Claim subordination is the opposite of alchemy.  In most bankruptcy cases, creditors might look for ways to improve their treatment.  Claim subordination in the bankruptcy code provides a mechanism to force a creditor to receive worse treatment (relative to other non-subordinated claims which is, admittedly, not that great of treatment).


In bankruptcy, there are a few ways for a claim to be subordinated.  A claim could be subordinated because you did something bad.  A claim could be functionally subordinated by having debt determined to be equity.  Or, among others, a claim could arise as a result of a transaction involving the sale of stock of the bankrupt debtor or its affiliate.  It is the last one that has come up recently in a Fifth Circuit opinion in a way I thought was interesting because it deals with guaranties.

 I. The Underlying Case

The underlying bankruptcy case involves the debtor American Housing Foundation (“AHF”) which, prior to entering bankruptcy, operated to promote and develop low income housing and obtain Low Income Housing Tax Credits (known as “LIHTC”).  Each actual housing project was operated out of a specific single purpose entity (“SPE”) which was controlled by AHF.

In the course of its operations, AHF would form limited partnerships with AHF as general partner.  AHF would then solicit and obtain investors to put money into the LPs in exchange for limited partnership interests.  That money invested into the LP was then supposed to be put into a specific SPE (which actually held the asset) as unsecured debt to cover pre-financing costs.

Other than the opportunity to receive a distribution from the LP, inventors would also be able to claim a LIHTC.  But to sweeten the deal even more, AHF provided a guaranty of the money invested into the LP to each investor.  Some the guaranty agreements even provided for interest.

To make a long story short, AHF acquired property too quickly and exhausted capital needed for operations of existing projects.  This apparently caused AHF to use some new cash to fund operations, pay dividends and fraudulently divert some of the cash to the principal of AHF.   This proved untenable and AHF was put into an involuntary bankruptcy case.  As is usually the case, after the bankruptcy filing everyone got sued.

 II. Guaranty Subordination

Templeton was an investor in several of the LIHTC LPs.  As was typical, Templeton received LP interest in exchange for his investment and also received a guaranty from AHF.

While the notion of a guaranty of an investment might not seem too far off mark, the careful lender will recall that a guaranty is a contract for the repayment of debt. In contrast, an equity investment is not debt.  The Fifth Circuit touches on this issue in its opinion.  However, what is ultimately the legal reason for subordinating the guaranty obligation is section 510(b) of the Bankruptcy Code.

I would commend to you the actual text of 510(b), but the Fifth Circuit summarizes the section as such:

“Accordingly, this provision makes clear that claims arising from equity investments in a debtor’s affiliate should be treated the same as equity investments in the debtor itself–i.e., both are subordinated to the claims of general creditors.”

So, because Templeton’s “guaranty” from AHF arose from the sale of the LP interest, any recovery on account of the guaranty was automatically subordinated to the other creditors of AHF for the purposes of distribution.  In this case, Templeton is projected to receive nothing if subordinated as opposed to ~40% as a general unsecured creditor.

III. Things to Consider

Regardless of whether a guaranty of an equity investment is enforceable as such (notwithstanding the lack of actual debt), the guaranty will be subject to mandatory subordination if the guarantor files bankruptcy and the equity company is an affiliate of the guarantor.

This particular type of subordination puts the claim below general unsecured creditors, which puts any chance of recovery in the “very unlikely” category.

By the same token, if you are a lender and your collateral is a lien in such guaranty, then you face the same prospect of subordination as the borrower.

Finally, the opinion discusses other issues of some note, which did not make it into this post because of length.  The opinion discusses preference ordinary course defense, and valuation for the purposes of fraudulent transfers.

Templeton v O’Cheskey (In the Matter of: American Housing Foundation), case no. 14-10563, in the United States Court of Appeals for the Fifth Circuit.  Opinion revised June 8, 2015.

Opinion is here.

I have found this to be true over and over again.  Maybe it’s just my line of work.

Grump Cat

Part of my regular practice is being called in by the transactional lawyers (paper pushers) as they paper up a new loan or re-fi.  My job in those situations is to give my thoughts on what will happen should the worst occur (eg, default, receivership, bankruptcy, lawsuit, etc.) and how to minimize the risks to the lender.

Often times, identifying potential fraudulent transfer exposure on the front end is of concern when the lender creates some type of relationship with a non-borrower affiliate or insider of the borrower. The usual situation is a guarantor, but other situations exist such as payment from a non-borrower affiliate.  A recent 5th Circuit case discusses such a situation.

The BackgroundSkip this if you are Familiar with Fraudulent Transfers

There are a few types of “fraudulent transfers” under both federal and state law.  Generally speaking, however, a fraudulent transfer occurs in two ways:

  1. When bad guy transfers something of value to the other guy in exchange for something that is less than reasonably equivalent value.  Think, cow for the beans. Or,
  2. When the bad guy transfers something to 2nd bad guy in an out-and-out fraudulent scheme.

I have oversimplified it to fit into a minimal of bullet points.  The gist is to recover value when the transferor (sender) transfers value to another party when the transfer would reduce the overall value of the transferor.  The underlying idea being that other creditors need protection from a transferor sending all its assets to his buddy in exchange for minimal or no value in order to defeat collection by other creditors.

Many of you have already had to deal with this issue in lending.  For the un-litigated, this arises for lenders in situations where the bank is receiving payments from a non-borrower on account of an existing loan.  In that situation, the bank may be receiving money (the value) but not giving anything back to the non-borrower in exchange.  (In a normal repayment, the funds paid by a borrower credit the debt, thus equivalent value exchange).

The Recent RulingThe Netting Effect

 In the case of a lender who is taking funds from a non-borrower in good faith, there is some protection when sued for fraudulent transfer under the bankruptcy code.  This was the issue recently discussed in Williams v. FDIC in the Fifth Circuit.

At issue was what happens when a unknowing lender has received a fraudulent transfer from a non-borrower because of actual fraud, but the non-borrower transferor actually received some (but not full) indirect benefit.  Specifically, the non-borrower affiliate company directly paid the mortgage payment to the lender on commercial property as “rent” thereby staving off foreclosure on behalf of the building owner (who was the borrower).

In this case, the Fifth Circuit said that the good faith lender is liable for fraudulent transfer, but the lender was only liable for the net amount received greater than the benefit obtained by the transferor.

  •  Ex:  Lender was paid $100.  Non-Borrower transferor obtained $70 in value.  Bank is liable for $30.

Why is this important?  The lender need not be a party to a fraudulent scheme to get tagged with a fraudulent transfer lawsuit.  In that situation, even if the lender can show that it exchanged reasonably equivalent value (the normal bank defense), if the payment was part of an actual fraudulent scheme the bank had no idea existed – the bank will still be liable for the “net” positive it received over the transferor’s “net” negative.

This type of risk is, of course, inherently difficult to quantify.  A valuation of the unknown benefit is obviously a difficult proposition on the front end.  This remains true at the time the lender determines to accept payment from the non-borrower.  Additionally, the retrospective value determined may not always be the prospective value anticipated.

Just something to think about when you are assessing the risk of accepting funds from non-borrowers and looping in insiders and affiliates to the obligation stack.

Over the last few weeks, I’ve commented on the new version of the OCC’s Commercial Real Estate Lending Handbook (I give it a gentlemen’s C); and I listed a few legal topics that deserve some guidance from the OCC. “Guidance” could even merely be a list of important topics (ending with a warning that the list is NOT an all-inclusive list). I expect legal issues to be identified and put on the “check the box” list by the OCC  – with the banks expect to check the box. The "Blank" List   Unfortunately, instead of leading the class by at least listing legal issues associated with risks in commercial real estate lending, the OCC implicitly affirms those banks that under value and under utilize legal counsel.  (Let’s resist the temptation to comment on “why” this takes place.) Fortunately, some banks are very good at identifying and monitoring legal issues. Several of them do this by a simple two step process:

  1. List key legal provisions in loan documents
  2. Instruct legal counsel to report, in writing AND PRIOR to closing, if these provisions are altered

Here is a sample list (it is NOT an exhaustive or all-inclusive list):  legal counsel must report (in writing) any changes, from the bank’s standard form, in loan document provisions that cover the following –

  • grace period, late charges and default interest
  • prepayment, lockout and yield maintenance
  • transfer restrictions (due on sale) provisions
  • subordinate financing (due on encumbrance provisions)
  • material deviations in, or deletions of, the remedies provisions (unless required under the governing law of the state in which the collateral is located)
  • recourse provisions
  • environmental provisions
  • taxes and insurance premiums escrows
  • any reserves or other escrows
  • granting clauses or form description of collateral contained in such granting clauses (unless required under the governing law of the state in which the collateral is located)
  • casualty or condemnation provisions
  • addition of a provision allowing a release of collateral (unless expressly provided for in the credit approval)
  • lender approval process relating to amendments, renewals or termination of major leases (or new leases)
  • cooperation provisions, including use of any future technology required by lender (such as on-line reporting and delivery of required materials and information)
  • WARNING: __________ [this list is not “all-inclusive” and you should revise it as needed]

My suggestion is that every bank (or other lender) take this approach.  Surely at some point, the OCC will view this simple approach as a key to safe and sound banking practices. Please share you comments below.                

Last month, the Office of the Comptroller of the Currency published the Commercial Real Estate Lending handbook (August 2013).  The 128 page handbook gives guidance to bank examiners and bankers on risks inherent in commercial real estate (“CRE”) lending.  It replaces a 95 page version published in 1995 (and revised in 1998). For this new school year and since commerical real estae lending is increasing in the “recovering” economy, I expected the OCC’s CRE lending handbook to grade-out with an “A+.” Instead, it is a solid, gentleman’s “C.” Make that a fraternity “C.”

Your Company is in this picture, too!
And probably make that a “C” for your company, too.   Like the OCC’s handbook, in many companies there is a disconnect or chasm between the business platform and legal issues undergirding the platform.  The “C” grade is NOT limited to the OCC and the banking sector. The OCC’s Commercial Real Estate Lending handbook takes an inconsistent approach in the role or importance of basic legal issues as a subset of risk management.  The approach swings from:

  • “legal light”: a few topics list legal issues and mention lawyers, but the topics are limited in number –
    • in the context of environmental risks,  handbook lists specific legal issues (p. 71)
    • the term “counsel” appears 5 times:
      • in the review of (ground) lease documents  (p. 53)
      • in assessing environmental risks (p. 70)
      • in the review of loan docs and other agreements “to determine if the improvement” comply with applicable laws and restriction (p. 104)
      • in the review of takeout agreements (p.107)
      • in the review of completion insurance bonds (p. 108)
  • “I know it when I see it – but you have to guess what I see”: some topics include the use of the phrases “legally bound” and “legally enforceable,” but with no guidance on “how” an examiner or banker is to verify or arrive at these legal conclusion (assuming the examiner or banker is not an experienced commercial real estate lawyer) –
    • what do these phrases mean or require?  They are not defined in the Glossary (Appendix C). Are legal opinions required? Does this require hiring a lawyer? If “yes,” this sidesteps the reality that most Companies are seeking ways to spend LESS money on lawyers.
    • similarly, the handbook contains references to “appropriate” loan documentation and “loan documentation policies.”  Again, what do these phrases mean or require?  Broad generalizations give no guidance on loan document provisions, and are not helpful in addressing or mitigating risk.
  • neglect: most topics simply do not include any reference to anything legal –
    • maybe for purposes of the OCC handbook, legal issues simply are outside the scope of the OCC handbook.  If this is the OCC’s approach, then legal issues should be disclaimed, with no mention of legal issues.
    • one of my problems with this “neglect” approach is that it denies reality.  Legal issues are part of the DNA of safe and sound lending, and risk management.  Banks and the OCC acknowledtge this by spending millions of dollars on legal services.  Indeed, guidance might even help to control legal fees.

My expectation was that the handbook would give lists of “no” change provisions, or a list of legal topics that need to be addressed (with the ability of a bank to explain any deviation from the provisions or list). Clearly, either I misunderstand the uses of the handbook, or the OCC missed an opportunity to give more meaningful guidance. Perhaps the gentleman’s “C” is too gentle. In future posts, I’ll describe a few of my favorite “no-no change” provision, and give an overview on current legal topics covered at several recent seminars. Please post your comments and perspectives below.

In addition to the events that create “full recourse” liability (for the entire loan), bad boy liability also includes losses or damages incurred by the Lender based upon another list of “bad” events or triggers.  I’m sure that Jim Wallenstein will cover this at his presentation during the University of Texas Mortgage Lending Institute. Like the “full recourse” list, this second type of “bad boy” liability (for Lender’s “loss or damages”) has grown significantly “longer” during this great downturn.

Combine full recourse liability with the list below (loss or damages liability), and the “no liability” deal looks like this:

          Here’s my current version of the list of bad boy recourse events that trigger liability for Lender’s losses or damages (but NOT for liability for the entire loan) due to the following:

  • any mechanic’s or materialman’s lien
  • failure of Borrower to pay any of the property taxes
  • failure of Borrower to maintain the insurance (and reimburse Lender for forced placed insurance)
  • any fraud or material misrepresentation, gross negligence or willful misconduct by Borrower or any employee, contractor, agent, or person in control of Borrower in connection with the ownership or operation of the property or any aspect of the loan
  • misapplication, misappropriation or conversion of (i) any insurance proceeds paid by reason of any loss, damage or destruction, (ii) any condemnation awards, or (iii) any rents following a default or (iv) any lease security deposits, lease advance deposits or rents collected in advance (including lease credit enhancements, such as a letter of credit)
  •  any collateral taken from the property by or on behalf of Borrower, and not replaced with collateral of the same utility and of the same of greater value
  • following foreclosure, any loss or damages incurred by Lender resulting from the failure of Borrower to deliver or surrender the property to the foreclosure sale purchaser
  • any loss or damage from (i) waste to the property caused by intentional acts or intentional omissions of Borrower, or the removal or disposal of any collateral after a default, (ii) any act of arson by borrower or any person affiliated with or in control of Borrower; or (iii) the seizure or forfeiture of the property, or any portion thereof, or Borrower’s interest therein, resulting from criminal wrongdoing by Borrower or person  affiliated with or in control of Borrower
  •  any fees or commissions paid by Borrower (or on behalf of Borrower) after the occurrence of a default to any person (directly or indirectly) affiliated with or in control of Borrower
  • from any failure by Borrower to permit on-site inspections of the property
  • from any litigation or other legal proceeding related to the loan filed by Borrower, or any person (directly or indirectly) affiliated with or in control of Borrower (after a default), that delays, opposes, impedes, obstructs, hinders, enjoins or otherwise interferes with or frustrates the efforts of Lender to exercise any rights and remedies available to Lender under the loan
  • from the failure of Borrower to fully perform any of the Borrower’s indemnification of Lender under the loan
  • Borrower contests, delays or otherwise hinders or opposes (following a default) any of Lender’s enforcement actions or remedies
  • my new favorite: failure to furnish access to on-line services (as a co-admininstrator), and then after a default, to relinquish full control to Lender

And, of course, under both the full recourse events and the loss or damages events, Borrower is liable for Lender’s enforcement costs. So, back to my point: at what point does all of this simply equate (on a practical level), to a full recourse (but dressed like non-recoruse) loan? Please share your perspective or experience below. Enforcement Costs” means all costs, reasonable attorneys’ fees, legal expenses and other costs incurred or expended by Lender in collecting or enforcing any of the Guaranteed Obligations or due to any default in the performance of the Guaranteed Obligations or in enforcing any right granted hereunder or under the Loan Documents.

Several months ago, I mused that, due to the conservative trending of commercial real estate lending, the list of “bad boy” exceptions (to a “no personal liability” deal) could be viewed as a full recourse deal.  In other words, the exceptions to “no liability” could be so expansive or long, the practical reality equates to full liability. Now you have it (no personal liability); now you don’t.   Take a look at my current list of “bad boy” carve outs:

  • Unauthorized transfer (note: transfer of voting rights in borrower [or a controlling party of borrower] is an unauthorized transfer)
  • Unauthorized liens
  • Change in entity constituency or control
  • Violation of hedge agreements, letters of credit or other contracts covering additional collateral or debt enhancement
  • Failure to maintain the collateral
  • Violation of key operating licenses or permits
  • Breach of financial covenants & reporting covenants
  • Breach of single or special purpose entity covenants
  • Breach by the property manager of terms covering turnover of property and operating information
  • Voluntary or involuntary Federal or state bankruptcy or insolvency proceedings, including an application for the appointment of a custodian, receiver, trustee, or examiner
  • Borrower makes an assignment for the benefit of creditors, or admits, in writing or in any legal proceeding, its insolvency or inability to pay its debts as they become due
  • Borrower (or any person owning [directly or indirectly] an interest in Borrower) solicits, facilitates or arranges debtor-in-possession financing to Borrower in anticipation of a bankruptcy or insolvency proceeding
  • Breach of cash management provisions
  • Breach of insurance coverages (and failure to reimburse Lender for its cost of forced placed coverage)
  • Failure to turn over tenant letters of credit, lease termination payments and space contraction payments
  • Failure to deliver access and ownership of technology used in buildingprojectcollateral operations, marketing, leasing and communication
  • Failure to cooperate with Lender in any efforts to contest tax valuation
  • _____________ (I’m sure that I’m missing something here)

The topic of bad boy liability will be covered by Jim Wallenstein at the up-coming University of Texas Law School’s Mortgage Lending Institute (I’ll be talking on technology issues – more on that later).  I can’t wait to hear Jim’s spin on all of this. Give us your spin by commenting below.  (And yes, I’m back from a short break.)

Credit enhancement of commercial construction lending has a new, important twist to the traditional (full) payment and performance guaranty: the burn-off events go beyond valuation and debt service thresholds to also include many of the check list items utilized by permanent lenders.  The burn off has a new price.

  Finally, construction loans are bubbling up for the  “right” real estate developer in the “right” market, with the “right” product, with the “right” tenants in tow, and with the “right” amount of cash to bake into the project (before the first substantial draw on the construction loan).  And the competition among the lenders often gives the developer (or the key sponsor) the ability to back away from the full payment and performance guaranty – a staple of construction lenders who require it until the project is built, occupied and cash flowing (link to Federal banking materials). In the “old” economy (pre-2007), the burn-off triggers or bench marks were simple: show a specified appraised value and a healthy debt service coverage. In the “new” economy, what may project by a construction lender (at the closing of the construction loan) to be an attractive project for a take-out lender might miss the mark, as those lenders move on to a more favored asset class (not commercial real estate), or to a more favored type of commercial real estate – or to a different region of the country.  (GASP) So, what is a construction lender to do? Add items typically found on the take-out lender’s check list as “new” burn-off triggers or bench marks. Why? Make it easier to quickly close the take-out loan, so that the construction lender can book the profit.  Sure, the  construction lender makes a good return on the loan during construction.  But it does NOT want the project as the ultimate return.  It wants the money back. Here are a few check list items showing up as burn-off conditions:

  • project and tenant certificates of occupancy
  • tenant estoppels and subordination agreements (running for the benefit of any future project-secured lender)
  • as-built survey
  • down-dated title policy, with endorsements typically required by permanent lenders (including any assignee of the loan as an insured)
  • copies of all operating permits
  • copies of evidence of utility service
  • as-built plans (with approvals by applicable third-parties, such as an architectural control committee)
  •  . . .

Of course, this can cause some heart-burn or angst on the part of the developer. One reply is this: how is this really different from the “one-time” close programs (in the old economy), where a bank and a life insurance company teamed up to do exactly this same thing (close the construction loan and then agree that if the specified check list requirements are met, then the life company would take over the loan, but modified with a new interest rate and a new maturity date)? The only difference is the economy: life companies don’t need to team up with a construction lender to source new loans. With the CMBS market “challenged”  and few banks or mortgage REITs active in the long-term finance market, life companies are . . . enjoying it. If you have any thoughts or comments, please post them below.    

Once upon a time and in a very simple time,  construction lenders required full payment and performance guarantees, and only permanent lenders offered non-recourse financing (with “bad-boy” liability).  Now, even some construction lenders include a variation of non-recourse liability (with “bad-boy” events) in their structure.  And, the list of “triggers” or events that form the basis for liability is growing.  If this trend continues –

  • will the number or bundle of “bad-boy” events be substantial enough to constitute, in a practical sense, the “end” of the non-recourse loan structure?

The time-line seems to say “yes.”

Traditionally, permanent lenders (typically life insurance companies) were the only commercial real estate lenders who incorporated the concept of “non-recourse” liability into their lending product.  In the structure, neither the borrower nor the guarantor (or indemnitor) was liable for the repayment of the loan.  If the project or local market went bad, the lender could obtain title to the property, but could not sue them for recovery of the balance of the loan.

Importantly, the triggers or events for liability were few in number: maybe 6 or 8.

Back in the day, life and liability was simple:

  • construction loan (high risk period since tenants were not paying rent): 100% liability
  • permanent loan (once tenants paying rent, then risk much lower): short list of bad-boy events as the only basis for liability

However, securitization of commercial real estate loans (CMBS) and the recent “down turn” of the economy introduced a much larger set of bad-boy events (Courtney Bristow’s article on dealing with distressed CMBS loans gives a nice over view – it is the #1 download from L360 [and the former TT4L blog]).

I’m confident that the list of bad-boy liability events will continue to grow.  For example, technology issues alone will father more bad-boy events.  (Take a look at my other posts.)

The non-recourse (bad-boy) liability structure is becoming form over substance.

If you view this differently, or want to give me a course correction, please comment below.



People don’t “connect” their ownership (even a minority ownership) with their liability under bad-boy or non-recourse carveout agreements (whether in the form of an indemnity, or as a guaranty).   So, minority owners often transfer ownership without getting a release from bad boy liability .  It could be a costly mistake.

With deals under water and little hope of near term (or whenever term) recovery of value, many minority owners are turning to their tax advisors for guidance on gathering “all” of their losses into a single year, which can be wise tax planning.

Typically, a minority owner may transfer its ownership interest (to another owner) without the consent or approval of the mortgage lender.

But if the minority owner “stops” here (merely looking at the prohibitions or conditions on ownership transfers), she is missing a very important topic.

The topic is the minority owner’s liability for “bad boy” events.

My experience is this: boiler plate provisions,which permit a minority owner to exit ownership without the lender’s consent, do NOT have a corresponding tie-in to an automatic release of the exiting minority owner from bad boy liability.  In other words, they do not mirror each other.


  • Good tax planning (aggregating losses in a single year)
  • But the contingent liability (of the bad boy guaranty) remains

This lesson is now being taught every day across America.

Please post your comments, or experience in this, below.

We’re in that part of the cycle where many of us are focusing on guaranty agreements, which run the full spectrum from full payment and performance guaranties to “bad boy” indemnification agreements (my recent comment).

One issue being litigated is the bad boy or recourse event tied to a breach of these types of covenants in commercial mortgage documents:

  • failure to maintain adequate capital in the Borrower (to the extent there exists cash flow from operations)
  • failure of Borrower to remain solvent (to the extent there exists cash flow from operations)

These provisions constitute part of the “single purpose” or “special purpose” nature of the Borrower, which lenders require in situations involving a “bankruptcy remote” borrower entity  (as part of the loan structure).  This is very common in permanent loans from lenders such as life insurance companies, GSEs and CMBS lenders.

The use of these provisions as a basis for bad-boy liability is now being recognized (or enforced) by various trial and appellate courts.

One example is this recent Michigan case:

  • Wells Fargo Bank, NA v. Cherryland Mall Ltd. P’ship, et al. (Mich. App. Dec. 27, 2011) (link)

This case might be accepted for review by the Michigan Supreme Court.  So, the ultimate outcome of this case still is “open” – but my personal bet is that the case either will NOT be accepted for review, or the court will review the case but not change the outcome (it will reach the same result).

I’m sure that commentators will take the results of these cases (liability of the guarantor or indemnitor) and spin it into dire predictions of the “end” of the commercial real estate finance world.

It will be an over-reaction.

The fundamental concept behind bad-boy liability for these events or triggers is simple, and even intuitive:

  • run the borrower’s operations and balance sheet like a business; in other words, not as a your personal check book
  • don’t strip cash from operations out of the borrower; in other words, don’t run it into the ground
  • in return, ownership (as bad-boy guarantors) will not have personal liability on the commercial mortgage debt if the local or national economy falls into the ditch (like the one we’re in right now).

If I’m making this too simple, or if you have another perspective, please comment below.