As uncertain market conditions prevail, especially in the commercial real estate industry, a secured lender in a defaulted loan scenario may want to take possession of real estate collateral prior to a mortgage foreclosure sale or may decide that it wants rent payments to be made directly to it under an assignment of leases and rents. While this may seem like the best course to protect the lender’s interests and avoid further loss, lenders should cautiously consider the legalities surrounding taking such steps and assess the potential liability they may face for taking such actions.
As an extreme example of what could go wrong, in Commonwealth v. Advantage Bank, 406 Mass. 885 (1990), a lender faced a criminal complaint after it started foreclosure proceedings against a borrower which owned a multiple-family dwelling. Lead paint violations had been assessed against the borrower prior to the lender’s foreclosure action. After the borrower defaulted, the lender started the foreclosure process and appointed an agent to collect the rents. The lender also paid a water bill and ordered oil for the heating system, but apparently took no action with respect to violations of the Massachusetts lead paint laws. The Massachusetts Department of Public Health then served an additional notice of lead paint violations on the lender. The wording of the applicable lead paint statute requires mortgagees to take actual physical possession to be liable under the statute. The Massachusetts Supreme Judicial Court found that in merely collecting the rents and not having consummated the foreclosure sale, the lender was not in actual physical possession and, therefore, could not be liable for criminal sanctions as an “owner” of the mortgaged property. There could have been potential unintended consequences for the lender, however, had it been more aggressive in its actions to take control of the property.
As a preliminary matter, while there may be good reasons 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 from the collateral, it is a bedrock principle that a lender has no legal responsibility in regard to its real estate collateral unless and until it actually takes physical possession of or exercises control over the real estate. A lender does not have a duty to act. 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. 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 defence even if more would have been realized by the mortgage had it been promptly foreclosed.” Lewis v. Blume, 226 Mass. 505, 508 (1917).
If a lender takes possession of collateral prior to the actual foreclosure, a myriad of legal responsibilities and considerations may 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 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 property insurance coverage. Breach of these duties could expose the lender to potential liability to its borrower, tenants of the property (as further discussed below), and, even to junior lienholders, or, as evident in the Advantage Bank example, potential criminal liability to the Commonwealth. 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 the lender was liable to its borrower under M.G.L. c. 93A for the loss of value in three properties after the condition of the properties continued to deteriorate in the possession of the lender before the properties were sold at tax foreclosure sales.
There are additional risks if the lender takes possession of a property occupied by residential or commercial tenants, again, as highlighted in the Advantage Bank case. 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 since the lender is effectively “standing in the shoes” of the landlord. This potential liability may also extend to third parties who have lawfully entered upon the premises and who are injured by defects or other dangerous conditions. What this means is that a lender must be certain it has sufficient liability insurance before taking possession of a mortgaged property or defer possession until sufficient insurance is obtained. Further, 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 potential risks to a lender in taking possession pre-foreclosure, a lender should explore other available options. For example, a properly perfected lender does not need to take possession of mortgaged property in order to collect rent pursuant to an assignment of leases and rents (although this can adversely affect a lender if the borrower files for bankruptcy, as discussed below). 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 rent collection efforts are ignored by the tenant, the tenant may well remain liable to the lender for the rent paid to the landlord rather than the lender under the Uniform Commercial Code, Section 9-406. If such collection efforts are actively opposed by the borrower, a lender may 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 less risky) to collect rents after obtaining such a court order.
To obtain an injunction to collect rents or to stop a borrower from interfering, the lender must show (a) a likelihood of success on the merits; (b) the potential for irreparable harm should the injunction not be granted; and (c) that the balancing of the harms to lender and borrower if an injunction were to be granted favors the lender. The first prong is easily demonstrated where defaulted commercial paper is at the heart of the lender’s claim. Payment defaults or failure to pay upon maturity are generally sufficient to satisfy the first prong. The second prong (i.e., showing irreparable harm) is more difficult to prove. While a lender can usually allege that a defaulting borrower is not maintaining the property, that the property is uninsured, or that the borrower is absconding with the rents – especially where the collateral is insufficient to repay the loan or there are no other apparent sources of recovery – Massachusetts courts consider this a high burden to meet. The lender should obtain an appraisal which will need to show, for example, a likely collateral shortfall or a property report evidencing a lack of maintenance or have other information to share with the court to demonstrate that the borrower lacks the resources to repay what is owed. The final prong (i.e., the balancing of the harms to the lender and borrower) is generally given less weight except that it permits a borrower to plead with a court to not deprive the borrower of the rent stream from the property. It is important to note that a lender’s right to collect the rents is governed by the UCC which simply requires notice to the tenant and does not require court intervention unless the tenant refuses to make rent payments to the lender.
We are often asked whether certain activities by a lender could be considered “constructive possession” by a lender. A lender is usually permitted to make advances to pay past due real estate taxes without the risk of being deemed to be in possession of the property. A lender may also obtain “force-placed” insurance on the property if proof of insurance is not forthcoming from the borrower without being deemed in possession. Similarly, a lender may opt to make construction loan 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, courts evaluate the actions taken by a lender on a case-by-case basis.
Lastly, something that is likely always on the lender’s mind when a borrower is in default, is what happens when a borrower files for bankruptcy and the lender is a mortgagee in possession or is in the process of finalizing a foreclosure? Generally, if the lender has an executed memorandum of sale after a completed foreclosure sale but before the borrower files bankruptcy, then that property is no longer an asset of the bankruptcy estate and is not subject to the bankruptcy proceedings (although recent cases by the Bankruptcy Court in Massachusetts have suggested that recording something at the applicable registry of deeds may be needed to avoid claims that the foreclosed property is part of the estate). If a foreclosure sale has not yet been completed, the property remains part of the bankruptcy estate and an automatic stay is put in place preventing the lender from taking further action. The lender must then decide if it will seek bankruptcy court approval to have the stay lifted to pursue the foreclosure process and whether it can meet the standards for obtaining relief from stay.
When the lender is merely a mortgagee in possession, possibly only collecting rents, the bankruptcy trustee can seek to have the collection of rents declared a voidable transfer and instead have the rents be paid directly to the bankruptcy estate. This can be especially frustrating for a lender when the borrower is already in substantial arrears. In Massachusetts, the Bankruptcy Court requires the lender’s actual entry and possession (known colloquially as “breaking the twig”) in order for the lender to have a superior claim to the rents over the bankruptcy trustee. A mere recorded assignment of leases and rents does not suffice for a lender to “win out” over a bankruptcy trustee and entitle it to collect the rents.
In summary, lenders should tread lightly when considering taking possession of collateral pre-foreclosure. Lenders should consider other options, such as exercising rights to collect rents, if that is the lender’s goal (provided that the lender is also wary of the bankruptcy implications). If a lender obtains possession, it must exercise prudent management of the property, including hiring a competent management company to secure, maintain and operate the mortgaged property. If court action/injunctive relief is required to take possession of the collateral, a lender should be prepared for the court hearing by having sufficient evidence that taking possession is necessary to aid in recovery of the loan.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.
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