Title Insurance for the Mezzanine Lender

Present-day real estate financing is significantly more complex than traditional financing. Sobered by borrower bankruptcies and compelled by rating agency requirements in the modern day era of mortgage securitizations, lenders are now looking to “mezzanine loans” to bridge the gap between senior debt and borrower equity. A mezzanine loan will often cover 50% to 90% of the equity required to acquire a property. In order to secure the repayment of a mezzanine loan, a lender customarily requires a pledge of the partnership or membership interests of the property owning entity.

In traditional mortgage transactions the borrower is required to obtain title insurance insuring the lender's mortgage lien on the real property. Ordinary title insurance is not available to the mezzanine lender because the collateral is not considered real property but rather a general intangible or investment property. The focus of this article is to explore the evolution of mezzanine financing and the various title insurance products available to the mezzanine lender in the current marketplace. Specifically, we look at the following forms of title insurance coverage: 1) the New York Insurance Rate and Service (TIRSA) Fairway Endorsement; 2) the TIRSA Non-Imputation Endorsement; 3) the TIRSA Mezzanine Financing Endorsement; and 4) the UCC Article 9 Insurance Policy.

The Evolution of Mezzanine Financing

A typical mortgage loan involves a loan amount of approximately 65% to 75% of the appraised value of a property and a first mortgage lien. In past second mortgages were used to give property owners additional borrowing power. However, the use of second mortgages as a means of subordinate financing has gradually declined over the past decade. The decline can be largely attributed to two factors: 1) the downturn in the real estate market in the early 1990s, and 2) the securitization of mortgage loans.

Two Types of Mezzanine Financing

As mentioned above, a mezzanine loan is often structured as a loan to the partners or members of a borrower and the loan is usually secured by a pledge of the respective partnership or membership interests. In the alternative, a lender may take a “preferred equity” position in the borrower in exchange for making a capital contribution. This interest is usually coupled with a right to a preferred return and/or other form of equity kicker as well as the right to approve certain major operating decisions. However, if a lender is an equity participant in the borrower, an issue may arise as to whether the loan should be considered debt or equity. A loan that is determined to be equity could lead to equitable subordination claims by other lenders or a claim by the borrower that the lender's equity position clogs the equity of redemption. If a preferred equity position is viewed as debt, there is a possibility that lender liability claims could arise in a foreclosure action if the participating lender is found to have exercised excessive control over the management of the mezzanine borrower.

Title Insurance Coverage Available to Mezzanine Lenders

The following forms of title insurance coverage are available to mezzanine lenders:

The TIRSA Fairway Endorsement

When a mezzanine lender forecloses on a pledge and becomes an equity owner of the insured, there is a risk that the transfer of ownership will trigger a termination of the insured entity's existence and a corresponding termination of the insured's title insurance coverage. While most governing documents of a limited liability company or partnership borrower will specifically state that the admission or withdrawal of a member or partner will not result in the termination or dissolution of the entity, the Fairway Endorsement provides affirmative coverage that the title insurance policy continue in effect notwithstanding any transfer of an ownership interest to the mezzanine lender pursuant to the pledge.

TIRSA Non-Imputation Endorsement

“Matters known to the Insured” are excluded from coverage under a typical policy of title insurance. When the insured is an entity, “knowledge” is imputed to the equity owners of the insured. A mezzanine lender will seek affirmative coverage from the title insurer that upon acquisition of an ownership interest in the insured entity, the lender will not be denied coverage as a result of matters known to equity owners other than the lender.

TIRSA Mezzanine Financing Endorsement

As mezzanine financing became more popular, the Fairway Endorsement and the Non-Imputation Endorsement were made part of a single endorsement known as the TIRSA Mezzanine Financing Endorsement. In addition to Fairway and Non-Imputation coverage, the Mezzanine Financing Endorsement offers certain additional protections to a lender that acquires a pledge. The endorsement offers a form of coverage known as “Contingent Loan Coverage” and provides for the payment of insurance proceeds under an owner's policy directly to the lender whether or not the lender has acquired an ownership interest by realizing on its collateral. This is contrary to the requirement in a typical owner's policy where the insured must actually suffer a loss before the insurance proceeds are payable under a title policy. In the event a mezzanine lender acquires an interest in the insured, the amount of proceeds payable to such lender under a Mezzanine Endorsement is equal to the total loss payable under the policy less a percentage of the loss equal to the percentage of partnership or membership interest not owned directly or indirectly by the mezzanine lender at the time of loss. To the extent any portion of a mezzanine loan is repaid to the lender, the lender is required to return any proceeds received from the title company; however, the title company may not exercise its subrogation rights until the lender recovers all amounts outstanding under the mezzanine loan. The cost of a mezzanine endorsement is approximately 30% of the owner's premium.

If a mezzanine lender has a preferred equity interest in the borrower, the lender will require a separate owner's policy with an insured amount equal to the value of its ownership interest. If a mezzanine lender makes its equity contribution after the effective date of the original owner's policy, the effective date of the mezzanine lender's title policy will be the date the contribution is first made. Thus, a borrower can find itself in the position of having to pay a portion of the owner's premium for a second time in order to satisfy the lender's title insurance requirements.

While the mezzanine endorsement provides a significant level of coverage to a mezzanine lender, the lender is not insured against perfection or priority claims. For these matters, mezzanine lenders will look to an opinion of borrower's counsel and/or a UCC-9 Policy of Insurance.

The UCC 9 Policy

As mentioned above, a mezzanine loan is often secured by a pledge of the equity interests in the borrower. In order to perfect its lien on pledged collateral under Revised Article 9, the lender has three options: 1) filing a UCC-1 statement; 2) taking possession of the certificates evidencing the equity interest; or 3) taking control in the instance where the collateral is deemed an investment security.

The UCC Article 9 Policy covers risks due to lack of: 1) attachment; 2) perfection; and 3) priority. The policy covers all three modes of perfection discussed above (ie, filing, possession and control). In addition to the property owned by the debtor on the date of issuance, the UCC Policy can also cover after-acquired property of the debtor. The maximum amount recoverable under a UCC Article 9 Policy is the least of: 1) the face amount of the policy; 2) the indebtedness outstanding under the loan at the time of the loss as reduced by the amount the insured is able to recover on the collateral; and 3) the value of the collateral as reduced by the amount the insured is able to recover on the collateral. Unlike the Mezzanine Endorsement, the insurer is required to make payment of a claim within 30 days after the insured's loss or damage, except that if a litigation is commenced prior to the 30-day period, no payment shall be made until a final unappealable judicial determination is made.

Conclusion

Challenges in American commerce have historically been met by adaptation. As mezzanine financing developed, title insurance has adapted. Two products are now available in New York: the TIRSA Mezzanine Financing Endorsement (comprising in part, the TIRSA Fairway Endorsement and the TIRSA Non-Imputation Endorsement) and the UCC 9 Policy.

Present-day real estate financing is significantly more complex than traditional financing. Sobered by borrower bankruptcies and compelled by rating agency requirements in the modern day era of mortgage securitizations, lenders are now looking to “mezzanine loans” to bridge the gap between senior debt and borrower equity. A mezzanine loan will often cover 50% to 90% of the equity required to acquire a property. In order to secure the repayment of a mezzanine loan, a lender customarily requires a pledge of the partnership or membership interests of the property owning entity.

In traditional mortgage transactions the borrower is required to obtain title insurance insuring the lender's mortgage lien on the real property. Ordinary title insurance is not available to the mezzanine lender because the collateral is not considered real property but rather a general intangible or investment property. The focus of this article is to explore the evolution of mezzanine financing and the various title insurance products available to the mezzanine lender in the current marketplace. Specifically, we look at the following forms of title insurance coverage: 1) the New York Insurance Rate and Service (TIRSA) Fairway Endorsement; 2) the TIRSA Non-Imputation Endorsement; 3) the TIRSA Mezzanine Financing Endorsement; and 4) the UCC Article 9 Insurance Policy.

The Evolution of Mezzanine Financing

A typical mortgage loan involves a loan amount of approximately 65% to 75% of the appraised value of a property and a first mortgage lien. In past second mortgages were used to give property owners additional borrowing power. However, the use of second mortgages as a means of subordinate financing has gradually declined over the past decade. The decline can be largely attributed to two factors: 1) the downturn in the real estate market in the early 1990s, and 2) the securitization of mortgage loans.

Two Types of Mezzanine Financing

As mentioned above, a mezzanine loan is often structured as a loan to the partners or members of a borrower and the loan is usually secured by a pledge of the respective partnership or membership interests. In the alternative, a lender may take a “preferred equity” position in the borrower in exchange for making a capital contribution. This interest is usually coupled with a right to a preferred return and/or other form of equity kicker as well as the right to approve certain major operating decisions. However, if a lender is an equity participant in the borrower, an issue may arise as to whether the loan should be considered debt or equity. A loan that is determined to be equity could lead to equitable subordination claims by other lenders or a claim by the borrower that the lender's equity position clogs the equity of redemption. If a preferred equity position is viewed as debt, there is a possibility that lender liability claims could arise in a foreclosure action if the participating lender is found to have exercised excessive control over the management of the mezzanine borrower.

Title Insurance Coverage Available to Mezzanine Lenders

The following forms of title insurance coverage are available to mezzanine lenders:

The TIRSA Fairway Endorsement

When a mezzanine lender forecloses on a pledge and becomes an equity owner of the insured, there is a risk that the transfer of ownership will trigger a termination of the insured entity's existence and a corresponding termination of the insured's title insurance coverage. While most governing documents of a limited liability company or partnership borrower will specifically state that the admission or withdrawal of a member or partner will not result in the termination or dissolution of the entity, the Fairway Endorsement provides affirmative coverage that the title insurance policy continue in effect notwithstanding any transfer of an ownership interest to the mezzanine lender pursuant to the pledge.

TIRSA Non-Imputation Endorsement

“Matters known to the Insured” are excluded from coverage under a typical policy of title insurance. When the insured is an entity, “knowledge” is imputed to the equity owners of the insured. A mezzanine lender will seek affirmative coverage from the title insurer that upon acquisition of an ownership interest in the insured entity, the lender will not be denied coverage as a result of matters known to equity owners other than the lender.

TIRSA Mezzanine Financing Endorsement

As mezzanine financing became more popular, the Fairway Endorsement and the Non-Imputation Endorsement were made part of a single endorsement known as the TIRSA Mezzanine Financing Endorsement. In addition to Fairway and Non-Imputation coverage, the Mezzanine Financing Endorsement offers certain additional protections to a lender that acquires a pledge. The endorsement offers a form of coverage known as “Contingent Loan Coverage” and provides for the payment of insurance proceeds under an owner's policy directly to the lender whether or not the lender has acquired an ownership interest by realizing on its collateral. This is contrary to the requirement in a typical owner's policy where the insured must actually suffer a loss before the insurance proceeds are payable under a title policy. In the event a mezzanine lender acquires an interest in the insured, the amount of proceeds payable to such lender under a Mezzanine Endorsement is equal to the total loss payable under the policy less a percentage of the loss equal to the percentage of partnership or membership interest not owned directly or indirectly by the mezzanine lender at the time of loss. To the extent any portion of a mezzanine loan is repaid to the lender, the lender is required to return any proceeds received from the title company; however, the title company may not exercise its subrogation rights until the lender recovers all amounts outstanding under the mezzanine loan. The cost of a mezzanine endorsement is approximately 30% of the owner's premium.

If a mezzanine lender has a preferred equity interest in the borrower, the lender will require a separate owner's policy with an insured amount equal to the value of its ownership interest. If a mezzanine lender makes its equity contribution after the effective date of the original owner's policy, the effective date of the mezzanine lender's title policy will be the date the contribution is first made. Thus, a borrower can find itself in the position of having to pay a portion of the owner's premium for a second time in order to satisfy the lender's title insurance requirements.

While the mezzanine endorsement provides a significant level of coverage to a mezzanine lender, the lender is not insured against perfection or priority claims. For these matters, mezzanine lenders will look to an opinion of borrower's counsel and/or a UCC-9 Policy of Insurance.

The UCC 9 Policy

As mentioned above, a mezzanine loan is often secured by a pledge of the equity interests in the borrower. In order to perfect its lien on pledged collateral under Revised Article 9, the lender has three options: 1) filing a UCC-1 statement; 2) taking possession of the certificates evidencing the equity interest; or 3) taking control in the instance where the collateral is deemed an investment security.

The UCC Article 9 Policy covers risks due to lack of: 1) attachment; 2) perfection; and 3) priority. The policy covers all three modes of perfection discussed above (ie, filing, possession and control). In addition to the property owned by the debtor on the date of issuance, the UCC Policy can also cover after-acquired property of the debtor. The maximum amount recoverable under a UCC Article 9 Policy is the least of: 1) the face amount of the policy; 2) the indebtedness outstanding under the loan at the time of the loss as reduced by the amount the insured is able to recover on the collateral; and 3) the value of the collateral as reduced by the amount the insured is able to recover on the collateral. Unlike the Mezzanine Endorsement, the insurer is required to make payment of a claim within 30 days after the insured's loss or damage, except that if a litigation is commenced prior to the 30-day period, no payment shall be made until a final unappealable judicial determination is made.

Conclusion

Challenges in American commerce have historically been met by adaptation. As mezzanine financing developed, title insurance has adapted. Two products are now available in New York: the TIRSA Mezzanine Financing Endorsement (comprising in part, the TIRSA Fairway Endorsement and the TIRSA Non-Imputation Endorsement) and the UCC 9 Policy.