By Kevin Sholette

Special Counsel | Real Estate

This article is a brief refresher on the basics of New York’s one-action rule. Following an event of default, typical commercial real estate loan documents give the lender the right to pursue alternative remedies simultaneously, or in any order it chooses. For example, if a borrower is in default on a mortgage loan beyond any applicable notice and cure periods, the mortgage usually provides the lender the right to foreclose its mortgage while simultaneously suing on the note or, if applicable, a guaranty. However, every lender needs to be aware that some states have enacted so-called “one-action rules” which, in many circumstances, restrict a lender’s right to simultaneously pursue multiple legal actions to recover the debt. We would note that one-action rules can vary greatly from state to state, and this article specifically focuses on New York’s application of the rule.

In the State of New York, N.Y. Real Prop. Actions Law § 1301(3) states that “[w]hile the action is pending or after final judgment for the plaintiff therein, no other action shall be commenced or maintained to recover any part of the mortgage debt, without leave of the court in which the former action was brought.” The result of this statute is that if a lender wants to exercise remedies to recover debt secured by a lien on Property located in the State of New York, then it must choose between pursuing an action at law to recover on the note (and, if applicable, any guaranty) or to pursue an action in equity to foreclose on the mortgage.[1] This restriction forces the lender to select its exercise of remedies carefully in order to maximize its recovery and avoid several potential pitfalls.

When choosing its remedies, one of the most obvious concerns for the lender is simply one of timing. Pursuant to § 1301(1), if a lender elects to enforce the note and/or guaranty and obtains a money judgment against the defendant, the lender must first exhaust its collection efforts on the judgment by executing against the defendant’s property in the appropriate county, before it is permitted to foreclose on its mortgage.[2] This process could be time consuming, resulting in opportunity costs for the lender as well as the risk that the value or condition of the collateral deteriorates in the interim. For this reason, it is most common for lenders in New York to choose a foreclosure action over seeking a money judgment.

Pursuing a foreclosure in New York is not without its own potential pitfalls. In many cases, the winning bid in the foreclosure sale, whether by the lender as a credit bid or a third party, ends up being less than the lender’s outstanding debt (including interest and costs). If the value of the property does not exceed the outstanding amount of the debt, the lender is going to be the most likely winner at the foreclosure sale, as there is unlikely to be a third party willing to match its credit bid. In such situations, the lender must apply with the court for a deficiency judgment in order to try to recover the difference between the sale price and the outstanding debt. Unfortunately for the lender, though, the deficiency judgment will not necessarily equal the difference between the sale price and its outstanding debt. Rather, the deficiency judgment will be equal to the difference between the outstanding debt and the greater of (a) the fair market value of the property, as determined by the court, and (b) the sale price of the property.[3] Notably, then, the court can find that the sale price was not representative of the true market value of the property, resulting in a deficiency judgment that is less than the difference between the sale price and the outstanding amount of the debt.[4] This rule was intentionally designed to protect mortgagors from lenders that might otherwise be incentivized to suppress the bidding at the foreclosure sale, purchase the property at a bargain price and then obtain the benefit of an exaggerated deficiency judgment.[5] Therefore, the rule applies regardless of whether the lender or a third party is the winning bidder at the foreclosure sale.[6]

Another concern for lenders in electing to pursue a foreclosure action in New York is that once a foreclosure action has been commenced, any claim on a guaranty can’t be pursued until the foreclosure is completed, and the recovery thereunder will be limited to the amount of the deficiency judgment, which, as noted above, may not be sufficient to make the lender whole.[7] In contrast, if the lender were to sue on the guaranty instead of foreclosing, the lender would potentially be able to obtain a judgment against the guarantor for the full amount of the guaranteed obligations.[8]

Second, if a lender chooses to bring a foreclosure action, it must be careful to name any parties that are responsible for the debt, including any guarantors, in such foreclosure action or else they risk losing the ability to make a claim against such parties altogether.[9] This rule is codified in § 1371(1), which makes an obligor’s liability for a deficiency judgment conditioned on the obligor being named as a defendant in the foreclosure suit.

Third, the lender must also make sure to apply for a deficiency judgment against all appropriate parties, including any guarantors. Pursuant to § 1371(3), if no motion for a deficiency judgment is made following a foreclosure sale, the proceeds of the sale (regardless of the amount) will be deemed to fully satisfy the mortgage debt, and the lender will have no further right to recover any deficiency in any action or proceeding. Furthermore, “when mortgage debt is deemed satisfied, so also is the liability of the guarantor of that debt.”[10]

Between the one-action rule set forth in RPAPL §1301 and the limitations on deficiency judgments set forth in RPAPL §1371, lenders in New York that want to exercise remedies need to carefully consider their litigation strategy in order to maximize the efficiency and amount of their recovery.

[1] Trustco Bank v. Pearl Mont Commons, L.L.C., 47 N.Y.S.3d 644, 649 (Sup. Ct. 2016) (quoting Gizzi v. Hall, 767 N.Y.S.2d 469, 471 (App. Div. 2003)) (“A foreclosure plaintiff ‘may proceed at law to recover on the note or proceed in equity to foreclose on the mortgage, but must only elect one of these alternate remedies.’”)

[2] See Simms v. Soraci, 675 N.Y.S.2d 295, 295 (App. Div. 1998).

[3] N.Y. Real Prop. Acts. Law § 1371(2) (Consol. 2021).

[4] See id.

[5] Sanders v. Palmer, 499 N.E.2d 1242, 1243-45 (N.Y. 1986).

[6] Id. at 1245.

[7] Id.; Letchworth Realty, L.L.C. v. LLHC Realty, L.L.C., No. 6:15-CV-06680-FPG, 2020 U.S. Dist. LEXIS 163220, at *3 (W.D.N.Y. Sep. 6, 2020).

[8] Note that any such judgment would be unsecured and, as mentioned above, the lender would have to first execute against the judgment and be able to show that it was unable to satisfy the judgment, before being able to make a claim on its mortgage.

[9] Sanders, 68 N.Y.2d at 1245-46; Letchworth, 2020 U.S. Dist. LEXIS 163220, at *4-*5; Merchs. Nat’l Bank v. Wagner, 402 N.Y.S.2d 936, 939 (Sup. Ct. 1978).

[10] Trustco v. Pearl Mont Commons, 47 N.Y.S.3d 644, 650 (N.Y. Sup. Ct. 2016).

By Duncan Hubbard

Partner | Real Estate

By Livia Li

Associate | Real Estate

It’s not news that the COVID-19 pandemic has exacerbated losses in sectors that are reliant on footfall − namely, the retail and leisure industry. Prior to the pandemic, the general weakness in the “bricks and mortar” retail industry has given rise to a series of company voluntary arrangements, and companies struggling to meet fixed rent have used CVA as a tool to renegotiate reductions for fixed rent leases, and in some cases, completely overhauling the fixed rent to turnover-based measurements. Due to the pandemic, along with measures announced by the Government on a stop on forfeiture over non-payment of rent, it wouldn’t be uncommon for businesses to be sitting on a debt pile of unpaid rent arrears since March 2020.

Last week, the High Court handed down a momentous judgment on a rescuing plan presented by Virgin Active which relies on wiping out the majority of the rent arrears. It was a test case on the new rules around scheme of arrangement introduced last year, which no longer requires 75% votes from all creditors to be obtained, provided certain conditions are met. 

This article revisits the current rules around pre-insolvency restructuring and how this could affect landlords, as well as the implications of the Virgin Active case.

The Rise and Rise of CVA 

Until last year, tenants who are not yet insolvent but are nevertheless struggling with cash flow pressures have looked at company voluntary arrangements (“CVA”), which is a procedure undertaken between a company and its creditors under Part I of the Insolvency Act 1986 (“IA 1986”). The CVA is not a formal insolvency arrangement, but is a tool companies could use in restructuring their unsecured debts. 

CVA does not compromise claims of secured creditors and only involves unsecured creditors (such as landlords) and, amongst other criteria, once passed by 75% of all unsecured creditors (measured by value of the aggregate debt) the arrangement binds all unsecured creditors. Due to the recent decline in the retail sector, which was exacerbated by the pandemic, companies in the retail industry have been increasingly using this strategy as a tool to renegotiate rent reductions and/or write-offs of rent arrears with landlords. Recent examples include the New Look CVA, where the CVA included moving rents to turnover rents and 3-year rent concession periods.

For more discussion on the use of CVA and how this could affect landlords, please see our earlier article here. 

New Rules for Scheme of Arrangement 

In addition to the above, The Corporate Insolvency and Governance Act 2020 (“CIGA”), which came into place on 26 June 2020, provided an additional restructuring tool which is seen to be favourable for companies with respect to Restructuring Plans. Prior to CIGA, the scheme of arrangement under Part 26A of the Companies Act 2006 provides under s901F that the Restructuring Plan may be approved if a number representing 75% in value of the creditors or class of creditors or members or class of members have voted for the Restructuring Plan. With the introduction of CIGA, however, a new restructuring process is introduced under s901G Companies Act 2006, which provides that, if the Restructuring Plan has not been approved by 75% of the creditors, provided that the following two conditions are met, then the court may sanction the Restructuring Plan notwithstanding such Restructuring Plan was not endorsed by 75% of the creditors. These two conditions are:

Condition (A) − the court is satisfied that, if the Restructuring Plan was to be sanctioned, none of the dissenting class would be worse off than they would be compared to the relevant alternative; and

Condition (B) − the Restructuring Plan was agreed to by over 75% of one class of creditors who are in the class of creditors who would receive a payment or have a genuine economic interest in the company if the company was to be subject to the relevant alternative.

There are two key factors here (highlighted in bold above):

• the conditions require a satisfaction of a “no worse off” test by the dissenting creditors, when compared to the likely outcome in the “relevant alternative.” The relevant alternative is the situation the court considers as most likely to occur if the Restructuring Plan were not to be sanctioned; and  
• the Restructuring Plan can be sanctioned so long as over 75% of one class of creditors who, if the relevant alternative were to occur, would be “in the money” (and therefore have a genuine economic interest) and would receive a payment, have endorsed the Restructuring Plan.

If these two conditions are met, the court may, in its absolute discretion, decide whether or not to invoke s901G to sanction the Restructuring Plan.

The Virgin Active Case – A Test Case for s901G

This provision has been tested twice since its introduction: in DeepOcean 1 UK Limited [2021] EWHC 138 (Ch), and Virgin Active Holdings Ltd & Ors, Re [2021] EWHC 1246 (Ch) (“Virgin Active”), the latter which is of most relevance to landlords.

In Virgin Active, Virgin Active Holdings Limited and Virgin Active Health Clubs Limited (together, Virgin Active) sought court sanction of a Restructuring Plan pursuant to 901F of the Companies Act 2006.

The Restructuring Plan in short consisted of, amongst other things, certain recapitalisation and injection of new money by the shareholders, and also a substantial reduction of certain classes of rental arrears. The leases were split into different classes according to the importance of the premises to the revival of the business and revenue, with Class A leases classified as most important. The Restructuring Plan was approved by over 75% of secured creditors and also over 75% of landlords of Class A leases. It was largely opposed by the rest of the landlords and other unsecured creditors. 

It was submitted and accepted by the court that, if the Restructuring Plan was not approved, the relevant alternative in this instance was administration for around 6 weeks with an objective to sell certain arms of the business (Scenario 1) or liquidation of the companies (Scenario 2). It was further submitted and accepted by the court that Scenario 1 will achieve a return for the secured creditors in the region of 84.6 p/£ for Scenario 1, and only 21.8 p/£ for Scenario 2.

The court found that the liquidity crisis facing the companies is so acute that administration (Scenario 1) is the relevant alternative in this instance if the Restructuring Plan was not sanctioned (therefore satisfying Condition A). It follows that if the administrators pursue on an accelerated sale, it is highly likely that the claims by the landlords which were in dissent of the Restructuring Plan are unlikely to recover any payment. This is because, in an administration, the commercial negotiation of any assignment of any lease as part of a sale of a business is likely to require the landlord to agree to a rent that is less than the contractual amount and a write-off of any arrears. Therefore, it was the view of the court that Condition B is also satisfied.

Finally, the court is within its discretion to decide whether to apply s901G to sanction the Restructuring Plan, and the court was satisfied that the legislation was sufficiently wide to allow it to exercise such discretion and would exercise such discretion in this instance.

The Implication for Landlords and Their Lenders

The implication for landlords from the introduction of s901G Companies Act 2006 and the judgment in Virgin Active provides that the size of the claim of the landlord (which would be relevant for voting rights in CVA) is less relevant and the question is whether such claim is likely going to result in a payment in the relevant alternative, which often in practice is administration or liquidation. This new regime and the court cases have effectively diminished the voting powers of unsecured creditors in situations where the company is closer to formal insolvency processes.

For the lenders, the movement towards a more favourable restructuring regime for companies (tenants) means that increasing focus should now be placed on the financial capability and financial performance of the underlying tenants, and in particular, those considered as “key tenants” who make up a material proportion of the rental income. This could include additional covenants on information reporting on certain tenants, and additional warning triggers relating to the tenants and adjustment of financial covenant thresholds to include additional buffers against adverse events.