Category: Bankruptcy

FTC Obtains Injunction, Asset Freeze on Alleged Mortgage Scam

The National Law Review recently published an article by Steven Eichorn of Ifrah Law regarding a Recent FTC Injunction:

The Federal Trade Commission has obtained an order from the federal court for the Central District of California for a preliminary injunction and asset freeze against all the defendants in an alleged mortgage modification scam.

The complaint was filed against California-based Sameer Lakhany and a number of related corporate entities for violating the Federal Trade Commission Act and the Mortgage Assistance Relief Services Rule, now known as Regulation O.This was the first FTC complaint against a mortgage relief scheme that falsely promised to get help for homeowners who joined with other homeowners to file so-called “mass joinder” lawsuits against their lenders.

The complaint listed two separate alleged schemes that collected over $1 million in fees and used images of President Obama to urge consumers to call for modifications under the “Obama Loan Modification Programs.”

The first scheme was a loan modification plan under which the defendants allegedly promised substantial relief to unwary homeowners from unaffordable mortgages and foreclosures. Their website featured a seal indicating that it was an “NHLA accredited mortgage advocate” and that NHLA is “a regulatory body in the loan modification industry to insure only the highest standards and practices are being performed. They have an A rating with the BBB.” Unfortunately, the NHLA is not a “regulatory body” and it actually has an “F” rating with the BBB.

The defendants reinforced their sales pitch by portraying themselves as nonprofit housing counselors that received outside funding for all their operating costs, except for a “forensic loan audit” fee. According to the FTC, the defendants told consumers that these audits would uncover lender violations 90 percent of the time or more and that the violations would provide leverage over their lenders and force the lenders to grant a loan modification. The defendants typically charged consumers between $795 and $1595 for this “audit.” Also, if the “audit” did not turn up any violations, the consumers could get a 70 percent refund. Unfortunately, there were often no violations found, any “violations” did not materially change the lender’s position, and it was nearly impossible to actually get a refund for this fee.

The second alleged scheme was that the defendants created a law firm, Precision Law Center, and attempted to sell consumers legal services. Precision Law Center was supposed to be a “full service law firm”, with a wide variety of practice areas. It even claimed to “have assembled an aggressive and talented team of litigators to address the lenders in a Court of Law.” However, the FTC charged that the firm never did anything besides for filing a few complaints, which were mostly dismissed.

To assist Precision Law Center in getting new clients, the defendants sent out direct mail from their law firm that resembled a class action settlement notice. The notice “promised” consumers that if they sued their lenders along with other homeowners in a “mass joinder” lawsuit, they could obtain favorable mortgage concessions from their lenders or stop the foreclosure process. The fee to participate in this lawsuit was usually between $6,000 to $10,000. The material also allegedly claimed that 80 to 85 percent of these suits are successful and that consumers might also receive their homes free and clear and be refunded all other charges.

The defendants’ direct mail solicitation also contained an official-looking form designed to mimic a federal tax form or class action settlement notice. It had prominent markings urging the time sensitivity of the materials and it requested an immediate response.

Obviously, these defendants employed many egregious marketing techniques that crossed the FTC’s line of permissibility. However, in light of the FTC’s renewed focus on Internet marketing, even a traditional marketing campaign should be carefully crafted with legal ramifications in mind.

As a final note, it is always smart not to antagonize the FTC by proclaiming (like the defendants here did) that they are “Allowed to Accept Retainer Fees” because it was “Not covered by FTC.” We couldn’t think of a better way to get onto the FTC’s radar screen!

© 2012 Ifrah PLLC

The BankAtlantic Bancorp Decision — Roadblock or Detour to Open Bank Sale of Distressed Banks?

Recently The National Law Review published an article regarding The Bank Atlantic Bancorp Decision written by The Financial Institutions Group of Schiff Hardin LLP : 

Any bank holding company with trust preferred securities (“TRuPs”) outstanding and in need of capital in this stressed operating environment for banks has had its strategic options limited by a recent decision of the Delaware Chancery Court. The court’s opinion makes it more difficult to recapitalize a distressed bank by giving the TRuPs bondholders enhanced blocking power. This newsletter summarizes the recent court action, explains its implications for bank recapitalizations, and offers the strategic solution of a Bankruptcy Code Section 363 sale to address capital needs while reconciling the rights and remedies of TRuPs trustees and bondholders.

The February 27, 2012 decision of the Delaware Court of Chancery to permanently enjoin the proposed sale of the stock in a financially distressed bank as “substantially all of the assets” of a savings bank holding company in violation of several indentures for outstanding issues of TRuPS offers many lessons for boards of directors, CEOs, investment bankers and lawyers dealing with the recapitalization or sale of distressed banks. In re BankAtlantic Bancorp, Inc. Litigation, Slip. Op. Consol. C.A. No. 7068 VCL (Del. Ch. February 27, 2012). Vice Chancellor Laster held that the sale met both tests for a sale of substantially all of a corporation’s assets. It met the quantitative test because the $306 million book value of the common stock in BankAtlantic, a federal savings bank (“Bank”) constituted approximately 90% of the $341 million book value of all assets of BankAtlantic Bancorp (“Holdco”) and the bank accounted for 69% of consolidated revenues and Holdco’s principal source of liquidity. The sale likewise met the qualitative test because Holdco’s public filings referred to itself as a “unitary savings bank holding company,” which was contractually bound not to compete with the buyer of Bank and owned no other subsidiaries other than a workout subsidiary to warehouse nonperforming assets. The plaintiffs were entitled to enjoin the transaction because the TRuPS trustees and holders would have been irreparably injured by the transfer of the Bank stock that left Holdco without sufficient liquid assets to pay the accelerated TRuPS.

The transaction and its context

The transaction culminated a series of efforts by Holdco to escape from $630 million in losses during 2008-2010 from commercial real estate loans in South Florida. Bank was blocked from paying dividends or upstreaming assets under a cease and desist order. Bank had raised some cash from a branch sale transaction in 2011 after a prior unsuccessful sales effort. Holdco tried unsuccessfully to raise equity capital and floated three partially subscribed rights offerings during 2009-2011. Holdco and its principals lost a summary judgment and a jury verdict for securities fraud in part of a class action about misstatement of loan losses. Finally, 11 issues of TRuPS, aggregating $25 million principal amount had been placed on interest deferral since early 2009. While Holdco was not formally insolvent or in capital violation under its cease and desist order, the accrual of deferred interest on the TRuPS increased the debt to $322 million by 2011 and a projected $368 million by 2013.

The court found that Holdco ran a sales process, but its controlling stockholders rejected every structure other than the transaction selected. One buyer expressed interest in a cash purchase of Bank for $158 million but cut its bid to $50 million after the securities fraud verdict was entered against Holdco. Instead, Holdco opted for a sale of its stock in Bank in an innovative transaction that involved no cash payment from the buyer, BB&T, other than a $10 million payment for a covenant not to compete from Holdco’s insiders. The transaction offered a 10% premium over deposits for the Bank stock, because BB&T would assume $3.4 billion in liabilities (principally to depositors) but only purchase $3.1 billion in assets. To adjust its balance sheet for closing, Bank planned to drop cash and nonperforming and criticized assets with a book value of $623.6 million into a new subsidiary named Retained Asset LLC (“Residco”). At closing, the membership interest in Residco would be distributed by Bank to Holdco. Residco was projected to generate $14 million in annual interest income, but Holdco’s annual expenses, including TRuPS interest, topped $30 million. To obtain regulatory approval, BB&T agreed to recapitalize Bank after closing with $538.8 million to fill the capital hole left by the creation of Residco and achieve a 6.84% ratio of tangible common equity to tangible assets).

One of Holdco’s investment banks called BB&T’s recapitalization the “purchase price” of the transaction, in effect satisfying the contingent liability that took the form of the amount of new capital necessary to meet ongoing capital requirements. Its other investment banker issued a fairness opinion that the book value of the membership interest in Residco was a fair purchase price. In either event, Holdco’s pro forma balance sheet after closing would improve by over $300 million and current deferred interest on the TRuPS would be paid. Holdco’s stock jumped 111% while one publicly traded issue of TRuPS rose 99.5% in value. Nevertheless, several TRuPS trustees and holders (including several activist secondary buyers) filed suit, perhaps because the transaction did not even generate cash sufficient to match Holdco’s prior offer to purchase the TRuPS for twenty cents on the dollar in early 2010.

What constitutes “substantially all of the assets” of a single bank holding company?

The plaintiffs successfully interrupted the transaction by enforcing a common “boilerplate” provision that appears in all of Holdco’s TRuPS indentures. The indentures allow acceleration of the TRuPS upon the sale of “substantially all of the assets” of Holdco unless the buyer assumes the indenture. Under established New York law, which each underwriter provided was to govern, the court applied both a “quantitative” and a “qualitative” test of what constitutes “substantially all of the assets.” Even if the seller retains assets making up most of its book value, the sale of the crown jewels of a company can trigger the qualitative test by fundamentally changing the nature or character of the seller’s business.

The court held that the transaction met both tests. The transaction satisfied the qualitative test because Holdco sold its sole banking subsidiary, which generated the dominant share of revenues, provided all of Holdco’s liquidity and cash flow and employed almost all of the employees of the combined enterprise. Holdco’s business was fundamentally changed by the transaction because it was contractually bound not to compete with the buyer in the banking business. The court also found that the quantitative test was satisfied because the book value of the Bank stock (the $306 million) constituted 90% of the book value of Holdco’s assets ($341 million). The court rejected Holdco’s argument that the Bank stock had no value. Holdco argued that the book value of Residco (which was stripped out of Bank at closing) should be deducted from the book value of the Bank stock, leaving a “negative book value” of over $300 million. The court found this counter-intuitive because BB&T was buying the “good bank” and leaving behind the “bad bank.” Evidence of the positive value of Bank was the fairness opinion of one of Holdco’s investment bankers, which pointed out that BB&T thought that Bank’s franchise was worth enough to justify a $538.8 million post-closing investment to recapitalize it.

The court also rejected Holdco’s “valueless stock” argument because New York excluded the buyer’s purchase price from the total assets of the seller in determining whether the seller sold “substantially all” of such assets. The court pointed to statements by Holdco’s insiders that the membership interest in Residco was the “purchase price.” One of Holdco’s investment bankers opined that Holdco received a fair price equal to 166% price-to-book ratio calculated by dividing the book value of Residco by the book value of the Bank stock ($607/306 million). Indeed, the court observed that no transaction would meet the “substantially all of the assets” test if the seller’s assets were grossed up by the purchase price paid.

Availability of Injunctive Relief

The court granted the plaintiffs’ request for a permanent injunction against the transaction because it held that they would be irreparably harmed. Even though the TRuPS would receive $39 million to pay down deferred interest, Holdco lacked the liquidity to pay the remaining $290 million that would be due on the acceleration of the TRuPS. Holdco would have had no assets to pay the TRuPS except a “fire sale” of the assets of Residco that would have been “suicide” according to Holdco’s principal stockholder. The court also believed that the $10 million to be paid to senior executives and shareholders in new severance and non-compete agreements violated the established liquidation rules giving creditors priority over shareholders. It also pointed to New York law holding that creditors are irreparably injured by transferring all collectible assets, which fundamentally shifts the risks that creditors agreed to assume.

The court rejected the view that an “untenable” status quo made the balance of hardships favor Holdco. While the court noted that there was a risk that Holdco would fail, it pointed to the fact that Holdco was not presently insolvent or in violation of its capital requirements, particularly because the TRuPS still counted as Tier I capital for Bank. It seemed particularly concerned with flaws in Holdco’s sales process whereby the controlling shareholder frustrated other alternatives to the transaction by misstatements to the board and the frustration of other bidders. Even though the only bid on the table offered just $50 million, the court believed that it might have been superior to the creditors if the TRuPS had been assumed. In essence, Holdco never made a case that such a transaction was impossible.

Post-Litigation Settlement

Two weeks after the decision in the BankAtlantic litigation, BB&T and Holdco revised the transaction to include the assumption of the TRuPS. BB&T protected its investment, however, by its simultaneous acquisition of a 95% preferred membership interest in an LLC to be formed to hold $424 million in loans and $17 million in real estate and associated deposits, escrows, rights, obligations, loss reserves and claims (presumably the bulk of the assets that BB&T previously agreed to leave behind in Residco). BB&T’s preferred interest will terminate when it receives a preferred amount of distributions equal to the additional $285 million investment that it made by assuming the TRuPS indentures. Finally, BB&T received Holdco’s guaranty of the preferred amount of distributions. The legal fees of the TRuPS trustees in the BankAtlantic litigation will be paid from the transaction. In sum, the TRuPS holders received exactly what they wanted.

Lessons Learned

The BankAtlantic litigation shows a number of developments in the distressed, open-bank arena:

  • The terms of TRuPS indentures can impede an open-bank sale even if the sale improves the holding company balance sheet, pays deferred interest and offers the prospect of full payment to creditors and value to shareholders. Most distressed bank situations do not offer such advantages to holding company creditors and shareholders.
  • TRuPS holders have become better organized and are able to persuade or direct trustees to take legal action to contest transactions. The ruling in the BankAtlantic litigation will encourage more aggressive litigation in the future.
  • Analogous events of default allow acceleration of secured and unsecured bank loans to bank holding companies.
  • Courts will closely scrutinize the marketing process where a seller restricts bidders to a structure that benefits insiders and does not allow all bidders reasonable due diligence.
  •  Non-bankruptcy courts may not give much weight to the difficult regulatory and economic environment for open-bank sales of financially distressed banks.
  • To be persuasive, the investment bankers’ fairness opinions must pass the common-sense test, even in a transaction that positively benefits creditors.

Would a Bankruptcy Court have approved the Original Transaction as a Section 363 Sale of Holdco’s stock in Bank?

The court’s ruling suggests that Holdco may have had a more favorable outcome if it had structured the original transaction to close in a Section 363 sale of assets in a Chapter 11 proceeding. See Fisher, J.M., Bankruptcy Sales to Facilitate Open-Bank Recapitalizations, Pratt’s Journal of Bankruptcy Law (January 2011) at 64. Bankruptcy courts are more familiar with the practical exigencies of selling financially distressed businesses, a point that the Chancery Court discounted. These include the need for a speedy sale and the fact that creditors may have to wait to be paid and be satisfied with a partial payment of their claims. In essence, the BB&T bid could have been signed up with the contingency that the bankruptcy court (i) approve bidding procedures setting a marketing period for higher and better bids for a reasonable but brief period after the bankruptcy and giving BB&T a breakup fee as compensation for being the stalking horse, (ii) allow other bidders to compete against the price and structure of the stalking horse bid so long as the other bidder had comparable financial qualifications, due diligence and financing contingencies, if any, and comparable ability to obtain regulatory approval, and (iii) approve the sale to the highest and best bid based on the values received by Holdco’s creditors with due regard to the urgent risk of regulatory action.

A bankruptcy would involve several key differences in the judicial process:

  • The existence of a default and acceleration under the TRuPS indentures would be irrelevant because the automatic stay prohibits the TRuPS trustees from exercising remedies.
  • Bankruptcy courts are comfortable with a stalking horse process, particularly where there has been substantial pre-bankruptcy marketing.
  • All constituencies, including TRuPS and shareholders, have input into the judicial process approving bidding procedures that test the stalking horse bid and ultimate fairness of the value provided to holding company stakeholders.
  • Bankruptcy courts are accustomed to considering valuation testimony as well as treating the judicially approved auction result as the “market” value.
  • The $626 million value of the Residco membership interest would have been considered a substantial purchase price to be balanced against the investment banker’s valuation of the BankAtlantic stock. The “book value” of the Bank stock likely would have been viewed as inflated, in light of the value of Residco and the large investment that BB&T was required to make to recapitalize Bank after closing.
  • A fair auction process and the protections afforded a buyer under Section 363 might have induced competitive bidding by the other interested party and likely captured the proposed noncompete payment from BBT to insiders for the benefit of creditors.
  • The holding company could have taken its time, protected by the automatic stay or a discharge, in working out the nonperforming assets in Residco.
  • The holding company might have been able to preserve valuable tax attributes through a plan of reorganization.

Even though the matter appears to be settled, the BankAtlantic decision suggests a change in the landscape for the open-bank sale of a financially distressed bank and a possible detour through bankruptcy that can level the playing field for all stakeholders.

© 2012 Schiff Hardin LLP

DOJ Goes After Smaller Fraudsters, Lets Big Fish Escape

An article featured recently in The National Law Review regarding the Department of Justice’s Prosecuting Fraud was written by Nicole Kardell of Ifrah Law:

Successful criminal prosecutions of mortgage fraud seem to have one thing in common: a fraud figure well below $10 million. One of the recent cases that generated a fair amount of press involved the convictions of co-conspirators in a mortgage scheme carried out by an ex-NFL player. That scheme, which took place during the housing boom in the early 2000’s, resulted in 10 convictions. Former Dallas Cowboy linebacker Eugene Lockhart is facing jail time of up to 10 years. The nine other individuals are looking at sentences of roughly two to five years.

The mortgage scheme – which led to convictions for wire fraud, conspiracy to commit wire fraud, and making false statements to a federal agency – seems pretty typical of the conduct that prosecutors have been going after: the use of “straw borrowers” to apply for loans on home purchases; falsification of data on loan applications to ensure that straw borrowers would qualify for home loans; and creation of artificially high appraisal values for the homes to be purchased by the straw borrowers. In the case of Lockhart and his cohorts, the Justice Department alleges that the scheme resulted in an actual loss to lenders of roughly $3 million.

While $3 million is not a trivial sum, it is a very tiny portion of the housing industry. Even the total amount in all similar prosecutions nationwide is quite small. Recent headline prosecutions involving similar schemes include a Florida case valued at $8 million in loan proceeds, an Alabama case valued at $2 million, and a New York case valued at $82 million in loan proceeds. At least the latter is a more aggressive number (as apparently was one of the defendants in the New York case, who moonlighted as a dominatrix in a Manhattan club).

The government has been touting these prosecutions as a part of a major crackdown on the mortgage business. The DOJ press statements note that“[m]ortgage fraud is a major focus of President Barack Obama’s Financial Fraud Enforcement Task Force.” But these are comparatively minor matters if one looks to the real causes of the housing crash that led to the 2008 financial crisis. Bank of America, Goldman Sachs, JPMorgan Chase, and Wells Fargo, who were all in the business of packaging and selling subprime mortgages, have been more or less covered with Teflon.

The lack of criminal prosecutions against the big banks in the subprime crisis has been written about many times. But that doesn’t mean it’s not worth repeating. Something seems just wrong about the DOJ’s focus on the smaller fraudsters and its soft approach to the bigger players.

Hopefully, the SEC’s recent decision to send Wells notices to Goldman Sachs, JPMorgan Chase, and Wells Fargo indicating possible enforcement proceedings, means that at least these banks could face some civil liability for their role in the housing crash. And Bank of America recently settled a False Claims Act case with the Feds for $1 billion. But approaching the banks with civil actions, and skirting individual culpability, sends the message that once you reach a certain level of success, you are above the law.

© 2012 Ifrah PLLC

Secured Lender Successfully Invokes Seldom Used Tool to Protect Collateral in Bankruptcy

Recently The National Law Review published an article about Protecting Collateral in Bankruptcy by Mark A. Berkoff, Robert Radasevich, Nicholas M. Miller, William Choslovsky and Kevin G. Schneider of Neal, Gerber & Eisenberg LLP:

The commercial real estate market continues to struggle.  Beyond poor market conditions, financing difficulties and other well known issues of late, many mortgage holders, realizing that their properties are worth significantly less than their mortgage balance, are walking away from the properties or otherwise looking for a way to reduce their mortgage obligation to the property’s current depressed market value, including through a chapter 11 bankruptcy process.  Ultimately, the question in that situation becomes:  who will take the loss on their balance sheet—the lender or the borrower?  Often, the loss falls on the lender.

On January 19, 2012, however, the United States Court of Appeals for the Seventh Circuit issued an opinion, authored by Judge Richard A. Posner, representing a significant victory for undersecured lenders holding distressed real estate collateral.  In that case, In re River East Plaza, LLC, No. 11-3263, — F.3d —-, 2012 U.S. App. LEXIS 1048 (7th Cir. Jan. 19, 2012), the subject property was the River East Art Center located near Navy Pier in downtown Chicago.  Neal, Gerber & Eisenberg LLP (“NGE”) was lead counsel to the property owner’s senior secured lender, LNV Corp., an affiliate of Beal Bank.

The facts are straightforward:  When the building’s owner and mortgagor, River East Plaza, LLC (“River East” or the “Debtor”), defaulted on its mortgage, LNV successfully pursued difficult foreclosure proceedings in state court and obtained a foreclosure sale order in February 2011, nearly two years after River East defaulted on its mortgage.  Then, just 11 hours before the scheduled foreclosure sale, River East filed for chapter 11 bankruptcy protection, automatically halting the foreclosure sale.

Because this was a single asset real estate (“SARE”)[1] case, River East was subject to special Bankruptcy Code rules designed to put pressure on SARE debtors to move their cases quickly.

Once a Debtor files for bankruptcy, an estate is created and the Debtor is protected by an automatic stay that prohibits creditors of the Debtor from taking certain actions to collect debts, enforce remedies or complete litigation without obtaining relief from the automatic stay from the Bankruptcy Judge.  Among other things, in a SARE case, a Debtor has only 90 days to start making monthly mortgage payments to its lender or to file a plan of reorganization “that has a reasonable possibility of being confirmed within a reasonable time”.  If one of these conditions isn’t satisfied, then the Bankruptcy Judge must modify the automatic stay and may allow the lender to pursue its state court remedies (i.e. complete its foreclosure).  11 U.S.C. § 362(d)(3).

In this case, however, the Debtor did not make any mortgage payments to the lender within 90 days after the bankruptcy filing.  Therefore, the sole issue was whether this Debtor had timely filed a plan of reorganization that had a “reasonable possibility of being confirmed within a reasonable time.”  Id.  The Debtor filed a plan that, in effect, proposed to cash out the lender at a very distressed price, well below LNV’s $38.3 million claim.  While it was undisputed that the value of the real estate had fallen precipitously in the current real estate recession and that the property was “underwater,” the Debtor valued the property at what LNV viewed as an artificially low $15 million (and also valued LNV’s claim, after accounting for taxes and mechanics liens, at $13.5 million).  Because LNV was unwilling to accept a lowball cash out, it objected to the Debtor’s plan andalso made the strategic decision to make what is called a “section 1111(b) election” – a provision that has been in the Bankruptcy Code for over 30 years, but is seldom invoked.

The statute is awkwardly worded, confusing and hard to interpret, which may explain why it is seldom invoked, but the key takeaway is that section 1111(b):

  1. Allows a secured creditor to “elect” to have its entire claim treated as secured (even if the lender is undersecured (i.e. claim is worth $38.3 million and debtor (borrower) believes the lender’s secured interest in the collateral is worth only $13.5 million));
  2. Allows the secured lender to retain its lien on the property until that secured claim is paid in full;
  3. Is appropriate when the secured creditor believes the property is undervalued and will appreciate, and when the lender believes the reorganized debtor may later default under its confirmed plan; BUT
  4. The secured creditor, in making the election, must agree to waive its undersecured deficiency claim (in this case approximately $25 million).

As the Seventh Circuit stated:

. . . an under-secured creditor who decides, as LNV has decided, to participate in his debtor’s bankruptcy proceeding has a secured claim for the value of the collateral at the time of bankruptcy and an unsecured claim for the balance.  11 U.S.C. § 1111(b)(1)(A).  But generally he can exchange his two claims for a single secured claim equal to the face amount of the unpaid balance of the mortgage.  §§ 1111(b)(1)(B), (2).  LNV made this choice, so instead of having a secured claim for $13.5 million and an unsecured claim for $24.8 million it has a secured claim for $38.3 million and no unsecured claim . . .

The swap is attractive to a mortgagee who believes both that the property that secures his mortgage is undervalued and that the reorganized firm is likely to default again . . .

River East Plaza, 2012 U.S. App. LEXIS 1048, at *7-8.

The Debtor responded to LNV’s § 1111(b) election by filing an amended plan that offered LNV the option of receiving (1) a cash out of the secured portion of its claim at the distressed price of approximately $13.5 million, plus a dividend of 4% on LNV’s $25 million deficiency claim (meaning an additional $1 million); or(2) approximately $13.5 million in 30-year U.S. Treasury bonds paying approximately 3% interest (which, “through the magic of compound interest”, would pay LNV a total of $38.3 million in 30 years).

In so doing, the Debtor proposed to retain the property, to strip LNV’s lien from the property and, instead, give LNV a lien on the long-term Treasury Bonds so that the Debtor could obtain construction financing, develop the property, realize the benefit of any appreciation or improvement in the real estate market and, presumably, sell the property for a very tidy profit in a few years.  LNV, meanwhile, would be effectively cashed out for $13.5 million on its $38.3 million claim.

Needless to say, LNV vehemently opposed this tactic and immediately filed a motion to terminate the automatic stay on the grounds that the Debtor’s amended plan “was not likely to be confirmed in a reasonable time” because the Debtor was proposing to retain the property while stripping LNV’s lien in violation of section 1111(b) and other plan-related provisions of the Bankruptcy Code.  LNV argued that its § 1111(b) election ensured it the right to retainitslien on the real estate and benefit from any appreciation in the real estate market until its claim was paid in full.

The Debtor argued that it was able to do this because, among other things, giving LNV the lien on Treasury Bonds was giving LNV the “indubitable equivalent”[2] of its lien on the real estate, which the Bankruptcy Code allows under certain circumstances when a plan proponent (normally the debtor) attempts to cram a plan down the throat of an objecting secured creditor.[3]  LNV countered that even ifthe Debtor could use the “indubitable equivalent” standard of cram down, a lien on stagnant 30-year Treasury Bonds was not the indubitable equivalent of a lien on real estate that can and does fluctuate wildly in value.

Bankruptcy Judge Wedoff agreed with LNV and lifted the automatic stay to allow the foreclosure to proceed, and he also dismissed the bankruptcy case.  River East successfully requested a direct appeal to the Seventh Circuit, which ultimately affirmed Bankruptcy Judge Wedoff’s decisions.

In a key ruling for secured creditors, the Seventh Circuit determined that the Debtor had delayed the secured creditor long enough and that Judge Wedoff appropriately lifted the stay and dismissed the bankruptcy case.  The Seventh Circuit also determined that the proposed replacement lien on 30-year Treasury Bonds was not the indubitable equivalent of LNV’s lien on the property because the risk profiles of the two forms of collateral were not equivalent.

Judge Posner observed that:

River East argues that the reason LNV chose to convert the entire $38.3 million debt that it was owed to a secured claim is that it wanted to thwart the bankruptcy proceeding.  No doubt.  LNV wanted to foreclose its mortgage and doubtless expected to be the high bidder at the foreclosure sale and thus become the building’s owner and so the sole beneficiary of any appreciation if and when the real estate market recovered.  But there is nothing wrong with a secured creditor’s wanting the automatic stay lifted so that it can maximize the recovery of the money owed it.

* * *

Banning substitution of collateral indeed makes good sense when as in the present case the creditor is undersecured . . .

River East, 2012 U.S. App. LEXIS 1048, at *12.

The Court also explained that:

And so it comes as no surprise that the lien on the Treasury bonds proposed by River East would not be equivalent to LNV’s retaining its lien on the building.  Suppose the building turns out to be worth $40 million five years from now, yet River East, having borrowed heavily in the interim to finance improvements that bring the building’s value up to that level, defaults.  With its lien intact and the bankruptcy court unlikely in this second round of bankruptcy to stay foreclosure, LNV would be able to foreclose, and so would be paid in full.  In contrast, if its lien were transferred to the substituted collateral, it would have to wait another 25 years to recover the $38.3 million owed it.

Id. at *14.

Judge Posner summed up the case as follows:

River East’s aim may have been to cash out LNV’s lien in a period of economic depression and reap the future appreciation in the building’s value when the economy rebounds.  Such a cashout is not the indubitable equivalent of a lien on the real estate, and to require it would be inconsistent with section 1111(b) of the Code, which allows the secured creditor to defeat such a tactic by writing up his secured claim to the full amount of the debt, at the price of giving up his unsecured claim to the difference between the current value of the debt and of the security.

Id. at *17 (emphasis added).

So, at least in this jurisdiction, secured lenders holding distressed real estate as collateral when a borrower files a SARE chapter 11 case now have another arrow in their quiver that can be used and must be considered.  Depending on the facts of your particular case, the §1111(b) election may just be “checkmate” to a debtor that is (i) frustrating a secured lender’s remedies on a defaulted mortgage, (ii) stringing out the lender in foreclosure court and then filing a bankruptcy petition on the eve of foreclosure to attempt to retain their property, and (iii) attempting to cash out the secured lender at a historically low price or give it inferior collateral in an effort to cram down a bankruptcy plan that hurts the lender.  Such “tactics” will no longer be tolerated in the Seventh Circuit.

[1]           The Bankruptcy Code defines SARE as a nonresidential property, or a residential property containing five or more apartments or other residential units, “on which no substantial business is being conducted by a Debtor other than the business of operating the real property and activities incidental thereto.”  11 U.S.C. §101(51B).

[2]           The Bankruptcy Code does not define indubitable equivalence.

[3]           A complete discussion of the parameters of “cram down,” which is technically complicated under the Bankruptcy Code, is beyond the scope of this article.

© 2012 Neal, Gerber & Eisenberg LLP.

Section 550 of the Bankruptcy Code Won’t Cap the Flow of Avoidance Action Liability

Recently The National Law Review published an article by Renée M. Dailey and Mark E. Dendinger of Bracewell & Giuliani LLP regarding Bankruptcy Codes:

Tronox Incorporated and certain affiliates (the “Debtors”) emerged from Chapter 11 in February 2011 armed with a new capital structure and operational game plan, but that’s yesterday’s news. The flavor of the month is last Friday’s decision by Justice Allan L. Gropper (located here) in a still pending adversary proceeding in the United States Bankruptcy Court for the Southern District of New York (the “Court”) filed by the Debtors against Anadarko Petroleum Corporation and certain affiliates (“Anadarko”) seeking to recover an alleged fraudulent transfer. The Court dismissed Anadarko’s summary judgment motion, holding that while section 550 of the Bankruptcy Code provides a floor for creditor recoveries, it does not impose a cap on creditor recoveries following the determination of avoidance action liability.

In the adversary complaint, the Debtors alleged that in a prepetition transaction their predecessor corporation separated profitable oil and gas exploration and production assets from multi-billion dollar environmental and tort liabilities, in order to permit Anadarko to acquire the cleansed assets all while leaving behind significant environmental liabilities. The Debtors’ extensive environmental liabilities finally caught up with them and in January 2009 the Debtors filed for Chapter 11 protection. The Debtor’s plan of reorganization incorporated a settlement agreement by and amongst the Debtors, the environmental and tort plaintiffs and general unsecured creditors that handed general unsecured creditors the keys to the car (i.e., 100% of the Debtors’ equity) and left the environmental and tort creditors looking for alternate transportation – proceeds from the pending adversary proceeding – as the main source of their recovery. With the adversary proceeding trial starting in May, Anadarko and the Debtors filed competing motions for partial summary judgment on the limited issue of damages. The issue at hand was the interpretation of section 550(a), specifically the clause “for the benefit of the estate” and whether it places a damage cap on prospective fraudulent transfer liability.

By way of background, section 550 prescribes the damages owed by a transferee once a fraudulent transfer is avoided by a bankruptcy court. Specifically, subsection (a) permits the debtor in possession to recover either the value of the property or the property itself “for the benefit of the estate.” 11 U.S.C. § 550(a). In its motion for partial summary judgment, Anadarko argued that this language capped its liability, if any, in the fraudulent conveyance litigation to the total claims of the environmental and tort plaintiffs that would benefit from any fraudulent transfer litigation judgment. Specifically, Anadarko argued that the Debtors were inappropriately seeking to recover approximately $15.5 billion, despite the fact that the total amount of the environmental and tort claims at the time of prepetition transfer of assets was no more than $2 billion. The Debtors, on the other hand, asserted that the plain language of section 550(a) and relevant case law imposed no such ceiling on the Debtors’ potential recovery in the litigation.

The Court found no support for a damage cap in the plain words of section 550, and instead noted that the concept of the bankruptcy estate was broad and not limited to the interests or quantum of claims of creditors. The Court further focused on judicial interpretation of the “benefit of the estate” language and what other courts had determined constituted a “benefit” to the estate in order to permit the litigation to go forward. The Court determined that a “benefit” could either be direct (e.g., increased distribution to creditors) or indirect (e.g., increased chance of a successful Chapter 11 reorganization) and that the prospect of a recovery in the adversary proceeding had already benefited the Debtors’ estate by paving the way for a confirmable plan and raising the recovery for general unsecured creditors. Having established some benefit to the estate that could be (and here had been) obtained by bringing the avoidance action, the Court found no case law support for reading a cap on recovery into the same language. Indeed, the Court noted the significance that section 550 does not provide that a transfer can be avoided only “to the extent of the benefit to the estate.”

Anadarko further argued that because the Debtors relied on Oklahoma fraudulent transfer law – as incorporated by section 544(b) of the Bankruptcy Code – as the basis for a liability determination, the limitation under Oklahoma’s law that a creditor may not recover more than the amount of its claim should apply. The Court rejected this argument noting that such limitation was only relevant where an individual creditor was seeking to recover in a non-bankruptcy scenario and noted that the language of section 550 preempted relevant state law in this regard.

The Court noted that whether other relevant law would mitigate any ultimate finding of liability would require a full trial to drill down on the merits. All that is clear now is that section 550 does not cap the flow of damages from the liability well . . .

© 2012 Bracewell & Giuliani LLP

Common Attornment Provision Held Ineffective After Master Lease and Sublease Rejected in Bankruptcy by Debtor-Sublandlord

Posted in the National Law Review an article by attorney  Howard J. Berman of  Greenberg Traurig regarding a subtenant of commercial office space was permitted to vacate its leased premises after the rejection of the master lease and sublease by the debtor-sublandlord:

GT Law

In Green Tree Serv., LLC v. DBSI Landmark Towers LLC,1 a case that is significant for landlords and leasing attorneys, the Eighth Circuit recently held that a subtenant of commercial office space was permitted to vacate its leased premises after the rejection of the master lease and sublease by the debtor-sublandlord, notwithstanding an attornment provision in the sublease requiring the subtenant to attorn2 to the landlord when the landlord either terminates the master lease or otherwise succeeds to the interest of the sublandlord under the master lease.

Because the Eighth Circuit’s decision hinges on an interpretation of an attornment provision that is common in many sublease agreements, landlords and practitioners must be careful to draft attornment provisions that do not run afoul of the decision.

 

 

In a strict construction of the attornment provision, the court determined that because the master lease was rejected by the debtor-sublandlord and not terminated by the landlord, the attornment provision was never triggered. Because the Eighth Circuit’s decision hinges on an interpretation of an attornment provision that is common in many sublease agreements, landlords and practitioners must be careful to draft attornment provisions that do not run afoul of the Eighth Circuit’s decision.

In Green Tree, the landlord leased an office building to the debtor, DBSI Landmark Towers Leaseco, LLC (“DBSI”), under a master lease. DBSI then subleased the property to Green Tree Servicing, LLC (“Green Tree”). The master lease agreement between the landlord and tenantsublandlord DBSI required that any sublease include a provision providing for the subtenant to attorn to the landlord in certain circumstances. The sublease agreement entered into between DBSI and subtenant Green Tree required Green Tree to attorn to the landlord if the “[landlord] ‘terminates the Master Lease’ or ‘otherwise succeeds to the interest of [DBSI] under the foregoing Lease.’” 3

After tenant DBSI filed for bankruptcy, it rejected its master lease as well as its sublease with Green Tree pursuant to order of the bankruptcy court. In its motion to reject, DBSI indicated that the sublease would be terminated as a result of the rejection. In response, Green Tree exercised its rights under section 365(h) of the Bankruptcy Code (which allows a tenant whose lease is rejected by a debtor-lessor to either remain in possession or treat the lease as terminated) to treat the sublease as terminated.4 Although sublandlord DBSI did not object to Green Tree’s election to terminate the sublease, the landlord objected, claiming that the terms of the sublease required subtenant Green Tree to attorn to the landlord.5Green Tree then commenced an action in Minnesota state court seeking a declaration that the sublease was terminated and that it could vacate its premises. The landlord removed the case to federal court and cross-claimed for a judgment affirming the sublease.

The Eighth Circuit rejected Green Tree’s argument that because it exercised its right to terminate the sublease under section 365(h) it had no obligation to the landlord under the attornment provision in the sublease, stating “nothing in section 365(h) indicates that a debtor-lessor’s rejection of a lease extinguishes a third party’s rights and obligations under the lease.”6 The court then analyzed the language of the attornment provision strictly and determined that it would be triggered only when the landlord terminates the master lease or otherwise succeeds to the interest of sublandlord DBSI.7 Because DBSI and not the landlord rejected the master lease in DBSI’s bankruptcy case and because DBSI rejected and terminated the sublease, the court held that the attornment provision was never triggered and that subtenant Green Tree was free to vacate the premises. 8In reaching this conclusion, the court noted that DBSI never assigned its contractual interest in the sublease to the landlord prior to DBSI’s rejection and termination of the sublease and that the landlord “could not succeed to the interest in the sublease that no longer existed . . . .”9 Here, the only contractual interest to survive under the sublease was the landlord’s right to attornment, which right was not triggered.10

In light of the court’s strict interpretation of the attornment provision, landlords must be careful to include language in attornment provisions in both the master lease and sublease making it clear that a subtenant must attorn to the landlord in the event that a master lease and/or sublease is rejected under section 365 of the Bankruptcy Code by a debtor-sublandlord.

1__F. 3d__, 2011 WL 3802800 (8th Cir. Aug. 30, 2011).

2The term “attorn” means ‘“[t]o agree to be the tenant of a new landlord.’” Id. at *1 n. 5 (quoting Black’s Law Dictionary,
147 (9th ed. 2009)).

3Green Tree Serv., 2011 WL 3802800 at *1

411 U.S.C. § 365(h)(1)(A) provides in pertinent part:

If the trustee rejects an unexpired lease of real property under which the debtor is the lessor and –

(i) if the rejection by the trustee amounts to such a breach as would entitle the lessee to treat such lease as terminated by virtue of its terms, applicable nonbankruptcy law, or any agreement made by the lessee, then the lessee under such lease may treat such lease as terminated by the rejection . . .

5 See Green Tree Serv., 2011 WL 3802800 at *1.
6 Id. at *2 (citation omitted).
7 Id. at *3.
8 Id. at *3.
9 Id.
10Id.

©2011 Greenberg Traurig, LLP. All rights reserved.

Troubled Loan Workouts: Qualified Professionals Can Help Maximize Recovery for All Parties

Posted in the National Law Review an article by Norman B. Newman of Much Shelist Denenberg Ament & Rubenstein P.C. regarding workout of a financially troubled loans:

The workout of a financially troubled loan requires the participants—typically the lender, the borrower and the guarantors—to be well versed in legal and business principals, coupled with an ability to understand the emotional aspects of the situation. The primary goal of a troubled loan workout is to maximize the recovery to all parties involved. That end result is best achieved when each party is represented by qualified professionals, including a loan officer who is familiar with the situation, as well as experienced attorneys and workout consultants. Collectively, these resources offer a vast network of appraisers, real estate and business brokers, buyers, prospective lenders and other contacts—all of whom are familiar with financially troubled business matters.

From the lender’s side, a loan workout officer will bring to the table a thorough understanding of the loan documents and know what collateral has been pledged, as well as the extent of the perfection of the security interests granted to the lender. The loan officer will be able to communicate with the borrower and the guarantors with respect to the existing defaults under the loan documents. This individual will also know the lender’s rights in light of the default and whether the lender is choosing to presently exercise its rights under the loan documents or reserve exercising them until a future date.

From a legal prospective, it is essential that all parties involved in a troubled loan workout be represented by attorneys experienced in handling financial distress matters. The lender’s attorney will review the loan documents, examine collateral perfection issues and assist in providing updated UCC, tax lien and judgment lien searches. This attorney will also be able to advise the lender as to the various remedies available in the exercise of its rights against the borrower and the guarantors, including in-court and out-of-court options.

The other parties should also turn to legal counsel for advice regarding their rights, remedies and obligations under the operative documents. Attorneys for the borrower and guarantors will advise their clients how best to cooperate with the lender in a consensual workout scenario or what defenses might be available in an adversarial situation. This advice will also cover in-court and out-of-court options, including the availability of bankruptcy relief as part of a consensual loan workout.

Assuming the lender does not need to take immediate action to get control over or liquidate its collateral, most troubled loan workouts involve some period of forbearance that affords the borrower additional time to resolve its financial problems. Under a limited forbearance arrangement, the lender gives up little, while both the borrower and the lender have an opportunity to pursue various benefits. At this stage, the parties should involve experienced workout consultants who, for example, will help analyze the borrower’s business and provide advice regarding the profitability and viability of the enterprise. They often help prepare short-term and long-term cash flow projections and budgets or test such projections and budgets when they are prepared by the borrower. Additionally, they typically play a role in determining the best way to maximize the recovery to all parties, whether it be a reorganization of the borrower, a sale or an orderly liquidation of the borrower’s assets. If a restructure or reorganization is the chosen solution, workout consultants will help determine what additional funds might be necessary to accomplish the desired result.

The workout of a financially troubled loan involves complex legal and business issues, as well as the emotions of the business owners or the guarantors of the borrower’s indebtedness. Partnering with experienced attorneys and other workout professionals is an essential step towards navigating these difficult waters and ensuring a successful outcome for all of the parties involved.

© 2011 Much Shelist Denenberg Ament & Rubenstein, P.C.

Justice Department Investigation of S&P

Recently posted in the National Law Review an article by Jared Wade of Risk and Insurance Management Society, Inc. (RIMS) regarding the Justice Department investigating S&P:

The Justice Department is investigating Standard & Poor’s for improperly rating the garbage mortgage-backed securities that tanked the economy once the world caught on that they were toxic assets.

The anonymous folks who leaked this info to the press claim that the inquiry began prior to S&P’s downgrade of U.S. debt, but many have speculated that the fervor and depth of the probe has ratcheted up since the nation lost its AAA-status.

Either way, the law dogs are — finally — poking around in the ratings world.

The Justice Department has been asking about instances in which the company’s analysts wanted to award lower ratings on mortgage bonds but may have been overruled by other S.& P. business managers, according to the people with knowledge of the interviews. If the government finds enough evidence to support such a case, which is likely to be a civil case, it could undercut S.& P.’s longstanding claim that its analysts act independently from business concerns.

It is unclear if the Justice Department investigation involves the other two ratings agencies, Moody’s and Fitch, or only S.& P.

Any inquiry should of course involve looking at all three. Each overrated the used diaper mortgage-backed securities to a baffling degree. Whether or not it was incompetence or something more insidious is really the only question, I have. I presume they are capable of both.

But if this investigation focuses solely on S&P then it falls even more into how one talking head on MSNBC’s The Daily Rundown described it: more of a Washington story than a Wall Street one.

Honestly, the only weird thing about hearing today about an investigation going on right now is that it was something I expected to hear in 2008.

In related news, and not just to toot our own horn, but I would feel remiss not to mention that our Risk Management magazine cover story this month was titled “The Future of Ratings” and examines “how rating agencies gained so much power, helped tank the economy and figure into the future of risk assessment.”

I’m not going to pretend that I knew just how much play rating agencies would be getting in August when I commissioned the piece a few months ago. I’m many things, but clairvoyant is not one of them. But the piece speaks to many of the questionable issues surrounding the ratings world that have been curiously dormant in the mainstream media for years until recently.

A wonderful writer, Lori Widmer, did a fine job so please do give it a read.

Risk Management Magazine and Risk Management Monitor. Copyright 2011 Risk and Insurance Management Society, Inc. All rights reserved.

Unsecured Creditors Beware! The Western District of Texas Bankruptcy Court Declares an Unsecured Creditor Cannot Have Its Cake (Unsecured Claim) and Eat It Too (Post-Petition Legal Fees)

Recently posted in the National Law Review an article by Evan D. Flaschen, Renée M. Dailey, Mark E. Dendinger of Bracewell & Giuliani LLP about the issue of whether an unsecured creditor can recover post-petition legal fees under the Bankruptcy Code:

Bankruptcy courts have long debated the issue of whether an unsecured creditor can recover post-petition legal fees under the Bankruptcy Code. In the recent decision of In re Seda France, Inc. (located here(opens in a new window)), Justice Craig A. Gargotta of the United States Bankruptcy Court for the Western District of Texas denied an unsecured creditor’s claim for post-petition fees. In doing so, the Court has once again left the unsecured creditor with a bad taste in its mouth by declaring that an unsecured creditor seeking post-petition fees is asking permission to have its cake (a claim for principal, interest and pre-petition legal fees under applicable loan documents) and eat it too (a claim for post-petition legal fees).

Proponents of the view that an unsecured creditor cannot recover post-petition legal fees point to section 506(b) of the Bankruptcy Code, which allows as part of a creditor’s secured claim the reasonable attorneys’ fees and costs incurred during the post-petition period, and note the Bankruptcy Code is silent on anunsecured creditor’s right to post-petition legal fees. Essentially, the argument is since Congress provided for post-petition fees for secured creditors, it could have explicitly provided for post-petition fees for unsecured creditors but chose not to. Proponents of the alternative view cite the Second Circuit decision United Merchants and its progeny, where those courts refused to read the plain language of section 506(b) as a limitation on an unsecured creditor’s claim for recovery of post-petition legal expenses. The theory is that while the Bankruptcy Code does not expressly permit the recovery of an unsecured creditor’s claim for post-petition attorneys’ fees, it does not expressly exclude them either. The basic tenant is that if Congress intended to disallow an unsecured creditor’s claim for post-petition legal fees it could have done so explicitly.

In Seda, Aegis Texas Venture Fund II, LP (“Aegis”) timely filed a proof of claim in Seda’s Chapter 11 bankruptcy case claiming its entitlement to principal, interest and pre-petition attorneys’ fees under its loan documents with Seda as well as post-petition attorneys’ fees for the duration of the case. Aegis made various arguments in support of the allowance of its post-petition legal expenses including: (1) the explicit award of post-petition fees to secured creditors under section 506(b) does not mean that such a provision should not be implicitly read into section 502(b) (i.e., unim est exclusion alterius (“the express mention of one thing excludes all others”) does not apply), (2) the United States Supreme Court decision in Timbers does not control as Timbers denied claims of anundersecured creditor for unmatured interest caused by a delay in foreclosing on its collateral, (3) the right to payment of attorneys’ fees and costs exists pre-petition and it should be irrelevant to the analysis that such fees are technically incurred post-petition, (4) because the Bankruptcy Code is silent on the disallowance of an unsecured creditor’s post-petition attorneys’ fees, these claims should remain intact, and (5) recovery of post-petition attorneys’ fees and costs is particularly appropriate where, as in Seda, the debtor’s estate is solvent and all unsecured creditors are to be paid in full as part of a confirmed Chapter 11 plan.

The Seda Court rejected Aegis’ arguments and held that an unsecured creditor is not entitled to post-petition attorneys’ fees even where there is an underlying contractual right to such fees and unsecured creditors are being paid in full. With respect to Aegis’ argument on the proper interpretation of sections 506(b) and 502(b), the Court cited the many instances in the Bankruptcy Code where Congress expressed its desire to award post-petition attorneys’ fees (e.g., section 506(b)), and found that Congress could have easily provided for the recovery of attorneys’ fees for unsecured creditors had that been its intent. Regarding Aegis’ argument that Timbers does not control, the Court held that in reaching its decision on the disallowance of a claim for unmatured interest the Timbers Court found support in the notion that section 506(b) of the Bankruptcy Code does not expressly permit post-petition interest to be paid to unsecured creditors. The SedaCourt held this ruling should apply equally to attorneys’ fees to prohibit recovery of post-petition fees and expenses by unsecured creditors. The Court further held that section 502(b) of the Bankruptcy Code provides that a court should determine claim amounts “as of the date of the filing of the petition,” and therefore attorneys’ fees incurred after the petition date would not be recoverable by an unsecured creditor. In response to Aegis’ argument that non-bankruptcy rights, including the right to recover post-petition attorneys’ fees should be protected, the Seda Court noted that the central purpose of the bankruptcy system is “to secure equality among creditors of a bankrupt” and that an unsecured creditor’s recovery of post-petition legal fees, even based on a contractual right, would prejudice other unsecured creditors. The Court held this is true even in the case where the debtor was solvent and paying all unsecured creditors in full. The Court noted that a debtor’s right to seek protection under the Bankruptcy Code is not premised on the solvency or insolvency of the debtor and, therefore, the solvency of the debtor has no bearing on the allowance of unsecured creditors’ post-petition legal fees.

Seda is the latest installment in the continued debate among the courts whether to allow an unsecured creditor’s post-petition attorneys’ fees. The Seda Court is of the view that an unsecured creditor cannot recover post-petition legal fees for the foregoing reasons, most notably that the Bankruptcy Code is silent on their provision and public policy disfavors the recovery of one unsecured creditor’s legal expenses incurred during the post-petition period to the prejudice of other unsecured creditors. Depending on the venue of the case, there will undoubtedly be many more instances of unsecured creditors seeking recovery of their post-petition attorneys’ fees in a bankruptcy case until the Supreme Court definitively rules on the issue. Until then, keep asking for that cake . . . .

© 2011 Bracewell & Giuliani LLP