First Union Case before Second Circuit Questions Validity of Deed-in-Lieu Transactions in New York

April 2018

In re The First Union Baptist Church of the Bronx ,1 which is slated for argument this spring before the Second Circuit, illustrates the risks real estate lenders face when using deeds in lieu of foreclosure in New York, and the additional risks in lending to non-profit organizations.

The issue in First Union Baptist is whether the provision in a judicially-approved settlement agreement that allowed the lender to record a deed delivered in a deed-in-lieu arrangement is valid, or whether the Settlement Agreement cannot extinguish the mortgagor’s equity of redemption.

The Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”) found that the settlement agreement operated as a mortgage, and that it was unenforceable because it extinguished the borrower’s equity of redemption under New York Real Property Law § 320. It also held that the deed-in-lieu provision improperly penalized the borrower and amounted to a “giant windfall” for the lender.

The District Court reversed, finding that the settlement agreement was not a mortgage, and that the borrower retained no equity of redemption. Rather, it found that the deed-in-lieu provision was “one of a number of interdependent terms in an Agreement that first and foremost provided relief to a debtor whose rights to the Property were plainly and unambiguously at an end,” and held that the deed-in-lieu provision was not an “inappropriate penalty.” 

Overview

First Union Baptist Church of the Bronx filed a chapter 11 proceeding on October 1, 2012 to halt a scheduled foreclosure sale of property it owned at 2064 Grand Concourse in the Bronx.  First Union originally entered into a loan agreement with Carver Federal Savings, which had obtained a judgment of foreclosure in July 2012. During the course of the chapter 11 case, Carver sold the loan to TD Capital.

After five months of negotiation, First Union and TD Capital entered into the settlement agreement in May 2014, which provided that First Union would continue to own the property, with the right to sell or finance it until June 2015, when a $1.5 million payment would be due. Until June 2015, First Union would make monthly use and occupancy payments of approximately $9,400.

The Deed-in-Lieu of Foreclosure

As part of the settlement agreement, First Union delivered a deed in lieu of foreclosure. If First Union defaulted in the first 180 days, TD Capital could pursue a sale pursuant to its foreclosure judgment. If there was a default after 180 days, TD Capital could record the deed. If TD Capital pursued its foreclosure sale, First Union could retain its right of redemption, but there was no right of redemption if TD Capital recorded the deed. Because First Union was a chapter 11 debtor, the Bankruptcy Court was required to approve the settlement agreement with TD Capital; on June 27, 2014, Bankruptcy Judge Gropper approved it.

After the settlement agreement was approved, First Union began to make payments, although its payments were frequently late. In May 2015, First Union entered into non-binding term sheet with Thorobird Companies, LLC, a developer. Under the agreement in principle, Thorobird would build a new 50-unit apartment building that would include space for the church, and it would advance funds to First Union to repay the TD Capital debt. But the agreement in principle was subject to further negotiations and documentation, and did not obligate Thorobird to advance funds to First Union.

First Union failed to make a payment due to TD Capital on May 1, 2015, which gave TD Capital the right to record the deed. At trial, the evidence showed that First Union mailed a payment to TD Capital on June 1. That same day, a TD Capital representative advised First Union’s pastor that TD Capital had not received payment, and extended the payment date to June 2. When no payment arrived by the end of day on June 2, TD Capital sent the deed to the title company and it was recorded. The check arrived at TD Capital on June 3.

The Bankruptcy Court Decision

First Union returned to Bankruptcy Court and brought two claims. First, that it retained a right of redemption in the property that could not be extinguished except through a foreclosure sale; and second, that the provisions of the settlement agreement that gave TD Capital the right to record the deed were void because they were an impermissible penalty. When First Union returned to Bankruptcy Court, Judge Gropper had retired and Judge Michael Wiles took jurisdiction.

First Union argued that the settlement agreement was a mortgage, and that the delivery of the deed was a security arrangement and not an outright conveyance of the property. It further argued that because the settlement agreement did not provide that it retained an equity of redemption, the delivery of the deed and its recordation were void. The Bankruptcy Court agreed, ruling that New York courts are protective of a mortgagor’s equity of redemption, and that any provision in a mortgage that waives the right of redemption upon the occurrence of a future default is void.

The Bankruptcy Court said that where a deed in lieu of foreclosure is delivered as part of a workout agreement, but where it appears that the delivery of the deed is intended as security, the agreement must be treated as a mortgage. The question of whether the deed is given for security, or is an absolute conveyance, depends on the intent of the parties. If the intent is not clear, courts should resolve doubtful cases in favor of finding that the arrangement is a mortgage and not a conveyance. The Bankruptcy Court reviewed the settlement agreement and concluded that “the evidence makes it overwhelmingly clear that the parties did not intend to accomplish an absolute conveyance…In fact, no reasonable argument could be made to the contrary.” Because the settlement agreement was a mortgage, it ruled that the recording of the deed was void because it stripped First Union of its equity of redemption.

First Union’s second argument was that the recordation of the deed was a penalty that was not enforceable. Judge Wiles had little difficulty finding that the deed-in-lieu was a penalty. He reasoned that TD Capital’s damages -- the amount of debt due -- were easy to calculate. But he was troubled by the fact that that TD Capital was permitted to record the deed irrespective of the value of the Property or the amount of debt due to it. He pointed to the existence of the development agreement with Thorobird as evidence that the Property was worth more than the debt owed to TD, even though the record shows no indication that evidence that the value of the Property was introduced. He also fretted about the possibility that TD Capital would receive a “giant windfall” if it acquired ownership of the Property.

The District Court Rejects the Bankruptcy Court’s Determinations
On appeal, the District Court rejected the Bankruptcy Court’s determinations in their entirety. First, it found that the Bankruptcy Court had improperly ignored the Second Circuit’s decision in Meyerson v. Werner .2

In Meyerson, parties to a dispute had negotiated an agreement under which a deed-in-lieu of foreclosure was to be delivered, and the settlement agreement was approved by the court. Later the defaulting party challenged the deed-in-lieu provision as an unenforceable mortgage. On review, the Second Circuit held that a freely negotiated agreement, intended to be binding on the parties, should be enforced, even if those terms were inconsistent with the equity of redemption.

Applying Meyerson, Judge Katherine Forrest found that Bankruptcy Judge Gropper had carefully considered the terms of the settlement agreement when he had approved it. Judge Forrest also reviewed the terms of the settlement agreement and ruled that it did not operate as a mortgage: the payments made by First Union were labeled as use and occupancy payments, they were not related to interest rates on the debt owed to TD Capital, and they did not affect the principal balance owed to TD Capital. Finding the intent of the parties clear from the document, the District Court held that it was incorrect for the Bankruptcy Court to have held an evidentiary hearing to determine the parties’ intent.

The District Court similarly rejected the Bankruptcy Court’s finding that the settlement agreement was an unenforceable penalty, finding that the fixed amount, namely the value of the property as of the time of the settlement agreement, was likely close to the value of the debt owed to TD Capital. It thus held that the Bankruptcy Court’s examination into the value of the Thorobird development plan was an error which it termed “a distraction from the matter at hand.” It also found that the delivery of the deed-in-lieu was an essential part of the settlement agreement, and should be enforced.

The two courts fundamentally disagreed; how can such divergent findings be reconciled? The Bankruptcy Court found the intent of the parties unclear, and determined that it needed evidence as to the parties’ intent. Based on the evidence, it found that the settlement agreement was a mortgage, that it improperly cut off First Union’s equity of redemption, and that the deed-in-lieu was an improper penalty. The District Court rejected each of those determinations and reversed, which brings the case to the Second Circuit.

Second Circuit Review: Observations for Lenders
There are several observations from this case that lenders should consider. First, the borrower was a church in the Bronx, and Judge Wiles’ solicitude for the church, and the risk that it would lose its property, is evident throughout the opinion. In addition, Judge Wiles was clearly influenced by the testimony concerning the possible Thorobird development as indicating that the property was worth more than the $1.5 million owed to TD Capital. Although the Bankruptcy Court’s opinion does not establish a value for the property, Judge Wiles refers to the “giant windfall” that TD Capital would receive if that provision were enforced, despite the apparent lack of evidence in the record to support that view.

These are the lessons for lenders: first, loans to churches and other not-for-profit organizations are inherently riskier than loans to traditional commercial borrowers because judges will sometimes go to great lengths to protect such borrowers. Unfortunately, that’s a risk that is difficult to protect against, except through careful analysis of the collateral and the borrower’s ability to repay.

Second, there is a tension between New York law regarding equity of redemption, and the Meyerson line of cases, which holds that, in a judicially approved settlement, the equity of redemption can be waived through deed-in-lieu provisions. That tension injects uncertainty into reliance on deed-in-lieu transactions, which are common in real estate workouts. Those issues are directly raised by First Union, and lenders and their counsel can hope for additional clarity on these issues from the Second Circuit’s ruling.
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1. Case 18-639

2. 683 F.2d 723 (2d Cir. 1982)


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© 2018 Herrick, Feinstein LLP. This alert is provided by Herrick, Feinstein LLP to keep its clients and other interested parties informed of current legal developments that may affect or otherwise be of interest to them. The information is not intended as legal advice or legal opinion and should not be construed as such.