Bad Boys Get Spanked: New York Courts Uphold Recourse Guaranties

Michael Feinman and Joseph McFalls

Two recent New York cases have provided additional clarity with regard to the enforceability of “recourse carve-out” (or “bad boy”) guaranties in commercial mortgage transactions. The two cases-Bank of America, N.A. v. Lightstone Holdings, LLC, July 14, 2011, Case No. 601853 (Lightstone) and, UBS Commercial Mortgage Trust 2007-FL1 v. Garrison Special Opportunities Fund L.P., March 8, 2011, Case No. 652412 (Garrison)-were decided by the New York Supreme Court (which is a trial level court, despite the court’s name) in New York County (Manhattan), and were decided by the same judge, Justice Melvin Schweitzer. In both cases, the lender was awarded summary judgment for the amount it sought to recover.
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These decisions are significant for several reasons. First, the courts dismissed arguments that recourse carve-out guaranties violate public policy or are unenforceable penalties. Second, the courts ratified a common provision of the carve-out guaranty-that a voluntary bankruptcy filing triggers full recourse. Finally, the courts found that the guaranties were suitable for determination on summary judgment.

Recourse Guaranties

Recourse carve-out guaranties are required by lenders in most commercial real estate loans, whether the loans are portfolio loans or are securitized in the CMBS market. Because the borrowers are single purpose entities (SPEs) whose only asset is the real estate being financed, the guaranties seek to make a principal of the borrower-a “warm body,” that is, an individual or entity with financial assets other than the mortgaged property-responsible if certain bad acts occur. The carve-out guaranty is intended to be a deterrent to the borrower’s control parties, who might have economic or other reasons-such as the prospect of an attractive settlement-to harm the collateral or interfere with the lender’s bargained-for enforcement. There are two categories of “bad acts” in most of the carve-out guaranties in the marketplace: (i) those, such as diversion of rents or waste of the property, that give rise to the guarantor being liable for the lender’s damages, and (ii) those more serious transgressions for which the guarantor becomes liable for full repayment of the loan.

Bankruptcy Provisions

Both the Lightstone and the Garrison cases involved the full recourse provisions of a carve-out guaranty, triggered by a voluntary bankruptcy filing. In Lightstone, the borrower and its principal, David Lichtenstein, purchased Extended Stay Hotels with substantial mezzanine financing, secured by membership pledges. The borrower and Mr. Lichtenstein executed a guaranty stating that the mezzanine debt became fully recourse up to a specified cap of $100 million if the borrower or its affiliates filed a voluntary bankruptcy petition. In June of 2009, a voluntary bankruptcy petition was filed by the borrower (a mezzanine loan borrower) as well as by the underlying property owners, and the lender demanded payment by the guarantor of a $100 million liability pursuant to the guaranty.

In the Garrison case, the facts were somewhat unusual in that the recourse guaranty in question was delivered pursuant to workout discussions between the lender and the guarantor, who had acquired the property after the loan was in place. In connection with the workout discussions, UBS agreed to a forbearance period in return for a guaranty from Garrison that it would be fully liable for the loan if a voluntary bankruptcy filing occurred. After Garrison commenced a UCC foreclosure, the borrower filed for bankruptcy, thus triggering the guaranty.

Failed Substantive Arguments Against Enforcement

In both Lightstone and Garrison, the guarantors argued that the recourse guaranty violated public policy or constituted an unenforceable penalty. The “void as against public policy” argument had three prongs. First, it was argued that the bankruptcy provision in the guaranty violated public policy due to the possibility that it would cause a conflict of interest between the guarantor’s fiduciary duty to the borrower’s creditors and the guarantor’s self-interest. The argument suggests that a guaranty tied to another entity’s bankruptcy thwarts the public policy purposes of the Bankruptcy Code. It aims to apply the reasoning behind Section 365(e) of the Bankruptcy Code-prohibiting “ipso facto” clauses, which condition termination or default under an executory contract on the commencement of a bankruptcy case-to situations where the party seeking to avoid enforcement of the contract is not a party to the bankruptcy case. However, the Court in Garrison compared the situation to a typical parent-subsidiary guaranty and rejected any claim that public policy considerations should override the contract.

Second, the bankruptcy provision was alleged to be violative of public policy because it rewarded a lender’s aggressive tactics to secure an especially favorable deal not available in bankruptcy, thereby further exacerbating the already distressed commercial real estate market. Third, the defendants claimed that the guaranty constituted a penalty as it sought to punish the defendants for committing bad acts. The Garrison court rejected these arguments, declaring that the Court was not the proper venue to address the actions of an aggressive lender and that it would not “rewrite the rules relating to commercial real estate financing,” instead leaving such action to the legislative or executive branches. The Lightstone court concurred, stating “there is no public policy that would authorize defendants to walk away from their contractual obligations.”

The defendants’ argument that the guaranty represented a penalty was similarly unsuccessful. In each case, the Court found that the defendants, in the guaranty document, had knowingly and explicitly waived the right to raise this defense and that this waiver would be enforced because the defendants were sophisticated real estate investors familiar with these guaranties and the waivers they contained. Further, even if the defense had not been waived, the Court found it to be unavailing because the guaranty, in the words of the Garrison court, was an element of “legitimate financing arrangements with respect to real estate transactions and have been upheld in New York State and federal court.”

Failed Procedural Arguments

Procedural arguments were also central to each of the defendants’ cases. Both cases were decided on summary judgment under New York Civil Practice Law and Rules (CPLR) Section 3213. This statute, entitled “Motion for Summary Judgment in Lieu of Complaint,” allows plaintiffs to file for summary judgment at the outset of the litigation “[w]hen an action is based upon an instrument for the payment of money only or upon any judgment.” The defendants in both cases argued that the recourse guaranty was not suitable for this accelerated procedure because it contained other obligations, including performance obligations, as well as provisions that required reference to extrinsic documents. But the Court in both cases found that for purposes of the specific lawsuit-which demanded payment for the specific act of a voluntary bankruptcy filing-the guaranty was an instrument for the payment of money only, notwithstanding that the guaranty included other provisions which did not qualify as “payment of money only” provisions.

One must be mindful of the limitation of these rulings, particularly with regard to the summary judgment ruling. Neither case addressed a “damages” provision in the recourse guaranty being enforced. In fact, the Lightstone court suggested that, if damages were at issue, the expedited summary judgment statute might be unavailable. Also, because the determination of whether the guarantor was liable under the guaranty was limited to whether or not a voluntary bankruptcy had been filed, both courts did not need to address whether interpretation of provisions in the underlying loan agreement or other documents was necessary. A case where the court needs to go outside of the four corners of the guaranty document would be a more difficult one for summary judgment purposes.

Conclusion

Borrowers and lenders in New York and elsewhere should take note of these two recent decisions. It is now apparent that recourse guaranties and the bankruptcy provisions therein will likely be enforced by courts, notwithstanding public policy objections. Moreover, where a clear trigger—such as a voluntary bankruptcy filing—appears in the guaranty, parties should anticipate that the guaranty can be enforced on an expedited basis.

*This article will appear in the October 2011 issue of Pratt’s Journal of Bankruptcy Law.

Bankruptcy Court Holds Foreign Mail Interception Order Not Enforceable in Chapter 15 as Against Public Policy

Michael Meehan

Chapter 15 of the Bankruptcy Code provides a comprehensive scheme for recognizing and giving effect to foreign insolvency proceedings.  Section 1506, however, permits a court to refuse to recognize or enforce a foreign order that “would be manifestly contrary to the public policy of the United States.”  In one of the few reported decisions to utilize and construe Section 1506, Judge Allan L. Gropper of the Bankruptcy Court for the Southern District of New York recently denied a foreign representative’s request for relief as “manifestly contrary” to U.S. policy.

The case, In re Toft, involved a doctor, Jürgen Toft, who was the subject of a German insolvency proceeding.  The doctor refused to cooperate with the administrator of that proceeding, hid assets and fled to an unknown country. The German Court subsequently entered a Mail Interception Order (the “Order”), permissible under German law, that authorized the administrator to intercept the doctor’s postal and electronic mail.  Believing that the doctor may have relocated to London, the administrator sought and obtained an order from an English court recognizing and enforcing the Order in England.

The foreign representative then sought enforcement of the Order in the United States through Chapter 15.  The sole reason for seeking recognition from the U.S. court was that the debtor’s email accounts were stored on Internet Service Providers (“ISPs”) located in the United States.  The doctor had no property in the United States, there was no indication that the doctor was residing in the United States, and there were no lawsuits pending in the United States.  The representative sought undisclosed production of past emails, as well as the ability to monitor future email correspondence.  The doctor was not provided notice of the Chapter 15 proceeding, and the administrator specifically requested that no notice be provided so that he could investigate the doctor’s emails undetected.

The foreign representative argued that various provisions of Chapter 15 required the U.S. court to recognize and give effect to the Order.  Specifically, the representative pointed to Section 1521(a)(4), which, upon recognition of a foreign proceeding, entitles a foreign representative to the “delivery of information concerning that debtor’s assets, affairs, rights, obligations or liabilities.”  The German representative also pointed to Section 1509(b)(3), which states that, “subject to the limitations that might be imposed consistent with this chapter,” a U.S. court “shall grant comity or cooperation to the foreign representative” seeking relief from the court.

Judge Gropper first analyzed whether the U.S. court even had jurisdiction to hear the case.  In finding jurisdiction proper, Judge Gropper found that the absence of tangible property or business in the United States was not fatal to the foreign representative’s request.  He stated that jurisdiction under Chapter 15 does not require an inquiry into the debtor’s nexus to the United States; rather, it is a proceeding ancillary to a foreign proceeding.  If the foreign representative sought an additional, plenary proceeding under Section 1511, the representative would then be required to demonstrate that the debtor has assets in the United States.  Judge Gropper reasoned that, by imposing this requirement for plenary proceedings, “the statute contemplates the commencement of a Chapter 15 case even where there are no assets of the debtor in the United States.”

Judge Gropper then raised the issue of whether enforcement of the Order would be manifestly contrary to U.S. public policy under Section 1506.  Although he conceded that Section 1506 should be used sparingly and restricted to impingement on “fundamental principles of law,” Judge Gropper held that this was “one of the rare cases” in which the relief requested by the foreign representative was manifestly contrary to U.S. public policy.

The court focused primarily on the fact that enforcing the Order would likely violate the Wiretap Act, 18 U.S.C. § 2511, et seq., and the Electronic Communications Privacy Act, 18 U.S.C. §§ 2701, et seq., (the “Privacy Act”).  The Wiretap Act guards against the intentional interception of electronic communication; the only exceptions to the law require consent of one of the parties to the electronic communication, or a warrant.  The Privacy Act prevents unauthorized third parties from accessing or obtaining stored electronic communications, and the available exceptions require a search warrant or subpoena.  The court found that “the relief sought would directly compromise privacy rights subject to a comprehensive scheme of statutory protection, available to aliens, built on constitutional safeguards incorporated in the Fourth Amendment as well as the constitutions of many States.”

The court also held that, contrary to the assertions of the foreign representative, the relief requested exceeds what would be available to an estate administrator or trustee in a U.S. bankruptcy proceeding.  The foreign administrator had argued that the requested relief would be available in a U.S. proceeding under Bankruptcy Rule 2004 and under Section 704 of the Code.  His petition cited U.S. cases where bankruptcy trustees have been authorized to intercept a debtor’s mail and even investigate a debtor’s residence.  The court found this argument unconvincing, as in each case cited by the foreign administrator the debtor was given sufficient notice of the proceeding and an opportunity to object.  Further, the court recognized that the bankruptcy trustee would not have authority to circumvent the Wiretap Act or the Privacy Act, nor could the actions of a trustee fall under the exceptions of either statute; therefore, enforcing the Order could subject the foreign administrator and any agents to criminal liability.

The Court’s holding is a narrow one, the implications of which may not be far-reaching.  Nonetheless, the case provides an important reminder that the principles of comity embodying Chapter 15 are not limitless

Supreme Court Adopts Amendments to Bankruptcy Rule 2019 to Force Debt Traders and Equity Traders to Disclose

Regina Kelbon and Lora M. Epstein

Recently, the Supreme Court adopted amendments to Rule 2019 of the Federal Rules of Bankruptcy Procedure (“New Rule 2019”) which will largely affect debt traders, equity traders and other creditors who for many years have been able to take positions in bankruptcy cases without disclosing private information about their financial transactions, trading procedures and habits and economic claims and interests. New Rule 2019 expands the disclosures required by creditors or equity traders who, acting in concert, participate in Chapter 9 or 11 bankruptcy cases and broadens the scope of the rule to reach unofficial committees and informal groups. This disclosure rule is in response to the recent influx of bankruptcies over the past few years that have resulted in confusing and inconsistent decisions as to whom must disclose and what information they must provide.

If approved by Congress, New Rule 2019 will require disclosures by every group or committee that consists of or represents, and every entity that represents, multiple creditors or equity traders acting in concert, as well as each creditor or equity trader who is a member of such group or committee, regarding, among other things:

  • Formation of the committee or group; or
  • Employment of the entity; and
  • Name and address, nature and amounts of each “disclosable economic interest” held in relation to the debtor and in special circumstances, the quarter and year in which each “disclosable economic interest” was acquired.

This clearly delves deep into areas of financial transactions that creditors prefer to keep confidential. In limiting the disgorgement of information, the amendments do not require disclosure on the price paid for the claims, an important exclusion that came out of lobbying from debt traders and other creditors following the initial proposal of the amendments 18 months ago. Though New Rule 2019 falls short of such price disclosure, it nevertheless expands the scope and the requirements of the rule as it currently stands.

Additionally, since New Rule 2019 applies to groups as well as committees, debt traders or equity traders who form an informal group will have a difficult time avoiding the disclosure requirements by arguing, as they have done in the past, that they are not a committee. Moreover, the disclosure requirements are no longer aggregate holdings but rather must be reported on an individual basis. New Rule 2019 also requires updated disclosures by any party if facts materially change after the initial disclosure is made.

New Rule 2019 also makes it harder for stakeholders to avoid disclosure given the intentionally broad definition of “disclosable economic interest” as “any claim, interest, pledge, lien, option, participation, derivative instrument, or any other right or derivative right that grants the holder an economic interest that is affected by the value, acquisition, or disposition of a claim or interest”.

As well, New Rule 2019 defines “represents” as taking “a position before the court or to solicit votes regarding the confirmation of a plan on behalf of another”, thereby reaching a broad universe.

Certain exemptions from reporting include groups or committees composed entirely of affiliates or insiders of one another and exemptions from reporting for each of the following entities solely because of its status as: (i) indenture trustee, (ii) an agent for one or more other entities under an agreement for the extension of credit, (iii) a class action representative or (iv) a governmental unit that is not a person. This exception parts with the current rule that includes an indenture trustee in the disclosure requirements but it is worth noting that the “solely because” language in the rule indicates that there might be circumstances where the exempted parties could be required to disclose under the rule.

Furthermore, while certain provisions of the New Rule 2019 expressly do not apply to official committees, other more limited provisions may apply.

Importantly, the court still has discretion in imposing sanctions for failing to comply with the rule, including disallowing certain participation in the case or invalidating a vote on a reorganization plan.

Congressional approval is anticipated such that the amendments should be effective on December 1, 2011. Though the effect of New Rule 2019 remains to be seen, it does require broader disclosure and more transparency. This outcome may deter creditor participation in bankruptcy cases or the trading of distressed debt. Likewise, the rule could potentially discourage creditors from working together as a group, which would be an unintended workaround to avoid all the disclosure required under the rule and would effectively negate the rule itself.

For more information on Rule 2019 and the proposed amendments, please contact Regina Stango Kelbon, 302-425-6424.

 A copy of the proposed rule is available at:  http://www.supremecourt.gov/orders/courtorders/frbk11.pdf

Sixth Circuit Holds that Giving Undersecured Lender Replacement Liens in its Own Collateral Does Not Provide Adequate Protection for a Debtor’s Ability To Use Cash Collateral

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In In re Buttermilk Towne Center, LLC, 54 Bankr. Ct. Dec. 13 (6th Cir. 2010), the Court of Appeals for the Sixth Circuit dealt with the right of a Kentucky debtor to use rents previously pledged as collateral for a loan to pay bankruptcy expenses.  In Buttermilk, the lender, Bank of America, was undersecured and the debtor, a real estate developer whose sole asset was the property under development, had no cash to pay its bankruptcy expenses, including legal fees.  The debtor wished to use rents to maintain the property and pay the costs of administering its bankruptcy case.

In Buttermilk, the debtor sought the court’s permission to use cash collateral over the objection of the bank.  The bank was secured by a mortgage on the property, along with an assignment of all rents collected from the property.  After filing for bankruptcy, the debtor sought to use the rents as cash collateral to fund its operation and administrative costs.  The bank objected, arguing that the rents were not cash collateral because they were not the debtor’s property.  Alternatively, the bank argued that even if the rents were cash collateral, the Bankruptcy Code required the bank to receive adequate protection for the use of those rents and that adequate protection was not provided.  The debtor countered that it would provide adequate protection by granting the bank additional liens on the property and the rents.

The court held that the rents were property of the estate. The court was convinced that the rent assignment was intended as security for the bank’s loan to the debtor.  The court concluded that, under Kentucky law, the rents were property of the estate.  The court noted the difference between Kentucky and New Jersey law on this point, distinguishing the Third Circuit’s holding in Jason Realty L.P. v. First Fidelity Bank, N.A. (In re Jason Realty, L.P.), 59 F.3d 423 (3d Cir. 1995).  The Third Circuit held that, under New Jersey law, an assignment of rents conveyed ownership of those rents to the assignee.  There was no comparable law in Kentucky.

Finally, having concluded that the rents were cash collateral, the court determined the debtor did not provide the bank with adequate protection.  The Buttermilk court reasoned that since the debtor was “out of the money,” the bank would not be adequately protected by replacement liens in the rents.  The court found that, if the debtor was permitted to use the rents for purposes other than maintaining the property, it would result in a diminution of the bank’s secured claim.

Delaware Bankruptcy Judge Denies Unsecured Creditors Committee’s Retention Applications

Stanley Tarr

On November 4, 2010, Mary F. Walrath, United States Bankruptcy Judge for the District of Delaware, denied the applications of the official committee of unsecured creditors of Universal Building Products to retain Arent Fox LLP and Elliot Greenleaf & Siedzikowski, P.C. as counsel finding sufficient factual evidence to disqualify those firms from serving as committee counsel. The bankruptcy court denied the retention applications of those two law firms because – (1) it found that the law firms and an intermediary, Dr. Haishan Liu, were acting in concert to cold-call creditors that Dr. Liu did not represent for the purpose of being retained by the creditors to attend a committee formation meeting and to cast a proxy in favor of the two law firms for counsel; and (2) the firms did not make fulsome disclosures at the outset of their efforts in support of Dr. Liu’s attempts to obtain proxies from creditors to attend the committee formation meeting.

The bankruptcy court found that this solicitation process violated the Model Rules of Professional Conduct and Delaware Layers’ Rules of Professional Conduct.  Between August 4, 2010 (when the debtor filed for bankruptcy) and August 13, 2010 (when the committee was formed), the law firms improperly encouraged and assisted Dr. Liu to solicit unrepresented creditors.  The solicitation centered on Dr. Liu contacting foreign creditors, many of whom did not speak English, and offering to help those creditors in the bankruptcy.  The solicitation included a request for proxies so that the law firms would be retained.  Dr. Liu then expected the committee to retain him as a translator.

Further, the court found the law firms’ initial disclosures were deficient and that subsequent disclosures by the law firms (filed only after concerns about them were expressed by the Debtors and the United States Trustee and after discovery revealed what had occurred) were insufficient to cure those deficiencies.  The court held that the failure to provide complete and accurate disclosure at the outset warranted denial of the committee’s retention applications.

Finally, as a result of the law firms’ actions, the court urged the United States Trustee to (i) consider implementing procedures to reduce the likelihood of undue influence on the decision of a committee to hire professionals and (ii) consider amending the questionnaire it sends to prospective committee members to include questions regarding whether they were solicited by anyone in connection with the case.

Real Estate Company’s Chapter 11 Held to be Bad Faith Filing

Samuel Becker

Pitcairn Properties Holdings Inc. is a Real Estate development and management company. The Company had sold preferred stock to PPH Investments LLC. Pitcairn was unable to comply with the terms of the preferred stock and the preferred stockholder attempted to exercise its rights including the right to take control of Pitcairn’s Board of Directors. Pitcairn filed an injunction proceeding in the Delaware Court of Chancery to thwart PPH’s attempt to exercise its board stacking rights. Prior to the Chancery Court entering an order, Pitcairn filed a chapter 11 petition (Case No. 10-12764).

The Bankruptcy Case was assigned to Judge Peter J. Walsh, but due to Judge Walsh’s unavailability Judge Christopher S. Sontchi presided at the first day hearing on September 2, 2010. At the hearing, Judge Sontchi expressed concern over whether the debtor’s chapter 11 petition had been filed in good faith and directed the Debtor to show cause why the case should not be dismissed as a bad faith filing.

At a hearing the next day, Judge Sontchi stated that the Chancery Court action was not a debtor versus creditor fight as much as it was a shareholder versus board of directors fight. The evidence presented was that Pitcairn was solvent and that the only conflict in the case was a two party dispute. Judge Sontchi noted that there were some defaults on obligations to creditors, but those creditors were not actively pursuing the defaults. Judge Sontchi then lifted the automatic stay and remanded the Chancery Court action to allow the preferred shareholder to proceed.

Judge Sontchi discussed the law on bad faith bankruptcy filings, citing the Third Circuit case of In re: 15376 Memorial Corp., 589 F.3d 605 (3d Cir. 2009), for the proposition that for a bankruptcy case to be filed in good faith, there must be a proper reorganization purpose and it must not have been filed solely as a litigation tactic. Judge Sontchi then concluded that Pitcairn’s case would be dismissed because there was no reorganization purpose and the case was filed as a litigation tactic. The Debtor asked for and was denied a stay of the order by both the Bankruptcy Court and the District Court.