Many commercial leases contain provisions granting landlords a lien on the tenant’s assets. These leases often provide that property abandoned by the tenant upon termination of the lease belongs to the landlord. These lease provisions reduce the security granted to commercial lenders because they can create conflicting priorities of liens.

Article 9 of the Uniform Commercial Code does not always address the priority of non-Article 9 liens. Worse, landlord liens are expressly excluded from the scope of Article 9. See 810 Ill. Comp. Stat. 5/9-109(d). If the debtor defaults, the secured creditor is likely to find itself in a priority fight with the landlord over the collateral.

It can get worse than a simple priority fight. In this economy it is not uncommon for businesses to abruptly close shop and abandon their property on the leased premises. As a result, the landlord is often the first party to discover the debtor’s insolvency. This gives the landlord a huge head start in the race to the courthouse door to obtain a judicial order confirming the landlord’s ownership. In some cases the secured creditor is not aware of the location of the collateral. In such a scenario, the landlord may have disposed the debtor’s property before the secured creditor became aware of the default. In addition, if the landlord does not cooperate the secured creditor may not be able to access the premises to remove the collateral without a court order.

However, the secured creditor may be able to reach an agreement with the landlord regarding the collateral. Many landlords do not have the interest or ability to hold auctions for abandoned property. So long as they obtain some redress for their damages, the landlord may permit the secured creditor to remove the collateral from the premises. Removal of the collateral also makes it easier to relet the premises.

Many of the secured creditor’s nightmares with respect to landlords can be avoided with two simple measures (1) regular inspections of the tenant’s business facilities to ensure that the collateral has not been moved; and (2) obtaining landlord waivers where the landlord recognizes the lien and permits the secured creditor to remove the collateral upon default. Most landlords understand that the health of their tenant’s business depends on their ability to secure adequate financing. As a result landlords generally are willing to waive their lien rights in exchange for a relatively nominal amount (often partial rent while the premises are accessed by the secured creditor).

One final item to note, which is overlooked with surprising frequency.  Secured creditors should not engage in self help when their collateral is under lock and key under premises owned by another party.  Article 9 security interests will not provide a defense to a charge of breaking and entering.

A previous entry highlighted some of the perils of stock pledges. It can get worse.

The most glaring limitation in a pledge of stock of a privately held company is the absence of a public market for the stock. This potentially saddles the creditor with stock that it cannot sell (absent a shareholder agreement with mandatory buy-sell provisions).  Additionally, if the stock pledge does not include all or a controlling amount of the company the creditor may not be able to elect directors of the company to force a sale of the company.  This could leave the creditor in the position of Don Quixote tilting at windmills.

However, even with these limitations stock pledges are still fairly common.

To begin with, they are often the most cost effective way to obtain a security interest.  Since the lien is perfected by possession of the stock certificate or blank stock powers, both parties can avoid UCC filing costs (or even worse, mortgage filing costs) and requirements.  Enforcing the lien upon default involves simply signing over the stock to the creditor’s name and enforcing rights as a shareholder to sell the stock or vote to force a sale of the company.  This may permit the creditor to act without court action, particularly when the pledge gives the creditor vote of a controlling interest in stock.

Stock pledges are often not as intrusive in the day to day operations of the business and do not preclude the ability to obtain additional financing or trigger defaults on existing financing (Note: encumbering stock can trigger a default under many standard bank documents).  In some cases, the company may have sufficient value that even the acquisition of a minority interest may have inherent values.

While stock pledges are not perfect even when properly perfected, the circumstances of the transaction may make them the appropriate form of security.  The pros and cons of doing so should be carefully considered.

Here is a scenario to ponder.  A Debtor issues two Promissory Notes, one to Creditor A and the other to Creditor B.  The Note to Creditor A is dated earlier and is secured by a properly perfected pledge in the Debtor’s stock.  The Note to Creditor B is secured by a properly perfected and filed UCC financing statement on all assets of the Debtor.  There is no Intercreditor and Subordination Agreement between Creditor A and Creditor B.  Debtor defaults.  Would you rather be Creditor A or Creditor B?

Article 9 of the UCC addresses a number of priority scenarios when different creditors lien against the same asset. See 810 ILCS 5/9-317 to 810 ILCS 5/9-339. However, it does not provide much guidance as to the practical economic effect of two creditors who properly perfected their liens against different assets.

In the scenario above, Creditor A may enforce its pledge to gain voting control of the Debtor and attempt to sell the business.  However, Creditor B still has a valid lien against the Debtor’s assets that will not be extinguished by Creditor A assuming control of the Debtor.  Creditor B can still proceed against the assets and recover its obligations, possibly leaving Creditor A with a shell company.

Creditor A would be in a better position if it had an Intercreditor and Subordination Agreement with Creditor B that ensured Creditor A was paid off before Creditor B.  However, this scenario also presents the lesson to creditors often cited by Alastor “Mad-Eye” Moody in the Harry Potter books – “Eternal Vigilance.”  Know what your debtors are up to and what encumbrances they are racking up.

This scenario also highlights certain limitations of using stock pledges to secure debt.  These will be explored further in a later blog.

Every mortgage holder, title company, mechanic’s lien holder, or attorney assisting any party with an interest in lien rights on property realizes that the law regarding property rights is changing more quickly now than it has for years - perhaps decades.  Courts are inundated with property foreclosures, and personal experience and conversations with others working through lien priority claims reveals that parties are faced with numerous complicated, unique, and just plain strange legal issues as a result.  The sheer volume of claims passing through the courts simply guarantees a larger number of odd issues regarding deficiencies in recordings, failures to obtain proper documentation, tests of consumer laws related to mechanic’s liens, cases of outright fraud, and even (as we saw last year in Cook County) reluctance of public officials to carry out their duties in foreclosure actions.  As courts are repeatedly faced with these issues that differ wildly from the plain vanilla property rights and lien priority issues to which they are accustomed, they will undoubtedly create a wealth of new or expanded law that parties will need to consider when entering any relationship regarding real property.

Moreover, government entities are increasing their own efforts to stem the tide of what they now perceive as a foreclosure crisis, through both large and small proposed changes to laws and regulations relevant to mortgages and other liens.  In Illinois alone, there has been a steady stream of proposals for changes to mechanic’s lien and mortgage foreclosure laws, mostly aimed at attempts to protect individuals subject to liens on their residences.

Even small proposed changes could have a major impact on a number of cases.  One Illinois bill proposes requiring mechanic’s lien claimants to notify an owner before placing a lien on owner-occupied property (HB236).  Such a simple and easily overlooked requirement could make every difference in litigation, potentially devastating a contractor’s ability to obtain lien priority over a mortgage holder under the existent mechanics lien laws.

Larger proposed changes would have a more immediate and apparent impact.  One proposal set forth in the Illinois House at the end of 2008 (an amendment to HB2973 in the 2008 session) would require mortgage holders to advise homeowners upon whom they wished to foreclose to obtain housing counseling, staying any legal action for 30 days and allowing homeowners who sought counseling to obtain longer stays.  The proposal would have ultimately required mortgage holders to agree to counseling plans to save a residence from foreclosure, and explicitly could not be waived.

Illinois is hardly alone in considering changes that would affect lienholders’ rights in property and the processes to create and enforce those rights.  In Iowa, the legislature is considering a bill that would require mortgage brokers to enter into agency relationships with borrowers, with attendant changes in duties to the borrowers.  New Jersey has considered legislation that would require mediation to establish terms that may enable a homeowner in foreclosure to remain in the home, coupled with a mandatory six month forbearance period.  California considered a 90 day moratorium on all mortgage foreclosures.  The list goes on.

In the end, it is inevitable that there will be changes in laws related to real estate.  Whether changes are made through case law or legislation, they will occur, and it is likely that they will occur soon.  It is imperative that any party interested in creating, maintaining, protecting, contesting, or enforcing lien rights in real property stay abreast of the development of the law in this area, or at least be sure that someone is doing so on their behalf.