More and more lenders are adding equity pledges as credit enhancements to commercial real estate loans. This structure combines the benefits of commercial real estate mortgages and mezzanine loans. Also referred to as a dual collateral approach or accommodation pledge, with an equity pledge, the lender obtains a security interest in the membership interests of the borrower in addition to the security interest in the real estate.
The difference between an equity pledge structure and a traditional mezzanine loan is the borrower. In a traditional mezzanine loan, the pledgor is the borrower and the loan secured by the borrower’s ownership interests in the subsidiary that owns the real estate. In an equity pledge loan structure, the borrower is the entity that owns and pledges the real estate and the owner of the borrower pledges the ownership interests in the borrower as a third party pledgor. With the addition of the equity pledge, the lender controls both the real property and the ownership of its borrower, and can choose its remedy in the event of default – the lender may foreclose on the ownership interest, foreclose on the real property, or both. Foreclosure on the equity interest through a UCC sale is often quicker and less expensive as compared to foreclosing on the real estate. Since COVID, the timing on real estate foreclosure proceedings has increased significantly. On the other hand, foreclosure on the real property wipes out junior liens on the real property and the foreclosing entity does not step into the borrower’s other liabilities. Unless prohibited by state law, the lender can choose both.
To facilitate an equity pledge, the borrower opts in to UCC Article 8 and certificates its membership interests, so that its membership interests are treated as investment property or securities under Article 8, rather than as general intangibles under Article 9. This allows the lender to perfect its security interest in Article 8 equity interests by possession or control, which has priority over a security interest perfected by filing, which is the only option for perfecting a security interest in intangibles. Further, UCC 8-303 grants “protected purchaser status” against other creditors, meaning that a protected purchaser acquires its interest in the security free of any adverse claim. There is no comparable status for general intangibles. To be granted protected purchaser status, a lender secured by a security must: (i) have given value; (ii) have no notice of any adverse claim; and (iii) obtain control of the certificated or uncertificated security¹.
In addition to opting into Article 8 and certificating the membership interests, the borrower’s operating agreement should include provisions that: (a) the member or manager cannot un-opt-in while the loan is outstanding; (b) no additional members or membership interests can be added while the loan is outstanding; and (c) if the borrower is manager-managed, the member can remove the manager without cause. Because limited liability ownership interest consists of two separate and distinct rights – economic rights and governance rights – the lender’s security agreement should clearly grant the lender governance rights. This is particularly important for Delaware limited liability companies, as the Delaware Limited Liability Company Act 18-101(8) provides that if the security agreement and UCC describe the collateral as “membership interest,” limited liability company interest,” or similar, the description only grants a security interest in the members’ economic rights. With an equity pledge, the lender’s goal is control over the entity rather than distributions of profits. Also, the lender should check that the permitted transfer language in its mortgage and loan agreement do not allow any change in the ownership of the borrower while the loan is outstanding. If available, the lender may also request a mezzanine endorsement from the title company.
Ideally, the pledgor will be a special purpose entity (“SPE”) whose sole purpose is owning and managing the borrower. If the pledgor is not an SPE, the lender should review any other debt instruments to confirm that the equity interest has not already been pledged as collateral and consent is not required from another lender for the pledge. In any case, all of the pledgor’s entity documents should be reviewed to confirm that a pledge is not been prohibited in the operating agreement or any other agreement, such as option agreements. The lender should run a full lien search and watch for “all asset” UCC filings. Because of the increased risk, often lenders will require that one single pledgor own 100% of the membership interest in the borrower.
In addition to the increased due diligence requirements, the equity pledge structure will necessitate additional loan documentation. The lender should plan to include: (1) consent resolution from the pledgor, specifically authorizing the pledge of membership interests; (2) membership interest security interest, granting both governance and economic rights; (3) irrevocable proxy; (4) irrevocable power/instrument of transfer of membership interest, (5) UCC-1, filed in the domicile of pledgor; and (6) hold the original executed membership certificate.
A properly documented equity pledge provided the lenders with greater flexibility and the ability to choose its remedies in the event of loan default. Although the additional due diligence and documentation requirements may make this loan structure too expensive or cumbersome for many real estate loan transactions, it can provide a valuable credit enhancement in certain cases.
¹ Although it is possible for the lender to meet the control requirement for an uncertificated security, we would recommend that the borrower create certificate for the membership interests and deliver the originals to the lender for safe-keeping
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