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© Sidley Austin LLPDC1 982509v.2 July 20, 2007 02:31 PM

Bankruptcy Update: Mezzanine FinancingAmerican College of Real Estate Lawyers

Fall 2007 Program

By: David R. Kuney1

Sidley Austin LLP

Part 1Background

I. Mezzanine financing: definition and purpose.

A. Mezzanine financing is generally understood to mean a form of real estate financing in which a lender makes a loan to an entity, typically a limited liability company. The entity, which is the owner of shares or of membership interests in a lower tier entity, then assigns to the lender its membership interests in such other entity. In real estate finance the lower tier entity is typically a limited liability company which is the owner of a fee interest in commercial real property. The entity which owns the fee interest typically has a conventional mortgage on its fee interest. The mezzanine loan is thus structurally subordinated to the fee mortgage.

B. The property owner obtains separate financing from a mortgage lender. Thus, the mezzanine lender and mortgage lender do not share the same collateral or borrower, and the mezzanine loan is "structurally subordinate" to the mortgage loan. Foreclosure of the mortgage loan will wipe out the property interest of the property owner, and thus leave the mezzanine lender with valueless equity interest collateral.

C. The mezzanine borrower is typically a limited liability company (an “LLC”) which is a form of statutory business organization that combines some of the advantages of a partnership and some of a corporation. As in a corporation, the investors have limited liability. Members own an undivided interest in the company’s property and are entitled to share in the overall profits and loss ratably according to their investment or as otherwise provided by the organic documents. Fraser v. Major League Soccer, LLC, 97 F. Supp. 2d 130 (D. Mass. 2000).

D. This form of financing has become a widely used method of providing additional capital to real estate developers, while minimizing the risk to the first mortgage lender. See Thomas R. Fileti, Subordinate and Mezzanine Real Estate Financing, SL004 ALI-ABA 1363, 1371 (July 27, 2005) (hereinafter, “Fileti”).

II. The risks of mezzanine financing.

1 David Kuney is a partner in the law firm of Sidley Austin LLP and is a member of the corporate restructuring group; his office is in Washington, D.C. He may be reached at [email protected]. These materials are offered solely for educational purposes and do not constitute legal advice and do not reflect the views of Sidley Austin LLP.

2© Sidley Austin LLP

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A. Different than traditional real estate lending. Mezzanine financing involves substantially different risks than traditional real estate lending. It has been suggested that these risks are not well understood due to the absence of any recent historical experience of significant defaults and enforcement actions. See Leanne R. Dunn and Peter Dopsch, Mezzanine Loan Foreclosure: UCC Sales of Equity Interests Under Revised Article 9, REAL ESTATE FIN. J. (2002) (hereafter “Dunn”), reprinted in Fileti, supra.2 This outline identifies some of the principal risks and explores certain judicial and statutory outcomes.

B. Structural subordination; credit risk. Generally, the mezzanine loan is an amount which represents the equity value between the first mortgage loan amount and the appraised value of the underlying real property. For that reason, the inherent credit risk is substantial, especially where the loan to value ratio approaches 100%.

C. Creation of security interest; bifurcated ownership interest in “management” and “economics.” There are certain risks associated with the inability of a member to “assign” or transfer its management interest without the consent of other members, and hence a lack of clarity on the ability of a lender to foreclose on the entirety of the interest.

D. Perfection risk: failure to use Article 8. Another risk involves the possible failure to use Article 8 of the Uniform Commercial Code (the “UCC”) 3 in addition to, or in lieu of Article 9, as a mode of perfection. An Article 8 perfection may trump a lender which has recorded under Article 9 of the UCC.

E. Foreclosure sale; obligation of commercial reasonableness. The foreclosure process is governed by the UCC which imposes substantially more burdensome obligations on a lender and subjects the lender to (a) an increased risk of injunction, (b) an increased risk of a damage claim and (c) a risk of a loss of any deficiency claim. The lack of standards and precedents specific to UCC foreclosure sales of mezzanine equity result in significant uncertainty for the mezzanine lender desiring to commence a foreclosure of its collateral. Dunn, supra, cited in Fileti, supra at 1423.

F. Risk of timing on foreclosure. Lastly, upon foreclosure by the fee lender, the mezzanine lender would ordinarily try to exercise its foreclosure rights prior to

2 “What is new to the current real estate cycle is that many mezzanine loans were made on a nonrecourse or limited recourse basis and are secured only by equity pledges. Therefore, when mezzanine loans go into default, there will be a greater focus on foreclosure sales of equity pledges under the UCC as the mezzanine lender's sole remedy unless a consensual workout can be achieved. In addition, Revised Article 9 of the UCC, recently adopted by every state, introduced certain changes in the enforcement provisions that are relevant to foreclosure of equity pledges. Prudent mezzanine lenders should be preparing for that situation by becoming familiar with the unique issues surrounding UCC foreclosure of equity pledges.” Dunn, supra, cited in Fileti, supra at 1422-23. (All citations to “Dunn” are based on the pagination of the article by Thomas Fileti, as there appears to be no separate publication).

3 Unless otherwise indicated, all citations to the “UCC” are to the 2007 edition published by the National Conference of Commissioners on Uniform State Laws (“NCCUSL”).



the effective date of any fee foreclosure sale. However, this goal may be unobtainable if there is no right to have a strict foreclosure (retention of the collateral in satisfaction) of the debt or a springing membership interest.

G. Effect of bankruptcy of mezzanine entity? What happens when the mezzanine entity files for bankruptcy in terms of whether any operating agreement is sought to be rejected under the principles pertaining to executory contract law under Bankruptcy Code section 11 U.S.C. § 365? If there is a consent provision which benefits the mezzanine lender, is that consent subject to being lost through a possible “rejection” of the operating agreement?

In summary, the mezzanine lender is taking a variety of risks, including a subordinated position on the real estate, a deferral of legal rights under an inter-creditor agreement, therisk of a complex foreclosure process, and the need to assert its rights as a new owner confronted with a possible foreclosure of the fee interest.

III. Risks related to creation and attachment: the “power” to assign the interest.

A. In order to have an enforceable security interest under the UCC, it is necessary that three steps occur, as set forth in UCC § 9-203(b):

1. There must be a valid security agreement.

2. Value must have been given by the lender.

3. The debtor must have rights in the collateral, including the right to transfer or assign the collateral.

B. The Official Comment to section 9-203 states, “[T]he baseline rule is that a security interest attaches only to whatever rights a debtor may have, broad or limited as those rights may be.”

C. Because “attachment” of the security interest is the critical first step, which in turn, is conditioned on the power of the debtor to transfer its interest, the issue for mezzanine lenders concerns the power of a debtor to assign its membership interest. The power to assign is limited under applicable state law because of the fundamental notion that a member’s interest is bifurcated into an economic and management interest. Carter G. Bishop and Daniel S. Kleinberger, LIMITED LIABILITY COMPANIES: TAX AND BUSINESS LAW, §8.06[1][a] (hereafter, “Bishop”).

1. This construct “operates to allow conveyance of a right to receive profits without giving the assignee an interest in the firm’s assets.” Thomas v. American Nat’l Bank, 704 S.W.2d 321, 323 (Tex. 1986).

D. The general rule in most LLC statutes is that the economic interest is freely assignable, whereas the management interest is not freely assignable. Assignment of the management interest requires the consent of the other members; one



commentator refers to this principle as the “pick your partner” principle, meaning that members have the right to control the admission of other members, but not the right to control the assignment of the economic interest.

E. In order to create a valid security interest in an LLC membership interest, so that the lender has effective control, the owner of the interest must have the legal right to assign all of the aspects of ownership, including the economic interest and the management interest. Although the economic interest can be assigned separately, it may be of little value to a lender which is seeking to gain control over the ownership of the fee interest, and then to restructure the loan with the mortgage lender on the fee. Thus, because a mezzanine lender is primarily interested in control and management, the key issue is whether the assignment of the interest is effective to convey the right to manage.

F. An example of the bifurcated nature of a member’s interest is found in the Delaware LLC Act. A member’s “interest” is defined as “a member’s share of the profits and losses of a limited liability company and a member’s right to receive distributions of the limited liability company’s assets.” DEL. CODE ANN. tit. 6, §18-101(8) (2006). The Delaware definition of an “interest” by itself does not include a right to manage.

G. However, the Delaware LLC Act provides that, “[u]nless otherwise provided in a limited liability company agreement, the management of a limited liability company shall be vested in its members in proportion to the then current percentage or other interest of members in the profits of the limited liability company owned by all of the members, the decision of members owning more than 50 percent of the said percentage or other interest in the profits controlling.” DEL. CODE ANN. tit. 6, § 18-402 (2006).

H. Under Delaware law, the interests of an owner are not freely assignable in the absence of the consent of other members or a provision in the operating agreement. The assignment of a member’s interest does not effectuate a transfer of any right to participate in management, “except as provided in the limited liability company agreement” and upon the approval of the other members orupon compliance with a procedure set forth in the limited liability company agreement:

(a) A limited liability company interest is assignable in whole or in part except as provided in a limited liability company agreement. The assignee of a member's limited liability company interest shall have no right to participate in the management of the business and affairs of a limited liability company except as provided in a limited liability company agreement and upon:



(1) The approval of all of the members of the limited liability company other than the member assigning the limited liability company interest; or

(2) Compliance with any procedure provided for in the limited liability company agreement.

(b) Unless otherwise provided in a limited liability company agreement:

(1) An assignment of a limited liability company interest does not entitle the assignee to become or to exercise any rights or powers of a member;

(2) An assignment of a limited liability company interest entitles the assignee to share in such profits and losses, to receive such distribution or distributions, and to receive such allocation of income, gain, loss, deduction, or credit or similar item to which the assignor was entitled, to the extent assigned . . .

DEL. CODE ANN. tit. 6, § 18-702 (2006).

I. “Many statutes provide generally that the transfer restrictions are subject to an LLC’s organic documents, and specifically that such documents can establish an alternate approval mechanism.” Bishop, supra at § 8.06[2][c][i].

IV. UCC § 9-408: the power to assign the membership interest and its limits.

A. The Delaware statutory limits on assignment must next be coordinated with statutory principles found in the UCC, both in Delaware and elsewhere.

B. UCC § 9-408 contains a series of rules which seek to coordinate with non-UCC provisions, by essentially providing that the lack of a right to assign does not mean that the security interest is ineffective for all purposes.

C. The first rule is that some restrictions on assignment, such as those which might be contained in an operating agreement, are ineffective “to the extent” that they would impair the creation or perfection of a security interest in such intangible:

(c) Legal restrictions on assignment generally ineffective. A rule of law, statute, or regulation that prohibits, restricts, or requires the consent of . . . account debtor [the partnership or LLC] to the assignment or transfer of, or creation of a security interest in . . . a general intangible . . . between an account debtor and a debtor, is ineffective to the extent that the rule of law, statute or regulation:

(1) would impair the creation, attachment or perfection of a security interest.



UCC § 9-408(c)(1).

D. Section 9-408(c) of the UCC would appear to mean that if the LLC operating agreement requires the consent of all members to an assignment, the failure to obtain such consent does not impair the creation or perfection of a security interest, but as noted below, may make enforcement of the interest virtually useless, such as by limiting or eliminating the right to foreclose upon the LLC interest.

E. UCC § 9-408(d) provides that even though a right may be assigned so as to create and perfect a security interest, the “effects” of that on the partnership may be that it need not recognize any attempt to liquidate or foreclose upon that interest:

(d) Limitation on ineffectiveness under subsections (a) and (c). To the extent that a term in . . . an agreement between an account debtor and a debtor which relates to a . . . general intangible or a rule of law, statute or regulation described in subsection (c) would be effective under law other than this article but is ineffective under subsection (a) or (c), the creation, attachment or perfection of a security interest in . . . the general intangible:

(1) is not enforceable against the . . . account debtor;

(2) does not impose a duty or obligation on . . . the account debtor;

(3) does not require the . . . account debtor to recognize the security interest, pay or render performance to the secured party, or accept payment or performance from the secured party;

(4) does not entitle the secured party to use or assign the debtor’s rights under the . . . general intangible . . . ; [and]

(6) does not entitle the secured party to enforce the security interest in the. . . general intangible.

UCC § 9-408(d).

F. The Official Comment to UCC § 9-408(d) describes this as a two-step analysis. In the first instance, the UCC makes “ineffective” an attempt to restrict the assignment of general intangibles. “This result allows the creation, attachment, and perfection of a security interest in a general intangible . . . On the other hand, subsection (d) protects the other party—the “account debtor” on a general intangible . . . —from adverse effects arising from the security interest. It leaves the account debtor or obligated person’s rights and obligations unaffected in all material respects if a restriction considered ineffective by subsection (a) or (c) would be effective under law other than Article 9.” Comment 2.



G. Example 1 in the Official Comments illustrates how this works with a non-exclusive license agreement. The licensee can grant a security interest in the license even though the license is not assignable. “However, under subsection (d) the secured party (absent the licensor’s agreement) is not entitled to enforce the license or to use, assign or otherwise enjoy the benefits of the licensed software, and the licensor need not recognize (or pay any attention to) the secured party.”

H. Definition of an “account debtor.”

1. UCC § 9-408 uses the term “account debtor” as it is defined in Section 9-102 of the UCC. The term refers to the party, other than the debtor, to a general intangible, including a permit, license, franchise, or the like. The definition of account debtor does not limit the term to persons who are obligated to pay under a general intangible. Rather, the term includes all persons who are obligated on a general intangible, including those who are obligated to render performance in exchange for payment. In some cases, e.g., the creation of a security interest in a franchisee’s rights under a franchise agreement, the principal payment obligation may be owed by the debtor (franchisee) to the account debtor (franchisor).

I. Delaware has a special section which overrides the UCC. DEL. CODE ANN. tit. 6, §18-1101(g) (2006) states:

(g) Sections 9-406 and 9-408 of this title do not apply to any interest in a limited liability company, including all rights, powers and interests arising under a limited liability company agreement or this chapter. This provision prevails over §§ 9-406 and 9-408 of this title.

J. In view of the Delaware statutory override, one author suggests that an assignment of even an economic interest may require consent of the other members.

Even this strategy will not always be effective though. Delaware has already adopted statutes overriding the UCC that provide that this new provision of the UCC does not apply to invalidate explicit restrictions on encumbering or transferring of limited partnership or limited liability company interests contained in the underlying operating agreements of the pledged entity. Following Delaware's lead, other states may do the same. Consequently, in these jurisdictions it may be impossible for a mezzanine lender to foreclose on even an economic interest pledge without consent of the remaining partners or members.

Dunn, cited in Fileti, supra at 1423 (emphasis added).

V. Obtaining consent as a required element of attachment of a lien.



A. A persistent issue is whether a mezzanine lender which seeks to take an assignment as collateral, or to acquire the interest in foreclosure, may do so where the lender lacks the consent of the other members?

B. In order to foreclose on an LLC membership interest, and to become a substitute or new member, the mezzanine lender will generally require the consent of the other members (assuming there are other members), unless the operating agreement provides otherwise. Otherwise, the “default” rule that restricts assignability may come into play.

C. Ideally, a mezzanine lender will have obtained advance consent from the other members in the original pledge and security agreement.

D. The principal risk is that a lender will not be able to obtain an effective transfer of the management interest without the consent of the other members.

Revised Article 9 of the UCC addressed this issue with a new provision that purports to override certain contractual prohibitions on the creation, attachment or enforcement of security interests in a payment intangible, which is defined as “a general intangible under which the account debtor's principal obligation is a monetary obligation.” It is fairly clear that if the original security interest granted by the mezzanine borrower was limited to just a so-called “economic pledge,” this new provision would act to permit the mezzanine lender to foreclose on the collateral even without consent of the other partners or members in the pledged entity.

Dunn, cited in Fileti, supra at 1427.

E. At least one author has suggested that if the pledge was of the entire interest, including management, then the interest may not be a payment intangible, andhence the UCC provision which seems to override the need for consent, is no longer operative. This risk was described as follows:

However, if the original pledged equity interest is the more common “full interest,” which includes voting and other control rights, then it is not clear that the new provision applies at all, because the pledged collateral may not squarely fit the definition of a payment intangible. If this is the case, then the new provision may not permit enforcement of only the economic portion of the pledged interest. Therefore, it may be wise in future transactions for mezzanine lenders to require that the mezzanine borrower execute two distinct security agreements: one creating a pledge on the “full interest” in the pledged entity and the other on just the "economic interest" so that the latter can



be foreclosed upon independent of the former if consents are an issue.

Dunn, cited in Fileti, supra at 1427.

VI. Perfection of a security interest in a membership interest under Article 9.

A. Perfection of a security interest in an LLC membership interest may be accomplished under either Article 8 or Article 9 of the Uniform Commercial code.

B. Perfection under Article 9 follows the rules for “general intangibles.” Article 9 defines a general intangible as “any personal property, including things in action, other than accounts, chattel paper, commercial tort claims, [and] deposit accounts . . . The term includes payment intangibles and software.” UCC § 9-102(42) (2006).

C. Perfection of an interest is accomplished by the filing of a UCC-1 in the appropriate jurisdiction. Priority rules follow the traditional rules that the first to file prevails.

As a general rule, for purposes of Article 9 of the UCC, a membership interest in an LLC is a “general intangible” and, as such, a security interest in that membership interest is perfected by filing a UCC-1 financing statement against the holder of the interest. This is true even where the limited liability company agreement may provide that the interest is represented by a certificate, much like a share certificate.

James O. Bourdeau, The Ins and Outs of Limited Liability Companies in New York, 25654 NBI-CLE 103, 112 (2005).

D. Limited partnerships have been held to be “general intangibles,” a security interest in which can be perfected by complying with Article 9 of the UCC. See Newcombe v. Sundara, 274 Ill.App.3d 590, 594 (Ill. App. 1995); Charter First Mtg., Inc. v. Oregon Bank, 7 U.C.C.Rep.Serv.2d 1644 (Bankr. D. Ore. 1988); Trapp v. Hancuh, 530 N.W.2d 879 (Minn. Ct. App. 1995).

VII. Perfection under Article 8 of the UCC.

A. The perfection of a security interest in an LLC membership interest may also be accomplished under Article 8. This is accomplished by electing to be treated under Article 8 in the operating agreement, that is by “opting in” to the statutory scheme.

B. Opting in may be achieved by having the operating agreement or general partnership agreement or limited partnership agreement contain minimal language



to the effect that the equity interests are governed by Article 8 of the applicable UCC.

C. If the members have “opted in” to Article 8, then perfection is by possession or control, depending on whether the membership interests are certificated:

However, if the limited liability company agreement expressly provides that the interests in that LLC are securities to be governed by Article 8 of the UCC, then the method for perfection of a security interest in that membership interest depends upon whether or not the membership interest is certificated or not. If Article 8 of the UCC is stated to apply, and the membership interest is certificated, then a security interest in that membership interest is perfected by taking delivery of the certificated interest. See UCC § 9-313(a), 8- 106(a) and § 8-301. If Article 8 of the UCC is stated to apply, and the membership interest is uncertificated, then a security interest in that membership interest is perfected through control of the uncertificated interest. See UCC § 9-314(c) and § 8-106(c).

Bourdeau, supra at 112.

D. As an investment property, a security interest perfected by control or possession would in most cases take priority over an interest that had been perfected previously only by filing, even if the subsequent party had actual knowledge. James D. Prendergast and Keith Pearson, How to perfect equity collateral under Article 8,” 20 PRAC. REAL EST. LAW. 33 (2004) (hereafter, “Prendergast”).

Part 2Enforcement Rights and Duties

I. Introduction.

A. In the event of default, a mezzanine lender will seek to foreclose upon the mezzanine’s borrower’s membership interest in the fee LLC. Typically, the concerns will be whether (i) the foreclosure sale will be effective to transfer both the economic and the management interest, (ii) a foreclosure sale can be accomplished before the fee lender foreclose on the real property and (iii) there is any notion of finality in terms of litigation over the method and manner of the foreclosure.

B. The foreclosure process is governed by the UCC, which imposes substantially more burdensome obligations on a lender and subjects the lender to (a) an increased risk of injunction, (b) an increased risk of a damage claim and (c) a risk of a loss of any deficiency claim. As noted above, “There is no question that the lack of standards and precedents specific to UCC foreclosure sales of mezzanine equity result in tremendous uncertainty for the mezzanine lender desiring to



commence a foreclosure of its collateral.” Dunn, supra, cited in Fileti, supra at 1423.

II. Foreclosure by public sale.

A. UCC § 9-610 provides that after default, a secured party may sell, lease, license or otherwise dispose of all or any of the collateral.

B. The sale must be commercially reasonable, in accordance with UCC § 9-610(b):

Every aspect of a disposition of collateral, including the method, manner, time, place, and other terms must be commercially reasonable. If commercially reasonable, a secured party may dispose of collateral by public or private proceedings, by one or more contracts, as a unit or in parcels, and at any time and place and on any terms.

UCC § 9-610(b).

C. In most cases, a sale may be either a “public disposition” or a “private disposition.” However, the private sale is unlikely in the case of a mezzanine lender. While the UCC permits a secured lender to foreclose generally by the use of a private or public sale, a private sale can only occur if the collateral is of a kind customarily sold on a recognized market. Because there is no recognized market for a membership interest, it has been generally recognized that a foreclosure under a mezzanine loan must be by a public sale. See part IV below.

D. Generally, foreclosure under the UCC is accomplished through a non-judicial sale, either public or private, pursuant to UCC § 9-610. Such sales are “nonjudicial” and are governed by requirements relating to advertising and notice.

E. The hallmark of a public sale is generally considered to be an auction where there is competitive bidding. “Although the term is not defined, as used in this Article, a ‘public disposition’ is one at which the price is determined after the public has had a meaningful opportunity for competitive bidding. ‘Meaningful opportunity’ is meant to imply that some form of advertisement or public notice must precede the sale (or other disposition) and that the public must have access to the sale (disposition).” UCC § 9-610, Official Comment 7.

F. Based on the quoted Comment 7, the basic elements of a public sale are the following:

1. Notice of default;

2. Advertising;

3. Opportunity to inspect; due diligence; and

4. Public auction.



G. The basic process is described by one commentator as follows:

A public sale is not limited strictly to the proverbial auction on the courthouse steps; it is any sale where the price is determined after the public has had a meaningful opportunity for competitive bidding. There must be public notice of the sale, an opportunity for bidders to “inspect” the collateral (which means access to information to evaluate the collateral rather than physical inspection in the case of intangible property) and a chance to participate in the bidding process.

Fileti, supra at 1423.

H. The use of a broker has been highly recommended:

One course the mezzanine lender should consider is retaining a broker to advise the lender on how to organize and conduct the sale and to market the interests to targeted potential bidders. This strategy can be helpful for several reasons.

First, many brokers are experienced in marketing equity interests in real estate entities because they typically structure a variety of real estate transactions. They can advise not only on where and how to advertise and conduct the sale, but they also can assist in organizing and distributing appropriate due diligence information to bidders.

Second, the fact that the foreclosing lender sought the advice of a qualified real estate sales expert will help demonstrate commercial reasonableness should the pledgor ultimately challenge the commercial reasonableness of the lender's foreclosure sale.


III. Public sale; securities issues.

A. A foreclosure sale of limited partnership or limited liability company interests, even pursuant to the UCC, also may be subject to applicable state and federal securities laws, further complicating the process. The mezzanine lender should initially consult with securities counsel to determine if this is the case and, if so, what limitations or requirements of the securities laws might be implicated by the UCC foreclosure sale process. Fileti, supra at 1426.

B. UCC § 8-103(c) provides that except for certain situations, equity interests in a limited liability company, a general partnership or a limited partnership are “not a



security unless it is dealt in or traded on securities exchanges or in securities markets. . . .” UCC § 8-103(c).

IV. No private sale of membership interests to secured party.

A. UCC § 9-610(c) states as follows:

(c) Purchase by secured party. A secured party may purchase collateral:

(1) at a public disposition; or

(2) at a private disposition only if the collateral is of a kind that is customarily sold on a recognized market or the subject of a widely distributed standard price quotations.

B. A private sale is generally not permitted if the lender seeks to acquire the membership interest itself:

UCC foreclosure sales may be public or private. However, the secured party may purchase at a private disposition only if the collateral is of a kind customarily sold on a recognized market or is the subject of widely distributed price quotations. Of course, this exception would not include collateral such as limited partnership or limited liability company interests not listed on a securities exchange. If the mezzanine lender expects or desires to be the purchaser at the foreclosure sale, which is usually the case, then the disposition must be structured as a public sale under the UCC.

See Fileti, supra at 1423 (citing Dunn).

V. Strict foreclosure : retention of the collateral in satisfaction of the debt; no springing membership interests?

A. “Strict foreclosure” is the right of a lender to retain collateral in full or partial satisfaction of a claim. Such a right might be of value to a mezzanine lender because, in theory, it would permit the mezzanine lender to become a member immediately upon default and notice, and without the attendant risks and delay of a UCC foreclosure sale. Such a right might also be important because the mezzanine lender may find that the first trust lender can foreclose and extinguish any interest in the real estate before the mezzanine lender can exercise its remedies.

B. While strict foreclosure would appear to be valuable in general, it is not likely to be available in the context of a pledge of an equity interest.

C. UCC § 9-620 provides that retention of the collateral can only occur if consent is given by a borrower after default:



(a) Conditions to acceptance in satisfaction. Except as otherwise provided subsection (g), a secured party may accept collateral in full or partial satisfaction of the obligation it secures only if:

(1) the debtor consents to the acceptance under subsection (c) . . .

* * *

(c) Debtor’s consent. For purposes of this subsection:

(1) a debtor consents to an acceptance of collateral in partial satisfaction of the obligation it secures only if the debtor agrees to the terms of the acceptance in a record authenticated after default; and

(2) a debtor consents to an acceptance of collateral in full satisfaction of the obligation it secures only if the debtor agrees to the terms of the acceptance in a record authenticated after default or the secured party:

(A) sends to the debtor after default a proposal that is unconditional or subject only to a condition that collateral not in the possession of the secured party be preserved or maintained; [and]

* * *

(C) does not receive a notification or objection authenticated by the debtor within 20 days after the proposal is sent.

D. The prohibition on a strict foreclosure is expressly made non-waivable. U.C.C. § 9-602(10).

E. It has been suggested that lenders may have the right to becoming a “springing member.” This right may be no different than a strict foreclosure, and hence may be unavailable unless the mezzanine lender can obtain post-default consent.

F. Given the provisions of UCC § 9-620, it would appear that a provision which permits the lender to “foreclose” on the collateral without a public or private sale violates this section.

G. It might be argued that a provision which purports to assign a management right to a lender, on a less than absolute basis (or temporarily) is not a foreclosure and hence is permitted. Since a right to manage may be vested in a non-member, such a provision may be effective, provided that the security agreement acts as a modification of the LLC agreement.

VI. Notice of the sale: can the foreclosure sale be conducted in time to prevent extinction by the first trust lender?



A. The UCC provides a ten-day safe harbor for notice of the sale to the debtor. UCC § 9-612(b).

B. However, it has been suggested that it probably is not commercially reasonable to expect potential bidders to inspect the underlying real property, perform a due diligence analysis and prepare a bid within that time frame. Dunn, cited in Fileti, supra at 1425.

C. If the underlying mortgage is in default, and there is a risk that foreclosure will occur, then the mezzanine lender may decide that the notice requirement does not apply, and invoke the UCC principle that notice is not required where the collateral threatens to decline in value. UCC § 9-611(d).

D. The “Whiting Pools” dilemma. Because the sale must be public, and must be done pursuant to auction and advertising, there will invariably be a significant time period between declaration of default and the proposed date for the sale of the collateral. This time gap will permit the borrower a sufficient time to file for relief under chapter 11. This time gap may create an issue under Whiting Pools. Generally, where a lender commences foreclosure, but has not yet acquired full title to the collateral, then the filing of a bankruptcy will result in the collateral remaining property of the estate, and will thus essentially unwind the foreclosure. United States v. Whiting Pools, Inc., 103 S.Ct. 2309, 462 U.S. 198 (1983).

VII. The lender’s obligation of “commercially reasonable.”

A. The UCC requires that every aspect of a foreclosure sale must be commercially reasonable. UCC § 9-610(b) states as follows:

(b) Commercially reasonable disposition. Every aspect of a disposition of collateral, including the method, manner, time, place, and other terms, must be commercially reasonable.

B. The standard for what constitutes commercially reasonable is not well-defined:

The UCC, however, provides very little guidance as to what constitutes a commercially reasonable sale. The challenge for the mezzanine lender conducting a UCC foreclosure sale of its equity pledge collateral is establishing commercially reasonable sale standards when little or no authority exists in the way of recognized market procedures, statutory safe harbors or reported case law.


C. Safe harbors. UCC § 9-627(b) provides certain safe harbors for what constitutes a commercially reasonable sale, none of which would appear to be of any value in a foreclosure by a mezzanine lender.



(b) Dispositions that are commercially reasonable. A disposition of collateral is made in a commercially reasonable manner if the disposition is made:

(1) in the usual manner on any recognized market;

(2) at a price current in any recognized market at the time of the disposition; or

(3) otherwise in conformity with reasonable commercial practices among dealers in the type of property that was the subject of the disposition.

UCC § 9-627(b).

D. Bankruptcy safe harbor. UCC § 9-627(c) provides a safe harbor for sales conducted in a bankruptcy proceeding, and states that if the sale is approved in a judicial proceeding or by a bona fide creditors committee, then the sale is “commercially reasonable.”

E. Real property foreclosure: “shock the conscience” standard. A foreclosure under state law of real property in most jurisdictions is not subject to any statutory or common law principle that the sale be “commercially reasonable,” and in general, the courts have approved sales prices which are well below the market price, provided that the price does not “shock the conscience of the court.” As acourt in Maryland stated:

It is a well established principle that a sale of property at a foreclosure sale will not be set aside in Maryland unless the price was “so inadequate as to shock the conscience of the Court.” Waring v. Guy, 248 Md. 544, 549, 237 A.2d 763, 766 (1968). The mere inadequacy of price is not sufficient. Id.; see also Garland v. Hill, 277 Md. 710, 712, 357 A.2d 374, 375 (1976).

Federal Land Bank of Baltimore, Inc. v. Esham, 43 Md.App. 446, 406 A.2d 928 (Md. App 1979).

F. Inadequacy of price. UCC § 9-627(a) states that “the fact that a greater amount could have been obtained by a collection, enforcement, disposition, or acceptance at a different time or in a different method from that selected by the secured party is not of itself sufficient to preclude the secured party from establishing that the collection, enforcement, disposition or acceptance was made in a commercially reasonable manner.

G. Divided judicial reaction on price term. The courts appear to be divided on the significance of the price term. For example, in Leasing Serv. Corp. v. Diamond Timber Inc., 559 F. Supp. 972, 979 (S.D.N.Y 1983), the court stated, “[c]ommercial reasonableness of a sale depends on the procedures employed, not on the proceeds it generates.” aff’d, 729 F.2d 1442 (2d Cir. 1983). However, in Mercantile Fin. Corp. v. Miller, 292 F. Supp. 797, 801 (E.D. Pa. 1968), the court



stated that a discrepancy between price paid and price obtainable “if substantial, is relevant to a determination of whether a challenged sale [is] ‘commercially reasonable.’ ” And, “[w]hile not itself sufficient to establish a violation of this section, a low price suggests that a court should scrutinize carefully all aspects of a disposition to ensure that each aspect was commercially reasonable. UCC 9-610, Official Comment 10. See In re Pettey, 288 B.R. 14 (Bankr. D. Mass. 2003).

H. A mezzanine lender may need to look to the normal practices of state law governing real estate foreclosures for guidance:

There is no question that the lack of standards and precedents specific to UCC foreclosure sales of mezzanine equity result in tremendous uncertainty for the mezzanine lender desiring to commence a foreclosure of its collateral. However, because mezzanine loan collateral is, in effect, a hybrid of real and personal property, it may be useful in some circumstances for the mezzanine lender to look to real property sale practices to draw logical and appropriate comparisons for commercial reasonableness. By considering the comparable procedures in real property transactions, both in the context of arm's length transactions and under real property foreclosure sales, the mezzanine lender may find some useful guidance. Such an analysis will assist in establishing commercial reasonableness in the foreclosure sale of mezzanine collateral.


VIII. Right to redeem collateral.

A. The UCC provides that a borrower and any secondary obligor may redeem the collateral after notice of foreclosure, and prior to disposition of the collateral or the entering into of a contract for its disposition. UCC § 9-623. .

B. This right cannot be waived in the loan documents. It may only be waived by a writing signed by the borrower and issued after default. UCC § 9-624.

C. This redemption right, coupled with the possible right to enjoin the sale, creates a greater uncertainty than would occur in the normal real property foreclosure. However, the ability to redeem requires that the borrower “tender” the “fulfillment of all obligations secured by the collateral” and “the reasonable expenses and attorney’s fees described in Section 9-615(a)(1).” UCC § 9-623(c).

D. The Comment states that in order to redeem the borrower must tender fulfillment of all obligations. “If the entire balance of a secured obligation has been accelerated, it would be necessary to tender the entire balance.” UCC § 9-623, Comment, 2.



Part 3Borrower’s Remedies for Lender’s Failure to Act

in A Commercially Reasonable Fashion

I. Failure to act in a commercially reasonable way; borrower’s remedies for non-compliance.

A. A key issue for the mezzanine lender concerns the remedies which may be available to a borrower who contends that either the sale, the sales process, the proceeds, or the entire “enforcement” has been commercially unreasonable.

B. Some of the available remedies may be more significant than others. For example, if an unreasonable sale results in the loss of a right to seek a deficiency claim, and if the obligation is non-recourse, then the remedy has no significance. However, if a borrower can seek to (a) enjoin the sale, (b) seek monetary damages for loss of an alleged surplus or other forms of damages or (c) seek to rescind or avoid the sale, then such remedies may be significant.

II. Enjoining the foreclosure sale.

A. The foreclosure on a mezzanine interest is markedly different from foreclosure on a real property interest. They are governed by different bodies of law, with sharply different public policies. Thus, there is a strong public policy in favor of finality of land transactions, with importance being given to the validity of recorded instruments and interests. Under the UCC, however, the emphasis is much more on insuring that all aspects of the sale and enforcement are done in a commercially reasonable fashion. Because the obligation to act in a commercially reasonable way is tied to both enforcement and foreclosure, the borrower’s opportunity to seek an injunction or otherwise delay and interfere with the foreclosure process is greatly increased.

B. Under state law in many jurisdictions, a foreclosure sale of real property can only be enjoined on the very limited grounds that the mortgage debt has been paid or that there is no default. The notion that a real estate foreclosure can be enjoined on the grounds of a lack of good faith would be far less likely to be considered by a state court.

C. However, UCC § 9-625(a) states that “[i]f it is established that a secured party is not proceeding in accordance with this article, a court may order or restrain collection, enforcement or disposition of collateral on appropriate terms and conditions.”

D. The Official Comment indicates that a borrower may seek injunctive relief for noncompliance “with any provision of this Article,” and not merely with noncompliance with “this Part of Article 9.” UCC § 9-625, Official Comment 2. In other words, if an aggrieved party claims there was a lack of good faith (UCC §



1-203), or the sale was not conducted or advertised in a commercially reasonably manner (§§ 9-607, 9-610), or there was a failure to give adequate notice (§§ 9-611 to 9-614), a borrower may have grounds for injunctive relief.

E. Given the notion that an injunction may be based on “any provisions of this Article,” an injunction right might exist for failure of a lender to act in a commercially reasonable fashion with respect to the administration of the loan or the manner and method of enforcing the loan, or for misconduct during a workout. An injunction is thus maintainable for failure to proceed “in accordance” with a standard of commercially reasonable and good faith. A breach of the duty of good faith might even include such grounds as the issuance of an improper notice of default, a violation of a pre-negotiation letter or a variety of issues which are embraced within the traditional notions of “lender liability.”

F. These standards are markedly different under the law in many states dealing with foreclosures on real property. For example, under Maryland law, a party seeking to enjoin a sale must state under oath that the debtor has paid the full debt, or that “there is no default” or “fraud was used by the secured party. . . in obtaining the lien.” There is no stated ground for conduct which is unreasonable related to the underlying loan transaction or the manner of the sale.

(b) Injunction to stay foreclosure. (1) Motion. The debtor, any party to the lien instrument, or any person who claims under the debtor a right to or interest in the property that is subordinate to the lien being foreclosed, may file a motion for an injunction to stay any sale or any proceedings after a sale under these rules. The motion shall not be granted unless the motion is supported by affidavit as to all facts asserted and contains: (1) a statement as to whether the moving party admits any amount of the debt to be due and payable as of the date the motion is filed, (2) if an amount is admitted, a statement that the moving party has paid the amount into court with the filing of the motion, and (3) a detailed statement of facts, showing that: (A) the debt and all interest due thereon have been fully paid, or (B) there is no default, or (C) fraud was used by the secured party, or with the secured party's knowledge, in obtaining the lien.

MD. CODE ANN., REAL PROP. § 14-209(b) (2006).

III. General rule: damages for non-compliance.

A. The general rule for a damage claim for non-compliance with the obligation to act in a commercially reasonable fashion and for other violations is found in UCC § 9-625.



B. UCC § 9-625(b) provides that a borrower may seek damages for “any loss caused by a failure to comply with this article. Loss caused by a failure to comply may include loss resulting from the debtor’s inability to obtain, or increased costs of, alternative financing.” UCC § 9-625(b).

C. The Official Comment underscores the guiding principle that the damage claim should be in an amount which is necessary to “put an eligible claimant in the position that it would have occupied had no violation occurred.” UCC § 9-625, Official Comment 3.

IV. Liability for surplus if lender acquires mezzanine interest.

A. The UCC contains a special provision which relates to the determination of a surplus or deficiency in those cases where the “transferee in the disposition is the secured party. . . .” UCC § 9-615(f)(1). This section states:

(f) Calculation of surplus or deficiency in disposition to person related to secured party. The surplus or deficiency following a disposition is calculated based on the amount of proceeds that would have been realized in a disposition complying with this part to a transferee other than the secured party, a person related to the secured party, or a secondary obligor if:

(1) the transferee in the disposition is the secured party, a person related to the secured party, or a secondary obligor; and

(2) the amount of proceeds of the disposition is significantly below the range of proceeds that a complying disposition to a person other than the secured party, a person related to the secured party, or a secondary obligor would have brought.

UCC § 9-615(f)(1).

B. In essence, UCC 9-615 creates a special “price rule” which means that if a lender buys in at a public sale of a membership interest, then the lender is liable for a “surplus” even without a showing that the sales process was not commercially reasonable, if the price is “significantly below” a price a third party might have paid.

C. This section significantly alters the legal standard by removing the defense that the lender acted reasonably, and making the lender liable for a potential surplus that might have been achieved. Thus, even if the auction yields no other buyers, and even if the auction was fair, the borrower might assert that a more diligent search for buyers, or a holding of the interest for a period of time, would have generated a bona fide third party buyer at a higher price.



V. Risk of loss of deficiency claim.

A. If a lender acts in a fashion which is found not to be commercially reasonable, it may lose the right to collect any deficiency:

Failure of the secured party to act in a commercially reasonable manner may subject the secured party to a possible loss of a right to a deficiency against the debtor, damages for loss of surplus or other damages. It is true that where the underlying debt is nonrecourse, which is frequently the case in real estate mezzanine loan structures, the secured party is not likely to be concerned with preserving rights to a deficiency claim; however, it is still essential to comply with the UCC requirement of commercial reasonableness to avoid other damage claims from the debtor.


B. If the mezzanine loan is non-recourse, then the loss of the deficiency may be unimportant.

VI. Legal action to set aside the foreclosure sale.

A. The UCC does not contain an explicit statement that a borrower’s remedies for wrongful conduct leading up, or in the foreclosure process, includes a right to rescind a foreclosure sale.

B. UCC § 9-617 provides that a transferee or purchaser at a foreclosure sale acquires the assets free of the debtor’s rights in the collateral “even if the secured party fails to comply with this article or the requirements for any judicial proceeding.” UCC § 9-617(b). It is arguable that since the Code expressly provides for the transfer of good title even in a defective sale, the borrower cannot move to set aside the sale.

C. However, UCC § 1-305 states that the various remedies are to be liberally administered and, as noted below, has led some courts to conclude that the listed remedies are not the exclusive remedies:

(a) The remedies provided by [the UCC] must be liberally administered to the end that the aggrieved party may be put in as good a position as if the other party had fully performed but neither consequential or special damages nor penal damages may be had expect as specifically provided in [the UCC] or by other rule of law.

D. In Jacobs v. Healey Ford-Subaru, Inc., 231 Conn. 707, 652 A.2d 496 (Conn. 1995), the court stated that the remedies under Article 9 for an improper foreclosure are not exclusive:



The creditor had argued that the remedy in § 9-507(1) was intended to be exclusive and that the debtor was therefore not entitled to avail himself of the absolute bar rule. In rejecting this claim, the court referred to § 1-106(1) of the Delaware UCC, which specifically recognizes the applicability of other remedies, providing that the remedies afforded by the UCC “shall be liberally administered . . . but neither consequential nor special nor penal damages may be had except as specifically provided in this subtitle or by other rule of law. (emphasis added.)” (Internal quotation marks omitted.) Wilmington Trust Co. v. Conner, supra at 779. The court concluded that “because of their learning, skill and experience, the drafters of the Uniform Commercial Code, had they truly intended the remedy to be exclusive, would have been scrupulously careful to state it. Their omission of language in § 9-507(1) expressly indicating exclusivity of the remedy thus speaks volumes against the correctness of [the] plaintiff's position.” (Internal quotation marks of the Delaware UCC omitted.)Id., at 780, additionally, the court relied on § 1-103 of the Delaware UCC, which provides that other rules of law may supplement the UCC unless they are displaced by particular UCC provisions. The Delaware court interpreted that section to mean that only if other provisions “explicitly” displace any other rule of law, will such provision be exclusive. Id., at 779. The court concluded that the drafters' failure to explicitly limit a debtor to § 9-507(1) reflects an intent that the remedy contained therein not be the debtor's sole recourse.

Jacobs, supra at 720-22.

E. See also Camden National Bank v. St. Clair, 309 A. 2d 329 (Me. 1973) (“in view of the omission of § 9-507(1) expressly to state that it provides an exclusive remedy for notification deficiencies, UCC § 1-103 becomes most significant. Its import is that the right of action established by § 9-507(1), absent clear expression to the contrary, must be held cumulative in the context of remedies previously, or otherwise, afforded”); see also Industrial Valley Bank & Trust Co. v. Nash, 349 Pa.Super. 27, 44, 502 A.2d 1254 (1985) (Motor Vehicle Sales Financing Act [“MVSFA”] provisions not intended to be exclusive; UCC and MVSFA are “in pari materia” and should be construed together to enhance the purposes of both statutes); Davenport v. Chrysler Credit Corp., 818 S.W.2d 23, 31 (Tenn. App. 1991) (UCC § 9-507[1] provides “remedies are not intended to be exclusive and, in fact, are cumulative to other remedies available to debtors under state law”); see generally Atlas Thrift Co. v. Horan, 27 Cal.App.3d 999, 1008, 104 Cal.Rptr. 315 (1972) (remedies available before adoption of UCC are not eliminated unless



UCC specifically deletes them); Christian v. First National Bank, 531 S.W.2d 832, 843 (Tex. App. 1975) (same).

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