"Clogging" and the Dual Collateral Loan: Modern Finance Meets English Common Law

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Reprinted with permission from the New Jersey Law Journal.

Real estate loan structures considered “non-traditional” in years past have become commonplace in modern finance. For example, where a conventional mortgage lender’s underwriting requirements include an 80 percent loan-to-value limitation with a prohibition against subordinate liens on the real estate, borrowers often seek to finance some portion of the remaining 20 percent component through a mezzanine lender who secures its loan with a lien on the equity interests of the borrowing entity. A more aggressive private lender unconstrained by such institutional requirements might seek to hedge the greater risk of a higher loan-to-value transaction with a “dual collateral” package that includes both a mortgage lien on the real estate and a Uniform Commercial Code ("UCC") lien on the controlling interest of the borrower. To varying degrees, both implicate an ancient doctrine rooted in English common law known as “clogging the equity of redemption,” as was seen in a recent New York case discussed below.

What is “Clogging”?

One of equity’s long revered maxims, the prohibition against clogging the equity of redemption rests on the foundational principle, “once a mortgage, always a mortgage.” See 4 Pomeroy, Equity Jurisprudence (5th ed., 1941), s. 1193 at 568 et seq. More expansively, when a borrower grants a mortgage on its property to a lender as security for a debt, it must always have the right to repay the debt, thereby extinguishing any claim of the lender to the property, and this right cannot be waived or abandoned as part of the initial transaction. Stated as such, the doctrine’s logic appears self-evident and uncontroversial — certainly not something that could have intrusive implications in modern real estate finance. In practice, however, it is not always as simple as it sounds.

The doctrine originated in 16th century England, when borrowers would give lenders a deed to the mortgaged property to be held in trust that the lender could immediately record upon a default, thereby transferring title from the borrower to itself without judicial process. Indeed, while in New Jersey we use the term “mortgage” to describe the relevant security instrument, many other jurisdictions still employ the English common law nomenclature, a “deed in trust.” The clogging doctrine was developed to reign in the aggressive and often unscrupulous practices of lenders seizing upon relatively minor borrower missteps to declare a mortgage default, accelerate the maturity date, and reap a windfall when the borrower could not come up with the funds needed to satisfy the debt. The excess of the property’s fair market value over the then-outstanding mortgage amount was thus irrevocably forfeited by the borrower to the lender upon the title transfer. In that sense, the clogging doctrine might also be seen as echoing the more familiar principle of broader jurisprudential applicability, “equity abhors a forfeiture.”

Distilled to its essence, the doctrine posits 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” its property up until that right is cut off through judicial foreclosure. This not only prohibits a mortgage lender from taking a deed to be held in escrow pending a borrower default, but also precludes a lender’s option to purchase the property from the borrower, the logic being that if a lender holds such an option, it remains in a position to frustrate the borrower’s redemption rights because upon the lender’s exercise of the option, the borrower would have lost its ability to reclaim unfettered ownership of the property.

New Jersey Clogging Law: The Humble Oil Case

There is a paucity of New Jersey case law on clogging, but it is comprehensively addressed in Humble Oil & Refining Company v. Doerr, 123 N.J. Super. 530 (Ch. Div., 1973). There, a gas station operator leased its property to a distributor, Humble Oil & Refining Company (“Humble Oil”), who then immediately subleased it back to the operator on the same rental terms (i.e., a “lease-leaseback” structure). At first blush, the transaction seems like a nullity: The rent to be received from Humble Oil by the operator was zeroed out by the sub-rent it simultaneously owed back under the sublease. The arrangement was nonetheless significant because the rent receivable by the operator was obviously supported by Humble Oil’s financial strength; thus, with Humble Oil’s creditworthiness now behind it, the operator could obtain otherwise unavailable bank financing secured by a mortgage on its gas station property and a pledge to the lender of its leasehold interest as Humble Oil’s landlord.

At the outset, this had every appearance of a “win-win-win.” The operator could borrow funds needed to upgrade its gas station; Humble Oil had a customer beholden to it by virtue of the lease-leaseback arrangement; and the bank had a creditworthy loan because in the event of a default, it would foreclose on the real estate and take over the operator’s position as landlord, thereafter receiving the rent payments directly from Humble Oil. However, there was one significant difference between the lease to Humble Oil and its sublease back to the operator: The former contained a fixed-price purchase option while the latter did not. Several years later, when the property had become much more valuable, Humble Oil sought to exercise the option. In response, the operator filed suit seeking to set aside the option on various grounds.

There are additional facts beyond the scope of this article; however, the import of the case in terms of clogging 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 what the court saw was not a true “lease-leaseback” arrangement, but a mortgage-secured loan by the bank to the gas station operator, guaranteed by Humble Oil. How did this implicate the clogging doctrine? The court concluded that just as a mortgagee is barred from extracting a purchase option from the mortgagor as part of the initial financing transaction, so too is the mortgagor’s guarantor.

Significantly, Humble Oil is a trial-level decision in a non-jury case, so the judge also served as fact-finder. In his opinion, Judge Ackerman noted that he neither found the operator to be particularly credible nor sympathetic (in terms of her protestations that she was somehow hoodwinked into the deal). He also found the option terms to be inoffensive when granted (at 50 percent above the then fair market value). Nonetheless, he concluded that the public policy underlying the clogging doctrine was sacrosanct and, thus, sufficient justification for voiding the option in Humble Oil’s hands.

New York Law: H.H. Cincinnati Textile L.P. v. Acres Capital Servicing LLC

The clogging doctrine arose recently in a case venued in New York County, H.H. Cincinnati Textile L.P. v. Acres Capital Servicing LLC, Index No. 652871/18 (Sup. Ct., N.Y.Co., 2018). There a lender financed the redevelopment of two historic properties in the Midwest by a borrower (a partnership), whose sole asset consisted of the properties. The project involved numerous complexities, but for purposes of this article the salient feature is that as security for the loan the borrower granted the lender a mortgage on the property and a pledge by the borrower’s partners of their equity interests in the borrower.

Significantly, this was structured as a single loan with dual collateral rather than broken down into two separate loans, one a real estate-secured mortgage loan, and the other, an equity-secured mezzanine loan. After default, the lender thus had the option of foreclosing on the real estate pursuant to the mortgage or the partnership interests pursuant to the equity pledge. Substantively, the result of either would be the same in that the lender gains control of the real estate, directly in the former case and indirectly in the latter. Procedurally, however, there is a dramatic difference: Judicial foreclosure of the mortgage can easily consume two to three years, while a UCC Article 9 execution sale requires only “commercial reasonableness” and 10 days’ prior notice. [Cf. N.J.S.A. 12A:9-610 and 611.]

When the lender advertised the sale of the partnership interests (to be conducted via auction at the office of lender’s counsel), the borrowers moved to enjoin it, arguing that allowing a mortgagee to proceed in that fashion amounted to an impermissible “clog” on their equity of redemption. The court disagreed, noting that the UCC afforded the borrowers the right to “redeem” their partnership interests right up until the time of the execution sale. [Cf. N.J.S.A. 12A:9-623]

Clogging and Third-Party Closing Opinions

Given the frequency of New York “choice of law” provisions in mortgage transactions, H.H. Cincinnati warrants consideration by New Jersey real estate finance practitioners. At present, it is unclear whether the case can be considered “New York law,” as it is an unpublished trial level opinion decided on a preliminary injunction motion. It is equally unclear whether a New Jersey court facing similar facts would follow H.H. Cincinnati’s rationale. Indeed, given Humble Oil’s deference to the clogging doctrine (which went so far as to void a purchase 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 where the underlying loan documents stipulate that New York law is to govern. Thus, the most prudent course of action for New Jersey practitioners rendering opinions when closing dual collateral loans would be to flag this issue as one unresolved under present law and possibly of such strong public policy here that New York law might not be followed.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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