New York State Assembly Reintroduces Legislation Imposing Recording Tax on Mezzanine Debt and Certain Preferred Equity Investments

This alert will first provide a brief overview of the key provisions of the bill, and then discuss some important implications that could arise from its passage.

What Would Change?

When first proposed in the New York State Senate in 2020, the bill imposed recording taxes only on newly created mezzanine loans.

However, the new proposal expands the scope of Section 291-k of the New York State Real Property Law (with conforming changes, as described below, to Section 250 of the New York State Tax Law and Section 9-601 of the New York State’s Uniform Commercial Code) to make clear that “whenever a mortgage instrument is recorded in the office of the recording officer of any county, any mezzanine debt or preferred equity investment related to the real property upon which the mortgage instrument is filed shall also be recorded with such mortgage instrument.”

New Section 291-k of the Real Property Law defines “mezzanine debt” and “preferred equity investments”—now subject to the reach of these provisions—as

“debt carried by a borrower that may be subordinate to the primary lien and is senior to the common shares of an entity or the borrower's equity and reported as assets for the purposes of financing such primary lien. This shall include non-traditional financing techniques such as a direct or indirect investment by a financing source in an entity that owns the equality [sic] interests of the underlying mortgage where the financing source has special rights or preferred rights such as: (i) the right to receive a special or preferred rate of return on its capital investment; and (ii) the right to an accelerated repayment of the investors capital contribution.” (emphasis added)²

This new provision of the Real Property law is stated as applying to both mezzanine debt and preferred equity investments if “both used by the borrower or mortgagor, or either mezzanine debt or preferred debt, if either is used by the borrower or mortgagor.”

The proposed legislation then amends Section 250 of the Tax law to make clear that “mezzanine debt and preferred equity investments” are taxable, and that the tax will be measured by the amount of “principal debtor obligations” which may be secured by a security agreement “in relation to real property upon which a mortgage instrument is filed.” This means that, if the legislation is passed, mezzanine debt and preferred equity investments with respect to commercial property in an amount or having a value of less than $500,000 would be taxed (at the State level) at the rate of $1 for each $100 of debt secured, and that mezzanine debt and preferred equity investments in commercial property in a greater amount or having a value of $500,000 or more would be taxed (at the State level) at the rate of $1.75 for each $100 of debt secured. The rate with respect to one, two, or three-family houses and individual residential condominium units securing $500,000 or more is $1.125 for each $100 of debt secured. Since the legislation authorizes counties and cities to impose a tax on the filing of the financing statement required to be filed by the proposed amendment to the UCC (described below), and since it is likely that they would follow suit, the effective net rate could equal the mortgage recording tax rate (or 2.85 percent of the “debt” secured in the case of commercial real property located in New York City and having a value in excess of $500,000).

The proposed legislation also amends Section 9-601 of the UCC to provide a new requirement that recording of a financing statement in the relevant county records is required to perfect “a security interest in mezzanine debt and/or a preferred equity investments.” Indeed, pursuant to Section 291-k of the Real Property Law, “[n]o remedy otherwise available to a secured party under article nine of the uniform commercial code shall be available to enforce a security agreement pertaining to mezzanine debt financing and/or preferred equity investments in relation to real property upon which a mortgage instrument is filed that is evidenced by a financing statement, unless that financing statement is filed and the tax imposed pursuant to the authority of subdivision four of section two hundred fifty-three of the tax law, has been paid.” (emphasis added).

Questions Raised by these Proposed Amendments.

The proposed legislation raises a number of questions, including the following:

Mezzanine Debt.

The proposed legislation appears to provide that mezzanine debt that is created when a mortgage loan is created will be subject to the tax. Specifically, as noted, it provides that “[w]henever a mortgage instrument is recorded in the office of the recording officer of any county, any mezzanine debt ... related to the real property upon which the mortgage instrument is filed shall also be recorded with such mortgage instrument.” However, it is not a stretch to imagine that this provision (and the balance of the amendments, read as a whole) could be interpreted to require (and that recording and filing offices might interpret this language as requiring) the filing of a financing statement in connection with any new mezzanine debt—even if created later than (and therefore not concurrently with) a mortgage loan.

And what if the pledge, directly or indirectly, is of less than 50 percent of the stock of the entity owning real estate, is mezzanine debt taxable? (We imagine that most of the mezzanine loans that the bill sponsors intended to tax involve pledges of 90 percent+ of equity interests.)

Preferred Equity.

As drafted, the proposed legislation affects not only mezzanine debt but also preferred equity investments. We believe this to be the case notwithstanding the fact that the proposed legislation defines mezzanine debt and preferred equity investments as “debt carried by the borrower that may be subordinate to the primary lien...,” and further notwithstanding the fact that the proposed amendments to the Tax Law make clear that the tax will be measured by the amount of “principal debtor obligations” which may be secured by a security agreement. Note that this confusion also arises when considering the financing statement to be completed and filed, as more fully discussed below.

Preferred equity investments are further defined as investments that are granted “special or preferred rates of return” and “accelerated repayment rights.” The statute provides that “[w]henever a mortgage instrument is recorded in the office of the recording officer of any county, any... preferred equity investment related to the real property upon which the mortgage instrument is filed shall also be recorded with such mortgage instrument.” When read literally, this may provide for a narrow range of covered transactions, i.e., preferred equity investment made when there is a “concurrent” mortgage transaction. However, the reach of the new statute as applied to other types of financing transactions is unknown.

While clearly aimed at real estate-specific transactions, the breadth of the statute suggests the possibility that any financing transaction that in any way involves interests in real estate also might be covered. Leveraged finance transactions, for example, often require the borrower and its subsidiaries to grant security interests and liens in substantially all of the assets of the borrower and of the target companies. Those assets often include real estate, even if real estate is not a significant component of the collateral package. Those assets also typically include the equity interests in all subsidiaries, and intercompany loans held by members of the borrower/guarantor group. Lenders in these transactions may now consider it prudent to make county-level UCC filings and pay the recording tax even in circumstances where real estate is only incidental to the transaction and when the equity interests in the real estate-owning company do not have significant value. Alternatively, they may feel forced to forego that collateral altogether.

UCC Filing.

The amendments to the UCC are particularly perplexing. The questions begin with the puzzling fact that the provision of UCC Article 9 that the drafters of the legislation are amending relates to remedies, rather than recording of financing statements.

Next, the proposed legislation provides that “[n]otwithstanding any provision of law to the contrary, a security interest in mezzanine debt and/or preferred equity investments related to the real property upon which a mortgage instrument is filed, may only be perfected by the filing of a financing statement... and only after the payment of any taxes due...” (emphasis added). While the other provisions of the proposed legislation seem to treat the mezzanine debt or preferred equity investment as the obligation that is to be secured (and also treat preferred equity as debt), this provision seems to treat them both as the property in which the security interest is being granted. i.e., the collateral for some other loan. Does this mean that secured parties are required to make a county-level filing in connection with a mezzanine loan (i.e., a loan to the direct or indirect owner of the property-owning company) that is secured by equity in the property-owning company? Or only when making a loan to someone else secured by the mezzanine debt or preferred equity investment itself?

A related question is whether perfection by filing now takes priority over perfection by other means.

When collateral is certificated or uncertificated securities, the UCC provides not only for perfection by filing but also for perfection by “control.” In the case of certificated securities, “control” is achieved by the creditor/secured party taking possession of the certificates together with a transfer power endorsed in blank. In the case of uncertificated securities, “control” is achieved by entering into a three-party control agreement among the issuer of the securities, the holder of the securities and the creditor/secured party. Perfection by “control” normally takes priority over perfection by filing. The proposed legislation, however, seems to ignore the availability of perfection by control, let alone its senior priority status. If a secured party is perfected by control, but neglected to make the county-level filing, the statute suggests that the secured party cannot even exercise its remedies in the collateral. Does this mean that perfection by control no longer gives a secured party priority? And if it does, what does priority mean?

The complication is particularly evident when the pledged assets in question are membership interests in limited liability companies or interests in limited partnerships. Both are common investment structures in mezzanine financing. Under the UCC as in effect in most jurisdictions of the United States, membership interests in limited liability companies and limited partnership interests are classified either as (x) general intangibles, which are perfected by recording a financing statement in the office of the secretary of state (or comparable office) of the pledgor’s state of formation or (y) securities, which, as noted above, can be perfected either by filing or by control (and preferably both). Standard market practice today is for membership interests in limited liability companies to be treated as certificated securities. This is sometimes the case for limited partnership interests, as well. The designation of these investments as “securities” is accomplished, first, by means of a provision in the LLC operating agreement or limited partnership agreement, known as an “Article 8 election,” by which the parties “opt in” to securities treatment. Second, the relevant company issues paper certificates representing the membership or limited partnership interest. Of course, lenders should cover all their bases, and should record financing statements with the applicable secretary of state in addition to taking possession of the certificates together with transfer powers endorsed in blank. Lenders already are accustomed to taking those steps.

Under the proposed bill, New York will now differ from other states, even in this very typical scenario. Because perfection by filing at the county level is now mandatory for perfection of security interests in certain types of equity interests, but other UCC provisions relating to priority remain unamended, it is unclear whether perfection by control still will have priority, and what effect the filing at the secretary of state level will have.

All of this may be resolvable if a transaction and its parties are entirely within the State of New York and do not touch any other jurisdiction. But many transactions affected by the proposed statute are multi-jurisdictional, and different applicable laws may result in different requirements for perfection. For example, if the pledgor is a Delaware corporation, perfection of security interest in an LLC membership interest may be achieved either by control (if the parties have taken appropriate steps to “opt-in” to securities treatment) or by filing a UCC-1 financing statement in the office of the Delaware Secretary of State. But if the proposed bill is passed, New York would recognize perfection in this class of equity only by filing in the county office in New York where the real property is located. And we wonder whether a Delaware court, if called upon to adjudicate a dispute over a security interest perfected both by filing in Delaware and possession of certificates in Delaware (i.e., satisfying all perfection requirements under Delaware law), could be persuaded to ignore the additional New York requirement altogether. That argument would be particularly persuasive if the security agreement by which the interests are pledged also is governed by Delaware law. (We note that the New York UCC does not specify the law that needs to govern that security agreement.)

The result is that mezzanine lenders and covered equity investors will now need to navigate the requirements of multiple jurisdictions and each jurisdiction’s choice of law provisions in order to be certain that the transaction complies with all applicable laws. The real concern is not disputes between the creditor and the borrower, but rather intercreditor disputes, because different creditors may be able to claim a competing or even superior security interests according to the laws of different jurisdictions. These complexities can create opportunities for delays and challenges in consummating financing transactions and, upon default, in foreclosing on collateral. They also may give rise to potentially costly litigation.

Indexing the Financing Statements.

Further complicating the perfection requirement is the fact that county recording offices will need to index financing statements for entities not within the property records. The bill at least on its face does not change the parties against whom a financing statement would have to be filed, meaning that the financing statement would need to be made against the pledgor of the interests. Nevertheless, the drafters envision (implicitly, it should be pointed out) that the records would appear in the county records for the property. While this makes sense for mortgages, which are recorded against the land (and not against the entity), and for fixture filings, which also relate to specific parcels of land, it creates logistical pitfalls in the context of mezzanine financing (where the secured party of record is not being granted a mortgage or interest in real estate) or an equity investor (who merely invests in an entity, not in the land). And, if nothing else, it is likely that New York will need to have its own, non-standard form of UCC-1 financing statement with boxes or line items that provide for the requisite information for this type of filing.

Conclusion

Although the first attempt at passage of the legislation failed to advance in committee, the strain on New York State and municipal budgets due to the COVID-19 pandemic (and the critical but ever-present need to find ways to raise revenue) may result in the bill being more seriously considered today, as Governor Cuomo recently outlined his proposed budget for the coming fiscal year. The final budget is expected sometime in April. If the legislation is passed as drafted, lenders and investors will have to contend with the issues and questions raised above, along with the additional costs of closing their loans or investments by reason of the new measures imposed by the bill.

^{2  Note that the proposed legislation specifically exempts loans made to the owner of a cooperative apartment if the owner is a shareholder of the ownership entity, has exclusive occupancy of such dwelling unit and has established and delimited rights under a proprietary lease.}