The New York County Supreme Court in CB Frontier v. Wilmington Trust, N.A., 2018 N.Y. Misc. LEXIS 3613 (Sup. Ct. N.Y. Cty. Aug. 20, 2018) recently held that an inclusionary housing floor area ratio (FAR) bonus, which enables developers to build more square footage than zoning regulations would ordinarily allow, “exists only for [the developer's] benefit, independent of the Property,” was not related to the mortgaged property, and therefore was not the lender's collateral for the mortgage on the Property. Id. at *1, *11. The Supreme Court's decision to grant summary judgment holding that the FAR bonus was not collateral under the mortgage surprised many in the commercial real estate community. While the decision has been appealed to the Appellate Division, the current decision raises areas of concern for lenders, and could lead borrowers (and lenders) to more closely scrutinize their existing loan documents to see if they will support a claim that a FAR bonus is not collateral under the mortgage.

Origin of the FAR Bonus Dispute

CB Frontier developed and owns two residential apartment buildings (the Property) in the Murray Hill section of New York City. The Property is comprised of 91 units, 19 of which are affordable housing units constructed pursuant to a regulatory agreement between CB Frontier and the New York City Department of Housing Preservation and Development (HPD). Under the regulatory agreement, HPD agreed to provide a 3.5 FAR bonus, which resulted in a bonus of 50,810 square feet. CB Frontier used 9,475 square feet of the FAR bonus on the Property and sold 15,977 square feet to a neighboring property owner on Feb. 17, 2016. After that sale, CB Frontier retained 25,358 square feet of FAR bonus.

In July 2016, after refinancing the property with LStar Capital Finance II, Inc. (LStar), CB Frontier sought to sell another portion of the FAR bonus. LStar, however, objected to the proposed sale on the grounds that the FAR bonus was collateral for its mortgage and a sale of the collateral without its consent would be a default. Because the FAR bonus was never explicitly addressed in the mortgage agreement between CB Frontier and LStar, both parties relied on more general language in the grants of security section. The section provided in relevant part that

Borrower [CB Frontier] does hereby irrevocably mortgage … and grant a security interest to Lender [LStar] and its successors and assigns [Wilmington] in … [inter alia] air rights and development rights … in any way now or hereafter belonging, relating or pertaining to the Land and the Improvements … .

CB Frontier, 2018 N.Y. Misc. LEXIS 3613, at *8 (emphasis added).

The parties agreed that the FAR bonus was a development right, but disputed whether it “belong[ed], relat[ed] or pertain[ed]” to the Property at the time the mortgage was entered into in 2016. LStar's argument that the FAR bonus fell within the scope of the mortgaged property focused on the phrase “related to,” and that the FAR bonus originated from “the specific way the 'Land' [was] used (for permanent affordable housing), and the design of its Improvements.” Doc. No. 106 at 17. In contrast, CB Frontier emphasized the word “now” and argued that, at the time the mortgage was granted, the FAR bonus “had no relationship or connection to the Property” because “[i]t had been separated—in essence reaped—from the Land before CB Frontier granted the mortgage to LStar.” Doc. No. 69 at 20. CB Frontier noted that FAR bonuses are created by the HPD's inclusionary housing program, and thus “are granted to developers, not to property.” Id. at 21.

Litigation Over the FAR Bonus

CB Frontier filed a declaratory judgment action in August 2016 regarding the FAR bonus. The defendants moved to dismiss the complaint based on the terms of the mortgage and the UCC-1 statement. The Supreme Court denied the motion to dismiss, which was affirmed by the First Department. The First Department held that a reasonable interpretation of the operative documents was “that the portion of the FAR bonus awarded to it by the City of New York that had not yet been transferred or applied to [CB Frontier's] properties could be transferred to another developer and was not subject to defendant's existing mortgage lien.” CB Frontier v. LStar Capital Fin. II, 61 N.Y.S.3d 15, 16 (1st Dep't 2017). The First Department noted that the operative documents were susceptible to more than one interpretation because “although the mortgage included 'all' … rights 'in any manner whatsoever' and 'in any way,' these inclusive terms were modified by the arguable limitation that they be 'belonging, relating to or pertaining to the land.'” Id.

The parties subsequently brought competing cross-motions for summary judgment regarding the ownership of the FAR bonus. The Supreme Court held that the FAR bonus was not collateral for the mortgage because it did not belong, relate, or pertain to the Property at the time the mortgage was granted. 2018 N.Y. Misc. LEXIS 3613, at *8-10.

First, the Supreme Court held that the FAR bonus did not belong or pertain to the Property. The Supreme Court relied on the language from HPD's “Certificate of Floor Area Compensation Transfer,” which authorizes reallocation of FAR bonus square footage among parcels. The certificate explicitly provides that it “may be conveyed or sold only by the Benefit Transferor named above [CB Frontier] … .” Id. Based on this language, the Supreme Court held that FAR bonuses are “granted to developers and [are] owned and transferable independent of any property[.]” Id. at *9-10.

Second, the Supreme Court held that the FAR bonus did not relate to the Property. In reaching that conclusion, the Supreme Court relied on the fact that the mortgage loan provided that only air and development rights “now or hereafter” relating to the Property were collateral. Id. at *11. The Supreme Court found that the FAR bonus was not captured by the temporal limitations of the mortgage loan because the Property could not benefit from the bonus at the time the mortgage was created and the only value of the FAR bonus in 2016 was that it could be sold to another developer. Id. Further, the Supreme Court noted that the easements identified as security for the mortgage loan “all … affect or otherwise touch the Property.” Id. Based on that observation, the Supreme Court held that “the term 'relating to' refers to rights that can be used on the Property or affect the use of the Property.” Id. The Supreme Court determined the FAR bonus could not “be used” or “affect the use of” the Property because the Property had already reached its maximum permitted floor area ratio when the mortgage was executed. Id. at *11-12.

Although the Supreme Court held that the mortgage agreement was unambiguous, it held in the alternative that, assuming the mortgage agreement was ambiguous, CB Frontier still would prevail because the agreement was drafted by the lender and thus any ambiguity had to be construed against the lender. Id. at *13. Accordingly, the Supreme Court concluded that even if the mortgage agreement was ambiguous “the Remaining FAR Bonus does not 'relate to' the Property and the Remaining FAR Bonus was not gained as collateral pursuant to Section 1.01(e) of the Mortgage.” Id.

The Supreme Court also supported its ruling in favor of CB Frontier by relying on the fact that there was no language in the mortgage agreement specifically concerning the FAR bonus. Id. at *12. The Supreme Court noted that the FAR bonus was not discussed prior to the LStar loan closing, nor was it appraised or considered as collateral in LStar's decision to make the loan. Id. Because the parties were sophisticated business professionals involved in commercial real estate development, represented by counsel during the underlying mortgage agreement negotiations, the Supreme Court held that it “should not now insert the FAR Bonus into the Mortgage.” Id. at *13.

Conclusion

The full consequences of the Supreme Court's decision will only be known after the Appellate Division decides the pending appeal. If CB Frontier prevails before the Appellate Division, there is the potential for increased litigation with respect to FAR bonuses arising from existing loan agreements that do not explicitly address whether the bonuses are collateral.

At a minimum, the Supreme Court's decision in CB Frontier serves as an important reminder of the need for precise drafting in the commercial real estate context and that New York courts will not award through litigation what a party could not obtain—or did not ask for—at the bargaining table. In light of the Supreme Court's decision, we expect sophisticated parties will more closely consider specifically addressing in their loan agreements whether FAR bonuses or other property-based incentives are part of the loan collateral.

Janice Mac Avoy is a partner in the real estate department and the litigation department and co-head of the real estate litigation practice at Fried, Frank, Harris, Shriver & Jacobson. Justin J. Santolli is special counsel in the litigation department. Litigation law clerk Elizabeth LoPresti assisted in the preparation of this article.