UCC Foreclosure Basics: Acquisition of Distressed Real Estate Mezzanine Debt

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We recently provided an outline of items to diligence when purchasing a mortgage loan in distress—and separately also discussed issues to diligence when purchasing a mezzanine loan in distress. This post (the third in this series) outlines Uniform Commercial Code (UCC) foreclosures in general terms and describes key considerations for mezzanine lenders (and the purchasers of distressed mezzanine loans) contemplating or planning a UCC foreclosure.

In our prior posts, we’ve emphasized how diligence is key. In this installment, we will explore how and why planning is also crucial!

As we’ve explained in earlier posts, a mezzanine loan is secured by a pledge of interests in a property owner, and enforcement of a mezzanine loan falls under the UCC. In this regard, note that while each State has a UCC, and certain States have enacted the “model UCC” (meaning reference should be made to each State’s UCC when crafting a UCC foreclosure), this post will describe certain overarching “principles” and best practices that are generally applicable across States.

Also, note that while the UCC does allow for judicial foreclosures (not unlike foreclosure on a real estate mortgage), here we will focus on the “self-help” remedies that are available to lenders under the UCC and that are more expeditious (i.e., faster and cheaper) to complete. These remedies—which are subject to UCC requirements that supplement (and often override) provisions in the mezzanine loan security documents—are:

  • A public sale
  • A private sale
  • Strict foreclosure

The fundamental and guiding principle that should inform the planning and execution of any UCC foreclosure is the requirement under the UCC that “[e]very aspect of a disposition of collateral, including the method, manner, time, place, and other terms, must be commercially reasonable.” In this regard, note that what is commercially reasonable is fact-specific and dependent on market conditions. Also note that any after-the-fact analysis by a court will focus on the process and procedure employed by the foreclosing lender. Consequently, experience and market awareness are key, and careful planning is critical!

Let us begin with a short description of the “public sale.” A public sale is one where there is a meaningful opportunity for competitive bidding and requires some form of advertisement (a notice of sale) to the general public—such as in industry publications where UCC foreclosures are typically advertised. Note that the UCC has several rules concerning the form and content of the notice of sale that must be given—and that while the UCC provides for a 10-day notice period as a safe harbor, longer periods of 30 days or more are common. In this regard, note that private parties may agree by contract (in a pledge and security agreement) to procedures or standards for public sale. If ever litigated, that agreement generally will be enforced by a court provided its terms are not manifestly unreasonable or inconsistent with express provisions of the UCC.

The secured lender may bid on the collateral in a public sale (unlike private sales). This is a key advantage for mezzanine lenders with a loan-to-own strategy.

In developing a commercially reasonable sale process—and keeping in mind the overarching principle that “[e]very aspect of a disposition of collateral, including the method, manner, time, place, and other terms, must be commercially reasonable”—a mezzanine lender should consider:

  • Retaining advisors, including a broker and/or auctioneer. Note that these professionals may be sources of information for those looking to acquire mezzanine debt or property through a loan to own strategy;
  • Outreach to prospective purchasers through multiple channels (for example, brokers will typically reach out to target lists of clients/contacts they think may be active in the market);
  • Information and time available for diligence, including the establishment of a data room;
  • Allowing prospective bidders to have access to the property before the auction, if possible;
  • Public notice requirements; and
  • Bidding procedures.

With regards to the public notice requirements, the statutory requirements contained in sections 9-613 and 9-614 of the UCC require that the secured lender (in the notice):

  • Include information about the debtor and the secured party, a description of the collateral, and the time and place of the auction; and
  • Provide for:
    • access to data site (typically upon execution of confidentiality agreements); and
    • deposit and closing timing issues and formal terms of sale.

Recall, in structuring any sale, that there may be “Qualified Transferee” and other requirements imposed by any Intercreditor Agreement (see prior posts on ICAs here and here)—the agreement that typically exists between a mortgage lender and a mezzanine lender. These may include requirements regarding who can be a foreclosing lender—and will likely also include requirements about actions that must be taken and deliveries that must be satisfied (such as the requirement to deliver supplemental guarantees)—all of which must be considered in preparing a public notice (and structuring any sale).

Once the planning stages are completed and the notice is placed, it’s time for the sale. Regarding the sale, note that:

  • An auction may be virtual;
  • The secured party does not necessarily need to accept the highest bid (e.g., it may be better to accept a lower price that is all-cash than a higher price that is part cash, part notes);
  • It is not necessary to show that the auction price was the best price available in the market; and
  • An auction can always be adjourned without a sale.

Also note, regarding credit bidding, that a mezzanine lender has the right to credit bid up to the full amount of its debt (and can bid additional amounts in cash) if desired. The credit bid amount can include all interest, fees and costs provided for in the mezzanine loan documents. Also note that the mezzanine lender should consider bidding less than the full amount of its debt to preserve its rights to pursue guarantors and other collateral.

We note that, as a practical matter, by the time of the auction, the mezzanine lender is likely to have a good sense of any market interest in the collateral so that it can structure its credit bid accordingly.

Besides a public sale, a secured lender may structure the sale as a “private sale,” a sale in which there has not been an advertisement that gave the public a meaningful opportunity to participate. In a private sale, the secured party cannot be the buyer of the collateral (except for certain collateral types with publicly quoted market prices). As with a public sale, a private sale must be conducted in a commercially reasonable manner. Otherwise, the creditor risks exposing itself to liability. Here, too, there is no need to demonstrate that the private sale yielded the best price available.

In addition, a secured lender may consider “strict foreclosure.” In a strict foreclosure, the secured party may make a proposal to the mezzanine borrower to accept the collateral in full or partial satisfaction of the mezzanine loan. The proposal must be consented to by the mezzanine borrower after the default has occurred. Strict foreclosure agreements are not subject to the “commercial reasonableness” standard, but must be made in “good faith.” This is a distinction without a difference and suggests retaining appraisers or other professionals is warranted.

A mezzanine lender whose enforcement efforts are not commercially reasonable or otherwise violate the UCC’s terms may expose itself to liability under the UCC. For example, and while we note that the following provisions can be altered by contract, a debtor or obligor may be able to seek injunctive relief against a sale which is not commercially reasonable (under UCC 9-625(a)). Similarly, a debtor or another junior secured creditor may seek a claim for damages against the lender (under UCC 9-625(b)-(c)) or may seek recovery of damages for loss of surplus (under UCC 9-625(d)).

To avoid such consequences, always keep in mind the requirement for commercial reasonableness and prepare carefully. Planning is key!

Because planning is key, an understanding of potential bankruptcy strategies and issues is required—and will be the topic of the next post in our series on the acquisition of distressed real estate debt.

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