One of the issues that lenders often face, and one that is likely to arise in the fallout of the Covid-19 pandemic, is whether, in a defaulted loan scenario, the lender should take possession of collateral prior to a foreclosure. In making such an assessment, a lender will need to consider several legal principles, including an assessment of the potential liability for taking such action.
As a preliminary matter, while there may be good reason to take possession of collateral sooner rather than later, such as ongoing fraud, the abuse, diversion or waste of the collateral, or the misuse of proceeds of the collateral, it is a bedrock principle that a lender has no legal responsibility in regard to its collateral unless and until it actually takes possession of or exercises control over it. For example, a lender has no obligation to conduct a real estate foreclosure at any particular time and can defer taking steps to foreclose even if the collateral is damaged or depreciates as a result. A lender does not have a duty to act. As the Massachusetts Supreme Judicial Court held over a century ago, with respect to real estate: “It is . . . established that mere forbearance to foreclose a mortgage given as security is no defense even if more would have been realized by the mortgage had it been promptly foreclosed.” Lewis v. Blume, 226 Mass. 505, 508 (1917). A similar situation arises in regard to equipment collateral. In the case of Arlington Tr. Co. v. Caimi, 414 Mass. 839, 846 (1993), a case in which Hackett Feinberg attorneys represented the lender, the SJC ruled that “[a] necessary prerequisite” to a claim that a lender was commercially unreasonable in regard to its UCC collateral “is possession, for one cannot dispose of what one does not have.”
If a lender does take possession of collateral prior to the actual foreclosure, a myriad of legal responsibilities and considerations ensue. When a mortgagee takes possession of real property, it assumes the duty to manage the property as a reasonably prudent owner would. A mortgagee, while in possession, is bound to use reasonable means to preserve the property from loss or injury. This duty may also include the responsibility to pay real estate taxes on the property if necessary to avoid a tax taking and to maintain insurance coverage. Breach of these duties could expose the lender to potential liability to its borrower and, perhaps, even junior lienholders. Recently, the Massachusetts Appeals Court affirmed this principle in Riverview Apartments, LLC v. City National Bank, et al, 98 Mass. App. Ct. 1106 (2020), when it determined that a lender could be liable to its borrower under M.G.L. c. 93A for the loss of value in three properties where the condition of the properties continued to deteriorate after the lender took possession which were then ultimately sold at tax foreclosure sale. Similarly, upon taking possession of equipment collateral, a lender assumes the responsibility of protecting and preserving the collateral, as well as disposing of it in a commercially reasonable manner.
There are additional risks if the lender takes possession of a property occupied by residential or commercial tenants. In such cases, the lender may become responsible for the habitability of the tenants’ individual units, and may likewise be responsible to remedy defects on the property or in its common areas, since the lender is effectively “standing in the shoes” of the landlord. This potential liability may also extend to third-parties lawfully on the premises who are injured by defects or other dangerous conditions. While secured lenders are generally exempt from environmental liability under state and federal law, they must take specific steps to qualify for the exemptions and would certainly benefit from an awareness of any potential environmental issues affecting a property before taking possession.
Due to the risks to a lender in taking possession pre-foreclosure, a lender should certainly explore other available options. For example, a properly perfected lender does not need to take possession of mortgaged real estate in order to collect the rents. Typically, the mortgage or assignment of leases and rents will permit a lender to simply notify the tenants to pay the lender (rather than the borrower) directly. If such collection efforts are opposed by the borrower, a lender many need to seek injunctive relief from the Courts directing tenants to make rent payments to the lender or enjoining the borrower from interfering with rent collections by the lender. As a general matter, it is always advisable (and is less risky) to collect rents after obtaining such a court order.
We are often asked whether certain activities by a lender could be construed as “possession” by a lender. A lender is usually permitted to make advances to pay past due real estate taxes without risking being deemed to be in possession. Similarly, a construction loan lender may opt to make construction advances directly to the borrower’s general contractor or the subcontractors if permitted under the loan documents in order to ensure that no mechanics liens attach to the mortgaged property and that all parties have been properly paid, without being deemed to be in possession. Since the determination of whether a lender is “in possession” is often dictated by whether a lender has control of the collateral, the actions taken by a lender should be judged on a case by case basis.
In short, lenders should be cautious about taking possession of collateral pre-foreclosure. In regard to UCC collateral, while a lender will likely need to take possession at some point prior to a secured party sale, it should be careful to protect and preserve the assets while the pre-sale marketing takes place. In regard to real estate, more complex issues arise. Lenders should consider other options, such as exercising rights to collect rents, if that is the lender’s goal. However, if possession is sought, a lender must exercise prudent management of the property, including hiring a competent management company to secure and operate the mortgaged premises and ensuring that it has adequate casualty and liability insurance covering the premises. The pros and cons of any effort to take possession should always be carefully weighed in consultation with counsel.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.