In many cases, borrowers and lenders are working together to weather this crisis. A forbearance agreement is often the first step—after a pre-negotiation agreement is entered into.
Many leveraged real estate projects are under increased strain due to the economic fallout from the coronavirus pandemic. For mezzanine lenders—including the mezzanine lender who is no longer willing to forbear or the mezzanine lender who has always had a “loan to own” view of its mezzanine loan—this circumstance may mean pursuing remedies under the UCC. While there are differences in states’ enactments of and case law interpreting the UCC (and other laws that may supplement or supplant the UCC), the following general principles apply to an exercise of remedies under the UCC.
Mezzanine Loans and Collateral
A real estate mezzanine loan is a loan made by a lender to the indirect owner(s) of real property. The mezzanine borrower does not directly own real property—it owns equity interests in the entity that owns real property (or, in the case of multiple levels of mezzanine debt, in the equity owner that is “higher” in the debt stack). Accordingly, in a mezzanine loan, the mezzanine lender takes a pledge of the equity interests owned by its borrower in order to secure its loan. The pledged equity interests usually represent 100 percent of the interests in an LLC. A mezzanine loan is almost always part of a capital structure where the real property owner is the borrower on a mortgage loan.
A simple mezzanine and mortgage loan structure would look like the diagram below:
Exercise of Remedies: Strict Foreclosure
For many mezzanine lenders, particularly those interested in a “loan to own” strategy, strict foreclosure may seem attractive. A strict foreclosure is the equivalent of a “deed in lieu” in a real estate context—the mezzanine lender accepts the collateral in full or partial satisfaction of the debt. However, the UCC provides non-waivable protections to the debtor and other parties with an interest in the transaction (e.g., a guarantor) or the collateral (e.g., a junior secured party). Those protections involve notifying the debtor and other parties with an interest in the collateral of the secured party’s proposal to accept the collateral. If the proposal is for a partial strict foreclosure (so that the secured party retains its rights to pursue a deficiency), then guarantors must also be notified. The debtor’s agreement to the strict foreclosure is required (although in the case of an unconditional proposal for full satisfaction of the debt, if the debtor fails to respond within a specific period, it is deemed to have agreed). If an objection is received from a party entitled to notice, then the secured party cannot proceed with the strict foreclosure. The UCC requirements for a strict foreclosure are largely procedural, but the lender must act in good faith.
Exercise of Remedies: Foreclosure Sales
Commercially Reasonable Disposition
A secured party has the right to cause a disposition of its collateral, and in some cases may purchase the collateral in that disposition. When collateral is being disposed of, the UCC provides protections to the debtor and to other parties with an interest in the transaction or the collateral.
The primary protection is that “[e]very aspect of a disposition of collateral, including the method, manner, time, place, and other terms, must be commercially reasonable.” Aspects of commercial reasonableness include the amount of notice given to the debtor and other parties, the efforts made to locate buyers (e.g., advertising and contacting brokers in the relevant industry), the content of published notices of the disposition and how the secured party determined the amount of its credit bid if it wants to purchase the collateral.
The UCC provides little guidance as to what is commercially reasonable, and the secured party and its advisors will need to make that determination based on the nature of the collateral. The UCC does state that “[a] disposition is made in a commercially reasonable manner if the disposition is made … in conformity with reasonable commercial practices among dealers in the type of property that was the subject of the disposition.” This leaves the secured party to look to case law and its advisors as to how to proceed.
Private Sale vs. Public Sale
A secured party generally cannot purchase the collateral at its own private sale. A lender who wants to purchase the collateral therefore will need to conduct a public sale. The UCC again provides limited guidance on the differences between a private sale and a public sale (at which the secured party can purchase the collateral). The UCC states that a public disposition “is one at which the price is determined after the public has had a meaningful opportunity for competitive bidding. ‘Meaningful opportunity’ is meant to imply that some form of advertisement or public notice must precede the sale (or other disposition) and that the public must have access to the sale (disposition).” Courts have interpreted this language not to require an outreach to the public generally, but to the types of buyers that are the likely purchasers for the particular type of asset. Again, case law and advisors will need to be consulted, taking into account whether the secured party wants to purchase the collateral and the additional time and expense that may be involved in conducting a public sale.
Diligence and Planning Before Action are Critical
Before deciding how to proceed in exercising (or forbearing from exercising) its remedies, a mezzanine lender needs to do a careful review of the transaction documents and related information.
Caroline Harcourt is a partner in Pillsbury’s Real Estate practice. Lynn Soukup is a partner in Pillsbury’s Finance practice, and Jacob Axelrod is a senior law clerk.
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