Court Rulings Could Rattle Resale Provisions

Sunrise Village, an idyllic shopping center in Puyallup, Wash., was financed with an unremarkable $75 million commercial loan. But the retail outlet might end up being the epicenter of another pitched battle for distressed debt holders trying to uphold traditional creditor rights in Chapter 11 bankruptcies.

A federal district court in Washington recently upheld a bankruptcy court ruling disallowing three hedge funds controlling portions of the shopping center's defaulted loan from voting on a reorganization plan that the owners — known as Meridian Sunrise Village — sought to pursue.

The district court ruled that the funds, engaged as "predatory lenders," were not "eligible assignees" entitled to a vote because Meridian, regardless of default, had such funds excluded from participation in loan syndication through its original credit agreement.

The decision has spread like brush fire in legal and investor circles surrounding bankruptcy case law, with worries about the potential disruption of distressed debtholders' rights to participate in Chapter 11 plans.

"It remains to be seen whether this holding [in Meridian] will be followed and if and how it will change the face of bankruptcy plan class construction and voting," said David Tawil, president and co-founder of Maglan Capital, a hedge fund specializing in investing in companies in bankruptcy or restructuring. (Maglan was not involved in the Meridian case).

It is rare for borrowers in syndicated and participated loans to have resale provisions, loan sale experts say.

"Most agreements make it very clear that the lender can sell it without restrictions," says Jon Winick, chief executive of Clark Street Capital, a Chicago advisory firm that handles loan sales. "Distressed borrowers would much rather deal with a bank than a hedge fund, but this is a provision that is rarely seen."

Still, borrowers have an advantage negotiating terms in an environment where banks are starved for loans and are willing to make concessions.

In an opinion piece, lawyers at Reed Smith, Jonathan Korman and Bart Cicuto wrote that the case "may also encourage borrowers to become more pro-active in scrutinizing a lender's assignment of its loans if the borrower feels that the assignment is beyond the scope of assignments permitted under the loan agreement."

If borrowers were to negotiate more strongly to deter banks from syndicating loans to so-called "vulture funds," the strategy for hedge funds and other stakeholders who buy distressed loans to gain control of assets could be stymied.

The secondary market for traded loans could also face some disruption with the legal ambiguity of how far credit agreement language protects borrower interests, even in the event of a default.

Additionally, in several analyses published since the district court's March decision, which is under appeal, legal observers say that, while the case is based partially on specific Washington state laws, it has broken new ground and could become a blueprint for subsequent Chapter 11 filers to dilute or deny distressed debt holders their traditional say in reorganization.

The Sunrise Village case, along with the high-profile bankruptcy case involving wireless technology provider Lightsquared, are running parallel with recent controversial court decisions that also focused on the rights of distressed debt holders, such as the limits on credit bidding.

The root of the Sunrise Village case was the original loan agreement Meridian signed with U.S. Bank in 2008, according to court documents. At the time, the owners of the prospective shopping center sought to exclude hedge funds and other vulture investors, negotiating a clause that gave the bank the right to syndicate the loan only to other institutions.

One of the developers with Meridian purportedly had a bad experience with a hedge fund operator. U.S. Bank (USB) ultimately syndicated the loan to a lender group consisting only of banks: Bank of America (BAC), Guaranty Bank and Trust and Citizens Business Bank.

The lender group in 2012 pushed Meridian into a nonmonetary default due to debt coverage covenants, according to court records. After several months of negotiation in which U.S. Bank sought a waiver of the contract's "eligible assignee" clause, the lender began charging Meridian the default interest rate on the loan to the tune of an additional $250,000 a month. Meridian's owners could not afford the bump, filing for bankruptcy protection in January 2013.

Bank of America, over Meridian's objections, transferred its interest to NB Distressed Debt Limited Fund, which later transferred half its interest to NB Distressed Master Fund and Strategic Value Special Situations Master Fund II, creating three creditor parties out of B of A's initial allocation.

When it came time to approve Meridian's reorganization, the three banks in the lender group approved, but the funds objected. Through the bankruptcy court's interpretation of the credit agreement, it was determined that the funds were not eligible to vote.

The hedge funds argued that the court too narrowly interpreted the definition of "financial institution" as a loan-making authority, rather than a money-managing entity.

The district court disagreed: "If the parties had intended 'financial institutions' to mean what the funds claim it means — any entity that manages money — then Bank of America was free to assign the loan to virtually any entity that has some remote connection to the management of money — up to and including a pawnbroker."

The Meridian case equated to the Lightsquared bankruptcy in some law firms' interpretations of the decision, noting the similarity of a hedge fund operator's claim seemingly violating credit agreements.

In the Lightsquared case, company management fought to void the stake held by creditor and DISH Network Chairman Charlie Ergen, alleging he used a Trojan Horse investment firm to secretly buy $1 billion of Lightsquared senior loans in violation of the company's stipulations against competitors holding its debt.

After the rejection of a reorganization plan, and the pulling of a $2 billion to $2.5 billion bankruptcy exit loan proposal, the Lightsquared bankruptcy has sent to court-ordered mediation that still has Ergen in line to parlay his claim. But the judge excoriated Ergen's behavior and indicated she would approve a marginalization of his stake.

The Meridian and Lightsquared cases were the subject of a curriculum "teach-in" on June 3 hosted by the Loans Syndication and Trading Association and London's Loan Market Association.

Lawyers at the New York symposium cautioned loan-market participants — including lenders and investors — that the cases spell out the need to carefully peruse credit agreement language to see whether their creditor rights could be subjugated under the eligible assignee issue.

"When drafting, say what you mean," said Douglas Schneller, a lawyer at Pillsbury Winthrop Shaw Pittman who was at the seminar, though not presenting.

"Make it as explicit as possible," Schneller said. "And if you're going into this, look carefully at the language. If challenged, things may turn out slightly differently."

Schneller and Tawil believe the scope of the Meridian case may be limited, as investment banks would rue excluding hedge funds vital to the syndicated and secondary market for nine- and 10-figure leveraged loans.

The interpretation of "eligible assignee" that would limit plan votes for hedge funds in bankruptcies could be subject to manipulation by borrowers who are working to gain "numerosity" approval — soliciting more than 50% of the class claim holders or two-thirds of the claimed dollar amount of the debt, believing that non-originators holding loans may have little or no say.

"The most troubling part of all this is the fact that the court alluded to an area that it didn't need to get to," Tawil says.

This article originally appeared in Leveraged Finance News. Robert Barba contributed to this report.