Mezzanine Foreclosures in the Time of Coronavirus

A recent New York County Supreme Court decision has temporarily halted a mezzanine UCC foreclosure sale by granting the borrower’s request for a stay based on allegations that the terms of the mezzanine foreclosure were not commercially reasonable in light of the COVID-19 pandemic and that the New York Governor’s moratorium on foreclosures of commercial properties precludes a mezzanine foreclosure. A hearing on the merits of the request will be held on May 18th.

Background

1248 Associates Mezz II LLC (“Plaintiff”) is the indirect owner of 100% of the equity interests in 1248 Associates LLC (“Property Owner”), which owns real property located at 12 East 48th Street in Manhattan (“Property”). On April 17, 2019, Plaintiff obtained a $7,000,000 junior mezzanine loan (the “Loan”) from 12E48 Mezz II LLC (“Defendant”). The Loan was secured by a pledge of Plaintiff’s ownership interests in the parent of the Property Owner (the “Collateral”). Proceeds of the Loan were to be used to develop the Property for hotel, timeshare and retail use. The Property was to be substantially completed by December 31, 2019. Plaintiff sent Defendant a default notice on January 16, 2020, alleging that substantial completion had not been achieved.

Prior to receipt of the default notice, Plaintiff had been in the process of negotiating takeout financing for the Loan and other debt relating to the Property. Defendant was apparently aware of, and participated in, those discussions. However, as the COVID-19 outbreak took hold in New York City, the negotiations fell apart in the middle of March 2020.

Numerous governmental orders relating to the COVID-19 pandemic have been issued which impact construction projects in New York, as well as certain lender remedies.

• On March 20, 2020, Governor Cuomo’s Executive Order 202.8 prohibited enforcement of any foreclosure of any residential or commercial property for a period of 90 days. 
• On March 22, 2020, the Chief Administrative Judge of the New York State Courts issued Administrative Order 78-20, prohibiting the filing of new non-essential matters in New York State Court.
• On March 23, 2020, Executive Order 202.10 prohibited non-essential public gatherings “of any size for any reason”. 
• On March 30, 2020, the Chief Administrative Judge eased filing restrictions for motions in existing matters, but the restrictions on the filing of new non-essential cases remains in place without a stated expiration date.

On March 31, 2020, Defendant began a non-judicial UCC foreclosure sale process by providing notice to Plaintiff that it intended to sell the Collateral to the highest qualified bidder at a “public sale” to be held on May 1, 2020 at the office of Defendant’s counsel in New York City. On April 17, 2020, Plaintiff received Defendant’s notice of the terms of the sale, which included the option of conducting a public auction virtually by WebEx in the event that the Governor’s mandate to avoid public assemblies continued. Defendant advertised the foreclosure sale by placing a single notice in the Commercial Mortgage Alert, an online, subscription-only publication, two weeks prior to the scheduled sale. The advertisement of the sale did not reference the possibility of a virtual auction and only referenced the sale occurring at a physical location.

On Wednesday, April 22, 2020, Plaintiff filed an emergency motion seeking a temporary restraining order to stop the UCC foreclosure sale, claiming that the sale process was not “commercially reasonable”, as required by the UCC, and that it was barred by the Governor’s restriction on foreclosures.

The Court’s Decisions

Late the next day, the New York Supreme Court issued an order denying Plaintiff’s request for a preliminary injunction as not being “essential” under the terms of the Court’s Administrative Order 78-20. On its face that sounds like a good result for a foreclosing mezzanine lender. However, in a handwritten annotation to the court order, Justice Nervo wrote that the TRO motion was not necessary because the relief being requested (i.e., the injunction stopping the UCC sale) was covered by the Governor’s Executive Orders.

On April 30, 2020, the Plaintiff filed a second emergency application to have its case considered “essential”, together with supporting documentation. Diverging from his prior decision, Justice Nervo issued a new order on April 30, 2020, allowing the request for the TRO to move forward as “essential”. Additionally, on the same day, Justice Nervo temporarily suspended the foreclosure sale (which had been scheduled for the following day) and set a hearing on the matter for May 18th.

Implications

The implications of this case are significant for mezzanine lenders considering their enforcement options with respect to property located in New York and beyond. Most mezzanine pledge agreements select New York as the governing law and forum, and specify a UCC sale in New York, although most pledged collateral consists of equity interests in Delaware entities. This case raises questions as to whether the New York Executive Orders and Administrative Orders limiting foreclosures and non-essential matters are broad enough to cover non-New York assets governed by the New York UCC and non-judicial foreclosures.

Additionally, this case will address whether the standard of “commercial reasonableness” as applied to a UCC sale during the pandemic will require a sale process different than prior market practice, in light of unprecedented restrictions on public gatherings and court closures. Plaintiff has requested that the Court prohibit any foreclosure sale until the expiration of Executive Order 202 (declaring a state of emergency in New York), which is currently set to expire on September 8, 2020 – far beyond the end of the 90 day stay on foreclosures provided by Executive Order 202.8.

Dechert’s global finance group is well-versed in the requirements that the UCC, and the courts, mandate for mezzanine foreclosures. We successfully represented a mezzanine lender in litigation through trial over the very issue of commercial reasonableness in a UCC foreclosure earlier this year – (see March 30, 2020 Atlas v. Macquarie Decision). Any UCC foreclosure contemplated during the pandemic must be thoughtfully considered and conducted in compliance with applicable governmental restrictions. We will provide an update on this matter after the May 18th hearing.