Real estate financing often includes more than just a mortgage. A borrower often obtains additional funds through a separate mezzanine loan, secured by a pledge of stakes in the entity that owns the mortgaged property. Since these property rights are not real estate, the rights of the lender are governed by the Uniform Commercial Code rather than real estate law. The UCC says that if the mezzanine loan defaults, the lender can foreclose relatively quickly and easily – at least compared to mortgage foreclosures in many states, including New York. This is because unlike New York mortgage foreclosures, UCC foreclosures do not force the lender to go to court.
Fast and streamlined mezzanine loan foreclosures are ideal for mezzanine lenders. But they put mezzanine borrowers at risk of losing their equity so quickly that they probably don’t have enough time to find new investors, new lenders, or any other way to recapitalize their project and save their investment. Even if a mezzanine lender generously gives the borrower 60 days notice of a foreclosure auction, the borrower still might not have enough time.
All of this became abundantly and painfully clear to some mezzanine borrowers during the pandemic. Aggressive or impatient lenders have made UCC foreclosure sales with relatively little notice. Those sales wiped out hundreds of millions of dollars in net worth, or at least the net worth that existed before the pandemic. In some cases, the courts have stepped in to slow the process down, but this is hardly a source of comfort for prospective mezzanine borrowers.
Perhaps when mezzanine borrowers negotiate new mezzanine loans, they shouldn’t accept the “standard” rights and remedies that UCC offers lenders, or that typically appear in standard collateral agreements for mezzanine loans. Perhaps borrowers should refuse to accept the risks of mezzanine loan foreclosures which can evolve at lightning speed.
Of course, mezzanine lenders believe that the entire UCC foreclosure process is completely satisfactory, standard and set in stone. “Everyone does it that way” and always has. Lenders will offer a predictable collection of arguments against any change. Whether or not a borrower can require improvements will largely depend on the state of the market and the timeliness of the borrower’s transaction. If multiple mezzanine lenders compete to offer an economically attractive mezzanine loan, then they might decide that they can address a borrower’s concerns about the mezzanine loan foreclosure process.
If a borrower has enough leverage to open this conversation, they should start by asking for assurance that a UCC foreclosure auction won’t happen so quickly that the borrower has no hope of doing anything to save it. his position. The UCC and most pledge agreements state that the mezzanine lender must give the borrower only 10 days notice before any foreclosure sale. This is of course nowhere near enough for the borrower to find new capital to pay off the mezzanine loan and avoid the sale.
In practice, mezzanine lenders often give 30 to 45 days notice before a foreclosure sale. It’s not really enough time either.
Maybe a borrower should insist on being given 120 days’ notice of sale, to try and give them enough time to save their investment. The lender could reasonably attach a price tag, payable in cash, as a condition of such an extension.
A borrower might also think of other parts of the UCC foreclosure sale process. For example, the terms of any UCC foreclosure sale often require that the winning bidder on the sale make a deposit of 10% of the highest bid. Then, within 24 hours, the winning bidder must pay the remaining 90% and complete the purchase of the guarantee. Maybe 5% or less should be enough. And maybe the closing should be at least 30 days after the auction. These changes would make it easier for the borrower to place the winning bid and close.
The lender will of course also have to agree that the borrower or his representative can bid on the foreclosure sale. Lenders often prohibit this. The borrower should also try to ensure that the winning bid can be freely transferred if necessary.
As a last suggestion, but not necessarily the last word, the borrower may want the lender to agree to never use a particularly powerful weapon – the “hard foreclosure” process. This mechanism allows the lender to automatically acquire its collateral if it sends a notice to the borrower and the borrower does not object within a certain period of time.
Such changes would help a mezzanine borrower reduce the risk of their investment suddenly losing. Although the vast majority of mezzanine lenders would resist such measures, a desirable borrower with a desirable transaction might prevail. A slightly higher interest rate might help.
If a mezzanine lender responds to a borrower’s demand for smoother, smoother foreclosure procedures, the mezzanine lender will need to look at the other side of the capital pile as well. He should make sure that no concession creates new problems in the relationship with the mortgage lender. It’s a separate discussion.