Presented By: Kasowitz Benson Torres LLP
Mezzanine Loans: Avoiding Surprises in Foreclosures
By Jennifer S. Recine, partner and co-chair of Kasowitz Benson Torres’ Real Estate Litigation Group, and Darwin Huang, real estate transactional partner at Kasowitz Benson Torres December 6, 2022 3:00 pmreprints
The COVID pandemic brought with it both a significant increase in mezzanine loan defaults and a frustratingly unpredictable legal landscape for mezzanine lenders and borrowers. During the pandemic, mezzanine borrowers may have thought that they were protected by the New York State-mandated foreclosure moratorium. As it turned out, mezzanine borrowers were not protected by that moratorium because the Uniform Commercial Code (UCC), which governs mezzanine loans, provides a “quasi” foreclosure mechanism — a sale of the pledged equity interest in the property owner — that operates outside of the court system. Certain mezzanine borrowers, however, have been able to prevent such “quasi” foreclosures with the aid of the judicial system, as discussed below.
The increase in mezzanine loan defaults has also created a new class of unexpected equity holders: mezzanine lenders who end up holding the equity after a UCC foreclosure, and thereby assuming responsibility for construction or development projects they are ill-prepared to manage, and for repayment of the more traditional mortgage loans secured by the frequently distressed underlying real property assets. While mezzanine lenders always risked becoming equity holders, in better economic times the risk was far lower. The increase in mezzanine loan defaults arising first from the pandemic, and now from rising interest rates and a softening real estate market, has put many more mezzanine lenders in the position of project sponsor than was contemplated prior to March of 2020.
In this environment, mezzanine borrowers and lenders alike must assess the challenges and opportunities that arise when a mezzanine loan is in default.
Mezzanine loans: Greater return with a catch
Mezzanine loans are sources of additional funds when the proceeds of mortgage loans and equity are not adequate to meet borrowers’ financing needs. Mezzanine loans are attractive to lenders because they typically come with higher interest rates than traditional mortgage loans. As always, there is no free lunch: The higher interest brings with it higher risk.
Unlike traditional mortgage loans, which are secured by interests in real property, mezzanine loans are secured by equity interests in the property owner/mortgage borrower. The process for foreclosing on a defaulted mezzanine loan is governed by UCC Section 9-610(a), which provides that “after default, a secured party may sell, lease, license or otherwise dispose of any or all of the collateral in its present condition or following any commercially reasonable preparation or processing.” When a mezzanine lender forecloses, it initiates a “UCC sale” of the pledged equity interest in the mortgage borrower. If no purchaser steps up during the UCC sale process to pay more for the equity, the mezzanine lender will frequently end up owning the equity itself through a credit bid. With the equity comes the responsibility for developing and/or operating the property, and servicing the mortgage loan.
Mezzanine foreclosures during COVID: Two case studies
Case law concerning UCC foreclosures has not been well developed. The pandemic brought a few interesting — and conflicting — court decisions that blurred the distinction between a traditional mortgage foreclosure and a UCC sale initiated after a mezzanine loan default.
In one case, 1248 Assoc. Mezzii LLC v. 12E48 Mezz II LLC, 2020 WL 2569405 at *1 (Sup Ct. N.Y. May 18, 2020), the plaintiff, a mezzanine loan borrower, sought an injunction to prevent the defendant lender from conducting a sale of the plaintiff’s membership interest in the financed property after the plaintiff defaulted. The plaintiff argued that the March 20, 2020, executive order of former Gov. Andrew M. Cuomo, which placed a moratorium on residential and commercial foreclosures, applied to prevent the UCC foreclosure. The lender countered that the executive order was inapplicable since it addressed foreclosures on real property, a judicial proceeding, whereas the sale at issue was for a disposition of collateral pursuant to Article 9 of the UCC, and therefore a nonjudicial proceeding. The court sided with the lender, explaining that the executive order “addresses enforcement of a judicially ordered foreclosure, [but the] sale of the pledged interests in this matter results from the parties’ agreement, as guided by the UCC,” and was therefore unaffected by the executive order.
In seeming diametric opposition, the court in D2 Mark LLC v. OREI VI Invs. LLC, 2020 WL 3432950 at *4 (Sup. Ct. N.Y. Cnty. June 23, 2020), issued a preliminary injunction halting a UCC foreclosure sale of equity interests in a hotel after the plaintiff defaulted on its mezzanine loan, finding that “the proposed foreclosure sale may not be commercially reasonable” as required by Article 9 of the UCC, given the context of pandemic-era restrictions. The borrower’s expert testified that the sale was not “crafted in a way to accommodate New York City’s ‘stay at home’ orders and other state and local mandates in response to COVID-19.” Specifically, the hotel could not be inspected for 27 days of the 36-day notice period initiated by the lender, as ordinarily required under Article 9 of the UCC. Accordingly, the court sided with the borrower, citing former Gov. Cuomo’s executive orders, relying upon “persuasive authority that support plaintiff’s contention that what is reasonable during normal business times, may not be reasonable during a pandemic.”
These are just two of a number of examples of the courts’ conflicting decisions about the extent to which a mezzanine lender can close on a UCC sale of a defaulted mezzanine loan under extenuating circumstances. Now that the pandemic-related restrictions have been lifted, mezzanine loan foreclosures should have more predictable outcomes, leaving the rights of most mezzanine lenders protected against defaulting borrowers. That said, the magnitude of mezzanine loans in jeopardy as the market continues to soften ensures that there will be a significant development of case law during this market cycle, and it is unclear whether that growing body of case law will favor mezzanine lenders or borrowers.
Mezzanine lending to stabilized assets vs. construction loans
The decision of a mezzanine lender to foreclose in the first place should include consideration of the quality of the underlying real estate and the lender’s ability to take on the responsibilities of the equity owner. Whether the real property at issue is a stabilized asset or a more complicated construction or development project is a key consideration in determining whether the result of the UCC foreclosure will be successful for the mezzanine lender.
If a mezzanine lender forecloses and becomes the equity owner of a stabilized asset — for example, a fully leased office building, something that few would have predicted pre-pandemic — the asset will likely generate a reliable source of income, making ongoing operation of the asset more manageable for the mezzanine lender, or would-be equity owner of the asset after the UCC foreclosure.
If, as is more often the case when a mezzanine lender is considering a UCC foreclosure, the underlying real estate is in distress, under construction or mid-development, the burden of overseeing — and often, paying for — the project’s completion complicates the question of whether, and how, to take over the equity. Completion costs may include budget overruns as a result of rising costs of materials and construction delays, which likely already occurred prior to the foreclosure and led to the default in the first place. In addition, when the mezzanine lender forecloses on its equity collateral, mechanics’ liens on the real estate are not extinguished, which adds an additional financial burden for the mezzanine lender.
We have seen an increase in the number of mezzanine lenders that have not thought through the consequences of the equity ownership taken on after a UCC foreclosure. Construction or development projects, including projects with significant liens and other issues, put those mezzanine lenders in a complicated position if they do not have the financial wherewithal and development expertise to navigate the project they are taking over. Mezzanine lenders should evaluate all attendant risks and liabilities and be well prepared to take on the responsibilities associated with equity ownership prior to initiating a UCC sale relating to a construction, development project, or an otherwise unstable asset.
Mezzanine financing can be an excellent investment opportunity. Investors should stay abreast, however, of the evolving state of the case law governing UCC foreclosure in evaluating whether, and how, to proceed. In addition, mezzanine lenders should consider the risks involved in assuming the equity upon a UCC sale.