Structured & Real Estate Finance Case Update - March 2010

This periodic update reports on recent legal opinions of relevance to commercial real estate lenders, developers and owners, with particular focus on state and federal court decisions involving litigation with respect to distressed or nonperforming assets. For further information concerning any of the reported opinions, please contact a member of Seyfarth Shaw’s Structured & Real Estate Finance Group.

In re Tousa (Bankr. S. D. Florida, Oct. 13, 2009)

The South Florida Bankruptcy Court in the Tousa case ordered various creditors that had benefitted from a fraudulent conveyance to disgorge $421,000,000 to the jointly-administered Tousa bankruptcy estates. The court also ordered the avoidance of liens on the assets of various Tousa subsidiary entities who were also debtors in the bankruptcy proceedings. This case may raise increased focus upon the legal theory of fraudulent conveyance, which was the rationale used by the bankruptcy court to order the money returned.

The two major elements of a fraudulent conveyance are that (1) a debtor makes a transfer for less than reasonably equivalent value and (2) the transfer either makes the debtor insolvent or occurs at a time when the debtor was already insolvent. In a nutshell, the doctrine of fraudulent conveyance (or fraudulent transfer) gives a legal remedy to pre-existing creditors when a borrower makes transfers to third parties while insolvent, unless the transfer is for “reasonably equivalent value.” Fraudulent conveyances may deprive a borrower’s pre-existing creditors of recourse to assets that they relied on in making loans to the borrower. Fraudulent conveyances are legally reversible because they remove assets from the borrower’s balance sheet without replacing them with other assets of “reasonably equivalent value.”

The parent debtor company in Tousa, called Tousa Inc., had previously incurred $500,000,000 in debt in a unsuccessful business venture. To refinance that debt, it arranged for itself and its subsidiaries to receive loans and to give liens in order to raise the money to repay its business debts. The subsidiaries, however, were not liable for the business debts being repaid. Consequently, the Tousa subsidiaries did not benefit from the liabilities they incurred and the liens they gave in the debt refinancing and loan transaction.

As Tousa has confirmed, the liabilities and obligations incurred by subsidiaries in support of their parent companies, often called “upstream” obligations, are especially vulnerable to fraudulent conveyance attack by disgruntled junior or unsecured creditors of a bankruptcy estate. As in Tousa, subsidiaries may not fully benefit from loans and liabilities incurred for the sole benefit of parent corporations. Thus, subsidiaries do not receive “reasonably equivalent value” for incurring liabilities or giving lien-backed guaranties of such loans. Moreover, such new liabilities and obligations can render subsidiaries insolvent if they are not so already.

The court ruled that the business creditors who had been repaid from the proceeds of the fraudulent loan transaction had to return $421,000,000 of principal and interest received. Section 550 of the Bankruptcy Code allows for the disgorgement of payments made to a secondary transferee of a fraudulent transfer, or to the “entity for whose benefit such transfer was made.” Here, Section 550 allowed for recourse to the parties whose business debts had been repaid with the loan proceeds even though the fraudulent transfer itself was received by the lending banks. The liens placed on the subsidiaries’ assets were also avoided.

Landmark National Bank v. Kesler (Kansas Supreme Court, Aug. 28, 2009)

A Kansas Supreme Court ruling concerned a dispute between real estate lenders with claims on the same collateral. In Kesler, a senior bank initiated a foreclosure action that eventually terminated a junior mortgage on the same property. The junior mortgage named Mortgage Electronic Registration Systems, Inc. (MERS) as mortgagee, but only as “nominee” for the actual junior lender. Senior lender properly served process upon the junior lender, who failed to answer and had a default judgment entered against it. In fact, the junior lender had previously assigned its note to another bank, Sovereign, and therefore no longer had an interest at stake in the legal proceedings. The junior lender apparently did not notify either MERS or Sovereign when it received notice of the lawsuit.

The use of MERS as a nominee is intended to facilitate the purchase and sale of mortgage loans. Lenders who put mortgages in MERS’s name retain equitable and economic ownership of their loans as well as servicing rights and obligations. MERS allows lenders to buy and sell interests in mortgage loans with other MERS participants without having to publicly record those transactions with county real estate offices.

Senior lender did not serve process upon MERS or Sovereign. The foreclosure action eventually culminated in a motion to confirm the results of a sheriff’s sale. Sovereign and MERS at that point became aware of the foreclosure proceedings and filed motions to intervene and to vacate the default judgment. Because Sovereign has no recorded interest in the mortgaged property, its motion was denied.

At issue before the Kansas Supreme Court was whether the trial court had abused its discretion in ruling that MERS, as a non-lender and holder of the junior mortgage in name only, was not a necessary party to the foreclosure proceedings and therefore not entitled to join the proceedings or to seek to vacate previous court orders. By holding that MERS was not so entitled, the trial court allowed the foreclosure sale to stand and the junior mortgage to be extinguished.

The Kansas Supreme Court in Kesler affirmed the lower ruling, holding that parties who do not hold a full range of substantive economic rights in mortgage loans—such as “nominees” like MERS—are not “lenders” and therefore do not have economic interests that are prejudiced by default judgments. As such, there was no “abuse of discretion” in denying MERS’s motions to vacate the default judgment or to intervene in the case.

The procedural posture of this case makes it appear more unfriendly to nominees and organizations like MERS than it actually is. The precise legal issue in Kesler was whether a trial court had “abused its discretion.” This question the court answered in the negative. The Kansas Supreme Court acknowledged that MERS may have been technically entitled to receive service of process, but reasoned that this precise question was not before it. The case calls renewed attention to the administrative and enforcement issues raised by the use of MERS as a nominee, issues which some lenders may not have focused on during the origination process and thereafter.

Trust for the Certificate Holders of the Merrill Lynch Mortgage Investors, Inc. Mortgage Pass-Through Certificates, Series 1999-C1 v. Love Funding Corporation (New York Court of Appeals, Oct. 15, 2009)

New York State’s highest court clarified New York State’s “champerty” statute and confirmed that the statute will not generally prevent buyers of distressed debt from enforcing their remedies through litigation when pursuing a legitimate claim.

In Love Funding, a REMIC Trust sued UBS Real Estate Securities, Inc. to enforce its remedies under a loan purchase agreement, alleging that UBS’s predecessor sold the Trust several defaulted loans, and demanding that they be repurchased. The Trust asserted that certain frauds committed by the borrowers put the loans in default at its outset, triggering the repurchase obligations of UBS under the UBS loan purchase agreement.

UBS was not the originator of these loans, but acquired some of them from Love Funding Corporation pursuant to a separate loan purchase agreement. Like the UBS loan purchase agreement, the Love Funding loan purchase agreement contained an analogous representation that none of the loans were in default at the time of the transfer to UBS. The agreement also provided that Love Funding would indemnify UBS for any loss related to said breach.

As part of the settlement arrangement between the Trust and UBS, UBS assigned to the Trust its rights under the Love Funding loan purchase agreement. The Trust subsequently sued Love Funding under the assigned agreement from UBS. The U.S. District Court for the Southern District of New York ruled that the assignment was void for champerty because the Trust’s primary purpose in taking the assignment was to bring a lawsuit against Love Funding. The decision was appealed to the U.S. Court of Appeals for the Second Circuit, which certified to the New York State Court of Appeals certain questions relating to New York State’s champerty statute.

The New York State Court of Appeals stated that New York’s champerty statute is generally limited in scope and largely directed toward preventing attorneys from filing suit merely as a vehicle to obtain costs. The court confirmed that the concept of champerty does not, therefore, apply when the purpose of the assignment is the pursuit of a legitimate claim. In the instant case, the court found the champerty doctrine inapplicable, because the Trust, as holder of a defaulted loan, would directly suffer the damages of a default. If, as a matter of fact, the Trust’s purpose in taking assignment of UBS’s rights under the Love Funding loan purchase agreement was to enforce its rights, then it did not violate New York’s champerty statute.

Roberts v. Tishman Speyer Properties, L.P. (New York Court of Appeals,
Oct. 22, 2009)

New York State’s highest court ruled that the owner of the massive apartment complexes known as Peter Cooper Village and Stuyvesant Town in Manhattan improperly overcharged rent to thousands of tenants. The court held that the current owner, a partnership of Tishman Speyer Properties and BlackRock Realty, and the former owner, Metropolitan Life, were not entitled to take advantage of the luxury decontrol provisions of the Rent Stabilization Law (RSL) while simultaneously receiving tax incentive benefits under New York City’s J-51 program.

The luxury decontrol provisions of the RSL generally provide that rent-stabilized apartments cease to be subject to rent stabilization if either: (1) in the case of a vacant apartment, the legal regulated rent equals $2,000 per month or more; or (2) in the case of an occupied apartment, the legal regulated rent equals $2,000 per month or more, and the combined annual income of all occupants exceeds $175,000 per year for the two preceding calendar years. The luxury decontrol provisions of the RSL, however, exclude housing accommodations which “became or become subject to [the RSL] by virtue of receiving [J-51] tax benefits….” For the last 13 years, the New York State Division of Housing and Community Renewal (DHCR), which administers the RSL, interpreted the J-51 exclusion to apply to properties that became rent stabilized as a condition of receiving J-51 benefits, not to properties that were already rent stabilized prior to receiving J-51 benefits.

In the instant action, MetLife applied for J-51 benefits in 1992, which was more than twenty years after the property became subject to the RSL. Thereafter, the luxury decontrol provisions of the RSL were enacted and, with DHCR’s approval, MetLife began charging market rents for those rental units that purportedly satisfied the requirements for luxury decontrol. In late 2006, after MetLife sold the properties to the Tishman Speyer partnership, nine residents on behalf of a putative class of current and former tenants sued MetLife and the Tishman Speyer partnership for overcharging rent during the period when the landlord received J-51 tax benefits. Consistent with DHCR’s interpretation, MetLife and the Tishman Speyer partnership argued, among other things, that the properties were not precluded from luxury decontrol because the properties were rent stabilized prior to receiving J-51 benefits. Therefore, the properties did not “become subject to the RSL by virtue of receiving J-51 benefits.”

The court rejected DHCR’s long standing interpretation of the J-51 exclusion to the luxury decontrol provisions of the RSL and found that building owners that receive J-51 benefits forfeit their rights under the luxury decontrol provision even if the properties were already subject to the RSL. Accordingly, the court affirmed the decision of the Appellate Division to reinstating the tenants’ complaint.

The court’s decision leaves many open issues for the lower court to decide including, the retroactive effect of its decision, the statute of limitations and class certification, among other defenses that may be applicable to particular tenants. (Since the decision, the parties have entered into a stipulation which resolves some of the issues with respect to the Peter Cooper Village/Stuyvesant Town complex, and provides for a consultant to calculate permissible rents at that complex, but the impact of the decision on many other apartments in New York remains very unclear.)

Stein v. Paradigm Mirasol, LLC (11th Cir., Sept. 30, 2009)

The United States Court of Appeals for the Eleventh Circuit issued a ruling clarifying the limits of the Interstate Land Sales Full Disclosure Act (ILSFDA), ruling that a contract of sale of real property was exempt from the statute where plaintiff buyers had an adequate remedy to force the defendant developer to complete construction within two years.

The ILSFDA, among other things, requires developers selling property to provide prospective purchasers with a property report prior to the execution of a sales contract, unless the contract obligates the seller to erect the building within two years.

Alan and Karen Stein entered into a contract with Paradigm Mirasol, LLC for the sale of a residential condominium unit in Florida. Paradigm never gave the Steins a property report but the contract obligated Paradigm to complete construction within two years, subject to two provisions analyzed by the court. The first was the “force majeure” clause, which excused construction delays provided they were caused by certain circumstances beyond the control of Paradigm. The second provision was the “liquidated damages” clause, which limited the Stein’s remedies to specific performance or return of their contract deposit.

Paradigm completed construction within two years and was prepared to close on the sale. The Steins, however, refused to close and sued Paradigm for violating the ILSFDA by not providing them with a property report. Paradigm argued that it was exempt from the requirements of the ILSFDA because the contract obligated it to complete construction within two years.

The lower court ruled in favor of the Steins, holding that Paradigm was not exempt from the ILSFDA because the contract’s force majeure clause and liquidated damages clause rendered Paradigm’s obligation “illusory.”

On appeal, the court reversed the lower court’s decision finding in favor of Paradigm. The court reasoned that the Steins had an effective remedy under the contract that would threaten or inflict enough damage to Paradigm to effectively obligate it to complete construction within two years. The court also found that the force majeure clause did not transform Paradigm’s obligation into an option because it relates to matters beyond its control. In short, the court rejected the argument that either of these provisions rendered the contract of sale voidable pursuant to the ILSFDA and remanded in order for judgment to be entered in favor of Paradigm.

CSFB 2001-CP-4 Princeton Park Corporate Center, LLC v. SB Rental I, LLC (Superior Court of New Jersey, Appellate Division, Aug. 11, 2009)

The Superior Court of New Jersey, Appellate Division, confirmed that non-recourse carve-outs in commercial mortgage loans are enforceable in New Jersey.

In CSFB, a commercial mortgage borrower granted a $400,000 second mortgage on real property collateral without obtaining the consent of the existing first mortgage lender. The borrower satisfied the subordinate debt in full after only seven months. The first mortgage loan was generally “non-recourse;” however, following an uncontested foreclosure of the first mortgage more than a year later, the first mortgage lender asserted that the subordinate financing triggered a non-recourse carve-out provision in the loan documents, resulting in the borrower and guarantors’ becoming personally liable for the approximately $5 million loan balance remaining after the foreclosure sale. The court agreed.

In an attempt to invoke a judicial inquiry into the “reasonableness” of the result, the borrower argued that the carve-out provision was a liquidated damages clause and that the application of personal liability for the full amount of the debt constituted an unenforceable penalty. The court rejected that argument, finding that such non-recourse carve-outs are not liquidated damages provisions because they “operate principally to define the terms and conditions of personal liability, and not to affix probable damages.” Also, the court found that such carve-out provisions provide only for actual damages, namely the deficiency on the loan following the sale of the collateral at foreclosure. Such an amount is “fixed by the terms of the loan” and is therefore neither “speculative nor incalculable.” The court was not swayed by the defendant’s “cure” of the breach by satisfying in full the subordinate financing long before the foreclosure on the first mortgage.

The CSFB decision follows in the footsteps of pro-lender decisions by federal courts in Illinois and Massachusetts. See Heller v. Lee, 2002 WL 1888591 (not reported in F.Supp.2d) (N.D. Ill. 2002); Blue Hills Office Park LLC v. J.P. Morgan Chase Bank, 477 F.Supp.2d 366 (D.Mass. 2007). The decisions in CSFB, Heller, and Blue Hills suggest that courts may not require a lender to show substantial, direct harm resulting from the triggering of a carve-out provision before relying on same to assert full personal liability against a borrower or guarantor.