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I’ll admit it.  One of my favorite words is “allonge”.  It breaks up my otherwise decumbent register with something exotic.  Legally, it’s a way to assign a promissory note to another party who then has the rights to assert the promissory note against the obligors.  The last post discussed the importance of compliance with simple legal requirements.  But, what happens if the simple act of signing the allonge is done by an entity which doesn’t exist?  Does the new note holder have the right to assert the promissory note against the obligors. The Fifth Circuit says, “Yes”.

Credit: M.C. Escher

In this case the commercial real estate special purpose entity (“SPE”) and its guarantors fought to avoid a foreclosure (and deficiency) with the lender, and eventually get poured out by the 5th Circuit.  However, I am writing about the opinion because of an interesting holding concerning the various assignments that occurred of the promissory note following execution.

In the case, the SPE borrower (“Borrower”) was obligated on a commercial mortgage note.  After the promissory note was originally executed by the Borrower and original lender the note was transferred several times by assignment and accompanying allonge.  Eventually, the note was assigned to US Bank, as trustee for a CMBS trust.

One of the intermediate assignments was from Greenpoint Mortgage Funding to Aurora Bank.

Borrower was able to prove to the trial court that Aurora Bank did not actually exist at the time of the assignment into Aurora Bank. On this basis, the Borrower sought to attack US Bank’s ability to assert the note against the Borrower.  In considering the argument, the 5th Circuit held:

“This logic and conclusion treats as legally insignificant whether Aurora existed at the time of the transfers and therefore had a legal capacity to either endorse the Note or assign the Deed to US Bank.  Assuming without holding that any of the Deed assignments from Greenpoint to Aurora to US Bank were forgeries under Texas law…,and acknowledging that a forgery makes a Deed assignment void…, when the foreclosing party is the holder of the promissory note, any defects in the Deed assignment are irrelevant.”

This holding is predicated almost entirely on the rule that the mortgage follows the note, which is discussed in some detail in the opinion.

For the litigators, the opinion also contains good language concerning diversity with regard to trusts.  For the UCC folks, the opinion has a full paragraph discussing instrument negotiation.  Finally, the case has a brief discussion on fraudulent misrepresentation.

Interestingly, despite raising a host of legal challenges, the Borrower and the guarantors appear never to have raised a challenge to the note being an instrument – which would remove the holder in due course rights which underpin the opinion.

So, the lesson here: good news for all you banks out there who do not exist yet hold debt.

5th Circuit opinion in SGK Properties, LLC v. US Bank, case no. 17-20130

 

 

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.

Sometimes a buyer is upset because he received less than he paid for.  On the other hand, sometimes the buyer is upset because he received way more than he paid for.  In a recent Texas Supreme Court decision, the buyer of contracts out of bankruptcy realized too late that it had purchased tens of millions in liability under an undisclosed indemnity agreement which had been dormant for years.

Indemnity Cat

To understand what happened, it’s helpful to have a general understanding of two things.  First, what is an executory contract.  Second, how does a sale process work in bankruptcy.

An executory contract is any contract under which both sides still owe an obligation under the contract at the time of the bankruptcy filing of one of the parties.

In defining an executory contract, the US Supreme Court has stated:

“Congress intended the term to mean a contract on which performance is due to some extent on both sides.

The Fifth Circuit has said:

“an agreement is executory if at the time of the bankruptcy filing, the failure of either party to complete performance would constitute a material breach of the contract, thereby excusing the performance of the other party.”

The characterization of an executory contract is important because the bankruptcy code has special provisions on how they must be treated.  One of the features of an executory contract is that it can be treated as an asset which can be “sold” to a third party; even over the objection of the contract counter-party.

Importantly, to sell an executory contract, the purchaser must take the contract subject to all of its terms.  The process is referred to as the assumption/rejection process.  (because the executory contract can also be rejected, which is a way to jettison liability on a bad contract).

As an asset of the bankruptcy case, an executory contract can be sold (technically assigned) either on its own or as part of a larger purchase.   This can done in a couple of ways, but one of the safer ways to do it is in a chapter 11 plan.  That was the case in Noble Energy v. ConocoPhillips in the Texas Supreme Court.

Noble purchased a slew of oil and gas properties and rights from a bankrupt debtor.  Prior to bankruptcy, the Debtor had entered into a number of transactions with ConocoPhillips.  One of the transactions included an environmental indemnity agreement which broadly and forever required ConocoPhillips and the Debtor to indemnify each other for environmental claims made against oil and gas properties they traded.

Unfortunately for Noble, those indemnity agreements were never disclosed in any way in the bankruptcy case – not even in the applicable purchase agreement.  Fortunately for ConocoPhillips, when Noble purchased the assets from the Debtor:

The Plan provides that any executory contracts not specifically referenced were to be assumed and assigned to Noble unless rejected at closing.  Noble agreed to the Plan and the APA has language that basically said “the assets and contracts we are purchasing includes, but is not limited to x y & z.”

Here was the error for Noble (in my humble opinion).  Noble had no actual knowledge of the existing indemnity agreement.  However, it agreed to assume – with all the burdens – ALL executory contracts unless specifically rejected.  Noble did not know about the indemnity agreements, so it did not “specifically reject” the unknown contracts.

Now, fast forward 10 years and ConocoPhillips sues Noble for $63 million based on the dormant environmental indemnity provision.

In the case, the Texas Supreme Court holds (importantly for the bankruptcy folks), that the cross indemnity provision was legally an executory contract which could be “sold” in bankruptcy.  The Texas Supreme Court holds (importantly for the transactional folks) that the unlimited scope of the purchase caused the unknown and undisclosed indemnity agreement to be part of the asset purchase agreement and bankruptcy plan thereby binding Noble to the terms.  Interestingly the environmental claim arose prior to the bankruptcy case, but the claim for indemnity was not made until after the purchase by Noble was completed.

While there is some interesting points on bankruptcy law in the opinion, the larger lesson from this case is that the common desire in drafting APAs to capture as much as possible may backfire if the purchaser unknowingly captures an indemnity that is sleeping.

Noble Energy, Inc. v. ConocoPhillips Company, cause no. 15-0502, Supreme Court of Texas.  June 23, 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.

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.)

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.

It is often surprising to me how often people are unaware of the fairly high risk of being sued in connection with a chapter 11 bankruptcy case when there is money in the case.  Many times, non-debtor parties’ falsely comfort themselves with the belief they will not be sued because existing management wouldn’t want to ruin a business relationship.  The reality is that in large chapter 11 cases, you are just as likely to be sued by the creditors committee as anyone else as a lender.

get sued

Bankruptcy, at its most basic, is the attempt to monetize and equitably (and constitutionally) distribute whatever assets exist of the bankrupt entity.  Outside of bankruptcy, the obvious assets are normally the tangible widgets.  Inside of bankruptcy, the causes of action also become value for trade.

To understand how a third party lender can be sued by an unknown entity on a cause of action which makes no business sense, a quick review of statutory committees is helpful.

Under the Bankruptcy Code a committee of unsecured creditors may be formed to represent the interests of the larger body of unsecured creditors.  Importantly, this committee will have its attorneys’ fees paid by the bankrupt debtor.  This committee, now funded and represented will go about to seek the best recovery for its constituents.  One source of recovery is lawsuits, which are typically unencumbered.

Of course, a committee that did not exist prior to the bankruptcy filing will not typically have standing to sue for pre-bankruptcy wrongs.  However, the Bankruptcy Code and Court’s provide a mechanism to assign those causes of action to the unsecured creditor’s committee as payment on their unsecured debt.

Meaning – if you are a lender you might get sued by a group of angry unsecured creditors after the bankruptcy is filed. The bankruptcy case of Energy Futures Holding (“EFH”) provides a good illustration.

How could that happen?  If a bankrupt debtor unjustifiably fails (or is unable) to pursue a cause of action, the unsecured creditors committee may petition the court to be permitted to pursue the cause of action.  That is what the unsecured creditors committee is currently doing in the EFH case.

In the EFH case, certain subsidiaries were obligated on the LBO debt of the holding company.  The subs didn’t receive the money and even had a provision in the loan documents which essentially said they were only obligated to the extent that the obligation wasn’t a fraudulent transfer in bankruptcy.  Nonetheless, they allegedly paid a disproportionate share of debt service which payment are alleged to be fraudulent transfers.

After the bankruptcy case was filed, the lenders included a provision in the post-petition financing agreement that the bankrupt debtors would not sue the lenders for the pre-bankruptcy payment by the subs (now debtors in bankruptcy).

After the order permitted in the post bankruptcy financing was entered, the unsecured creditors committee in the EFH case was created.  Just recently, the unsecured creditors committee has requested that it be permitted to pursue fraudulent transfer causes of action against the lenders because the Debtor has waived the ability to do so.  The total asserted liability is $8 billion.

At present, the EFH bankruptcy court has not ruled on the request by the unsecured creditors committee.  However, it would not be unusual for the Court to grant such a request.  The legal issues are somewhat technical, but the practical considerations are fairly straightforward – the $8 billion lawsuit is not going to be pursued for legal and business reasons by the bankrupt borrowers but regardless it remains a valuable asset for potential recovery for creditors.

The take home consideration for lenders is this: the lenders sought pre-bankruptcy loan language they thought would shield them from a lawsuit, the lenders sought and obtained a post-bankruptcy waiver of pursuit of the lawsuit by the borrowers – however, the lenders are now facing the prospect that the unsecured creditors committee (who did not exist until after the post-bankruptcy waiver) will sue the lenders for $8 billion.

The loan document language may be of some comfort to you.  However, as a lender, in bankruptcy it might not be the borrower who sues you.

In re Energy Future Holdings Corp., case no. 14-10979, pending in the United States Bankruptcy Court for the District of Delaware.

Motion of the EFH Official Committee for Entry of an Order Granting Derivative Standing and Authority to Prosecute and Settle Claims on Behalf of the Luminant Debtors’ Estates. [dkt 3605]

Bitcoin is one of several crypto-currencies which are exchanged generally outside of sovereign control and all electronically.  In early 2014, a Bitcoin exchange named Mt. Gox filed bankruptcy in Tokyo and subsequently sought additional protection in the US by filing a chapter 15 bankruptcy petition.  Just recently, the bankruptcy trustee in Tokyo has announced he will begin to pay back account holders in Bitcoin using a US based bitcoin exchange.

Dogecoin is another crypto-currency and is my personal favorite because of the mascot.
Dogecoin is another crypto-currency and is my personal favorite because of the mascot.

First, some background.  Skip this is you are familiar with Bitcoin

Bitcoin is not a “coin” at all in the traditional sense.  Rather, one bitcoin is essentially a complex mathematical code which is recorded on a public ledger as one bitcoin.  That bitcoin has a two security keys which permit the bitcoin to be owned by (and transferred) by a person.

  1. The public key allows the bitcoin to be utilized by the bitcoin exchanges.
  2. The private key is what is used by the bitcoin holder to transfer the bitcoin value to the recipient.

So, in a sense, your bitcoin “wallet” will not hold any coins (or currency), but rather your bitcoin private keys.  When you spend bitcoins from your wallet, you are using your private key to tell the online public ledger to reflect a transfer of bitcoin to a new owner.  That new owner gets a new private key and the bitcoin transaction is complete.

The mathematics and cryptography are significantly more complicated than that.  But, from a consumer standpoint, this is essentially what the transaction looks like.

Unlike sovereign issued (and backed) currency, Bitcoin has no government backing and very little government regulation.

  • There is no Federal Reserve or similar body for bitcoin.
  • There is no government producing bitcoin.
  • Regulations (or lack of regulation) vary significantly globally.
  • All bitcoins are produced by “mining” which is basically utilizing a very complex mathematical proof to create a one-of-a-kind number, which is the bitcoin.

The amount of computing power to mine bitcoins is not insignificant because of the complexity.  Thus, Bitcoin exchanges, such as Mt. Gox will commit resources to do so and will offer exchange services, payment services, wallets and other ancillary quasi-banking services to consumer account holders.

Second, what is going on in the Mt. Gox Case.

When Mt. Gox filed bankruptcy, one of the stated reasons for the bankruptcy was that it had lost 850,000 bitcoins.  At the time, the value of these was about $500,000.00 (USD).

After the bankruptcy was filed, the bankruptcy trustee found about 200,000 of the lost bitcoins.  However, much of the remaining unaccounted bitcoins belonged to account holders at Mt. Gox.  Although, Mt. Gox did hold bitcoin on its own account.  The loss was attributed to hackers and technical issues with the exchange site itself.

After proceeding with the bankruptcy case, the bankruptcy trustee had suggested that the Mr. Gox bitcoins be converted to USD and then used to repay the account holders at Mt. Gox who had lost their bitcoins.  In an interesting turn of events, the creditors demanded to be repaid in bitcoin.  The reasons probably vary, but it is likely the creditors did not want the already volatile bitcoin market to tank when the bitcoins were exchanged for cash.

In order to go about that, the bankruptcy trustee has enlisted the help of another bitcoin exchange named Kraken, which is based in the US.

Finally, things to consider

From an overview perspective; the first thing to consider is that Bitcoin specifically, and perhaps the other crypto-currencies, are not going away despite high profile failures such as Mt. Gox.  Some domestic retailers are now accepting Bitcoin for day-to-day exchanges as they would cash.  Notwithstanding, the market remains very volatile.

At a more narrow level, a bankruptcy court (even in Japan) that pays the creditors in non-sovereign backed crypto-currency should raise a few eyebrows. In this case, it appears that the payment in bitcoin was at the request of the creditors.  However, it is not clear what would happen if account holders had demanded USD (or yen), but received bitcoin while non-account holder creditors were paid from liquidating traditional hard assets in cash.

Obviously there are significant other issues to consider which are not covered in this humble blog post.  Regardless, these issues and others are on the horizon.