Lenders are faced with an ever-increasing number of defaultedcommercial real estate mortgages, forcing them to either modify theloan or foreclose on the collateral Workouts remain attractive forlenders with loans in which the value of the property isinsufficient to repay the outstanding balance.

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This active workout market has caused lenders to employ variousnon-traditional means to make themselves whole. One such method isthe use of an equity kicker, equity participation, sharedappreciation or contingent interest loan, in which the lenderreceives, in addition to traditional interest payments, the rightto a percentage of the income or profits from the property. Withthe promise of future income, a lender may be more willing tonegotiate terms with the defaulting borrower.

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A mortgage loan with an equity participation generally involvesa below market, fixed interest-rate payment to the lender at a highloan-to-value ratio and additional interest payments. It is basedon the gross or net cash flow generated by the operation of theproperty. Shared appreciation payments may also be calculated basedon a percentage of the appreciated value of the property at thetime of any stipulated equity event, such as a sale or othertransfer.

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Lenders must be aware of various legal complications inconnection with equity participations. One possible complication isthat the equity participation will constitute additional interestthat may violate applicable usury laws. Though in many states usurystatutes do not apply to commercial transactions, in certainjurisdictions lenders must structure the equity participation toavoid violating usury restrictions.

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Lenders should also consider whether the right to receive apercentage of the borrower's income will survive the maturity ofthe loan. In certain jurisdictions, a mortgage containing an equityparticipation that grants a right to receive gross or net incomecannot survive the payment in full of the loan. A lender in thatcase should structure the participation at a fixed amount due onthe maturity date of the loan. The lender may also considerstructuring the equity participation as an agreement, separate andindependent of the mortgage, so that the right to receive profitssurvives the termination or release of the mortgage. However, thiscontractual agreement would not typically be recorded against theproperty in the manner that a mortgage is recorded and thirdparties would not be afforded notice of the contractualagreement.

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Another legal claim that a borrower could make is that theequity participation violates the common law doctrine prohibitingany clog of the equity of redemption. Under common law, noagreement between a mortgagor and mortgagee may prevent the formerfrom redeeming and retaining ownership of the property by payingthe indebtedness in full prior to a valid foreclosure decree. Ifany provision in the loan documents prevents the mortgagor frombeing able to redeem the property after default, then suchprovision may be invalidated as a "clog" on the equity ofredemption.

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Clogging issues should not normally arise in connection withcontingent interest and shared appreciation mortgage loans. Themortgagor will have the opportunity to redeem the property in asubsequent foreclosure. Since these types of transactions makecapital available to borrowers and allow lenders to participate inthe properties' value over time, courts would be reluctant toinvalidate them. A lender may also avoid a clogging issue byassigning a set value to the equity participation and allowing theborrower to liquidate the equity participation by paying suchamount.When a lender foreclosures in an equity participation loanwith a contingent interest or shared appreciation, borrowers haveargued that the mortgage is a disguised equity interest of thelender in the property and the proceeding should be dismissed. Toavoid such a claim, the mortgage should clearly state that thecontingent interest or shared appreciation components are part ofthe mortgage loan transaction and do not grant the lender anyequity in the property.


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