lender have their borrower opt into Article 8 of the U.C.C. and have the equity interest in the borrower entity be certificated. This will have the pledge equity interest be a security for purposes of Article 8 and investment property for Article 9. Therefore control of the certificates will be the best method of perfection, trumping a perfection by filing a financing statement.

He also advocates having the borrower deliver an irrevocable proxy granting the lender the right to vote the pledged equity interest in all matters related to Article 8 of the U.C.C. This would be a defense against the borrower opting back out of Article 8. At a minimum, the organizational documents of the borrower should prohibit the borrower from opting-out of Article 8.

He further advocates having the mezzanine lender file a financing statement under Article 9 of the U.C.C. against the pledged equity interest. This would put a future lender on notice that there is an adverse claim against the borrower and prevent this future lender from trumping the mezzanine lender (if the borrower is up to some shenanigans).

As an employee of U.C.C. insurance company, he of course advocates that the mezzanine lender obtain U.C.C. insurance.

None of this should be new information to anyone who engages in mezzanine lending or borrowing. I liked Mr. Pendergast’s approach of showing the pros and cons of each position. He also walks through the steps a sneaky borrower might take.

In March, 2007, Moody’s released their rating methodology for Mezzanine Loans: Moody’s Approach to Rating Commercial Real Estate Mezzanine Loans.

This report outlines Moody’s view of a baseline, “credit neutral” mezzanine loan structure and how they apply that view in rating mezzanine loans.

Baseline Expectations:

• Mezzanine Loan Agreement – comparable to CRE mortgage loan agreement.
• Underwriting – same third party deliverables as a mortgage loan
• SPE – Borrowers should be special purpose, bankruptcy remote entities. They should have independent directors and non-consolidation opinions at the same thresholds that apply to REMICs.
• Pledge of 100% membership
• Recourse Carve-out Guaranties
• Cash Management – hard lockbox
• Maturity – same date as mortgage loan
• Certificated entities – opt-in to Article 8 of the UCC
• Title Insurance – ALTA 16 Mezzanine financing endorsement
• Intercreditor agreement – expects the 2002 CMSA form of agreement
• Interest Rate Caps