INSIGHT: UCC Foreclosures, Mezzanine Loans, and Covid-19: What is ‘Commercially Reasonable’ in a Pandemic?

While mezzanine loans provide an attractive option for borrowers to finance real estate deals in good economic times, the recent economic downturn caused by the coronavirus pandemic has severely stressed mezzanine borrowers, causing some to default on their loans and others to face the very real possibility of default absent any meaningful forbearance or modification of their mezzanine loans.

Fortunately for mezzanine lenders, Article 9 of the U.C.C. provides a process for foreclosing on collateral without resorting to New York courts for help. Mezzanine lenders should proceed with caution when undertaking a nonjudicial foreclosure during the pandemic, however, as once previously acceptable approaches to disposing of collateral may now be insufficient. Since every aspect of a disposition of collateral under Article 9 of the Uniform Commercial Code (U.C.C.) must be commercially reasonable, mezzanine lenders must consider the method, manner, time, place, and other terms of the disposition to ensure it is reasonable given the present business climate. If they fail to do so, or are perceived to be trying to take advantage of the business disruption caused by the Covid-19 pandemic, courts may be expected to take action. See D2 Mark LLC v. Orei VI Investments LLC (enjoining U.C.C. sale for additional 30 days and ordering certain modifications to the notice and sale terms to account for changed market conditions as a result of the Covid-19 pandemic).

Even before the coronavirus pandemic, determining whether a disposition is commercially reasonable required a fact-intensive, case-by-case analysis. But, since customary practice and courses of dealing had emerged, foreclosing parties had some guideposts as to what had previously been considered commercially reasonable—or not—in the U.C.C. foreclosure context. Specifically, while the U.C.C. does not enumerate what constitutes a commercially reasonable disposition, it does provide general guidance in assessing secured party’s conduct. But, as the fall out of the pandemic continues to be felt by mezzanine borrowers, it is reasonable to expect that courts will increasingly be asked “what is a commercially reasonable sale … during the world-wide COVID-19 pandemic?”

In D2 Mark LLC v. Orei VI Investments LLC, the court was asked precisely that question. That case arose following the notice of a foreclosure sale following the mezzanine borrower’s first failure to make an interest payment under the terms of its mezzanine loan. In that case, the mezzanine lender was engaged in negotiations with the borrower at the time it noticed the U.C.C. foreclosure sale. And the sale itself had some particular conditions that the court found to be problematic under the circumstances. Those conditions included, among other things: a virtual or in-person sale, without specifying which it would be; a 36-day notice period, during the majority of which the governor’s stay-at-home order prevented an in-person inspection of the collateral; a prohibition of communication with the mezzanine borrower or its affiliates regarding the sale, without lender’s consent; a requirement of posting a 10% non-refundable deposit; followed by a closing within 24 hours of the sale; as well as some additional sale conditions. Although the D2 Mark LLC Court did enjoin the U.C.C. sale for 30 days because of some of the unique characteristics of that sale process, an exploration of general U.C.C. foreclosure principles and that opinion may help future U.C.C. foreclosures avoid a similar fate.

Mezzanine Loans

A mezzanine loan generally involves a creditor making a loan to the direct parent entity of a mortgage borrower. The loan is secured by a pledge of the parent entity’s equity interest (i.e., membership interest, partnership interest, etc.) in the underlying mortgage borrower. Unlike a traditional mortgage loan, a mezzanine loan is not secured by a security interest in real property. The equity interest in the mezzanine loan is considered personal property and thus involves an equity pledge that is governed by the U.C.C. Accordingly, where a mezzanine creditor seeks to foreclose on their loan, they are foreclosing on the pledged equity interest in the mortgage borrower and not the real property itself.

Nonjudicial Foreclosures Under the U.C.C.

Under ordinary circumstances, when mezzanine lenders hold non-performing loans, they have two choices. They can either attempt to reach some resolution or accommodation with their borrowers or they can foreclose on the pledged collateral. The U.C.C. provides that, “after [a] default, a secured party may sell, lease, license or otherwise dispose of any or all of the collateral in its present condition or following any commercially reasonable preparation or processing.” U.C.C. Section 9-610(a) (2019).

When the lender chooses to foreclose on the equity interests that were pledged as security for the mezzanine loan, the lender must ensure that the foreclosure is commercially reasonable. Section 9-610(b) requires that “[e]very aspect of the disposition of collateral, including the method, manner, time, place and other terms, must be commercially reasonable.” U.C.C Section 9-610(b). This provision is intended to serve as a safeguard for the debtor and other interested parties. The challenge inherent in this process, however, is that unlike judicial real-property foreclosures in New York, U.C.C. foreclosures are not supervised by a court in the first instance and, therefore, the lender conducting the foreclosure has considerably less guidance concerning what is—or is not—going to survive a legal challenge.

First, the U.C.C. states that the mere fact that a secured party could have obtained more by (1) engaging in a different manner of disposition or (2) disposing of the collateral at a different time does not preclude the secured party from establishing that it acted in a commercially reasonable manner. See U.C.C Section 9-627(a). Second, the U.C.C. states that a disposition of collateral is commercially reasonable if the disposition is made (1) in the usual manner on any recognized market, (2) at the price current in any recognized market at the time of the disposition, or (3) otherwise in conformity with reasonable commercial practices among dealers in the type of property that was the subject of the disposition. U.C.C Section 9-627(b)(1)-(3).

While all of this guidance is generally useful, it does not provide context for how this guidance should be adjusted—if at all—in the case of a profound market disruption. Parties seeking to determine whether a disposition is or was conducted in a commercially reasonable manner should look to the procedure and substance of the disposition at the time it occurred. Foreclosing mezzanine lenders that are concerned about challenges to foreclosures during the present market disruption, may find some comfort in the U.C.C.’s admonition that: the fact that a secured party might have been able to obtain a higher price through a different manner of disposition, or at a later time, does not mean that the disposition was not, by definition, commercially unreasonable. Similarly, given the U.C.C.’s direction to look at the “price current in any recognized market at the time of the disposition,” mezzanine lenders that foreclose during a disrupted market may be found to have acted reasonably, if the disposition was consistent with market activity during the disruption. U.C.C Section 9-627(b)(2). Defaulted borrowers may be expected to argue in response that forcing a sale in a disrupted market is manifestly unreasonable and may be expected to point to volatility in pricing or dramatic changes in pricing to support their arguments.

Method and Manner

Generally, a secured party can dispose of collateral in either of two ways under the U.C.C.: private disposition and public disposition. The official comments to Section 9-610 “encourages private dispositions on the assumption that they frequently will result in higher realization on collateral for the benefit of all concerned.” U.C.C Section 9-610 Official comment 2. But, a secured party is generally not permitted to purchase the collateral at its own private disposition. Accordingly, if the secured party wants to purchase the collateral, it must conduct a public disposition—or auction.

In Vornado PS, LLC v. Primestone Inv. Partners, L.P., a Delaware chancery court applying New York law found that the secured party’s decision to hold a public auction, as opposed to a private auction, was reasonable because the secured party was “one of the most interested and able potential purchasers” of the collateral.. The Court held that the U.C.C.’s general policy of encouraging private dispositions “must give way” under the circumstances because a private sale would have eliminated the secured party as a potential purchaser and potentially depress the ultimate selling price of the collateral.

Given current restrictions on social distancing, public gatherings, and the closures or restrictions surrounding occupancy of public spaces, an auction at the courthouse rotunda is not currently possible in quite the same “public” way it might have been before early-March of this year. So what is a secured party seeking to hold a public disposition to do? First, providing proper notice to the public is crucial. The official rules state that a “public disposition” is “one at which the price is determined after the public has had a meaningful opportunity for competitive bidding.” U.C.C Section 9-610 Official comment 7. A “meaningful opportunity” means that “some form of advertisement or public notice must precede the sale and that the public must have access to the sale … .”

This certainly begs the question of whether an auction can satisfy the U.C.C. in the current environment. Although a classic public auction with an auctioneer in a public building in New York City is not possible in the way that it was in early March, as with so many adaptations of technology to meet the needs of the business world during the pandemic, it is not difficult to imagine a commercially reasonable virtual auction as part of a U.C.C. foreclosure process. That virtual auction could take advantage of the pre-pandemic, well-established commercially reasonable methods of publicizing the sale, which did not depend on in-person communications and are still viable.

These methods may include, among other things, placing print ads in trade publication or online ads in locations reasonably calculated to reach a commercially reasonable audience with access to electronic due diligence rooms on request. Restrictions on social distancing and access to transportation played out in two ways in connection with the sale in the D2 Mark case. First, the court found that the timing of the notice, the due-diligence period, and the government’s stay-at-home orders resulted in potential bidders being unable to conduct inspections of the property for 27 of the 36 days of the notice period, “which deprives interested bidders of the chance to do due diligence” and may be unreasonable.. And second, the court directed that the notice be modified to “clearly state that bidders may participate virtually; the current notice is equivocal. Defendant’s notice must, at a minimum, comport with current CDC, state and local regulations.”.

Even outside periods of market disruption, it is often the case that the mezzanine lender will ultimately be the buyer because it will be the only bidder at the public disposition. Nevertheless, it is important to receive proper guidance and advice regarding advertising the sale to potential buyers to protect against a future challenge regarding the commercial reasonableness of the sale.

Time

Typically, the foreclosing party has latitude to decide when to hold the disposition or auction, so long as that timing is commercially reasonable. The U.C.C. does not specify a period within which a secured party must dispose of collateral following a default. The official comments note that “it may … be prudent not to dispose of goods when the market has collapsed.” U.C.C Section 9-610 Official comment 3. But, where a secured party holds on to collateral for a long period of time without disposing of it, it should have a good reason for its actions or it may be determined to not have acted in a “commercially reasonable manner.”

So, a mezzanine lender holding a defaulted loan may find itself between a rock and a hard place when deciding when, or whether, to schedule a disposition in the midst of a pandemic-induced market disruption. Certainly, a defaulting borrower whose interests are foreclosed upon during the pandemic may be expected to argue that it was manifestly unreasonable to schedule an auction before the market rebounds. While under the same circumstances, the lender may be expected to argue that it would be entirely unreasonable to expect it to wait for market activity that may or may not occur. In addition to the general obligation to act in good faith, market forces and the surrounding circumstances will likely dictate whether a party has acted reasonably in timing the disposition of the collateral.

The court in D2 Mark LLC had to resolve timing issues as the lender raced to foreclose on the collateral and the borrower argued that it was manifestly unreasonable to conduct the sale on just 36-days’ notice with so much uncertainty in the market. The court did not find that U.C.C. sales could not occur during the pandemic, but did find that an additional 30-days’ notice period was required, as well as some corrective notice procedures and easing of the sale conditions to allow for a more competitive and fair sale process. The court explained that: “Thirty days balances plaintiff’s reasonable request for more time and defendant’s objection to delay. The court agrees with plaintiff that expanding the time to market the Collateral and make a market for this unique hotel property is an elegant solution.”

Price

While, as stated above, the price alone is not sufficient to establish a violation under the U.C.C., “a low price suggests that,” if a transaction is challenged, “a court should scrutinize carefully all aspects of a disposition to ensure that each aspect was commercially reasonable.” U.C.C Section 9-627 Official comment 2. Where the transferee is the secured party, a person related to the secure party, or a secondary obligor, Section 9-615(f)(2) provides special rules for calculating a deficiency or surplus in the disposition that yields a price that is “significantly below the range of proceeds that a complying disposition to a person other than the secured party, a person related to the secured party, or a secondary obligor would have brought.”

In D2 Mark LLC, the court found that some of the original sale conditions, like the requirements of closing within twenty-four hours of the sale, the posting of a non-refundable ten-percent deposit at the sale, and restrictions on the borrower’s ability to bid or communication with potential bidders, were likely to reduce interest in the collateral and, therefore, may have “rigged” the foreclosure “so that, as a practical matter, only defendant can obtain the collateral.” See D2 Mark LLC. Accordingly, the court ordered certain changes to the process because there “is no recognized market here; defendant must make the market which is why the procedures defendant implements are crucial to create a commercially reasonable sale.”

Drafting With Reasonableness in Mind

Parties may want to consider including in their loan documents specific procedures that constitute a commercially reasonable disposition. Under U.C.C. Section 9-603, “the parties may determine by agreement the standards measuring the fulfillment of the rights of a debtor or obligor and the duties of a secured party if the standards are not manifestly unreasonable.” This may help shift the burden in favor of the lender and avoid potentially costly litigation later. For example, the parties may agree in the express language of their pledge and security agreement on, among other things:

• the location of the sale, including geographical location or a virtual location;
• the law that will govern the conduct of the sale;
• the qualifications of the auctioneer, or online auction methodology;
• the notification procedures for other secured parties;
• the general notice procedures to be followed, including where and for how long to publish information about the sale, including whether notice must appear in print or online locations.

Although challenges of the reasonableness of foreclosures are always possible, carefully drafted, negotiated provisions, should provide the parties with greater foreseeability about the likelihood of success of those challenges.

Conclusion

Despite the recent challenges presented by the coronavirus pandemic, mezzanine lenders may obtain relief by pursuing nonjudicial remedies found under Article 9 of the UCC. However, given the significant shifts in both the real estate market and business world generally, mezzanine lenders should obtain competent legal counsel to help ensure that their approach to nonjudicial foreclosure is “commercially reasonable” in all respects.

Obtaining guidance early can help limit the risk of legal challenges post-foreclosure and ensure the mezzanine lenders are maximizing the cost efficiencies provided by Article 9 of the UCC. To quote the D2 Mark LLC court, foreclosing mezzanine lenders would do well to remember that, “what is reasonable during normal business times, may not be reasonable during a pandemic.”

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Joshua Sohn is a partner at Stroock & Stroock & Lavan LLP. His practice spans a wide range of commercial and regulatory matters, with particular focus in complex disputes involving real estate, real estate finance, construction and securities matters. During his 20-year career, Josh has tried cases and argued appeals in New York state courts and U.S. federal courts. He has also arbitrated before regulatory bodies and private tribunals and has negotiated resolutions of disputes before, during and after litigation.

Michael McCarthy is a partner at Stroock & Stroock & Lavan LLP. He advises commercial lenders and borrowers in connection with mortgage and mezzanine financing secured by commercial real estate and in connection with real estate capital markets transactions, including repurchase facilities. He also counsels clients in connection with the acquisition and disposition of whole loans, participation interests, and subordinate notes and in connection with loan workouts, restructurings and foreclosures.

Daniel H. Lewkowicz is an associate at Stroock & Stroock & Lavan LLP. He is a commercial litigator whose practice focuses on representing institutions facing complex breach of contract claims, employment disputes, regulatory enforcement and government investigations. Daniel has dealt with matters involving copyright infringement, products liability and the First Amendment.

Amanda R. Fick-Cambria is an associate at Stroock & Stroock & Lavan LLP. She focuses her practice on commercial real estate transactions with a particular emphasis on leasing, acquisitions, developments and joint ventures.