Janice Mac Avoy
Matthew Parrott

An important decision confirming the enforceability of UCC pledges of equity interests that are routinely provided to mezzanine lenders as collateral in connection with complex commercial real estate financing transactions was recently handed down by Justice Barry R. Ostrager in HH Cincinnati Textile L.P. et al. v. Acres Capital Servicing LLC and DW Commercial Finance, LLC, No. 652871/2018, 2018 N.Y. Misc. LEXIS 2472 (Sup. Ct. June 8, 2018).

The court’s holding is highly significant. It represents the first written decision under New York law expressly confirming that when parties to complex commercial real estate financing transactions decide to include both a real property mortgage and a pledge of UCC security interests as collateral for the loan, the lender’s right to enforce its remedies pursuant to either security interest will be fully enforced.

The HH Cincinnati case arose after a real estate developer who had obtained a $20.3 million loan to finance real estate development projects in Kansas City and Cincinnati defaulted on its obligation to repay the loan at maturity. When the lender sought to exercise its right to conduct a UCC foreclosure sale of equity interests in the property-owning entity that had been pledged as collateral for the loan, the borrowers filed suit in New York seeking a temporary restraining order and preliminary injunction to enjoin the UCC sale.

Among other arguments, the borrowers asserted that the UCC foreclosure sale purportedly would “clog” the borrowers’ equity of redemption. While the borrowers initially obtained a short reprieve from the UCC foreclosure by convincing the court to grant the borrowers’ request for a temporary restraining order, the court subsequently vacated the TRO and denied the borrowers’ request for a preliminary injunction, permitting the UCC sale to move forward. In doing so, the court held that the lender’s foreclosure of its UCC security interest did not violate the borrowers’ equity of redemption.

Background – the Equity of Redemption

The equity of redemption is a fundamental protection for mortgage loan borrowers facing the prospect of foreclosure of their real property interests. Under this doctrine, the mortgage borrower has an equitable right to prevent the lender from completing a judicial foreclosure auction, and can redeem the property and retain ownership by repaying the mortgage loan in full at any time before the foreclosure auction gavel falls.

Courts have zealously guarded this fundamental borrower right for many decades, and it is well-settled that the equity of redemption “cannot be waived or abandoned by any stipulation of the parties … even if embodied in the mortgage.” See Mooney v. Byrne, 57 N.E. 163, 165 (N.Y. 1900); accord Goldblatt v. Iris Const. Corp., 211 N.Y.S.2d 234 (Sup. Ct. 1960) (holding that mortgage borrower’s equity of redemption is nonwaivable under New York law). See also NYCTL 1999-1 Trust v. 573 Jackson Ave. Realty Corp., 13 N.Y.3d 573 (2009) (“The equity of redemption, which long predates the RPAPL, allows property owners to redeem their property by tendering the full sum at any point before the property is actually sold at a foreclosure sale”).

Borrowers confronted with mortgage foreclosure litigation have frequently sought to build their defenses, at least in part, upon claims that the foreclosing lenders have improperly interfered with or “clogged” the equity of redemption by obstructing their ability to repay the mortgage loan, thereby depriving them of their ability to redeem the property in violation of the rule. See, e.g. Basile v. Erhal Holding Corp., 148 A.D.2d 484 (2d Dep’t 1989) (lender prohibited from enforcing deed in lieu of foreclosure agreement because it would have impaired borrower’s equity of redemption); Thompson v. Lewis, 182 A.D. 556, 559-60 (2d Dep’t 1918) (holding that 30 day limit could not be imposed on borrower’s right of equitable redemption); cf. Goldblatt, 211 N.Y.S.2d at 235-237 (holding that mortgagor may not waive equitable redemption right at time mortgage was made).

Although borrowers making this argument have previously asserted that a lender’s violation of the equity of redemption rule justifies a borrower’s avoidance of its debt obligation to the lender, at least one court has held in a non-published oral decision that, at most, the remedy for such a violation “is to restore [the borrower’s] right of redemption … rather than to void the loan agreement.” Transcript of Decision and Conference at 4, Wells Fargo Bank, N.A. v. 390 Park Avenue Assocs., et al., 16 Civ. 9112 (LGS) (S.D.N.Y. Nov. 21, 2017) (granting lender’s motion to dismiss argument that loan agreement was unenforceable based on lender’s alleged violation of borrower’s right of redemption by reason of mezzanine pledge of borrower equity interests).

The HH Cincinnati Decision

The clogging argument asserted by the defaulting borrowers in HH Cincinnati was somewhat unique, because it was premised upon the financing structure agreed upon by the parties when the loans were first issued, which involved a loan that was secured both by mortgages on the borrowers’ real property and by a UCC pledge of the ownership interests in the Limited Liability Company borrowers that owned the underlying mortgaged property. Despite the fact that they had agreed to this structure in order to obtain over $20 million in financing, the borrowers argued that the UCC equity pledge improperly clogged the borrowers’ equity of redemption because it gave the lender the option of foreclosing on the borrowers’ equity collateral rather than pursuing a judicial mortgage foreclosure proceeding pursuant to the mortgage loan.

In essence, the borrowers argued that permitting enforcement of the UCC pledge and allowing the lender to foreclose on the equity interests of the borrowers would violate the rule that the equity of redemption “cannot be waived or abandoned by any stipulation of the parties … even if embodied in the mortgage” because it would permit the lender to gain ownership of the underlying mortgaged property without the need for completing a mortgage foreclosure lawsuit. See Mooney, 57 N.E. at 165.

The HH Cincinnati court rejected the borrowers’ arguments. It held that there was no clogging of the borrowers’ redemption rights because the borrower had agreed at the outset of the transaction to provide both a real property mortgage and a UCC pledge, and the borrowers were entitled to redeem each of those interests separately under the applicable state’s real property law and Section 9-623 of the UCC:

Plaintiffs’ equitable right of redemption has not been, as they assert, “clogged” by the operative agreements. Plaintiffs, at this very moment, retain a right of redemption under UCC Section 9-623, which provides that redemption may occur at any time before a secured party disposes of the collateral at a foreclosure sale. Thus, the UCC provides a right of redemption if plaintiffs can fulfill their obligations under the applicable agreements. Additionally, there is nothing to prevent plaintiffs from taking part in the bidding process at the UCC sale.

The court’s ruling is significant because it unequivocally confirms the right of lenders to complex commercial real estate financing transactions to enforce and defend equity interest pledges, and confirms that parties can structure their transactions in a manner that permits the lender, upon the occurrence of a default, to elect whether to take indirect ownership of the collateralized properties through the foreclosure of pledged membership interests in the borrower entities pursuant to a UCC foreclosure, or to pursue a judicial mortgage foreclosure lawsuit.

Unlike judicial foreclosures—which can sometimes take two or more years to complete—UCC foreclosures are often a more attractive route for lenders seeking to enforce their remedies because they can be completed in as little as 30 to 60 days, and the UCC rules do not afford borrowers the same protections as are afforded under the RPAPL statutory procedures required when foreclosing a mortgage, which include the appointment of a referee to calculate the amount of the mortgage debt and to administer the auction of the mortgaged property at issue. See generally RPAPL §§ 1321(1), 1402.

Although borrower defendants have repeatedly raised similar clogging arguments in other cases, courts addressing the issue prior to HH Cincinnati have avoided directly addressing the issue. See, e.g. Symphony Space v. Pergola Props., 669 N.E.2d 799 (1996) (affirming First Department decision holding that option to purchase agreement was void in violation of the Rule against Perpetuities and declining to rule on whether the agreement clogged the equitable right of redemption); BH Sutton Mezz LLC and BH Sutton Mezz LLC v. Sutton 58 Associates, LLC, 650832/2016 (N.Y. Sup. Ct. February 17, 2016) (court did not address plaintiffs’ argument that bifurcation of debt into a senior mortgage loan and a mezzanine loan created UCC security interest that clogged equity of redemption because case was stayed pending plaintiffs’ bankruptcy petition).

While, on its face, the ruling in HH Cincinnati appears to run afoul of statements made in earlier court decisions to the effect that the equity of redemption is nonwaivable  because it enforces the lender’s right to pursue the shorter UCC foreclosure path rather than filing a judicial foreclosure action, the vast majority of such decisions were rendered many decades ago and did not involve the types of complex commercial real estate financing transactions that are routinely employed in the modern-day marketplace. A contrary precedent would have abrogated the enforceability of mezzanine loan security interests that are routinely relied upon in today’s marketplace, and could potentially have upended the viability of tens of billions of dollars in commercial real estate financing transactions. The court’s decision therefore comes as very good news both for lenders in the modern real estate financing arena, and for the borrowers who will continue to seek financing from them.

Janice Mac Avoy and Matthew D. Parrott are partners and co-chairs of the Real Estate Litigation Group at Fried Frank Harris Shriver & Jacobson LLP.  Cynthia Luo, an associate with the firm, assisted in the preparation of this article.