An English court has clarified mortgagees’ duties when enforcing on the property. Lenders should ensure a considered and informed sales process
Enforcing against the property of a distressed debtor and, in particular, exercising the power of sale by a secured lender in its capacity as a mortgagee raises various legal, as well as practical, issues. Not least of which is the risk of the debtor, or an aggrieved third party creditor of the debtor, alleging that the secured lender has failed to take appropriate steps to ensure that the best price is obtained for the mortgaged property on enforcement.
In such cases, secured lenders will frequently hear the refrain of 'you need to maximise value' by a plethora of other stakeholders with interests in the mortgaged property, including the debtor itself, its guarantors, shareholders and its other secured and unsecured junior creditors. In the midst of such a chorus of (at times) conflicting views, it would not be surprising if secured lenders struggled to recall the scope and limits of their legal duties when taking enforcement action. Lenders may find themselves asking: what does it actually mean to obtain the 'best price' for mortgaged property in distressed circumstances, and what is the best way to minimise the risk of a claim of a breach of duty.
The Alpstream decision
Fortunately for secured lenders, the English Court of Appeal very recently examined the scope of the duties of mortgagees when taking enforcement action in the decision of PK Airfinance SARL & Anor v Alpstream AG & Ors (2015). While the Court of Appeal was specifically concerned with the rights and duties of a mortgagee in the context of mortgages over various aircraft and shares in certain companies, the decision provides helpful clarity on a number of issues relevant to both debtors and their creditors in the context of an enforcement and realisation of security generally. These include:
- whether a mortgagee owes any legal duties to, or is otherwise required to protect the interests of, unsecured creditors when exercising its powers of enforcement to dispose of the mortgaged property;
- the means by which a mortgagee ought to conduct a sale process to ensure the best price is obtained for the mortgaged property;
- the significance and consequences of obtaining an independent valuation of the mortgaged property prior to a sale and for the purposes of determining the sale price;
- the validity and implications of a sale to a 'connected party' of the mortgagee; and
- the impact of contractual terms, such as the terms of an intercreditor agreement, in varying or in creating the legal duties of a mortgagee.
The Alpstream decision also provides useful guidance on the steps a secured lender should consider undertaking to demonstrate that it has fulfilled its legal duties, and thereby minimise the risk of challenge to the sales process by the debtor or its other creditors.
Mortgagees' duties during an enforcement
In the Alpstream decision, the Court of Appeal confirmed that when exercising its powers of sale in respect of mortgaged property, a mortgagee owes a duty to: act in good faith and use its powers for proper purposes; and take reasonable care to obtain the best price reasonably obtainable in respect of the mortgaged property at the date of the sale.
Importantly, the Court of Appeal reaffirmed that it is for the mortgagee to decide 'whether and when to sell, by reference to [the mortgagee's] own interests, even if the timing is unpropitious'. Indeed, in regards to the issue of timing of the sale, the mortgagee does not owe the mortgagor any duty of care in the choice of time to conduct the sale of the mortgaged property.
Further, the Court of Appeal confirmed that the mortgagee's duties are not owed to unsecured third party creditors. Rather, the mortgagee only owes such duties to those persons with a recognised interest in the value of the equity of redemption in the mortgaged property. That is, those persons with certain rights recognised in law in respect of the mortgaged property, including the right of the mortgagor to the return of the mortgaged property upon repayment of the relevant secured debt. These recognised persons are:
- the mortgagor of the property;
- any subsequent (or pari passu) secured creditor with a security interest over the same property;
- a co-mortgagor; and
- by virtue of its subrogation and other rights, a guarantor of the mortgagor's debt.
In confirming the class of stakeholders to whom the mortgagee owes its duties on an enforcement, Lord Justice Clarke considered that to extend the duties of the mortgagee to an unsecured junior lender or other possible eventual recipient of surplus proceeds from a sale (say, for example, pursuant to the terms of a contractual waterfall provision in an intercreditor agreement) would involve an unjustified departure from long established legal authority in relation to the duties of a mortgagee.
Determining the best price
So, if the legal duty owed by a mortgagee is to obtain the 'best price' from the sale of the mortgaged property, then it follows that the next critical issue for a mortgagee is how to effect the proposed realisation of the mortgaged property to ensure this duty is properly discharged.
The challenge for secured lenders in an enforcement context is to achieve balance between efficiency and recovery – that is, ensuring that any sale process is efficient in terms of costs, expenses and timing, but which will also maximise the sale proceeds, or at least ensure the proceed are sufficient to recover its secured debt.
"The Court of Appeal confirmed that the mortgagee’s duties are not owed to unsecured third party creditors"
In the Alpstream decision the Court of Appeal provided helpful guidance to secured lenders, reiterating that in relation to any sale of mortgaged property, the basic principle is that the secured creditor must demonstrate it has put the 'interests of the mortgagor first and hastaken reasonable precautions to obtain the best price reasonably obtainable at the time of sale'. However, notwithstanding that the mortgagor's interests are paramount, it remains up to the mortgagee to decide how to best conduct the disposal of the mortgaged property – whether by a private sale to a third party or by way of a public auction. The Court of Appeal stated that 'in practice, any sale must be by some form of auction or by private treaty", but that "it is for the mortgagee to decide which of those it should be'. It also reaffirmed Lord Justice Parker's observations in Michael v Miller (2004) that 'such decisions involve an exercise in informed judgment such that in exercising the power of sale a prudent mortgagee will take advice including, where appropriate, valuation advice.'
In the Alpstream decision, the fact that the secured lender pursued an auction process with an arguably poor and too brief marketing campaign and inadequate lead up was immaterial. That was because a private sale to a third party would not have, the Court of Appeal found based on the evidence, produced a better return. To this end, the court also considered the importance of market perception and the effect such perception may have in the context of a mortgagee sale, stating:
'The circumstances of a sale influence the price obtainable. The auction process itself is not intrinsically value destructive. It may, depending on the circumstances, produce the best price and be a good test of the market. What is likely to reduce the price otherwise obtainable is the perception of buyers that the sale is by the holder of a security interest who wishes to sell relatively swiftly, and not necessarily for as much as might be possible in easier circumstances, in order to recover the money which the mortgagor has wrongfully failed to pay. The fact that the sale is by auction with a relatively small period between announcement and auction may contribute to that impression; but a purchaser by private sale intended to be negotiated over a modest timescale may have the same understanding.'
It is also commonly argued by junior creditors that the mortgagee should ensure that the price paid upon the sale of mortgaged property (whether the sale is by auction or private treaty) is not less than the price determined by way of an independent expert valuation. However, on this point, the court in Alpstream considered that a purchaser of mortgaged property should not be required to pay any more than it is genuinely prepared to pay – including in circumstances where the purchaser is related or connected to the mortgagee. While an independent valuation may be useful, in some respects, in determining a proper price range for particular property, a mortgagee is under no obligation to ensure that the price paid on the sale of the property meets that valuation. In this regard, the Court of Appeal held:
'It may be that in the ordinary way an independent valuation is the best arbiter of such a price, although in practical terms I have my doubts whether it can always provide a clear and certain signpost. Just as a public auction ought to provide such a price, but circumstances may show that it does not (and the authorities reveal some examples of this, but on facts very far from the facts of our case), so one can visualise circumstances in which an independent valuation may be impugned.'
Sales to self
The Court of Appeal also considered the issue of a mortgagee arranging a so-called sale to self. While a mortgagee is generally prohibited from purchasing mortgaged property itself, in Alpstream the secured lender effectively transferred the repossessed property (in this case, the aircraft) to a trustee for the purposes of an auction, before purchasing the aircraft at the auction and then on-selling them to connected special purpose entities.
The Court of Appeal considered that, in itself, a sale to a connected party is not a sale to self and could not be invalidated on this ground. However, in such cases, the secured lender must bear the burden of proof to demonstrate it has discharged its duty to the mortgagor, showing that it has acted in good faith and for proper purposes, and taken reasonable care to obtain the best price reasonably obtainable in respect of the mortgaged property at the date of the sale. Therefore, with the burden of proof reversed in such cases, it is even more important for a secured lender to take active steps to demonstrate its duties have been discharged. For example, consideration should be given to engaging a professional adviser to determine the method of sale most likely to maximise the amount of recovery (and following such advice), along with ensuring a fulsome marketing campaign prior to any auction where a connected party of the mortgagee participates.
The Court of Appeal also considered the impact of voluntary contractual arrangements (in this case, as set out in the intercreditor agreement) between a mortgagee and unsecured creditors, and whether such arrangements created any duties towards such creditors. In particular, the court was asked to consider the impact of contractual payment waterfalls which, as in the Alpstream case, commonly entitle shareholders, and other subordinated and unsecured creditors, to receive surplus proceeds (if any) from an enforcement action against the mortgaged property.
In a reassuring outcome for secured lenders, the Court of Appeal rejected the notion that a mere contractual right to receive surplus proceeds from a sale of mortgaged property extended the duties owed by the mortgagee on the sale. A contractual right to receive payment pursuant to a payment waterfall will not give an unsecured creditor the benefit of any trust or other equitable interest in the mortgage property.
Key lessons for secured creditors
Notwithstanding the decision in Alpstream and the comfort that secured lenders may take from the Court of Appeal's analysis, the actions of mortgagees and secured lenders in relation to an enforcement will undoubtedly continue to be carefully scrutinised by the debtor and its the other creditors. As such, these sales processes continue to remain prone to challenge by disgruntled stakeholders.
However, Alpstream does provide valuable insights to secured lenders regarding practical steps they can take to minimise the risk of a successful challenge. They should engage experts to advise on the best sales process (including sales method, any reserve price and marketing strategy), and acting on such advice (bearing in mind the Court's views on the impact of perception – for example, trying to avoid creating a perception of a fire sale). Ensuring suitable marketing, over a reasonable timeframe in connection with any sale, and first gauging the prevailing market conditions for a sale of the mortgaged property is also recommended.
Mortgagees should continue to use special purpose vehicles when considering back-to-back or connected sales, although bearing in mind the reversed onus of proof in such circumstances. The language in the finance documents should make clear that the secured creditor owes no contractual duties to unsecured creditors in respect of any enforcement;
Secured lenders should ensure that all material unsecured debt is properly subordinated in right of payment against the secured debt and clear that it is clear the unsecured creditor shall take no benefit from any security.
Finally, they should consider obtaining an expert valuation of the mortgaged property. However, given the Court of Appeal's views on the utility of expert valuations, it is questionable whether one should be obtained given that such a valuation will not be conclusive and may conflict with the eventual price obtained for the property (whether as a result of an auction or private sale).
By Skadden Arps Slate Meagher & Flom associate Amin Doulai in London