For hundreds of years, mortgage lenders have been looking for ways to avoid both the procedural delays of the mortgage foreclosure process and the borrower's equitable right of redemption (ie, the right to redeem property secured by a loan that has been accelerated prior to foreclosure). In the 1600s, English courts protected a borrower's right of redemption by creating the doctrine against "clogging the equity of redemption," which had the effect of invalidating any mortgage term that restricted the borrower's right of redemption. Through the following centuries and into modern times, courts have shown a strong inclination to preserve this right.i
In today's mortgage lending world, the most common way that lenders attempt to skirt foreclosure (and its potential delays) is by taking a pledge of the equity interests in the borrower, allowing the lender to foreclose on the equity interests through a UCC sale (which is a quick process that can typically be completed in 90 days) instead of foreclosing on the real estate collateral (which in some jurisdictions can take longer than a year). This is often referred to as the "dual collateral" approach or an "accommodation pledge." However, even after hundreds of years, the parameters of the "clogging" doctrine remain unclear, and the value of an equity pledge may be outweighed by the potential litigation that could arise in connection with an attempted enforcement of the pledge.
The Dual Collateral Approach
If foreclosing on an equity pledge is quicker and more efficient than foreclosing on a mortgage, why don’t lenders skip the mortgage altogether? Despite the longer process, mortgages provide a couple of unique advantages over equity pledges. Encumbering the property with a mortgage lien ensures that if the borrower transfers or encumbers the property without the mortgage lender's consent, the mortgage will be there to protect the lender against such prohibited actions. Additionally, if a mortgage lender forecloses on its mortgage lien, such foreclosure will not only wipe out junior liens but also ensure that the foreclosing entity does not step into any of the borrower's other obligations and responsibilities. Foreclosing on the equity of the borrower would subject the lender to most of the liabilities of the borrower; the lender will step into the borrower's shoes.
The true value of the dual collateral approach is that a lender can decide at the time of foreclosing whether it would be more beneficial to foreclose quickly via UCC sale or to extinguish subordinate liens via mortgage foreclosure. Furthermore, unless prohibited by statute or the courts, after foreclosing on the pledge, the lender can elect at a later date to foreclose on its mortgage in order to take care of junior lien issues.
A pair of decisions by the Supreme Court of the State of New York has further obfuscated the enforceability of equity pledges for loans also secured by mortgages.
HH Cincinnati Textile L.P. v. Acres Capital Servicing LLC
In HH Cincinnati, a borrower was involved in the acquisition and redevelopment of commercial properties and obtained a loan from a lender that was secured by both a mortgage on one of its commercial properties and a pledge of the equity in the borrower. After the borrower defaulted, the lender attempted to foreclose on the equity pledge via a UCC sale. The borrower filed suit to obtain an injunction to halt the UCC sale, arguing that, among other things, the lender unlawfully "clogged" the borrower's right of redemption.
The court denied the borrower's motion for preliminary injunction but did not rule on the borrower's clogging claim. However, in a statement in the court's opinion not directly related to the ruling, the court stated that because the borrower retained redemption rights under the UCC, the borrower's right of redemption under commercial foreclosure laws was not clogged.
HH Mark Twain LP v. Acres Capital Servicing LLC
About two years after the HH Cincinnati decision, in HH Mark Twain, a case arising out of the same transaction as HH Cincinnati, the borrower brought new claims against the lender following completion of the UCC sale that was at issue in the HH Cincinnati decision, alleging that the sale of the equity by the lender was "commercially unreasonable" and violated its right of redemption. The lender filed a motion to dismiss the claims.
In deciding on the lender's motion to dismiss, the court ruled that most of the borrower's claims may continue, and the court specifically stated that it had not ruled on the borrower's clogging claims in its HH Cincinnati decision. Thus, any clarity lenders may have found in the HH Cincinnati decision was undone by the ruling in HH Mark Twain. Even after successfully completing the UCC sale, the lender still found itself embroiled in litigation.
As a possible alternative, a lender can structure a transaction as separate mortgage and mezzanine loans, with the mezzanine loan secured by an equity pledge. After a default, the lender could choose to enforce its remedies under either the mortgage loan through the mortgage foreclosure process or its remedies under the mezzanine loan through the UCC sale process. However, this approach does not necessarily relieve the lender of the risk posed by the dual collateral approach, as case law has made clear that courts generally see through any attempt to clog the right of redemption. Lenders utilizing this structure should make every effort to establish that the mezzanine loan is a separate transaction made for independent and valuable consideration.ii
Additionally, a mortgage lender utilizing the dual collateral approach could add as a non-recourse carveout any losses suffered by the lender as result of the borrower raising the clogging defense. While the enforceability of such a carveout has not been tested, including such a carveout may cause a borrower to pause before raising the clogging defense due to the potential liability to the non-recourse carveout guarantor.
The decisions in HH Cincinnati and HH Mark Twain make it clear that the dual collateral approach includes a significant risk that borrowers will raise the clogging argument as a defense to any UCC foreclosure of the equity, leading to a potentially long and costly legal battle. While structuring alternatives exist, the clogging defense still poses a risk. If an expeditious foreclosure process is the lender's primary goal, the lender may be jumping out of the frying pan and into the fire by attempting to foreclose on an equity pledge.
i See eg, Humble Oil & Ref. Co. v. Doerr, 303 A.2d 898, 907-08 (N.J. Super. Ct. 1973)
ii See eg, Russo v. Wolbers, 323 N.W.2d 385, 390 (Mich. Ct. App. 1982); Nau v. Vulcan Rail & Constr. Co., 36 N.E.2d 106, 110 (N.Y. 1941)