As borrowers continue to experience financial distress and loans go into default as a result of the ongoing coronavirus pandemic and related issues, lenders are now becoming more focused on the need to take a closer look at potentially foreclosing their mortgage and/or mezzanine loans. While there are still lingering questions, the results of a recent attempt to enforce such remedies with regards to a mezzanine loan may serve as another cautionary tale for mezzanine lenders to proceed with care in approaching any Uniform Commercial Code (UCC) foreclosure sale during the continuing global pandemic.

As we mentioned in our initial client alert on this subject, “Courts: A Foreclosure Pandemic Pause? (Part 1),” mezzanine loans are governed by the UCC, and the UCC requires that “[e]very aspect of a disposition of collateral, including the method, manner, time, place, and other terms, must be commercially reasonable.” This requirement of commercial reasonableness would apply to the method and efforts by the lender to locate potential buyers (through brokers, advertising, etc.), the content of published foreclosure notices, the location and method of bidding, the vetting of bidders, the amount of notice before the foreclosure sale, the availability of salient information relative to the interest being foreclosed, and the like.

In a recent case brought before the New York County Supreme Court (Shelbourne BRF LLC v. SR 677 BWAY LLC (Supreme Court of State of NY, August 3, 2020)), the court issued a preliminary injunction halting a UCC foreclosure sale, finding that an Administrative Order prohibiting the foreclosure of real property applied to the public auction of a mezzanine loan. The Administrative Order, issued by the Chief Judge of the New York Court of Appeals on July 23, 2020 (the “Administrative Order”), prohibits residential or commercial foreclosure sales through October 15, 2020. The Shelbourne case involves the foreclosure of membership interests in the property owner of an office building located in Albany, New York, after the borrower failed to make its debt payments and defaulted under the terms of its mezzanine loan. Unlike in the case of D2 Mark LLC v. OREI VI Investments, LLC (Supreme Court of State of NY, June 23, 2020), in which the court granted the borrower’s preliminary injunction to stop a UCC foreclosure sale and provided an extensive analysis of the manner and extent to which the sale was not commercially reasonable, the Shelbourne court reached its decision to grant the preliminary injunction largely based on the Administrative Order, without taking up the factual issue of commercial reasonableness. Despite the court’s acknowledgment that the Administrative Order did not specifically apply to UCC foreclosure sales by the language of the text, the court determined the Administrative Order was applicable to UCC foreclosure sales by reasoning that the value of the borrower’s membership interests was inextricably tied to the value of the underlying real property.

The court’s finding in the Shelbourne case stands in contrast with another recent case, 1248 Assoc. Mezz II LLC v. 12E48 Mezz II LLC (Supreme Court of State of NY, May 18, 2020), in which the court denied the borrower’s request to prevent its mezzanine lender from conducting a UCC foreclosure sale of membership interests in a hotel property owner. In that case, the court found that such a sale was not a mortgage foreclosure of real property subject to Governor Cuomo’s various Executive Orders, and the mezzanine lender was permitted to proceed with its sale. The Shelbourne court found that the same type of UCC foreclosure sale was in fact a foreclosure sale of real property and held that the sale fell under the scope the Administrative Order. Interestingly, the Shelbourne court noted the following: “[s]evere turmoil in the real estate market due to the pandemic makes the notion of a sale resulting in payment of fair market value highly uncertain. Bids will likely be discounted due to uncertainty about the continued length and severity of the pandemic . . . Consequently, it would be unreasonable to permit the foreclosure sale to proceed” (internal quotations omitted). It seems as though the court in the Shelbourne case correctly considered the membership interests at stake to be akin to real property interests, but failed to expound the analysis of commercial reasonableness in the given markets. Further, it is important to emphasize that the sale was not prevented in its entirety, but merely was delayed, although the delay past October 15, 2020 (or whenever the Administrative Order date may be further extended), does not mean the lender will necessarily receive greater value for its collateral than if the sale took place on August 3, 2020.

Given the courts’ disparate treatment of mezzanine loans and corresponding UCC foreclosure sales, mezzanine lenders should take care to approach their foreclosures with an abundance of caution, particularly during the ongoing pandemic. We will continue to monitor court cases related to foreclosures of mortgage and mezzanine loans and will provide further updates on any noteworthy decisions in such cases.

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