‘Clogging’ and the Double Collateralized Loan: Modern Finance Meets English Common Law | K&L Gates LLP

Reprinted with permission from the New Jersey Law Journal.

Mortgage loan structures that were considered “non-traditional” in the past have become commonplace in modern finance. For example, when a conventional mortgage lender’s underwriting requirements include an 80 percent limit on the value of the loan with a ban on subordinate liens on real estate, borrowers often seek to finance a portion of the remaining 20 percent. through a mezzanine lender who guarantees its loan with a lien on the interests of the borrowing entity. A more aggressive private lender unconstrained by such institutional requirements might seek to hedge the increased risk of a higher loan-to-value transaction with a set of “double guarantees” that include both a mortgage lien on real estate and a mortgage lien. Uniform Commercial Code (“UCC”) on the borrower’s majority stake. To varying degrees, both involve an ancient doctrine rooted in English common law known as “obstruction of the equity of redemption,” as seen in a recent New York case discussed below.

What is “clogging”?

One of the maxims long revered by fairness, the prohibition on obstructing the equity of redemption is based on the fundamental principle “once a mortgage, always a mortgage”. See 4 Pomeroy, Equity Jurisprudence (5th ed., 1941), art. 1193 to 568 and following. More broadly, when a borrower grants a mortgage on his property to a lender as security for a debt, he must always have the right to repay the debt, thereby extinguishing any claim of the lender on the asset, and this right cannot be waived or waived as part of the initial transaction. Stated as such, the logic of the doctrine seems obvious and uncontroversial – certainly not something that could have intrusive implications in modern real estate finance. In practice, however, this is not always as easy as it sounds.

The doctrine originated in the 16th century in England, when borrowers gave lenders a mortgage deed to hold in trust that the lender could immediately register in the event of default, thereby transferring the title of the borrower to himself without procedure. judicial. Indeed, while in New Jersey we use the term “mortgage” to describe the relevant security instrument, many other jurisdictions still use the English common law nomenclature, a “trust deed”. The plugging doctrine was developed to rule over the aggressive and often unscrupulous practices of lenders seizing borrowers’ relatively minor missteps to declare a mortgage default, speed up the due date, and reap a windfall when the borrower fails. could not find the funds to meet the debt. The excess of the fair market value of the property over the then unpaid mortgage amount was therefore irrevocably forfeited by the borrower for the benefit of the lender upon the transfer of ownership. In this sense, the doctrine of plugging could also be seen as echoing the more familiar principle of broader jurisprudential applicability, “fairness abhors confiscation”.

Distilled to its essence, the doctrine postulates that regardless of how a transaction is structured, if it is fundamentally a loan to a borrower secured by real estate, the borrower retains the right to ” redeem »his property until this right is cut off by judicial foreclosure. This not only prohibits a mortgage lender from taking a deed into receivership pending default by the borrower, but also precludes a lender’s option to purchase the borrower’s property, the logic being that if a lender holds such an option, it remains in a position to frustrate the borrower’s repurchase rights because upon exercise of the option by the lender, the borrower would have lost his ability to recover the property unhindered property.

New Jersey Sealing Act: the Humble oil Case

New Jersey case law on plugging is scarce, but it is dealt with extensively in Humble Oil & Refining Company v. Doerr, 123 NJ Super. 530 (Ch. Div., 1973). There, a service station operator leased his property to a distributor, Humble Oil & Refining Company (“Humble Oil”), who then immediately sublet it to the operator on the same lease terms (i.e. ie a “lease-lease” structure). . At first glance, the transaction appears to be null and void: the rent to be collected from Humble Oil by the operator was set to zero by the sub-rent that it owed simultaneously under the sublease. The arrangement was nonetheless significant because the rent to be received by the operator was obviously supported by the financial strength of Humble Oil; thus, with Humble Oil’s creditworthiness now behind it, the operator could secure otherwise unavailable bank financing secured by a mortgage on its gas station property and a pledge to the lender of its leasehold interest as the owner of Humble. Oil.

Initially, it had all the appearances of a “win-win-win”. The operator could borrow the necessary funds to modernize its gas station; Humble Oil had a customer indebted to it under the sale-leaseback agreement; and the bank had a creditworthy loan because in the event of default it would foreclose the building and take over the operator’s position as landlord, then receiving rent payments directly from Humble Oil. However, there was a significant difference between the lease to Humble Oil and its sublease to the operator: the former contained a fixed-price purchase option while the latter did not. Several years later, when the property became much more valuable, Humble Oil sought to exercise the option. In response, the operator filed a complaint to cancel the option for various reasons.

There are additional facts beyond the scope of this article; however, the significance of the case in terms of obstruction of jurisprudence is that the court ultimately sided with the operator, holding that the substance of the transaction had to be seen through its form, and this that the court saw was not a true “lease-lease”, but a mortgage loan guaranteed by the bank to the operator of the gas station, guaranteed by Humble Oil. How did this imply the doctrine of plugging? The court concluded that just as a mortgagor does not have the right to extract a purchase option from the mortgagor as part of the initial financing transaction, so does the mortgagor’s guarantor.

Significantly, Humble oil is a trial decision in a case without a jury, so the judge also served as an investigator. In his view, Judge Ackerman noted that he neither found the operator particularly credible nor likable (in terms of his protests that she was somehow cheated in the deal). He also found the option’s terms to be harmless when granted (at 50% above fair market value at the time). Nonetheless, he concluded that the public policy underlying the chinking doctrine was sacrosanct and, therefore, sufficient justification to overturn the option in the hands of Humble Oil.

New York law: HH Cincinnati Textile LP v. Acres Capital Servicing LLC

The clogging doctrine emerged recently in a case in New York County, HH Cincinnati Textile LP v. Acres Capital Servicing LLC, Index No. 652871/18 (Sup. Ct., NYCo., 2018). There, a lender funded the redevelopment of two historic properties in the Midwest by a borrower (a partnership), whose only asset was the properties. The project had many complexities, but for the purposes of this article, the main feature is that as collateral for the loan, the borrower granted the lender a mortgage on the property and a pledge by the borrower’s partners of their interests. in the borrower.

Significantly, this was structured as a single loan with a double guarantee rather than split into two separate loans, one a mortgage secured by real estate and the other a mezzanine loan secured by equity. After default, the lender therefore had the option of seizing the property under the mortgage or the interests in the company under the pledge. In essence, the result of either would be the same in that the lender takes control of the building, directly in the first case and indirectly in the second. Procedurally, however, there is a dramatic difference: Judicial foreclosure of the mortgage can easily take two to three years, while a sale by execution of Section 9 UCC only requires ” commercial reasonableness ‘and 10 days’ notice. [Cf. N.J.S.A. 12A:9-610 and 611.]

When the lender announced the sale of the partnership interests (which was to be carried out by auction at the lender’s attorney’s office), the borrowers decided to ban it, arguing that allowing a mortgagee to proceed in this manner amounted to an inadmissible “obstruction” to their equity in redemption. The court disagreed, noting that UCC gave borrowers the right to “redeem” their interests in the partnership until the time of the execution sale. [Cf. N.J.S.A. 12A:9-623]

Third party clogging and closure notices

Given the frequency of New York’s “choice of law” provisions in mortgage transactions, HH Cincinnati warrants consideration by New Jersey real estate finance practitioners. At this time, it is unclear whether the case qualifies as “New York law” as it is an unpublished trial-level opinion decided on a preliminary injunction motion. . It’s also unclear whether a New Jersey court facing similar facts would follow suit. HH Cincinnati reasoning. Indeed, given Humble oil compliance with the lock-up doctrine (which went so far as to cancel a call option even in the hands of a guarantor rather than the mortgagee), it is not certain that a New Jersey court would do so even when the underlying loan documents state that New Jersey York law must govern. Thus, the most prudent course of action for New Jersey practitioners giving advice when closing double collateralized loans would be to report this issue as unresolved under current law and possibly policy. public so strong here that New York law might not be followed.