Distressed Real Estate During COVID-19: New York State Court Order Finds UCC Foreclosures Are Not Suspended by New York E.O. 202.8.

The Litigation

The Manhattan hotel at the heart of the dispute faced a now-familiar situation that has played out numerous times during the crisis set off by the COVID-19 pandemic. The borrower was in negotiation for exit financing earlier this year, but negotiations broke down in the face of the uncertainty and closures caused by the pandemic. With the hotel still in default under the second mezzanine loan, but also with no clear future financing in place, the lender initiated a UCC foreclosure of its collateral (i.e., the equity interest in the parent of the property owner entity).

Much like the hotel itself, the foreclosure process was also affected by the pandemic. The closure of offices in response to the pandemic meant traditional features of a sale such as the sale occurring in person at an office had to be changed. Nonessential in-person meetings could not take place. The lender adapted to the closures and intended to conduct the sale online. At the same time, Governor Cuomo issued N.Y.E.O. 202.8, halting judicial foreclosures. Accordingly, the New York court system closed to nonessential activities, which included judicial foreclosures. N.Y.E.O. 202.8 was later updated (albeit during the subject litigation) to make clear that not simply finalizing, but also initiating, foreclosures was not allowed.

The borrower brought a lawsuit seeking injunctive relief to stop the mezzanine lender from proceeding with the UCC foreclosure sale. The borrower had two main arguments: First, the borrower argued that N.Y.E.O. 202.8 was meant to cover interests in real estate generally and so should be read to prevent the lender from foreclosing on equity interests in a company whose only asset was an indirect interest in real estate. Second, the borrower alleged the method used to conduct the sale was commercially unreasonable. The judge hearing the case initially agreed with the borrower and granted a temporary restraining order, including a notation in his order that N.Y.E.O. 202.8 covered UCC foreclosures. The foreclosing lender objected by arguing that, while N.Y.E.O. 202.8 prevents foreclosure to real estate, N.Y.E.O. 202.8 only applied to judicial foreclosures. The subject lender’s collateral was not a direct interest in real estate, but a pledge of the equity interests in an entity that had an indirect ownership interest in real estate. The lender argued that UCC foreclosures, in contrast to mortgage foreclosures, are a non-judicial remedy between the parties created by contract and governed by the provisions of the UCC, and the Executive Order upon which the borrower relied for protection did not suspend non-judicial contract remedies or the exercise of remedies under the UCC.

After a hearing on May 18, the court removed the initial notation that N.Y.E.O. 202.8 covered UCC foreclosures, effectively agreeing with the lender that UCC foreclosures were not covered by N.Y.E.O. 202.8 and that the subject UCC foreclosure may continue. The order went further, finding that injunctive relief was not appropriate in the case because monetary damages were available for the borrower after the UCC foreclosure was conducted. However, the order did not address the question of what constitutes a “commercially reasonable” sale under the UCC.

What it Means for Mezzanine Lenders and Borrowers:

In the short term, the court’s order clarifies the scope of N.Y.E.O. 202.8 and may provide mezzanine lenders comfort to proceed with a planned UCC foreclosure in New York. This may be especially true for loans involving borrowers whose projects were already in default or deemed to be under stress even before the COVID-19 pandemic. Similarly, mezzanine borrowers should not expect “cover” from N.Y.E.O. 202.8 absent some future amendment to the Executive Order by Governor Cuomo.

Mezzanine lenders should nonetheless remain cautious. The court’s order did not address the question of commercial reasonableness of a UCC sale, which the UCC imposes on all foreclosure sales. Breaking with previous market practices in the conduct of a UCC foreclosure sale comes with risks for the mezzanine lender.

Over the long term, mezzanine lenders—and especially borrowers—should consider the court’s order and evaluate how they wish to structure their financing. The court’s order that damages were an adequate remedy for an action involving real estate, albeit indirectly, should give borrowers pause who expect to be able to rely on injunctive relief because real estate is not fungible like other types of assets. This case is likely not to be the final decision on the issue as more distressed real estate projects head towards workouts and UCC foreclosures, and financing arrangements will need to be revaluated over the coming months. In many cases, mezzanine lending will still be the correct choice for the project to bridge the equity gap, but borrowers should be aware of the risks and not assume that a mezzanine loan is just another type of mortgage loan in all but name.

For more information, please reach out to your regular Pillsbury contact or the authors of this client alert.

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