Pledges of equity have been used for many years as the vehicle to allow mezzanine lenders to secure mezzanine loans. Now, lenders use pledges of equity as an essential structuring tool to implement a logical exit strategy in case of a default. The pledges of equity taken in conjunction with a lender making and securing a mortgage loan are most accurately described as Equity Control Pledges.
This article will explore a quick history of equity pledges in the context of mezzanine loans and the increasing use of Equity Control Pledges, describe the advantages of taking an Equity Control Pledge when no mezzanine financing is needed, and cover pitfalls and traps that can occur if these pledges are not properly documented.
Equity Pledges and Mezzanine Finance
Around 25 years ago, mezzanine financing was formulated as a byproduct of mortgage lenders seeking lower loan-to-value ratios in their real estate transactions. Additionally, mezzanine financing was developed as a method for the lender to achieve a higher return on their investment by making a loan at a higher, more risky level of the capital structure. After the 2008 economic implosion, mezzanine financing further increased. This growth was due, in part, to government tightening on the loan-to-value ratios of mortgage lenders and the introduction of the concept of a high volatility commercial real estate loan. Due to low interest rates over the past seven to ten years, many new mezzanine lenders have entered the marketplace in search of a vehicle to achieve a higher return on their investment.
With the recent rise in interest rates, loan-to-value ratios have lowered on lenders’ senior loans, which has created yet another opportunity for mezzanine finance to fill the need for increased debt on a borrower’s balance sheet. Because all mezzanine lenders secure their loans with a pledge of equity in the property-owning entity, obtaining a Uniform Commercial Code (UCC) insurance policy has also become best practice among the law firms representing these lenders.
Use of Equity Control Pledges
The UCCPlus Division of Fidelity National Title Group reviews dozens of loan documents each month that utilize pledges of equity as collateral for, predominantly, mezzanine loans. Recently, however, it has become much more common to see a lender make a loan with a parcel of real property as the primary asset, then secure that loan by means of a deed of trust/mortgage and also take an equity pledge of the ownership interest in the entity that owns the underlying real property.
Sometimes the required pledge is referred to as an “accommodation pledge”. The connotation of this phrase is that the borrower is obliging a small, insignificant “throw- in” request from the lender that is making the loan. The term “accommodation pledge” further implies that the pledge is an afterthought, a belt and suspenders duplicative lender request, or something not to be taken very seriously by the lender. However, the terminology is a complete misnomer.
When analyzing the overall structure of the lender’s collateral requirements as a condition of the loan secured by both the mortgage and the equity pledge, one realizes that the lender takes the pledge to achieve quicker control of the collateral in the event of a default under the terms of the loan. By using the more appropriate designation, Equity Control Pledge, the lender adds an important strategic option available to it in a default/workout scenario.
A Common Scenario
- Assume that a default occurs under the underlying mortgage documents by and between the borrower and the lender.
- Assume that the taking of the Equity Control Pledge is cross defaulted with the mortgage loan.
- Assume that any cure periods built into the loan documents have not been remedied by the borrower.
- Assume that the lender can exercise its remedies under either the terms of the mortgage loan documents or the terms of the Equity Control Pledge documents.
At that point the lender will have the remedial option of:
- Proceeding with a foreclosure of the underlying real property under the applicable state foreclosure statute/law; or
- Proceeding with the exercise of remedies provided for in Part 6 of Article 9 of the UCC as adopted in each state.
While this article will not cover all the various remedies provided under Article 9 of the UCC, the most common method by which a lender chooses to dispose of its collateral is to conduct a public sale.
Advantages of Conducting a Public Sale
In the context of an Equity Control Pledge, the lender may dispose of its collateral by successfully conducting and completing a public sale in a commercially reasonable manner and becoming the successful bidder at the public sale. After the sale, the lender would own property-owning entity, thereby “stepping into the shoes” of the property-owning entity and be in position to manage the underlying real estate asset.
Another possible outcome of a public sale is equally satisfactory to a lender. Rather than being the successful bidder at the public sale, another party could qualify itself to bid in at the sale and outbid the foreclosing lender. Since a lender, in the context of a public sale, can credit bid all the indebtedness owed to it by the defaulted borrower, any successful third-party qualified bidder would have to outbid the lender’s credit bid and the lender who required the equity control pledge would be made whole.
The principal advantage of a lender obtaining an Equity Control Pledge is the time frame in which a lender can successfully conduct a public sale. A lender, with counsel (who presumably has experience and knowledge of Article 9 and conducting Article 9 public sales) should be able to conduct a public sale within 60 to 90 days after the lender is able to exercise its remedies under the applicable loan documents.
Contrast that scenario with the lender’s other option – foreclose on the underlying mortgage. In many states, a mortgage foreclosure can take up to two years to conclude. This lengthy process is partly due to court backlogs, coupled with inefficiencies created in the aftermath of the Covid-19 pandemic.
The strategy of a lender taking both a mortgage and an Equity Control Pledge gives the lender greater flexibility to choose its remedies in the event of a default and the ability to get its debt paid off sooner and/or obtain control of the underlying real property more quickly.
Pitfalls and Traps
There are some very important caveats to the strategies and options of the lender that have been laid out above.
If a lender and its counsel make any mistake in the process and/or documentation that causes the lender to: i) not properly attach the security interest to the pledge of equity; ii) improperly perfect its security interest in the pledged collateral; or iii) fail to achieve a first-priority lien on that equity pledge, then the lender’s security interest on that pledged collateral will fail. The consequences of that type of error would be:
- Only a lender that has a properly perfected first-priority security interest in the pledge of equity can avail itself of the remedies available under Article 9 of the UCC as embodied in the loan documents and can thereby dispose of the collateral and conduct a public sale.
- If not properly perfected, borrower’s counsel will detect the defects and attempt to enjoin the public sale.
As is the case for mezzanine loans secured by pledges of equity, experienced counsel utilize best practice by obtaining a UCC insurance policy for Equity Control Pledges, and thereby shifting risk of claims against attachment, perfection and priority to the title company.
For more information on obtaining a UCC insurance policy for equity control pledges, please contact Gary Zimmerman at 312-223-2441 or firstname.lastname@example.org.