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Institutional real estate lenders and their counsel generally believe that leasehold mortgages are inferior to mortgages encumbering fee interests in real property. With a leasehold mortgage, the lender makes a loan secured by its borrower’s interest in a ground lease of real property owned by a third party, the ground lessor. This consensus view that fee mortgages are superior is based on the fact that real property mortgage collateral is tangible and will not terminate if a borrower defaults under the ground lease, an agreement with another party. By contrast, a leasehold is a contractual right granted by the ground lessor, which does not have independent, perpetual existence and may be extinguished under certain circumstances. Accordingly, lenders typically and reasonably prefer to secure their loans with fee interests, instead of leasehold interests, in real property.

When it comes to enforcing the lender’s remedies, however, the leasehold mortgagee may have an advantage over its “better-secured” fee mortgagee counterpart. By reason of the different nature of the leasehold mortgage loan, in the unfortunate event that the project becomes distressed, the lender may have certain options available to it that the fee mortgagee would not, provided that the lender diligently ensured that the ground lease contained particular leasehold mortgagee protections.1 In effect, the lender may get the benefit of a unique tool in a default or workout in exchange for taking the “inferior” leasehold mortgage instead of a fee mortgage.

Leasehold mortgage transactions typically include, among other things, the requirement that upon termination of the ground lease for any reason, including rejection of the ground lease in a bankruptcy proceeding, the ground lessor must, upon the request of the lender, enter into a new lease with the lender or its designee.2 This leasehold mortgagee protection may provide the lender with an advantage over its fee mortgagee counterpart because it may provide an extra-judicial avenue for the lender to realize on its collateral without “clogging the equity of redemption.”

To Clog or Not to Clog

The doctrine of clogging the equity of redemption is an old English common law doctrine that protects every borrower’s right to pay off its mortgage and free its collateral. The Restatement (Third) of Property explains the doctrine of clogging the equity of redemption as rendering unenforceable “any provision inserted to prevent a redemption on payment or performance of the debt or obligation for which the security was given.”3

Practically speaking, if a fee mortgagee acquires ownership of its collateral without going through a judicial foreclosure, it is extremely likely that it will violate commonly held prohibitions against clogging the equity of redemption. For instance, a purchase option granted to the lender as security for its loan and conditioned upon an event of default under the lender’s mortgage, or a clause that indefeasibly vests title to the collateral in the lender upon a default the lender’s mortgage, would be unenforceable because such provisions would frustrate the borrower’s right in equity to retain its property by paying off the debt.4

The prohibition against clogging the equity of redemption also applies to leasehold mortgages.5 A lender may not, for example, require that an assignment and assumption agreement for the transfer of the borrower’s leasehold interest be placed into escrow upon the closing of the loan with its release and effectiveness conditioned upon an event of default under the mortgage. The very nature of the leasehold mortgage, however, when combined with the “new lease” mortgagee protection, presents the lender with a parallel option that may not run afoul of the prohibition against clogging the equity of redemption. If the ground lease is terminated and subsequently the ground lessor gives the lender a new lease in accordance with the “new lease” mortgagee protection which was built into the ground lease itself, the lender may own the collateral via a new lease without foreclosing or violating the borrower’s equity of redemption.

The “new lease” mortgagee protection appears to allow the lender to avoid the “clogging” pitfall because: (1) the borrower’s right of redemption is extinguished as a result of its own misdeeds that cause defaults under the ground lease (as opposed to a default under the mortgage instrument itself), (2) once the ground lessor terminates the ground lease by reason of the ground lessee’s default, no collateral remains for the borrower to redeem, and (3) the lender succeeds to the collateral not by reason of enforcement of remedies under the mortgage but instead by reason of the ground lessor’s enforcement of its remedies under the ground lease and the lender’s rights granted thereunder.

As explained by the Superior Court of New Jersey, Appellate Division, while a remedy transferring the collateral to the lender which flows from a mortgage due to a default under the mortgage is an impermissible clog of the equity of redemption, a remedy which flows from a “distinct instrument” whose “enforcement is not dependent upon the mortgagor’s default” under the mortgage does not improperly clog the borrower’s equity of redemption.6

The safe-harbor provision in New York’s General Obligations Law mirrors this conclusion­—with respect to a loan of $2.5 million or more, the power to exercise an option or right does not clog the equity of redemption if it “is not dependent upon the occurrence of a default with respect to such loan, forbearance, mortgage or security interest.”7 Accordingly, under both New York and New Jersey law, it appears that a borrower’s default under a third-party contract (such as a ground lease) concerning an independent obligation, which leads to the termination of the ground lease and a new lease between the ground lessor and the lender, may lawfully provide the lender with an independent path to the collateral.

Additional Advantages

Notwithstanding the foregoing, the fee mortgagee may structure loan documentation to provide an avenue to realize on the collateral without having to foreclose on the mortgage.8 The reason the foregoing may present a relative advantage to the leasehold mortgagee, though, rests on practicality. The fee mortgagee’s arrangement (for example, an option to acquire an equity or other ownership interest in the collateral or in the property-owning entity), since it may not be conditioned upon a default under the mortgage, will likely have to be bargained-for by the fee mortgagee, at a possibly substantial cost. The “new lease” mortgagee protection, on the other hand, is a standard clause requested and granted in typical leasehold mortgage financings, and will not necessarily require additional negotiation or consideration.

While, it should be noted, the lender will probably be required to pay to the ground lessor all sums then due under the ground lease as a condition to execution and delivery of the new ground lease (i.e. unpaid ground rent), this cost likely pales in comparison to the cost of litigating foreclosure. In addition, while transfer taxes will be assessed in connection with a foreclosure sale, there may not be transfer tax payable in connection with the new lease (provided that, among other things, the term9 of the new lease and any options for renewal do not exceed 49 years).10

The “new lease” option may also be a significant time-saver when compared with the judicial foreclosure process. It was reported in April 2013 that the average time to complete a foreclosure in New York was 1,049 days (the longest foreclosure timeline of any state).11 The new lease process, on the other hand, takes only as long as is necessary for the ground lessor to deliver default notices and for eviction proceedings to run their course.12 It should be noted, of course, that the borrower may fight the termination of the ground lease and subsequent eviction and may otherwise avail itself of litigation options which may cause delays, but it is unlikely that these courses of action would cause the “new lease” process to last longer than the judicial foreclosure process.

Another possible advantage of the “new lease” option is that the lender may simultaneously pursue foreclosure and the new lease option. In New York, without the court’s permission, a lender may not maintain another action on the underlying debt during the pendency of a foreclosure action.13 Because the leasehold mortgagee does not need to initiate or maintain an action in order to pursue a new lease with the property owner, though, the limitations of R.P.A.P.L. §1301 are inapplicable. The lender and the ground lessor should realize, of course, that their communications may be discoverable and that those communications should be limited in nature and should only concern such topics as whether ground lease defaults exist and whether the lender qualifies for the leasehold mortgagee protections under the ground lease.

Drafting Considerations

The lender and its counsel must carefully navigate these issues. To that end, the lender and its counsel may want to consider certain “belt and suspenders” drafting options while they are originating a leasehold mortgage loan. The lender and its counsel should be careful to ensure that the “new lease” provision and any other leasehold mortgagee protections agreed to by the ground lessor, such as the granting of cure rights to the lender with regard to ground lessee defaults, should be included in the ground lease itself and not in a ground lessor’s estoppel or any other document delivered to the lender in connection with the loan.

Borrowers and their counsel may request that the “new lease” leasehold mortgagee protection only be available if the ground lease termination results from (1) the ground lessee’s rejection of the ground lease in bankruptcy or (2) other defaults not curable by the lender, but granting such requests may frustrate the intents of the clause and substantially impact credit ratings in securitizations.

Consideration should also be given to including a representation in the loan documentation that each and every provision of the loan documentation has been mutually negotiated, prepared and drafted, and that each party thereto has been represented by legal counsel; it might also be advisable to ask the borrower and ground lessor to include similar language in the ground lease. This language may be helpful during litigation in a state, like New Jersey, where fairness has been identified as an important factor in equity of redemption cases.14

In these states the court may see the lender as inherently negotiating from a position of power vis a vis the borrower, and the sophistication of the borrower and its counsel may be relevant.15 Fairness isn’t necessarily a consideration in New York, where “even by express agreement made at the inception of the instrument, the debtor may not waive his right to redeem.”16

Joshua S. Sohn is a partner in the litigation group, Jason R. Goldstein is a partner in the finance group and Joseph B. Rothenberg is an associate in the real estate group of DLA Piper.

ENDNOTES:

1. Modification of standard leasehold mortgagee protections (see footnote 2, below) may require exceptions to standard representations in a securitization.

2. http://www.standardandpoors.com/prot/ratings/articles/en/us/?articleType=HTML&assetID=1245339902571

3. Restatement (Third) of Property: Mortgages, §1.6(a).

4. See, e.g., Polish Nat’l Alliance v. White Eagle Hall Co., 98 A.D.2d 400 (N.Y. App. Div. 2d Dept. 1983); First Fed. S&L Ass’n v. Smith, 83 A.D.2d 601 (N.Y. App. Div. 2d Dept. 1981); Boyarsky v. Froccaro, 125 Misc. 2d 352 (N.Y. Sup. Ct. 1984); Mooney v. Byrne, 163 N.Y. 86 (N.Y. 1900); Wallace v. McCabe, 41 Misc. 2d 483 (N.Y. Sup. Ct. 1964); Sakow v. Bossi, 30 Misc. 2d 110 (N.Y. Sup. Ct. 1961); Baugham v. Slane, 181 Misc. 1041 (N.Y. Sup. Ct. 1943); Lee v. Beagell, 174 Misc. 6 (N.Y. Sup. Ct. 1940); Mann v. Sterling Holding Corp., 14 Misc. 2d 818 (N.Y. Sup. Ct. 1958); Gitlin v. Schneider, 42 Misc. 2d 230 (N.Y. Sup. Ct. 1964).

5. People ex rel. Grissler v. Dudley, 58 N.Y. 323, 329 (N.Y. 1874).

6. Mercer County Improvement Auth. v. Trenton Studios, 2008 N.J. Super. Unpub. LEXIS 1116, 32 (N.J. App. Div. Aug. 21, 2008).

7. New York General Obligations Law §5-334.

8. It should be noted that the question of whether the simultaneous origination of mortgage and mezzanine debt by one lender (and the application of the doctrine of “clogging the equity of redemption”) is outside the scope of this article.

9. The “new lease” mortgagee protection typically provides that the new lease shall be for the remaining term of the terminated ground lease.

10. NY CLS Tax §1401(e)

11. http://www.upi.com/Business_News/Real-Estate/2013/04/15/Foreclosure-processing-time-at-new-high/3401366060350/

12. These proceedings typically last between 1-6 months.

13. R.P.A.P.L. §1301(3); Marine Midland Bank N.A. v. Lake Huntington Dev. Group, Inc., 185 A.D.2d 395, 395 (N.Y. App. Div. 3d Dept. 1992), citing Dollar Dry Dock Bank v. Piping Rock Bldrs., 181 A.D.2d 709 (N.Y. App. Div. 2d Dept. 1992).

14. Humble Oil & Refining Co. v. Doerr, 123 N.J. Super. Ct. 530, 549 (Ch. Div. 1973).

15. Id. at 549.

16. Gitlin v. Schneider, 42 Misc. 2d 230, 237 (N.Y. Sup. Ct. 1964), quoting Mooney v. Byrne, 163 N.Y. 86, 57 N.E. 163 (N.Y. 1900).