Nature abhors a vacuum. Equipment finance abhors bankruptcy. Whether in securitized or large, single-asset financings, financiers structure transactions to be “bankruptcy remote.” This article will discuss a December 2021 bankruptcy court bench ruling that found certain protective provisions to be unenforceable and describe how those provisions might have been devised to survive the court’s scrutiny.
One structuring method has been to issue a “golden share” to a financier and to provide in the borrower’s organizational documents that consent of the golden share holder is required before the borrower can take any ‘major actions.’ Among the major actions would be filing a voluntary petition for reorganization under the bankruptcy code. Filing such a petition would prevent (under the automatic stay provision of the bankruptcy code) the creditor from enforcing typical default remedies such as foreclosure and sale of the collateral.
There is an inherent tension between the understandable desire of a financier to block the filing of a bankruptcy petition and resulting automatic stay versus the public policy right of a troubled debtor to seek bankruptcy code protection from creditors. Recent judicial decisions have struck down golden share blocking rights, and another recent case has upheld blocking rights in specific circumstances.
2016: A Bad Year
Lake Michigan Beach Pottawattamie Resort LLC, decided in April 2016 by a bankruptcy court in Chicago, upheld the filing of a bankruptcy petition despite the refusal of the special member to authorize such a material action as required by the operating agreement of the LLC. The special member had been imposed by the lender to the LLC (whose loan was collateralized by a mortgage on the resort property of the LLC) as a condition to its forbearance from pursuing remedies.
The LLC again defaulted on the loan, and on the day before the foreclosure sale was to occur, the LLC petitioned for relief under the bankruptcy code, thereby blocking the sale and any other remedies which the lender might have taken. The lender sued to dismiss the bankruptcy case on the grounds that the LLC had not complied with its operating agreement requirement for the special member to approve such a material action, but the court refused to dismiss, citing that the special member apparently was not “subject to normal director fiduciary duties” which would compel it to “vote in favor of a bankruptcy filing” if circumstances so warranted.
That same year, the judge in Intervention Energy Holdings, LLC ruled that giving a minority equity holder the right to veto a bankruptcy filing constituted an absolute waiver of the right to seek federal bankruptcy relief and was “contrary to federal public policy.” The bankruptcy judge in Delaware ruled that the bankruptcy proceedings were validly authorized by the LLC, notwithstanding the refusal of the equity holder to vote its common unit in favor of that action.
A glimmer of hope appeared in a 2018 decision issued by a federal court of appeals in Franchise Servs. of N. Am., which upheld the enforceability of major decision consent rights granted to a minority equity holder unless the equity holder has “actual control” by means of possessing “such formidable voting and managerial power that [it], as a practical matter, [is] no differently situated than if [it] had majority voting control.” The court also mused that the proper remedy would not be to invalidate the blocking right, but for the borrower to sue the equity holder for breach of fiduciary duty to the entity.
Trick or Treat
On Halloween 2021, the newly-formed holding company for a Midtown Manhattan office building filed for bankruptcy protection on behalf of itself and affiliates having an ownership interest in the 245 Park Ave. building. The building had lost a premier tenant, Major League Baseball, and the first lien mortgage on the building provided that failure to lease the space to another tenant by Nov. 1, 2021, would trigger either a $19 million cash deposit to, or an optional cash trap by, the first mortgagee.
Either alternative would leave insufficient funds to pay dividends on preferred equity held by an affiliate of SL Green (SLG). That failure would trigger mandatory accelerated redemption of that preferred equity, and absent payment of that redemption amount, the joint venture agreement between SLG and the other building owner provided that 245 Park could be sold in a foreclosure proceeding handled by SLG as the property manager.
By filing for bankruptcy protection on Oct. 31, 2021, the building owner prevented SLG from enforcing both its right to payment of the redemption price and its power to force a foreclosure sale, which would have been triggered the following day.
SLG previously acquired these rights when the building owner (HNA Group) approached SLG to invest in a joint venture for building ownership under an agreement which required joint authorization for major decisions, including filing for bankruptcy protection. Shortly afterwards, SLG was hired as property manager for the building. Earlier, SLG became a lender to the building with a minority interest in mezzanine C in the capital stack. Therefore, SLG was already a creditor when it acquired its 48% equity ownership.
Another element of the puzzle was that HNA was a full-floor tenant at 245 Park but was $7 million in rent arrears. It was alleged that HNA was cash-strapped and unwilling to invest the substantial amounts possibly needed to make the Major League Baseball space attractive to prospective tenants.
It also was alleged that HNA justifiably feared losing its equity investment if the Nov. 1, 2021, trigger event led to a forced sale. The record in the federal bankruptcy court proceeding reveals that, without obtaining SLG’s consent, HNA hired two restructuring experts, purportedly to exercise their independent judgment to decide whether HNA should file for bankruptcy protection, which was also done without SLG’s consent.
SLG was not alone. The other mezzanine lenders argued that their borrowers, also special purpose entities, should not have been included in the reorganization proceedings. They argued that the mezzanine loans were fully performing, that the documentary waterfall (in the event that the Major League Baseball space was not timely relet) already provided for payment of operating expenses as well as mortgage debt and mezzanine debt payments — but excluding equity distributions to HNA — and that there was adequate cash flow to service all of those obligations.
The mezzanine lenders further objected that the Chapter 11 proceeding resulted in siphoning cash from the HNA estate to the detriment of all creditors. The transcript of the hearing shows various mezzanine lenders’ counsel complaining, saying “this is not what Chapter 11 is for” and “this [is] primarily an effort by the debtors to elevate what is a narrow two-party dispute into a Chapter 11 leverage play” to benefit the equity owner of the building.
The Debtor Strikes Back
During that argument, counsel for HNA argued that SLG was asserting its blocking rights in effect as a creditor, rather than an equity holder, and the Lake Michigan doctrine should operate to deny the blocking rights. HNA noted the preferred equity carried an interest rate and a maturity date, which are characteristics of a debt instrument rather than equity ownership.
HNA also observed SLG was a creditor, albeit via a minority interest in the deeply subordinated mezzanine C loan. In what the bankruptcy judge termed a “close question,” the court agreed SLG’s ownership interest, particularly the redemption right if the Major League Baseball space was not relet by Nov. 1, 2021, was more akin to a debt investment and consequently did not fall within the ambit of the franchise services approach. The court’s bench ruling denied SLG’s (and other parties’) attempt to dismiss the bankruptcy proceeding.
Although SLG may have been overly aggressive in structuring its equity investment to provide for triggers, redemption and building sale rights, the fact remains that the fair market value of 245 Park (as of the end of 2020) exceeded its outstanding debt, the building cash flow was adequate to pay operating expenses and all debt services, and HNA blatantly ignored SLG’s numerous consent rights, including the decision to hire two independent agents who ultimately caused HNA to file for Chapter 11 protection.
So, regardless of whether SLG’s veto power over filing the Chapter 11 petition was enforceable, the “close question” could have been resolved by dismissing the bankruptcy proceeding and leaving the two joint venture parties to litigate their differences in non-bankruptcy proceedings, such as whether any foreclosure sale of the building was for a fair price and conducted according to applicable law.
How an investor can structure its interest to achieve an enforceable bankruptcy-blocking right is a developing area of law. Perhaps SLG could have documented its preferred equity interest more traditionally (without a maturity date or other debt-like features), with the LLC agreement providing, as a condition to SLG’s making its investment, that major decisions made without its consent would be void and relying on the first mortgage as the document providing for sale of the building if the Major League Baseball space had not been relet by a certain date.
As building manager, if SLG determined there really was sufficient value at 245 Park and the SLG equity had been documented to have a superior liquidation preference over the HNA equity, then sale of the building would have triggered payoff of the SLG equity in the ordinary course of distributing sale proceeds among claimants in the capital stack waterfall. SLG still would have been saddled with the “bad fact” of its pre-existing mezzanine C loan, but at least its equity investment would not have been tainted by debt-like features.
“Benched!” by Stephen T. Whelan was published in the May 2022 edition of Monitor Daily.