• Got Proceeds? Mezzanine and B Note Structures More Popular
  • October 15, 2003 | Author: Peter K. McKee
  • Law Firm: Andrews Kurth LLP - Dallas Office
  • As first mortgage underwriting standards tighten in response to the perception of heightened market risk, borrowers can be left short of loan proceeds. To fill that gap, borrowers are finding that it is cheaper to seek additional debt than it is to raise additional equity. The additional debt market continues to evolve and develop, and, while previously seen only for trophy properties, is increasingly available for conduit-type loans. Where the additional debt may not be in place at the time of the first mortgage closing, borrowers are best served by pre-wiring the first mortgage loan documents to anticipate such additional financing. Accommodating additional debt for CMBS loans on an after-market basis will be difficult in the face of pooling and servicing agreement requirements.

    Beyond the economic risks arising out of increased leverage, the interaction between first mortgage debt and additional debt creates unique legal risks depending on the structure. Listed below is a glossary of terms and basic distinctions between mezzanine, B Note and subordinate debt structures (in order of impact on first mortgages- least to greatest):

    Mezzanine Debt

    Debt owed by owner of borrowing entity, usually secured by a pledge of the owner's interest in the borrower; there is no lien on the property, nor is there any other structural attribute that would cause the first mortgage borrower to violate its special purpose entity covenants. Pursuant to intercreditor provisions, the mezzanine lender's rights are limited to notice and cure rights on borrower defaults, and the ability to take control of the borrower (by foreclosing on the pledge of the ownership interest), subject to the first lien debt. The mezzanine noteholder must be pre-approved by the first mortgage lender as an approved successor control party to sidestep due-on-sale conditions, and, from a rating agency standpoint, pass muster based on management expertise and financial wherewithal. In general, the mezzanine lender has greater control and flexibility in the exercise of remedies than does the B Noteholder or subordinate lender. Rating agencies prefer mezzanine debt to B Note structures.

    B Note Debt

    Debt owed by the borrower, evidenced by a separate note (B Note) but secured by the same mortgage as the first lien note (A Note). The A Note is intended to be securitized, while the B Note (representing additional leverage) often is not. Payments are allocated first to the A Note, and then to the B Note. Typical intercreditor provisions leave the B Noteholder with the remedy to purchase the A Note as the chief means of protecting its interest. Otherwise, it is subject to standstill requirements. Some role advising the special servicer in workout strategy may also be also be allowed the B Noteholder, but B Noteholder rights adversely impact the treatment the A Note receives in securitization. Yield expectations on B Notes are higher than on mezzanine debt.

    Subordinate Debt

    Debt owed by borrower (other than a limited amount of trade payables) that is behind the first mortgage debt in priority. Such debt can be secured (second lien) or unsecured. Subordination and standstill protections are expected by CMBS first mortgage lenders that (i) allow subordinate lenders to be paid only out of excess cash flow, (ii) forestall the exercise of remedies by subordinate lenders until after the first lien has been satisfied and bankruptcy preference periods have lapsed; and (iii) contain a non-petition covenant and an assignment of rights to vote in bankruptcy.