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WARNING: An Ownership Pledge In a Mortgage Transaction May Be Dangerous

Martin A. Schwartz

Over the last few years, certain nontraditional lenders and a few banks have asked for a pledge of the ownership interest in borrowers as additional security to their mortgage on the property. The typical reason provided is that this allows the lender to avoid a long and costly foreclosure if the borrower fails to make its mortgage payments.

While the above is true, it also allows the lender to substitute a nonjudicial proceeding for a judicial proceeding. A foreclosure is a judicial action and an equitable proceeding. This means that it is unlikely that a judge in a foreclosure action will allow a property to be forfeited for anything other than a serious default which materially impairs the lender’s security. So a failure to provide income statements or the borrower’s or guarantor’s financial statements is unlikely to allow a lender to acquire the borrower’s equity in the property through a foreclosure.

In addition, in the event of a dispute with the lender over the administration of the loan, the time period required to complete a contested foreclosure, typically about a year, allows for the possibility of refinancing and taking an existing difficult lender off the property.

Enforcement of a pledge does not involve any court or judge to monitor the fairness of the proceeding. In many cases, the entire proceeding can be completed in 30-60 days. Any failure to comply with the terms of the loan documents typically allows the lender to accelerate the debt after a 10-day notice and schedule a sale of the ownership interest. The speed of such proceedings, while favorable to a lender, makes it impossible to refinance a difficult or unsavory lender off the property and may even impair a well-capitalized borrower’s ability to repay the debt by truncating the period to acquire the necessary liquidity.

In today’s lending environment, where loan to value ratios are typically in the 50-60% range, a borrower’s equity interest in its property is substantial, and borrowers should be wary of providing an ownership pledge in addition to a mortgage. Any such pledge may involve a potential forfeiture of their investment if they fail or are unable to perform all of the covenants in the loan documents.

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