Closing Opinions for Dual Collateral Loans: The Issue of “Clogging”

The Issue of “Clogging”

Real estate loan structures considered “non-traditional” in years past have become commonplace in modern finance. For example, where a conventional mortgage lender’s underwriting requirements include an 80% loan-to-value limitation with a prohibition against subordinate liens on the real estate, borrowers often seek to finance some portion of the remaining 20% component through a mezzanine lender that secures its loan with a lien on the equity interests of the borrowing entity. A more aggressive private lender unconstrained by such institutional requirements might seek to hedge the greater risk of a higher loan-to-value transaction with a “dual collateral” package that includes both a mortgage lien on the real estate and a UCC lien on the controlling interest of the borrower. To varying degrees, both implicate an ancient doctrine rooted in English common law known as “clogging the equity of redemption,” as was seen in a recent New York case discussed below.

This doctrine has implications for lawyers giving enforceability opinions in financing transactions.

What is “Clogging”?

One of equity’s long revered maxims, the prohibition against clogging the equity of redemption rests on the foundational principle “once a mortgage, always a mortgage.” See 4 Pomeroy, Equity Jurisprudence (5th ed., 1941), §. 1193 at 568 et seq. More expansively, when a borrower grants a mortgage on its property to a lender as security for a debt, it must always have the right to repay the debt, thereby extinguishing any claim of the lender to the property, and this right cannot be waived or abandoned as part of the initial transaction. Stated as such, the doctrine’s logic appears self-evident and uncontroversial - certainly not something that could have intrusive implications in modern real estate finance. In practice, however, it is not always as simple as it sounds.

The doctrine originated in sixteenth century England, when borrowers would give lenders a deed to the mortgaged property to be held in trust but which the lender could immediately record upon a default, thereby transferring title from the borrower to the lender without judicial process. Indeed, while some states use the term “mortgage” to describe the relevant security instrument, many other jurisdictions still employ the English common law nomenclature, a “deed in trust” or a variant, a “deed of trust.” The clogging doctrine was developed to rein in the aggressive and often unscrupulous practices of lenders seizing upon relatively minor borrower missteps to declare a mortgage default, accelerate the maturity date, and reap a windfall when the borrower could not come up with the funds needed to satisfy the debt. The excess of the property’s fair market value over the then outstanding mortgage amount was thus irrevocably forfeited by the borrower to the lender upon the title transfer. In that sense, the clogging doctrine might also be seen as echoing the more familiar principle of broader jurisprudential applicability, “equity abhors a forfeiture.”

Distilled to its essence, the doctrine posits that regardless of how a transaction is structured, if it is fundamentally a loan to a borrower secured by real estate, the borrower retains the equitable right to “redeem” its property up until that right is cut off through judicial foreclosure. This not only prohibits a mortgage lender from taking a deed to be held in escrow pending a borrower default, but also precludes the lender’s option to purchase the property. The logic for this is that a lender with such a right remains in a position to frustrate the borrower’s redemption rights because upon the lender’s exercise of the option the borrower would have lost its ability to reclaim unfettered ownership of the property.

The doctrine is often relied upon to recharacterize various transactions that may take the shape of a sale-leaseback of real estate with a lessee purchase option, or even an outright sale coupled with a seller’s repurchase option. Where the substance as a mortgage loan transaction predominates over the form as a sale transaction, most courts sitting in equity will treat it as the former. The focus of this article, however, is not on invocation of the doctrine for transaction recharacterization purposes, but on the availability of the private UCC remedy of executing on the equity pledge in lieu of foreclosing on the real estate in a judicial proceeding when both forms of security are given for the same loan.

New York Law: H.H. Cincinnati Textile L.P. v. Acres Capital Servicing LLC

The clogging doctrine arose recently in this context in a case venued in New York County, H.H. Cincinnati Textile L.P. v. Acres Capital Servicing LLC, Index No. 652871/18 (Sup. Ct., N.Y.Co., 2018). In H.H. Cincinnati a lender financed the redevelopment of two historic properties in the Midwest by a borrower (a partnership) whose sole asset consisted of the properties. The project involved numerous complexities, but for purposes of this article the salient feature is that as security for the loan the borrower granted the lender both a mortgage on the property and a pledge by the partners of their equity interests in the borrower.

Significantly, this was structured as a single loan with dual collateral rather than broken down into two separate loans, one a real estate-secured mortgage loan and the other an equity-secured mezzanine loan. After default, the lender thus had the option of foreclosing on the real estate pursuant to the mortgage or the partnership interests pursuant to the equity pledge. Substantively, the result of either would be the same in that the lender gains control of the real estate, directly in the former case and indirectly in the latter. Procedurally, however, there is a dramatic difference: Judicial foreclosure of the mortgage can easily consume two to three years in some states, while a private sale pursuant to UCC Article 9 requires only “commercial reasonableness” and ten days’ prior notice. (See UCC §§ 9-610 - 612.)

When the lender advertised the sale of the partnership interests (to be conducted via auction at the office of lender’s counsel), the borrowers moved to enjoin it, arguing that allowing a mortgagee to proceed in that fashion amounted to an impermissible “clog” on their equity of redemption. The court disagreed, noting that the UCC afforded the borrowers the right to “redeem” their partnership interests right up until the time of the execution sale. (See UCC §9623.) Thus, in the court’s view, the right remained unfettered, albeit in a more constrained way.

Dual Collateral Loans and Third-Party Closing Opinions

Given the frequency of New York “choice of law” provisions in mortgage transactions, H.H. Cincinnati warrants consideration by real estate finance practitioners. At present, it is unclear whether the case can be considered “New York law,” as it is an unpublished trial level opinion decided on a preliminary injunction motion. It is equally unclear whether other state courts facing similar facts would follow H.H. Cincinnati’s rationale even when called upon to enforce loan documents stipulating the applicability of New York law. It is certainly foreseeable that some states would consider their respective “clogging” jurisprudence to be of such inviolability that public policy dictates override the parties’ New York choice of law agreement.

For example, in C. Phillip Johnson Full Gospel Ministries Inc. v. Investors Financial Services LLC, 418 Md 86 (2011), a borrower secured a loan made by a Maryland lender with real property located in Virginia. As part of the initial transaction, the lender required a deed in lieu of foreclosure from the borrower as additional security, which it promptly recorded after declaring a default. The borrower then sued in Maryland to set aside the deed recorded in Virginia.

While expressing deference to the Virginia judiciary (whose law was of stipulated applicability per the loan documents), the court nonetheless held that under Maryland law a deed in lieu of foreclosure executed at the time of a loan origination is, in fact, a mortgage; thus, the mortgagor’s equitable interest in the property could not be extinguished short of formal foreclosure proceedings. Moreover, in applying Maryland law to reach this conclusion, the court ruled that “the escrow deed finance arrangement is deeply repugnant to the public policy of this State.” Id., 418 Md. at 103.

The opinion references Peugh v. Davis, 96 U.S. 332 (1878), for the proposition that a mortgagor’s equity of redemption is “inseparably connected with a mortgage” and that “[t]his right cannot be waived or abandoned by a stipulation of the parties made at the time, even if embodied in the mortgage.” It is important to note, however, that C. Phillip Johnson Full Gospel Ministries Inc. and Peugh were focused on such waivers when extracted from the mortgagor at the time of the initial loan transaction. Both cases point out that a mortgagor can waive its equity of redemption if supported by consideration wholly separate from the loan itself, such as in the context of a workout after an event of default has already occurred. Cf. Ringling Joint Venture II v. Huntington National Bank, 595 So.2d 180 (1992).

Even in this context, however, it is important to be cognizant of the distinction between a mortgagor’s equitable right of redemption, versus a mortgagor’s statutory rights of redemption which vary from state to state. For example, in U.S. Bank National Assoc. v. RBP Realty, 888 N.W.2d 699 (Minn. App., 2016), the Minnesota Court of Appeals held that a state statute granting a mortgagor the right to redeem its property within six months after a sheriff’s sale was absolute and non-waivable. It thus ruled that a post-default workout agreement between the mortgagee and mortgagor to the contrary was unenforceable and that the mortgagor had the right to redeem notwithstanding the contrary provisions contained in the agreement.

Conclusion

Thus, the most prudent course of action when rendering third party opinions for dual collateral loans affecting real property in states where the law is not yet firmly settled would be to flag this issue as a possible caveat to enforceability. Also, because a state’s position on clogging may be considered a fundamental public policy issue, it is possible that a state’s law may override the parties’ choice of law stipulation in the loan documents.