A recent federal court decision suggests a new approach to receiverships, which recognizes certain challenges lenders face in the current economic climate. Specifically, lenders are increasingly faced with the question of how to effectively protect their collateral in situations where the borrower has proven to be an incapable steward, especially when additional funding may be required. In U.S. Bank National Association v. Nesbitt,1 the U.S. District Court for the Southern District of New York granted a trustee’s2 motion to appoint a receiver for eight hotel properties even though the lender had not instituted a foreclosure proceeding contemporaneously with, or prior to, its receiver motion.3 If followed by other courts, Nesbitt provides a mechanism for lenders to more easily protect their diminishing collateral by replacing ineffective property-level management with a receiver and a hand-picked property manager. This article also discusses particular mortgage provisions that may help lenders who seek the appointment of receivers.

The ‘Nesbitt’ Case

In Nesbitt, the plaintiff was a trustee for a $187.5 million loan made to owners of eight hotels operated as Embassy Suites franchises.4 The borrowers were separately organized limited liability companies operating in six different states.5 The hotels served as collateral for the loan.6 The defendant borrowers defaulted, and funds generated by the hotels were then trapped in a cash-management account controlled by the loan servicer.7 These funds were insufficient to make current payments on the debt. Under the loan agreement $1.2 million in combined principal and interest payments were due monthly and defendants were six months behind in their payments. Payments in arrears totaled over $11 million.

In addition, defendants’ licensor, Embassy Suites, threatened to pull its franchise because of unsatisfactory quality assurance evaluations (defined under the terms of the franchise agreement) at defendants’ hotels. Defendants estimated that they would require an additional $4.4 million injection of cash to meet Embassy Suites quality assurance standards and to prevent the revocation of the franchise. Following the $4.4 million infusion, more cash would be needed to pass subsequent examinations to maintain franchisee status. Unwilling to provide many millions of dollars in additional funding without any control over the properties, the trustee brought an action in federal court seeking the appointment of a receiver for the hotel properties. Plaintiff did not, however, initiate any foreclosure proceedings for any of the eight hotel properties or seek any other remedy at that time. Defendants moved to dismiss the action seeking the receiver, arguing that the court could not appoint a receiver because in that case the “receivership [was] not ancillary to some other final relief, and a receivership cannot be an end in itself.”8

In its analysis, among other things, the court examined the equities, analyzing the effect that a receivership would have on each party. The court paid particular attention to the fact that the borrowers’ business had already failed, so it could not credibly claim harm from the appointment of a receiver. The lender’s collateral, on the other hand, was in imminent and irreparable danger of being further destroyed as the hotels would “lose much of their value due to the loss of the Embassy Suites franchise license.”9 Moreover, the lender had already provided additional funding to defendants and still the hotels were providing insufficient revenue. The lender was faced, therefore, with the stark decision of injecting millions more into a failing business that was being managed by someone who has proven inept at managing those hotels. In addition, the properties were located in six different states, which would cause difficulty foreclosing on the properties individually. The court concluded that receivership best maintains the value of the collateral because lenders can seek new management and renegotiate with the franchisor. Receivership, the court concluded, was the most practical way to “preserve the property for the secured lender.”10 As such, the court granted plaintiff’s motion to appoint a receiver.

After concluding that the financial realities of the case required that a receiver be appointed, the Nesbitt court discussed the defendants’ argument that granting the motion to appoint a receiver could be an abuse of the court’s discretion because no other relief was being sought. It acknowledged caselaw that requires receivership to be accompanied by an additional court action, “when a receiver is sought pursuant to Rule 66 in a diversity case, ‘the appointment of a receiver in equity is not a substantive right but is a remedy that is ancillary to the primary relief prayed for in the suit.’”11 The court stated, however, that plaintiff was not only seeking appointment of a receiver to preserve the value of the hotels but to potentially liquidate them as well.12 Therefore, the court found that lender’s intent to foreclose and liquidate the collateral was enough other relief to allow the appointment of a receiver.13

New York’s Receivership Law

The standards for appointment of a receiver under New York state law and federal law are similar. Both require that a motion to appoint a receiver be ancillary to some other action. In New York, section 6401(a) of the CPLR states that the property must be the subject of an action aside from a motion to appoint a receiver. The provision states:

Upon motion of a person having an apparent interest in property which is the subject of an action…a temporary receiver of the property may be appointed…where there is danger that the property will be removed from the state, or lost, materially injured or destroyed.14

Essentially, this is the same requirement the court addressed in Nesbitt. Both state and federal law require the motion to appoint a receiver to be ancillary to the main action regarding the status of the property and both look to the possibility that the value of property will be harmed in some way. Nesbitt may be persuasive in New York because of these similarities. If state courts elect to follow Nesbitt, then motions to appoint a receiver do not necessarily need to be filed simultaneously with a foreclosure action as long as the lender intends to foreclose or liquidate.15

Outside Foreclosure Context

Under existing jurisprudence, receivership motions cannot be supported by an action in tort or for money damages because receivership is an equitable remedy.16 Outside of the foreclosure context, many New York cases deny appointment of a receiver based on this requirement. Nesbitt is a case technically outside of the foreclosure context because no foreclosure had been filed, yet the court decided to allow receivership in anticipation of the foreclosures that it deemed to be imminent.

Examination of some other receiver cases provide an interesting contrast. For example, in Fisher v. Meyerowitz, the sole surviving shareholder of a realty corporation, which had been held by two shareholders, brought an action against the estate of the deceased shareholder.17 The action sought damages for conversion, mismanagement and fraud, and plaintiff filed a derivative suit.18 Plaintiff sought a receiver to collect the rents, remove violations, and conduct the management of the realty corporation, arguing that there was a danger that the property would be removed, lost, materially injured or destroyed.19

The court denied appointment of a receiver because “all the causes of action are founded upon claims for damages resulting from conversion, fraud or mismanagement.”20 It concluded that the realty was not “subject to the action” and as such, receivership could not be applied simply to a “common-law action for money or one in tort, there being no specific subject matter.”21

Similarly, in Greenberg v. Greenberg, the plaintiff brought an action to cancel and rescind certain conveyances of real and personal property and sought the appointment of a receiver.22 Plaintiff wanted the receiver to take inventory and possession of the contents of certain safe-deposit vaults. The court denied the request, stating that the complaint alleged conversion, which only entitles the plaintiff to money damages. Thus, because plaintiff was only suing for money damages, there was no specific property which was subject of the action.

By contrast, the Nesbitt court’s decision balanced consideration of the formal requirement that the property be the “subject of the action” with the practical problems lenders face when considering foreclosure. Several significant factual differences make Nesbitt distinguishable from receivership requests in cases like Fisher and Greenberg. First, the plaintiff in Nesbitt was a lender whose ultimate intent was to foreclose on the properties.23 Second, the property was in danger of being significantly devalued through the loss of the franchise agreement with Embassy Suites. The loss was imminent and irreparable. Third, the plaintiff’s cause of action was not in tort and was not seeking monetary damages; it was simply trying to remove the borrowers from management to protect its assets.

Next, the defaulting defendants had eight hotels located in six states, which would have forced plaintiff to seek appointment of receivers in each state court—an inefficient and wasteful process. In addition, the defendants were not harmed by the appointment of a receiver. They were in default, six months behind in payments, and sought at least $4.4 million of additional funds just to stay afloat for the next six months. Lastly, the parties contemplated the appointment of a receiver in the loan agreement—a fact considered by the court, although not dispositive.24

Receivership Provisions

A lender can improve its chances of getting a receiver appointed through provisions in its loan agreement. The provision in the loan agreement in Nesbitt governing receivership stated that in the event of a default, the mortgagee “may…apply for the appointment of a receiver…of the Trust property.”25 The Nesbitt court criticized this provision because it lacked explicit consent by the defendants to the receivership appointment.26 Thus, the appointment was not automatic under the mortgage agreement and required an “‘adequate showing’ by the plaintiff.”27 If the language in Nesbitt were drafted differently, it would have strengthened the lender’s case.

Unlike the language in the Nesbitt loan agreement, other agreements are drafted—or can be drafted—to provide that the borrower consents to the appointment of a receiver, with or without notice, and that a court may not deny receivership on the basis that the property is not in danger of being removed, lost, materially injured or destroyed.28 New York Real Property Law section 254 governs the construction of clauses and covenants in mortgages and contains a provision that permits unilateral receivership appointment when drafted correctly. Subsection 10 states:

A covenant “that the holder of this mortgage, in any action to foreclose it, shall be entitled to the appointment of a receiver,” must be construed as meaning that the mortgagee, his heirs, successors or assigns, in any action to foreclose the mortgage, shall be entitled, without notice and without regard to adequacy of any security of the debt, to the appointment of a receiver[.]29

Receivership clauses that are consistent with RPAPL 254(10) are typically enforced in New York.30 For example, in Ditmars Lodging v. Mohola, the Appellate Division reversed the Supreme Court’s decision vacating a motion for a temporary receiver because the mortgage agreement granted to mortgagee the right to appoint a receiver “without notice and without regard to the adequacy of the security for the Debt and without regard for the solvency of [the] Borrower.”31 The court found that, based on section 254(10), the contract language precluded any inquiry into the adequacy of the collateral as security for the loan and whether receivership was necessary to protect the collateral. With similarly drafted language, a lender can avoid these complicated and difficult to predict analyses.32

Conclusion

In Nesbitt, the District Court for the Southern District of New York offered a new approach to receivership by discussing the practical challenges lenders face when borrowers default. The fact that the court gave consideration to factors including the impending loss of a valuable franchise agreement and the different jurisdictions where the property was located may give lenders more options when considering asking for receivership appointments in the future. It is unclear whether Nesbitt signals a shift to a more contextual approach by New York courts. These courts have seen an increased number of cases involving defaulted loans on commercial properties where significant value erodes while cases drag on because of procedural issues and outdated doctrines that reflect the thinking of a very different economy and marketplace.

Joshua Sohn and Jason Goldstein are members of DLA Piper. Matthew S. McElroy, a law clerk at the firm, assisted in the preparation of this article.

Endnotes:

1. U.S. Bank Nat’l Ass’n v. Nesbitt Bellevue Property, No. 12 Civ. 423, 2012 WL 1965341, (S.D.N.Y. May 30, 2012).

2. Movant was trustee under the Pooling Agreement. Id. at *1.

3. Id. at *6, 8.

4. Id. at *1.

5. Nesbitt, No. 12 Civ. 0423, Compl. ¶¶4-11.

6. Id. at *1.

7. Id. at *4.

8.Id. at *6.

9. Id. at *3.

10. Id. at *7.

11. Id. at *6 (citing Wright, Miller, Kane & Marcus, Federal Practice and Procedure §2983). “It is fundamental that a receivership cannot be the primary object of litigation. It is not an end in itself.” Id. (citing Gordon v. Washington, 295 U.S. 30, 37, 55 S.Ct. 584, 584 (1935)).

12. Id. at *7 (citing testimony that plaintiff’s asset manager had not commenced a foreclosure action but foreclosure was “the intent” unless borrower came up with a better proposal).

13. Id. at *7.

14. Real Prop. Acts. §1325(a) (emphasis added).

15. See supra notes 10-13 and accompanying text.

16. Fisher v. Meyerowitz, 220 N.Y.S.2d 920, 923, 31 Misc.2d 624, 627 (N.Y. Sup. Ct. 1961); Greenberg v. Greenberg, 10 N.Y.S.2d 726, 730 (N.Y. Sup. Ct. 1951).

17. Fisher, 220 N.Y.S.2d at 921.

18. Id. at 921-22.

19. Id. at 923.

20. Id.

21. Id.

22. Greenberg, 10 N.Y.S.2d at 729.

33. Nesbitt, 2012 WL 1965341 at *7.

24. Id. at *2.

25. Id.

26. Id.

27. Id.

28. Bruce J. Bergman, Bergman on New York Mortgage Foreclosures, §10.05(1) (Matthew Bender, 2012).

29. Real Prop. §254(10).

30. GECMC 2007-C1 Ditmars Lodging v. Mohola, 84 A.D.3d 1311, 924 N.Y.S.2d 531 (N.Y. App. Div. 2011). “Where, as here, the mortgage indenture includes provisions by which the mortgagor expressly consents to the appointment of a receiver ‘as a matter of right and without regard to the necessity to disprove adequacy of the security for the Obligations and the solvency of [the] Mortgagor or other persons liable for payment of the Obligations’, the plaintiff is entitled to the appointment of a temporary receiver.” Dunhill Asset Servs. III v. 175 Dixon Ave. Realty, No. 33023-11 (N.Y. Sup. Ct. Feb. 24, 2012); see also Naar v. I.J. Litwak & Co., 260 A.D.2d 613, 688 N.Y.S.2d 698 (N.Y. App. Div. 1999).

31. Ditmars Lodging, 924 N.Y.S.2d at 532.

32. Notably, this language prevents a court from applying balancing test weighing the receivership’s effect on the mortgagor’s interest in the property and the risk of harm to the collateral. It also avoids disputes over valuation of the mortgaged properties.