Recently, on the eve of closing a large mortgage loan for a regional mall intended for a single asset securitization, it was determined that there was an extremely remote risk that the mortgage might not be foreclosable due to a peculiarity of the improvements on the real property and local foreclosure practices.
It is not necessary for purposes of this article to explain the circumstances that created this risk, but only to note that, in order to mitigate the risk, the borrower agreed to grant to the mortgage lender a pledge of all of the equity interests in the borrower so that, in the extremely remote chance that the mortgage could not be foreclosed, the lender could exercise remedies and realize on its collateral through a UCC foreclosure of the pledged equity interests.
On the eve of closing the loan, one of the parties involved in the securitization of the loan objected to the proposed solution based on its concern that the pledge of the equity in the borrower might be found to “clog” the borrower’s equity of redemption, and as a result be unenforceable.
Any lawyer representing institutional lenders on a regular basis has come upon this concern from time to time. There have been times over the past 25 years when certain institutional mortgage lenders regularly took equity pledges in addition to a mortgage on the real property. Generally, concerns about clogging were overlooked at the time of loan origination on the theory that accepting the pledge does not create any clogging concern; at most the concern would arise only if and when the lender opted to foreclose the pledge rather than the mortgage.
In the case described above involving the single asset securitization, our firm, as the lender’s counsel, researched the issue and drafted a legal memorandum that persuaded all of the parties that the grant of the pledge would not under New York law be viewed as clogging the equity of redemption.1 We share our reasoning and the applicable case law below.
It is well settled law in New York that a mortgagor cannot waive its right of redemption. See Goldblatt v. Iris Const. Corp., 28 Misc. 2d 621, 211 N.Y.S.2d 234 (Sup. Ct. 1960). Accordingly, if the foreclosure by a mortgage lender of a pledge of the equity interests in the mortgage borrower given to the lender as additional collateral is found to constitute a wrongful denial or “clogging” of the mortgagor’s equity of redemption, such pledge would be unenforceable under New York law.
“There have been times over the past 25 years when certain institutional mortgage lenders regularly took equity pledges in addition to a mortgage on the real property.”
The following four cases are the foundational cases in New York that address a mortgage borrower’s “equity of redemption.” Other New York cases2 dealing with the equity of redemption under New York law generally cite to one or more of these four cases. Accordingly, an analysis of these four cases is essential in order to determine whether a foreclosure of a pledge of equity interests in a mortgage borrower would “clog” the borrower’s equity of redemption under New York law.
In Clark v. Henry, (N.Y. 1823), a debtor held a note and corresponding mortgage in the amount of $1,065 executed by a third-party borrower. The debtor assigned the note and mortgage to its creditor as security for payment of a separate $225 debt owed by the debtor to its creditor, as consideration for extending the due date of the $225 debt. When the debtor thereafter defaulted, the creditor insisted that the assignment of the note and mortgage was absolute as part of a sale, rather than for the purpose of securing the $225 debt.
The court held that the assignment was not a sale and that the debtor retained the equity of redemption. The court gave particular consideration to the debtor’s lack of sophistication and the imbalance of power between the parties, and also to the fact that the value of the assigned mortgage and note far exceeded the $225 debt.
“The court held that the assignment was not a sale and that the debtor retained the equity of redemption.”
In Horn v. Keteltas, 46 N.Y. 605 (1871), the plaintiff-borrower received a $10,000 loan from the defendant-lender. The lender advanced the funds to the borrower in exchange for an absolute deed to the plaintiff’s property. There was as an agreement that after one year the defendant would re-convey the property by deed to the borrower’s lawyer in exchange for $12,500. The court held that the deed was a mortgage and, accordingly, that the borrower retained a right of redemption until his equity was duly foreclosed. The case notes that the value of the borrower’s property greatly exceeded the amount of the loan.
In Odell v. Montross, 68 N.Y. 499 (1877), the plaintiff had executed an absolute deed to the defendant, which the court found was not intended as a conveyance but rather as a security for the payment of money. Sometime later the defendant paid $50 to the plaintiff, whereupon the plaintiff gave the defendant a receipt indicating that all claims between the parties had been satisfied. The defendant asserted that the $50 and corresponding receipt acted to (1) convert the deed from a security into an absolute conveyance and (2) release plaintiff’s right to redeem.
Based partly on the inadequacy of the receipt as a proper instrument for the conveyance of real property, the court held that the original deed was a mortgage, the receipt was not a deed, and that the plaintiff retained its right to redeem. The court added that a mortgagee may purchase the right of redemption from a mortgagor, but such transactions are carefully scrutinized and sustained only when they are fair in all respects and reflect adequate consideration.
“The court added that a mortgagee may purchase the right of redemption from a mortgagor, but such transactions are carefully scrutinized and sustained only when they are fair in all respects and reflect adequate consideration.”
Finally, in Mooney v. Byrne, 163 N.Y. 86, 57 N.E. 163 (1900), the plaintiff-borrower owed a third-party lender a debt of $3,000. The debt was secured by three mortgages on the plaintiff borrower’s property which were in the process of being foreclosed. The plaintiff gave the defendant a deed to the plaintiff’s property in exchange for the defendant paying the plaintiff’s $3,000 debt to the lender. The deed recited that it was given “as security.” The defendant took possession of the property.
Given that the borrower’s property was worth much more than the $3,000 debt owed to the defendant, the court held that the deed was a mortgage and that the plaintiff’s equity of redemption remained alive. The court added that the equity of redemption cannot be waived or abandoned by any stipulation of the parties, even if such stipulation is embodied in the mortgage.
When a lender is granted both a mortgage on the real property and a pledge of the equity in the mortgage borrower (herein described as a “dual collateral loan”), the intent is to enable the lender, at its option, either to judicially foreclose the mortgage or to foreclosure the pledge in accordance with the applicable Uniform Commercial Code provisions.
There are no New York3 cases that address the question of whether a UCC foreclosure of the equity in an entity whose sole asset is real property constitutes a clogging of the equity of redemption. However, it would seem that the case for concluding that the enforcement of the pledge clogs the borrower’s equity of redemption would need to be based on the claim that foreclosing the pledge enables the lender to foreclose the equity in the borrower (and therefore, to indirectly foreclose the equity in the borrower’s property) without having to comply with the statutory procedures for foreclosing a mortgage. This argument has no support in any of the four cases cited above, or in any subsequent New York cases dealing with the equity of redemption.
The four cases cited above, and subsequent New York cases dealing with the equity of redemption, all have fact patterns involving a situation where the borrower was effectively denied the opportunity to repay its loan and thus retain its property, so the court restored the borrower’s equity of redemption, i.e., the right to repay the loan and retain the property.
Other relevant factors in some of these cases were (i) a lack of sophistication by one of the parties and accordingly the taking of unfair advantage by the more sophisticated party, and (ii) the fact that, absent restoring the borrower’s equity of redemption, the lender would end up with title to a property that had a value materially in excess of the amount that the borrower owed the lender. There is not a single reported New York case finding a wrongful clogging of the equity of redemption where the mortgage borrower had the opportunity to repay the debt and retain the property.
“The four cases cited above, and subsequent New York cases dealing with the equity of redemption, all have fact patterns involving a situation where the borrower was effectively denied the opportunity to repay its loan and thus retain its property.”
Based on this case law, the pledge to a mortgage lender of the equity in the mortgage borrower should not constitute a clogging of the equity of redemption, for the following reasons:
- As noted above, all New York cases finding a clogging of the equity of redemption involved a finding that the borrower was effectively denied the right to repay the loan and retain its property. Not only would a borrower in a dual collateral loan have a right of repayment, but the borrower would have the protection of the statutory framework of the UCC for foreclosing personal property. This fact alone would appear to fully distinguish a dual collateral loan from any of the transactions found to constitute clogging in the New York case law.
- One of the factors sometimes cited in the case law to support the court’s restoring the borrower’s equity of redemption, is the need to protect the borrower from the lender obtaining title to the property for consideration far less than the property’s value. In a dual collateral loan, the UCC foreclosure process insures that the collateral will be foreclosed through a commercially reasonable sales process with the borrower being entitled to all proceeds of the foreclosure sale in excess of the debt (subject to the rights of other third parties); and in addition the borrower would usually also have the right to bid at the foreclosure if it so chooses.
- Another of the factors appearing in the case law is the need to protect an unsophisticated borrower from a forfeiture of its equity in the real property due to an unfair transaction structure imposed by a more sophisticated lender. The dual collateral loans that we address here are loan transactions between highly sophisticated parties represented by counsel.
The relative dearth of modern day New York case law addressing the clogging of the equity of redemption, and the total absence of any New York cases in which the enforceability of a UCC foreclosure is challenged on the basis of its clogging the equity of redemption, only serves to reinforce the above analysis and the conclusion that the doctrine of clogging the equity of redemption is not implicated by a properly conducted UCC foreclosure where the collateral being foreclosed was given as security for a bona fide loan between sophisticated parties.4
This article originally appeared in Law360 on March 22, 2013.