Over the last decade, commercial lenders have increasingly relied on “accommodation” pledges to obtain additional security in connection with mortgage loans. The typical structure involves a property-owning borrower entity obtaining financing secured by a mortgage, while the borrower’s sole member or parent entity—often referred to as the “mezzanine entity”—guaranties the mortgage loan. The mezzanine entity’s guaranty is separately secured by a pledge of its 100% ownership interests in the borrower.
If a borrower defaults, a mortgage lender must typically pursue a lengthy judicial foreclosure process. Armed with an accommodation pledge, however, the lender can pursue a more expeditious Uniform Commercial Code (“UCC”) sale of the mezzanine’s 100% equity interests in the borrower. Article 9 of the New York UCC requires the lender to market and conduct the public auction of the equity interests in a commercially reasonable manner. Upon consummation of the auction, the winning bidder will own 100% of the membership interests in the borrower entity, and thus control the underlying property. If the lender’s credit bid is the highest bid, the lender has effectively obtained control of the property in as little as a few months.
Unlike a mortgage foreclosure, a UCC sale of a borrower’s equity under a pledge does not extinguish subordinate liens against the assets of the borrower itself, and the lender takes ownership of the borrower via a UCC sale of the borrower’s equity subject to the obligations of the borrower and all liens on the borrower’s assets.
As accommodation pledges have become more prevalent, commercial real estate practitioners have debated whether they violate the centuries-old equitable doctrine that prohibits lenders from “clogging” a borrower’s right to pay off its mortgage loan and redeem the property at any time prior to the foreclosure sale. This right, known as the borrower’s “equity of redemption,” generally cannot be waived by an unsophisticated borrower under New York law. But even sophisticated commercial borrowers have argued that accommodation pledges clog their redemption right, as the UCC sale process shortens the amount of time they have to redeem the debt and is not always subject to judicial oversight. “Where the redemption right is lawfully waived, or where it is not actually impaired, courts will hopefully feel comfortable ruling for the lender and rejecting “clogging” claims, which will, in turn, provide a high level of reliability in structuring multi-tiered real estate financings,” as noted by Zachary G. Newman, Co-Chair of the American Bar Association’s Section of Litigation Commercial and Business Litigation Committee, and lead counsel in the Atlas Brookview case.
Until recently, no New York court had squarely addressed whether enforcing a mezzanine pledge taken in conjunction with a mortgage as security violates a borrower’s equity of redemption. At least one New York court had previously declined to enjoin a UCC sale based on a borrower’s clogging challenge and expressed doubt about the claim. HH Cincinnati Textile L.P. v. Acres Capital Servicing LLC, 2018 WL 3056919, at *3-4 (Sup. Ct. N.Y. Cnty. June 20, 2018) (Ostrager, J.). But the court later held that the denial of injunctive relief did not constitute a ruling on the merits.
In November 2021, the first New York court to address the issue on the merits dismissed a commercial borrower’s claim that the collateral pledge granted by its parent entity violated the equity of redemption. Atlas Brookview Mezzanine LLC v. DB Brookview LLC (Index No. 653986/2020; entered on Nov. 18, 2021). In Atlas Brookview, the borrower obtained a $64.9 million mortgage loan secured by a multifamily development in Illinois. The mortgage was governed by Illinois law, and the rest of the loan documents were governed by New York law. As additional security for the loan, Atlas Brookview Mezzanine LLC (“Atlas Mezzanine”), which owned 100% of the borrower entity, guaranteed the entire loan and entered into a pledge agreement securing the guaranty.
Following pre-maturity defaults in June, 2020, the lender scheduled a UCC foreclosure sale scheduled for August 25, 2020. The day before the scheduled auction, the court granted temporary injunctive relief delaying the sale. However, on October 15, 2020, Justice Andrew Borrok denied injunctive relief and noted that no New York court had sustained a “clogging the equity” challenge. The court also recognized that granting relief “would be upending the entire mezzanine lending business.” Following the denial of injunctive relief, the UCC foreclosure sale was rescheduled and consummated on February 17, 2021, and the lender became the owner of the borrower entity and gained control of the property.
Atlas Mezzanine’s other challenges to the UCC sale procedures were rendered moot by the consummated sale, but it continued to pursue its declaratory judgment claim arguing that the pledge agreement clogged the borrower’s equity of redemption and was void ab initio, thus requiring an unwind of the sale.
The lender moved to dismiss the declaratory judgment claim and argued that upholding the claim would seriously disrupt billions of dollars of mezzanine financing in New York state. In addition, the lender argued that a borrower retains a right to redeem the debt under Section 9-623 of the UCC until the auction is conducted. Moreover, the lender noted that the borrower was a sophisticated developer represented by competent counsel of its choice and that it expressly endorsed and benefitted from the collateral pledge structure. Further, the lender pointed to Illinois statutes that explicitly allow sophisticated mortgage borrowers to waive the right of redemption.
The borrower argued that the equity pledge structure had never been sanctioned by a New York court, and that it clearly violated its equity of redemption by cutting short the time to redeem the debt. The borrower argued that New York law does not permit any borrower to waive the redemption right, and that “the market effect if the motion [to dismiss] is granted, is that the structure will be viewed as sanctioned … and mortgage lenders everywhere will slap an equities pledge on top of every mortgage loan.” The borrower also argued that the streamlined UCC sale process could allow a lender to foreclose in as little as 30 days.
The Court did not rely on the Illinois law provisions that permit a borrower to waive its right of redemption. Nevertheless, the court rejected the borrower’s argument that the UCC sale had been conducted as a fire sale, and noted that the borrower had months to redeem the debt. Accordingly, the court appeared to recognize that mezzanine pledges do not clog a mortgage borrower’s equity of redemption because the borrower retains the right of redemption provided by UCC § 9-623.
Separately, the Court noted that “commercially sophisticated people represented by able counsel agree[d] that the collateral is sufficient to support the loan and voluntarily enter[ed] into a loan agreement that contemplates additional collateral.” Consistent with well-settled New York principles that seek to afford certainty to sophisticated commercial real estate parties, the court recognized that the borrower “entered into this structure voluntarily with the advice of good counsel” in connection with a $65 million loan. Accordingly, the court dismissed the declaratory judgment claim with prejudice.
The Court’s decision on the motion to dismiss, issued from the bench, recognized that the prior ruling in the HH Mark Twain case did not dismiss the equity-clogging claim on the merits. However, the Court found that prior decision merely stood for the proposition that the denial of a preliminary injunction “didn’t foreclose the issue at the motion to dismiss stage.”
Justice Borrok’s decision recognized that equity pledges are regularly negotiated and consented to by commercial parties, and that they constitute consensual “business terms” that are not foisted upon unsophisticated borrowers. Because the decision relied on the principle that agreements between sophisticated parties are generally enforceable, it provides comfort to commercial lenders that continue to obtain accommodation pledges in commercial real estate transactions. Nevertheless, the decision was issued from the bench and remains unreported, and no appellate court has addressed the issue. Accordingly, borrowers may continue to lodge challenges to accommodation pledges and the case law may continue to evolve until an appeals court settles the issue.
