Tough Times for Lenders

When things go south, it’s the little things that can get you into trouble.  When the servicer on a commercial mortgage sent the notice of foreclosure to the address on the deed of trust, but not to the known updated address of the obligors the obligors counter-sued for breach and the case has been pending now for eight years.  In a recent 5th Circuit opinion, the Court found that failure to serve the proper address can be an independent cause of action which is not precluded by the obligors own breach to repay the loan.

Things you don’t notice on takeoff can have an effect at landing

Around the year 2000, the original lender made a commercial mortgage loan to a multifamily apartment complex (“Borrower”) for several million dollars.  The original lender assigned the loan to Fannie Mae, which then used a national bank as a servicer (the “Servicer”).  The property met certain criteria which allowed it to qualify for low income tax credits, which were passed on to the Borrower limited partners of the various trusts in the corporate structure of the Borrower.

In 2010 the Borrower defaulted on the loan by non-payment of the monthly payments.  Upon default the servicing automatically transferred to Fannie, who hired a law firm to perform a non-judicial foreclosure of the property.

The law firm requested from the Servicer the addresses for the various notice parties for the non-judicial foreclosure, which the Servier provided.  The notice addresses provided by the Servicer were the notices contained in the relevant deed of trust related to the loan.

However, the Servicer had, for years, treated the deed of trust addresses as outdated and sent all prior correspondence to the new updated addresses.  That information was not shared with the law firm, who proceeded to send the statutory foreclosure notices to the old deed of trust addresses.

Long story short, the borrower and guarantors did not get the notices of default, acceleration or foreclosure.

The law firm proceeded to foreclose upon the property, which Fannie Mae bid in at the sale.  This triggered, among other things, an IRS recapture of the tax credits in an amount of $1.2MM, which Fannie then had to pay out of pocket.

After the sale, the borrower and guarantors filed a lawsuit against the law firm, the Servicer and Fannie Mae for a number of claims including breach of contract for failure to send the notices to the correct addresses.

After some litigation, the law firm and Servicer were eventually dismissed following motions for summary judgment, leaving only Fannie Mae – the note holder.

The guarantor’s motion for summary judgment on breach of contract was initially granted by the trial court, but then denied on reconsideration.  The basis for reconsideration was Fannie Mae’s assertion that the guarantor’s cannot prove breach of contract by Fannie Mae because the guarantor’s cannot prove that the Borrower was not in breach (ie, for non-payment).  As you may know, one of the elements for asserting a breach of contact claim is that the plaintiff was not in breach, itself.  However, like all Texas rules, there are exceptions.

After the MSJ/reconsideration ruling, the guarantors appealed to the 5th Circuit, who issued the recent opinion.  The 5th Circuit agrees with the general prospect that a plaintiff cannot assert a breach of contract claim if the plaintiff has also breached.  Importantly, the 5th recognized an exception to that rule.  The 5th stated:

“We conclude that Fannie Mae’s agreement in the deed of trust to give notice of foreclosure was independent of the [Guarantors’] agreement under the note to pay monthly installments to satisfy the debt.  The obligation to give notice of foreclosure would not even arise unless and until the [Guarantors] were in default under the note.”

In so holding, the 5th Circuit holds that a breach of the payment requirement is legally different from a notice requirement in the deed of trust, which can independently give rise to a claim by the borrower and guarantor against a lender/noteholder.

There are probably a few lessons here for everyone.  Perhaps most importantly is the time frame.  The initial notice of default was sent in 2010.  The simple issue of sending notice has given rise to a lawsuit that has now been pending for years after the notices went out.  Moreover, the 5th Circuit didn’t resolve the matter, it simply remanded the issues back to the trial Court.

Legal issues aside in the ruling, it’s important to remember that missing even small legal prerequisites in a collection scenario (with desperate guarantors) can expose note holders to serious jeopardy for years.

5th Circuit opinion in Williams v. Wells Fargo, case no. 16-20507

To paraphrase Count Ciano, Success has many fathers and failure has many targets.  You may recall a while back I wrote about how a loan to old General Motors (worth $1.5 billion) was accidentally rendered un-secured.  When GM entered bankruptcy, the loan was ultimately determined to be unsecured and lenders (presumably) lost billions.  As you might expect, some people were sued as a result.  One of those folks was the attorneys for GM.  Recently the 7th Circuit entered an opinion in their lawsuit.

By way of brief recap, prior to bankruptcy, GM had (among others) two secured loans.  The first was for $300MM and the other for $1.5B.  About a year prior to bankruptcy, the $300MM was up for maturity and GM was preparing to refinance.

In the $300MM refi GM was represented by Mayer Brown, LLP, a large and well respected law firm.  On the other side, JP Morgan was the agent for the lender syndicate and was represented by another well respected large law firm.

It turns out that at the same time, JP Morgan was also the agent for the $1.5B secured loan.  Both loans were perfected by separate UCC1.  Mayer Brown prepared the documents for the refi transaction.  Unfortunately, on the closing check list and closing documents sent to JP Morgan’s attorneys, the documents contained a release of the $1.5B UCC1.

In what might be the understatement of the year, the 7th Circuit writes:

“The big mistake was that the closing papers for the [$300MM] deal accidentally also terminated the lender’s security interest in the collateral securing the [$1.5B] loan.”

Apparently, all the parties missed the error (save one lone Mayer Brown paralegal, who was ignored).  The important part here is that JP Morgan’s attorney’s affirmatively approved the checklist and loan documents – which included the $1.5B release documents.  JP Morgan’s attorneys even went to far as to tell Mayer Brown “Nice job on the documents”.  (Again, a lesson on your emails being an exhibit).

Despite the colossal oversight and high stakes litigation that followed, no one bothered to tell the syndicate lenders until years later. At which time several brought their own lawsuits.

Strangely, despite the “easy to see” claims against JP Morgan and counsel (7th Circuit’s words, not mine), the lenders sued Mayer Brown.  The arguments are essentially 3 fold:

  • Mayer Brown was an attorney for JP Morgan in other matters, and therefore was acting as an attorney for JP Morgan in this matter,
  • Mayer Brown drafted the documents and therefore owed a duty to JP Morgan, and
  • Mayer Brown had an duty because the purpose of the documents were for JP Morgan’s loan.

In the recently released opinion by the 7th Circuit, Oakland Police, et al. v. Mayer Brown, LLP, the Court affirmed that all three arguments are not supportable and the claims must be dismissed.

There is a lot going on in the background of this case which makes it interesting, but the opinion is a great cite for the transactional lawyers who paper up complex transaction.  Specifically, the Court holds:

“By preparing the first draft, an attorney does not undertake a professional duty to all other parties in the deal”

The lender’s strongest argument (in my humble opinion) was that it relied on Mayer Brown not to misrepresent the effect of the documents.  While everyone seems to agree that the error was simply a mistake, the ruling appears to insulate a non-mistake from liability in exchanging documents.  This puts added pressure on all sides to review (and re-review) all turns of draft to ensure nothing new suddenly appears.

That lack of a complete review of a huge stack of documents on the 8th turn is usually a cost saving endeavor.  However, one should be mindful of such an argument.  The opinion points out that the original inclusion of the wrong release was based on an older UCC search which was used as a “cost-saving” measure by a Mayer Brown paralegal.  (on a $300MM refi).

As a side note, the Court also considers whether Mayer Brown became an “attorney of the transaction” similar to an attorney for a title company.  The Court found that was not the case, but it serves as a reminder that if the law firm holds money in “trust” as part of the transaction the law firm might inadvertently have became an “attorney of the transaction” and thus owe duties beyond its client.

In this case, for some reason, the lenders decided to sue a lawyer who didn’t represent them for malpractice without suing the actual attorneys representing them.  Surely something is going on in the background, but in this case, the alleged failure is on one party and the litigation target was on another.

Oakland Police & Fire Retirement Systems, et.al. v. Bayer Brown, LLP, cause no. 16-2983, In the United States Court of Appeals for the Seventh Circuit.  Decided June 28, 2017.

The Bankruptcy Code permits a bankruptcy trustee to “surcharge” a lender’s collateral when the cost will benefit the lender and there is also benefit to the bankruptcy estate.  The friction arises when the collateral is worth less than the lender’s secured claim plus the surcharged expenses.  In short, who is left holding the bag when the collateral is worth less than the trustee’s expenses and the secured debt?  In some ways it’s a question of necessity, but as a practical matter it’s a question on appraisals.

credit: Imagine Television, The Hurwitz Company, 20th Century Fox Television / heckyeahreactionsgifs

I. The Surcharge

The bankruptcy code allows bankruptcy trustees to recover the reasonably necessary costs of preserving a lender’s collateral from the collateral under certain circumstances.  Specifically, section 506(c) states:

“The trustee may recover from the property securing an allowed secured claim the reasonable, necessary costs and expenses of preserving, or disposing of, such property to the extent of any benefit to the holder of such claim, including the payment of all ad valorem property taxes with respect to the property.”

In the recent 5th circuit case, the court has stated that “to recover under this provision, the trustee bears the burden of proving the following: ‘(1) the expenditure was necessary, (2) the amounts expended were reasonable, and (3) the creditor benefited from the expense.’”

The underlying theory for all of this is that the estate should be reimbursed when it incurs expenses which the secured creditor would have incurred anyway while the estate moves to monetize value from the collateral as time moves on.  The idea being, if the collateral is worth less than the debt, than the trustee would simply abandon the asset to the secured creditor because it would be of no value to the bankruptcy estate.

The whole analysis revolves around the value of the asset.  Because; if the asset is worth less than the debt, there is no benefit to the estate to realize on by a sale and thus no reason to incur expense.

So, what happens if the appraisal is simply wrong and the asset is worth far less than the secured debt? Does the bankruptcy trustee get to surcharge the asset with a lien for expenses even though there is no hope of recovery for the bankruptcy estate from the asset?

In the Fifth Circuit, yes.

II. The Case

In the case of Southwest Securities, FSB v. Segner (In the Matter of Domistyle, Inc.), case 14-41463, pending in the United States Court of Appeals for the Fifth Circuit, the court found that the estate could surcharge the asset.

In short, the appraisal on real property collateral of the lender came back as millions more than the debt.  The lender did not challenge the appraisal.

All parties assumed the appraisal was correct and permitted the bankruptcy trustee (now liquidating trustee) to attempt to sell the property.

After a diligent marketing attempt it because obvious that the collateral was, in fact, worth millions less than the debt.  However, before figuring that out, the bankruptcy trustee had spent a significant amount of money on maintaining the property.

Thus, the question to the Fifth Circuit was: does a bankruptcy trustee get a super priority lien for expenses on the collateral when there was really no benefit at all to the bankruptcy estate in hindsight?

The answer in the Fifth Circuit is that a bankruptcy trustee can eat into the collateral value of expenses even when it becomes obvious that the collateral cannot be sold for any value to the bankruptcy estate.

III. Things to Consider

While the nuances of 506(c) deserve more attention than they are provided here, the headline message is that the lender needs to seek and assert an appraised value of collateral throughout a bankruptcy case.

If the lender in this case had shown early that there was no equity in the collateral, then it would not have to bear the burden of a new senior lien for expenses of maintaining the collateral while the secured creditor was held at bay.  Rather, in this case the lender simply did not contest the value.  (Which may mean that the lender’s appraised value also was higher than the debt).

While the opinion discusses the ins and outs of a surcharge under 506(c), the practical consideration is really how quickly and effectively can a lender assert an accurate collateral value to avoid the extra cost and expense of a bankruptcy surcharging against the collateral with no benefit at all to the bankruptcy estate.

Sometimes government regulators do funny things.  Sometimes their actions reflect that they are non-economic actors, sometimes its political, sometimes its bureaucracy and sometimes there is just no reason at all because no one knows who made the original decision. The recent Ally Bank borrower discrimination settlement in which no one knows who was actually discriminated against is a good example.

M. C. Escher: "ESCHER on ESCHER Exploring the Infinite", p. 66 Published in 1989 by HARRY N. ABRAMS, INC., New York Drawing Hands
M. C. Escher: “ESCHER on ESCHER Exploring the Infinite”, p. 66
Published in 1989 by HARRY N. ABRAMS, INC., New York
Drawing Hands

In 2013 the Department of Justice (“DOJ”) and the Consumer Financial Protection Bureau (“CFPB”) commenced actions against Ally Bank. The DOJ action was a civil action filed in Michigan, while the CFPB action was commenced as an administrative matter before the CFPB.

The crux of the allegations was that “…between April 1, 2011 and the present, Ally engaged in a pattern or practice of discrimination on the basis of race and national origin in violation of the ECOA based on the interest rate “dealer markup”—the difference between Ally’s buy rate and the contract rate—paid by African-American, Hispanic, an Asian/Pacific Islander borrowers who received automobile loans funded by Ally.”  DOJ Consent Order.  Ally did not admit to any wrongdoing.

Long story short, Ally simply agreed to pay $80 million in monetary damages, which were to be paid to the minorities who were allegedly discriminated against with the higher rates.  (This is in addition to $18 million in civil fines.)  The problem was, Ally was legally unable to know the races of any of its borrowers, so the DOJ and CFPB have no idea who gets the money.

To fix the problem, the DOJ and CFPB are using a complex methodology which, based on what I have read, seems to try to identify minorities by last name and location. The methodology, which is admitted to be less than totally accurate, is apparently the best option.

So, in case you missed that, the DOJ and CFPB are looking at last names to find minority borrowers to send money on account of borrower discrimination because the bank has no way of knowing who the minority borrowers are.

As I mentioned above, sometimes government regulators do funny things, like develop complex ways to isolate minority borrowers for compensation for discrimination when the lender has no way of knowing who are minorities they are alleged to have wronged.

In fairness, there may have been some smoking gun piece of evidence that the DOJ found which never made it to the light of day.  But, absent that, it seems at least possible that lenders could get sued by the DOJ and the CFPB for discrimination when even the lender doesn’t know who it is discriminating against.

DOJ consent order is here.

Read more here on The Detroit News.

One of the many tools of the FDIC in resolving failed banks is the Extender Statute which, by its terms, replaces existing statutes of limitation under state law by a period of years.  In simple terms, the Extender Statute creates a longer statute of limitations for bringing a lawsuit on behalf of the now defunct bank.  The technical nature, and the amount in contest has led some defendants in FDIC lawsuits to argue that the Extender Statute of 12 U.S.C § 1821(d)(14) applies only to statutes of limitation, and not to statutes of repose.  This argument has recently been declined in the 5th Circuit and, in doing so the 5th Circuit has allowed lawsuits against RBS Securities, Deutsche Bank Securities and Goldman Sachs with damages of almost a billion dollars to proceed despite state law.

time for that later

In short, Guaranty Bank failed after investing about $840 million into residential mortgage backed securities offered by the defendants RBS Securities, Inc., Deutsche Bank Securities, Inc. and Goldman Sachs & Co.  After Guaranty Bank failed the FDIC was appointed receiver and sued all of the defendants on a number of securities claims, including claims under Texas securities laws.  In response, the defendants asserted that the claims were barred by statute of repose in Texas.

 I. The Extender Statute

Following the Savings and Loan scandal and failure of the 1980’s, the U.S. Congress passed the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”). FIRREA did a lot of things beyond the scope of this post.  However, one of the things FIRREA did was create the Extender Statute.

 “The FDIC Extender Statute works by hooking any claims that are live at the time of the FDIC’s appointment as receiver and pulling them forward to a new, federal, minimum limitations period…”

At a minimum, the Extender Statute gives the FDIC 3 years from the date it is appointed receiver over a failed bank to decide whether to sue anyone for bad acts related to the failed bank.

In the case cited above, Guaranty Bank in Texas had failed, the FDIC had taken over and within three years of appointment as receiver, the FDIC sued RBS Securities, Deutsche Bank Securities and Goldman Sachs & Co. on claims related to alleged bad mortgage backed securities investments.

The issues in the appeal is that under Texas Securities Law (Tex. Rev. Civ. State. Art. 581-33(H)(2)(b)) the claims brought by the FDIC were barred by a statute of repose which ran shortly after the appointment of the FDIC as receiver.

II. Statutes of Limitations v. Repose

While the FDIC Extender Statute refers to a “statute of limitation”, the Texas Securities Law is a statute of repose.  Ordinarily the distinction is important, but not in this case.

To paraphrase the 5th Circuit: A statute of limitations creates a deadline for suing in a civil case based on the accrual of claim – which is typically when the damage is discovered or should have been discovered.  On the other hand, a statute of repose creates a deadline for suing in a civil case based on the last bad act – without regard to damage.

In the case, everyone agrees that the Texas Securities Law is a statute of repose and everyone agrees that the FDIC Extender Statute only references statutes of limitation.

III. The Holding

In 36 pages of dense and technical reasoning, the 5th Circuit holds that the Federal Extender Statute applies to extend statutes of limitation and the statute of repose under state law, such as the Texas Securities Law.

The statutory construction analysis is worthy of an attorney’s only blog post.  I will do you the favor of omitting the analysis here.  However, it is sufficient to say the opinion is comprehensive in its analysis.

IV. Why it Matters

Why does it matter?  RBS Securities, Deutsche Bank Securities and Goldman Sachs were all sued by the FDIC based on a failed bank’s investments into their residential mortgage backed securities trusts outside of state law prohibited time period.

When quantifying risk, the monetary exposure is just as important as the burn time of the limitations period.  Concerning this securities issue, the FDIC as managed to extend the otherwise applicable five year statute of repose to a eight year state of limitation in a case with damages near $1 billion.

If you are a lender and your counter-party is an FDIC insured bank, the statute of limitations on risk might be significantly longer than anticipated if the counter-party bank fails.

FDIC v. RBS Securities, Inc., case no. 14-51055 (cons w/ 51066), In the United States Court of Appeals for the Fifth Circuit.

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).

alchemy_lab

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 been told that in a traffic jam ambulance drivers are taught to move to the first opening available in traffic and figure out where to go after that.  Sometimes legal strategy takes that same philosophy.  In a recent 2nd Circuit Case, PriceWaterhouseCoopers, LLP (“PwC”) asserted in pari delicto to avoid immediate liability in a MF Global, Inc. (“MF Global”) related lawsuit.  What happens next, I assume has already been figured out by their very capable lawyers.

PP 68 PONTIAC AMBULANCE

It is helpful to know what the legal doctrine of in pari delicto means, if you do not already know.  The doctrine is “an affirmative defense which mandates that the courts will not intercede to resolve a dispute between two wrongdoers.”  In essence, if two wrongdoers come to court, the court will not resolve who is at fault.  More simply, if a party asserts they are not liable on a theory of in pari delicto, they are necessarily claiming to be a wrongdoer.

Following the collapse of MF Global a lot of people got sued.  Among the people who were sued were the D&Os of MF Global and PwC on behalf of MF Global.  PwC is alleged to have conducted audits of MF Global during the time in which MF Global is alleged to have “raided” (not my word) the commodities customers’ accounts in an attempt to keep MF Global afloat.   Stated in a broad stroke, the plaintiffs assert that PwC should have caught the alleged violations of the various securities laws, but did not.  The damages were asserted to be in the billions of dollars.

Here is where another legal concept comes into play – a derivative lawsuit:

In simple terms, a derivative lawsuit is where a third party brings a lawsuit on behalf of the primary party against a second party.

In this case, the aggrieved commodities customers filed a derivative lawsuit on behalf of MF Global against PwC claiming that PwC has violated securities laws when it raided the accounts.  Among PwC’s responses (of which, I presume there were many), PwC asserted the  affirmative defense of in pari delicto because the true party was MF Global (because it was a derivative lawsuit), and thus they were both wrongdoers.

Personally, I think it takes a lot of confidence on the part of PwC’s attorneys to assert the affirmative defense of in pari delicto in this, or any case.  In doing so, the client is being advised to assert that is a wrongdoer.

The case itself has been up and down the system.  However, it’s the recent ruling on May 22, 2015 which affirmed that PwC would not be liable to the commodities customers because PwC had prevailed on its affirmative defense of in pari delicto.  (The 2nd Cir. affirmed that there could be no professional negligence claim because PwC never worked for the plaintiffs).

What to take away from this decision and fact pattern for a lender?

  • Consider the true sources of recovery. If you are banking on a third party liability policy, then it might not be there.
  • Sometimes accountants might not act properly, and if they do, the lender might not be able to recover from them.

As a legal matter, this dispute is likely not over any time soon.  By essentially asserting wrongdoing, PwC has prevented liability from the derivative claimants, but has not addressed the potential for liability from other claimants.  Nevertheless, the tactic worked and now PwC is on to the next fight, having avoided liability at the first. In effect, PwC has gone for the first opening in heavy traffic and will figure out where to go after that.

Bearing Fund, LP., et al. v. PriceWaterhouseCoopers, LLP (In re MF Global Holdings Ltd. Investment Litigation), case no. 14-1249-cv, In the United States Court of Appeals for the Second Circuit, opinion issued May 22, 2015.

The Order is here.

Unexpected things happen in bankruptcy.   Some debts can be restructured, some debts can be reduced and some debts the debtor is just stuck with.  In contrast, outside of the bankruptcy ecosystem, economic interests are treated normally.  Because of the difference, a creditor’s activities for recovery in bankruptcy will, at times, seem at odds with their economic interests if viewed through the lens of a normal collection matter.

Credit:Paramount Pictures
Credit:Paramount Pictures

A currently pending adversary proceeding in the Energy Futures bankruptcy case is a good example of a creditor taking a somewhat counter-intuitive path to seek recovery.

As you may know, the bankruptcy case of Energy Future Holdings Corp. (“EFH”) is currently pending in Delaware.  As the name implies, EFH is an energy company.  The adversary I cite revolves around an affiliate of EFH who issued about $2 billion in notes under an indenture which contained a “make whole” provision.

As you may know, a “make whole” provision in a loan agreement basically provides that a borrower will need to pay some or all of the anticipated interest recovery to the creditor if the borrower pays the debt early.

In this case, the “make whole” provision was part of a large indenture issued by an affiliate of EFT on 2.18 billion in notes. For the purposes of the current litigation, a few of the provision are relevant:

  • First: Under the indenture, it was a default to file bankruptcy.
  • Second: Upon default by filing bankruptcy, the debt would automatically accelerate.
  • Third: Under any non-bankruptcy default, the acceleration would be permissive.
  • Fourth: If the borrower defaulted (other than filing bankruptcy), and tried to pay the debt back it would trigger the make whole provision, which amounts to approximate $13 million per month in interest costs.

So what happened?  The affiliate filed bankruptcy.  The bankrupt borrower asserted that the “make whole” provision was not triggered.  Realizing that this would be an issue, the indenture trustee attempted to deaccelerate the loan and assert the full “make whole” provision post-bankruptcy.

Based on the indenture, the bankruptcy court determined that the filing of the bankruptcy automatically accelerated the loan, which made the “make whole” provision inapplicable.

What is a creditor to do when faced with the consequences of an automatically triggered acceleration when, unexpectedly, it is not in the economic interest of the creditor?  Simple; try to deaccelerate the debt to be able to then trigger the “make whole” provision.  Well, not so simple.

As you may know, most bankruptcy courts have held that accelerating a debt post-bankruptcy is a violation of the automatic stay.  As it turns out, the opposite is also true.  In the recent order, the Bankruptcy Court held that attempting deaccelerate the loan was also a violation of the automatic stay.

As a result, the creditor (an indenture trustee) is now locked in an epic legal struggle to seek authority to deaccelerate a loan, which accelerated by the terms of the indenture upon the bankruptcy filing.  In contest is hundreds of millions of dollars under the “make whole” provision.

According to the Bankruptcy Court, there is nothing wrong with the “make whole” provision and it would normally be enforceable under state law.  The only issue is that the terms which caused the automatic acceleration preclude the “make whole” provisions and unwinding that automatic trigger would violate the automatic stay of the bankruptcy code.

Whereas most creditors would assume that the acceleration of debt and the collection options afforded by that act would be the logical next step in collection, the indenture trustee in the lawsuit must now fight to walk back those heavily negotiated provisions in the hopes of collecting on the debt is thought it bargained for under the indenture.

The take home message is be careful what you wish for, you just might get it.  In this case, the indenture called for an automatic acceleration of the debt upon bankruptcy filing. However, the effect of that acceleration precluded the make whole provision. In this case, it will cost the creditors hundreds of millions of dollars.

Delaware Trust Co. as Indenture Trustee v. Entergy Future Intermediate Holding Company, LLC and EFIH Finance, Inc. (In re Energy Future Holdings Corp.), Adversary No. 14-50363(CSS), pending in the United States Bankruptcy Court for the District of Delaware

 

(Apologies for the delay is writing.  Things are getting  little busy.)

It was not too long ago that a lender would consider an oil & gas company as a fairly safe credit.  However, the times are changing.

oil and gas donkey

 

It is no secret that the current lower gas prices are due to upstream excess production, either domestically (in the US) or in the mid-east.  This has led to much discussion about the financial future of many upstream exploration and production (“E&P”) companies in the near term as well as to the down-stream companies later in time.

As a corollary to that, most folks outside of Texas are likely not aware that a significant portion of the oil patch is serviced by smaller vendors whom you would likely not know by name.  These are the early warning companies that are expected to fail prior to the larger E&P companies.

Despite financing vehicles and hedging (learned from the last downturn, I am told), some of the E&P companies are already filing bankruptcy or seemingly moving in that direction.

  • Recently, Quicksilver Resources, Inc. and affiliates filed chapter 11 in Delaware (case no. 15-10585).   Quicksilver was (and remains) a E&P company based in Fort Worth, Texas.  It lists over $1BB in liabilities as well as over $1BB in assets.  Click here for the press release.
  • Another E&P company, Sabine Oil & Gas Corp. announced last week that it had retained restructuring counsel as well as a financial advisory firm.  Sabine is the product of merger last year with Forest Oil and claims operations in the Eagle Ford Shale, East Texas, North Texas and offshore.  Its last filed 10-K listed closed to $1BB in assets.  Click here for investor info from the Sabine investor page.
  • And finally, another E&P company I will mention is Dune Energy, Inc. based in Houston who filed bankruptcy in early March 2015 in Austin (case no. 15-10336).  Dune claims operations in Texas and offshore.  Its bankruptcy schedules listed $144.2MM in debt against $229.5MM in assets.  Click here for the Form 8-K.

Of course, there are more E&P companies who have filed (or may).  A quick check of the docket for the Western District of Texas appears to show a few of the smaller service companies who have recently filed chapter 11 also.  Most people I speak with in my field believe that we will see more oil & gas restructuring by the end of the year.  While these companies did very well even during the recent recession, as the economy has gotten better and production has increased, these companies are facing serious financial trouble.

Knowing when to cut your losses and walk a deal is a difficult skill to master.  In the construction loan context it is particularly difficult because a half completed building lacks the intended value anticipated on the loan.  On the other hand, cutting off disbursements causes a whole other set of risks including mechanic and materialman’s liens (“M&M Liens”) which often prime the lender’s mortgage lien.  While different types of insurance may help, the 7th Circuit recently held that priming M&M Liens incurred after the lender had cut off funding following borrower’s default were caused by the lender and therefore excluded from the title insurance coverage.  The result was essentially a total loss to the lender of ~$61MM.

Credit: LucasFilm, Ltd. / Imigur

The Project

The project was a commercial construction project in Kansas City, MO.  Basically what happened was that BB Syndication Services (the “Lender”) lent money on a construction loan to build the commercial development to its borrower.  The total line of credit was ~$86MM.

In the project, First American Title (the “Title Company”), acted as disbursing agent and insured against encumbrances on the property.  The idea being that prior to making a disbursement, the Title Company would check for liens, and barring liens would disburse the next construction draw.  The title insurance policy contained a exclusion to coverage which excluded any liens that are “created ,suffered, assumed or agreed to” by the Lender.

The 7th Circuit mentions some notable, but stereotypical, background facts in the opinion illustrative of deal that is going to go south present in this project:

  • The project was “fast tracked” and many contracts were signed before the plans were finalized. The result was that the initially cost estimate was almost immediately rendered inaccurate.
  • The construction company immediately warned all the parties that the changes would increase the initial estimate of $118MM by an additional $30-$40MM.
  • Notwithstanding the revised cost estimate the Lender opted to proceed even though there were no additional funds from the Lender or sponsors.
  • When ~$5MM had been disbursed the projected cost overruns began to come to light.
  • Undaunted, the Lender continued making disbursements and paid out over $61MM.

After the original contractor was fired by the borrower the Lender saw that the project was falling apart.  The new construction company determined they would need an additional $37MM (see above).  The Lender then declared the default and ceased making disbursements.  Two things happened when the Lender cut off the funds:

  1. Over $17MM in M&M Liens were filed (which primed the Lender), and
  2. The Borrower filed bankruptcy

 A Lawsuit About a Lawsuit

Most insurance coverage litigation is usually a lawsuit about another lawsuit in which there was a loss.  This was no different.  The Borrower filed bankruptcy and the bankruptcy court ultimately allowed $17MM in M&M Liens which all primed the Lender’s mortgage lien.  Next, the bankruptcy court conducted a judicial auction of the property which yielded $10MM.  Obviously this was not enough to pay the (now) first lien M&M Liens.  In the end, the lender settled for payment of $150K on its $61MM debt.

Faced with the loss, the Lender then turned and sued the Title Company on the title insurance policy.  The Title Company countered with their exclusion of liens “created, suffered, assumed or agreed to” by the Lender.

On appeal, the 7th Circuit held for the Title Company stating:

The liens at issue here related to outstanding work that remained unpaid when [Lender] cut off loan disbursements due to insufficient funds to complete the project.  As such, the liens arose directly from [Lender’s] action as the insured lender, so coverage seems squarely foreclosed by Exclusion 3(a).

The 7th Circuit dismissed the Lender’ argument that it had the contractual right to cease disbursements and was therefore not responsible for the M&M Liens.  The 7th Circuit reasoned that the right to cut off funding had nothing to do with the sub-contractor’s right to file M&M Lien claims.

Moreover, the 7th Circuit stated that the Lender could be seen to have caused the cost overrun itself because the Lender  knew well in advance that the project was out of balance.  The 7th Circuit goes so far as to state “Only the lender has the ability – and thus duty – to investigate and monitor the construction projects economic viability.  When liens arise from insufficient funds, the insured lender has ‘created’ them by failed to discover and prevent cost overruns…”

 What to Take Away from the Case

If anything, lenders should not rely on title insurance which contain the fairly common exclusion for M&M Liens that will arise following cut off of disbursements at issue in the case.  Circuits are split regarding this issue, but it remains a risk regardless of your location.  Obtaining performance bonds are likely a better option.

In addition to the legal holding about a title policy exclusion, another lesson is the cost of failing to walk away early from a project that is clearly not going to work.  The opinion mentions the Lender’s knowledge of the cost overruns over and over again.  Had the Lender walked at $5MM it would have almost certainly been made whole.  Knowing when to cut your losses is as much an art as it is a science and it cost the Lender over $61MM on this deal.

BB Syndication Services, Inc v. First American Title, case no. 13-2785, in the United States Court of Appeals for the Seventh Circuit.  Entered March 12, 2015.